Investment in startups: how venture capital funds work
What is venture capital and how does it invest in startups?
The world of startups and venture capital has emerged as a key driver of innovation and economic transformation in recent decades. This ecosystem, powered by early-stage companies with high growth potential—primarily in the tech sector—attracts investment funds willing to take significant risks in exchange for potentially high returns. However, behind this dynamic lies a complex legal framework that both entrepreneurs and investors must navigate, making success highly dependent on legal support aligned with strategic business goals.
Funding rounds and their impact on governance
Venture capital funds operate as investment vehicles that raise capital from institutions or individuals to finance startups at various stages. Their model centres on acquiring an equity stake in the startup, with the intention of selling it later at a significantly higher value—whether through an IPO, a third-party sale, or a share buyback. These investments are structured in funding rounds aligned with the startup’s development phase (pre-seed, seed, Series A, Series B, etc.). These rounds not only reflect the maturity of the business but also reshape ownership and governance structures, which, if not properly regulated, can lead to future disputes.
Key clauses in investment agreements: drag-along, tag-along and anti-dilution
The investment agreement is the primary legal instrument for regulating financial terms, defining each party’s rights, and creating mechanisms to balance interests and manage potential conflicts. For instance, drag-along clauses allow majority investors to compel minority shareholders to join in the sale of the company, while tag-along clauses ensure minority shareholders have the right to join such sales. These provisions help avoid deadlock in strategic decisions and highlight the delicate balance between founders’ control and the increasing influence of venture capital funds.
Another cornerstone is the anti-dilution clause, which protects investors from subsequent share issuances at lower valuations. While this offers security to investors, it may limit the startup’s ability to raise future capital—especially when facing operational or market challenges. A common scenario involves startups that, after several funding rounds, find themselves holding a minority stake. This dilution weakens both their influence and motivation, particularly when investors prioritise rapid exit strategies over long-term organic growth.
The startup’s legal structure also plays a significant role. While limited companies (SLs) and public limited companies (SAs) are the most common vehicles in Spain, some startups opt for more sophisticated structures, such as holding companies or foreign entities, to ease access to international capital. For this reason, before investing, venture capital funds undertake thorough due diligence that examines everything from legal structure to regulatory compliance—especially in regulated industries like fintech or health. For example, poorly drafted contracts, incomplete tax filings, or breaches of labour law can all pose risks that significantly reduce the startup’s appeal to potential buyers.
Governance after investment: control and implications
Once the investment is made, corporate governance becomes a key issue. Venture capital funds typically require a seat on the board or involvement in strategic committees, giving them influence over decisions such as executive hiring, geographical expansion, or M&A activity. Shareholders’ agreements often include veto rights over actions that could impact the company’s structure or long-term strategy. While these protections are important, they can create friction with founders, who may feel their autonomy is being compromised.
The exit: IPO, sale or buyback
Eventually, venture capital funds aim to monetise their investment via an IPO, third-party sale, or share buyback. At this stage, preferential rights to profit distribution become particularly relevant, ensuring the fund recovers its investment ahead of other shareholders. It is also essential to regulate the conditions under which a third-party sale may occur, since pressure from funds to achieve a successful exit can result in premature or undervalued acquisitions, far below the startup’s real potential.
Why specialist legal advice is essential
In this landscape, from both the fund’s and the startup’s perspective, specialised legal advice is indispensable. It ensures that investment agreements are balanced, that critical clauses like anti-dilution, drag-along and tag-along are properly negotiated, and that operational and regulatory risks are anticipated during due diligence. Moreover, it supports effective governance post-investment by mediating between founders and investors, aligning strategic and financial interests, and safeguarding the rights of all parties in critical decisions.
For all these reasons, the assistance of a qualified legal adviser is crucial to ensure solid legal frameworks that prevent disputes, optimise scalability, and allow startups to preserve their autonomy without compromising the returns expected by venture capital funds—ultimately enabling sustainable partnerships in a highly competitive environment.
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