Venture Capital Structure and Terms

June 11, 2010 by Frank Goley, Business Consultant

If you are a business or entrepreneur seeking venture capital, then understanding what venture capital is all about will significantly help you in that quest for it. In this blog post I will explore in detail typical Venture Capital Structure and Terms.

Investor Investment Objectives: Please see my previous blog post on Venture Capital Strategy for more details on the Investment Objectives.

–Consult the Fund’s Website and Prospectus for their Investment Objectives’ details to determine your deal strictly matches the Fund’s criteria.

Investor Profile: Obtain additional information on the Venture Capital Firm from industry contacts and its portfolio companies.

Structure Complexity: Often structured as purchases of Convertible Preferred Stock, with grants and contractual right.

–Negotiation of terms mostly occurs at the Term Sheet Phase (see sample term sheet following).Often leaves open the need for future funding as circumstance dictates.

Costs: Travel, Due Diligence, Commitment Fee, Legal, Accounting and Consulting.  $25,000 to $50,000 is typical, depending on size, scope stage and complexity of the deal.

Financial Statement, Cash Flow, Accounting and Tax Impacts

–Early stage Companies are high risk so the pay back must be high in relation to the start-up’s assets, which often results in a Harvest goal of a Company Sale or Buy Out at a much higher valuation.  Carefully determine how the intricacies of the Fund’s investment will affect your financial well-being, growth and exit strategy.

Types of Securities

–Most common are Common Stock, Convertible Preferred Stock and Convertible Debt Structures.

–Convertible Preferred Stock and Convertible Debt are often preferred forms of securities.  Convertible Preferred allows a lower valuation of the underlying Common Stock, giving rise to inexpensive Employee Stock Option Incentive Plans.  There are other accounting advantages and equity negotiation advantages to a lower valuation of Common Stock:  ie. Capital Gains Tax Implications, Equity Participation, etc

Convertible Preferred Stock

–It is convertible into Common Stock per agreed on Ratios, subject to adjustment for Stock Splits, Reverse Stock Splits, Dividends, etc.

–Voting Power is equivalent to the number of Common Stock in which it can be converted.

Liquidation Preference:  Preferred stock receives all liquidation proceeds up to the original sales price of the Preferred Stock, after which the remaining liquidation proceeds are shared among Common and Preferred Stock Holders as per agreement.

–Usually no mandatory dividends or sinking fund arrangement

–Permissive redemption

VC Constraints on a Company

–Company Valuation

–Equity Dilution

–Amount Invested at a time

–Board Representation

Anti-Dilution Protection

–Price-Based:  If the value of a Company fails to achieve expected levels in subsequent financing rounds, investors can seek an increase in the amount of equity for their investment.

–Adjustment triggered by a later valuation of say less than 100-120% of the prior valuation.

–Try to negotiate a less aggressive Anti-Dilution provision such as a Weighted Average Adjustment which considers both the valuation and the equity dilution involved.

–Avoid Price-Based Anti-Dilution Provisions that extend to more than one subsequent finance round, which creates dilution uncertainties for later investors.

-Beware of a Ratcheted Adjustment Provision which only considers the valuation element.

Registration Rights

–Demand Rights:  VC obtains the right to make a Company perform a Public Offering(s).

–Piggyback Rights:  VC reserves the right to participate in Public offerings initiated by the Company or others.

Pre-emptive Rights:  Investor has the right to purchase a Pro-Rata Portion of the Company Securities sold in subsequent offerings.

Covenants and Restrictions

–Contractual restrictions on salaries

–Restriction on outside business activities of principals and management

–Stock Repurchase if Management or Founders leave the Company within a specified time period, usually 2 to 5 years.

Representations and Warranties

–Company’s Valid Existence

–Accurate Due Diligence

–Accurate depiction of Company Organization and Ownership

–Company in Good Standing

–Company/ Principals have the Power & Authority to enter into the Financing transaction

–Litigation Disclosures

–Material Agreements, Contracts, Memorandums

–Contractual Default Disclosures–Compliance with Laws, Regulations and Ordinances

–Adequate Trade Secrets, Propriety Protections, Patent Rights, License Rights and Royalty Rights necessary for Company operations

–Not infringing on the Rights of other Companies

–Property Titles–Financial Statement Accuracy

–Good Faith Preparation of Business Plan

Equity Investor’s Compensation

Income from Company Earnings:  either as Dividends or Drawings (ie. Partnership)

Capital Gains:

–Sale of the Company

–VC sells interest back to Company or to other InvestorsDividend payouts are often minimized or accumulated so Company Cash Flows aren’t severely affected

–Retained Earnings realize a Greater Capital Gain for an Investor which can be more tax advantaged

–A combination of Dividend and Capital Gains payouts is common, creating a balance between Company Growth and tax advantages

Public Offering

Posted in Business Finance.

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