BUSINESS NEWSLETTER-VENTURE CAPITAL

Even though the "IT" revolution has shortened the time in which managers and
businesses have to respond to various economic data and information, cash is still
the life blood of business.  At the end of the day, businesses must generate cash
either internally (through sales and profitability) or externally (through financing).  
Internal growth and stability are ongoing goals of business, i.e. every business
wants to market and sell profitable products and/or services successfully.  But
startup businesses (startups) often depend heavily on external financing to
catapult themselves into the marketplace.  Additionally, businesses that are
already in the marketplace may seek external financing in order to develop product
lines, better position themselves in a market or to expand production or service
capabilities.  External financing is either debt or equity based.  Both have their
demands upon the business.  Many entrepreneurs use debt financing in strategies
such as leveraged buy-outs and to gain control of or acquire existing "target"
businesses or companies.  Others use equity financing to implement their
business plans.  When cash is accumulated through operations or secured by way
of financing, it miraculously becomes known as "capital."  The following table
synthesizes these strategies employed by startups.

What is Venture Capital?

The unmistakable "darling" of startup equity financing is the venture capital model.
So, what is venture capital and how is it distinguishable from other forms of equity
financing? I like to think of venture capitalists as sophisticated investors who know
how to protect their investment better than the "ordinary" person and who exploit that
"know how."  Though there are numerous definitions of venture capital, one of my
personal favorites is the following:

"Venture capital (VC) is funding invested, or available for
investment, in an enterprise that offers the probability of profit
along with the possibility of loss. Indeed, venture capital was
once known also as risk capital, but that term has fallen out
of usage, probably because investors don't like to see the
words "risk" and "capital" in close conjunction."

Years ago, my very first civil trial involved a venture capital deal gone bad.  The trial
was compounded (and involved both an unlawful detainer case, i.e. dispute over the
underlying lease, coupled with a civil case for breach of contract, fraud, etc.).  The
trials took several weeks, followed by months of contentious hearings and appeals.  
Oddly enough, as I look back, the trial was over and done before I realized that the
investor-plaintiff in the case was a venture capitalist.  Needless to say, the journey
along the "road" of VC financing is replete with examples of both success and
failure.  Some deals work; and some don't.  Therein lays the essence of VC
financing.  Hence, it is not so uncommon for venture capitalists to "strike it rich" and
equally not so uncommon for them to transmute themselves into vulture capitalists
(preying on unsuccessful VC deals and the "dreams" of young entrepreneurs).

Are VC Deals Simple or Complex?

To answer that question, we have to first understand the context in which VC deals
come about.  The great majority of VC deals follow a distinct pattern of development.  
Quite often, venture capital is the second or third stage of a traditional startup
financing sequence, which starts with the entrepreneurs putting their own available
funds into a shoestring operation ("bootstrapping"). Sometimes this is followed by
an “angel” investor getting involved in the startup. Generally an angel investor is
someone with spare funds and some personal or industry-related interest. An angel
investor may invest as little as $25,000 to $50,000, or as much as a half million
dollars.  Angels are sometimes referred to as "adventure" capitalists as they are
generally entrepreneurial themselves and sort of expand their sphere of influence
through this process of being "angels."  The investment provided by "angels" is
sometimes called "seed" money, the return of which will be harvested when the
business’s value is "stepped-up" at a later stage.

By contrast, venture capital funding takes place in "rounds."  Rounds may be
facilitated through the private placement process if the venture capitalists manage a
VC fund or if they wish to manage their risk through bringing in other venture
capitalists.  First-round venture capital funding may involve significant investment of
both liquidity or cash and managerial assistance. Though named the "first-round,"
the terminology is a misnomer for reasons stated above.  Nevertheless, it is labeled
the “first” because it initiates a distinct course of events that VC deals typically
utilize.  Second-round venture capital funding involves a larger cash outlay and
collaboration with stock brokers, initial public offering (IPO) underwriters and
security law attorneys, who will all work together to eventually sell stock of the
business on an exchange.  If this is the final round before the actual IPO it is often
referred to as the "mezzanine round."  The mechanics of an IPO are beyond the
scope of this article.  Suffice to say that IPOs constitute a significant area of
securities law.  The simplicity of VC deals can be depicted by the following
schematic.   

Post-money value is the value of the company after the VC injection.  Ideally, it is the
value of the company before the VC injection, plus the greater viability or value
created by the planned use of the VC.  The founders’ pre-money value may be
"stepped-up" using a ratio which may be industry specific and approximates the
upside potential for the business. The venture capitalists' and founders' stake in the
new company is expressed in terms of the post-money value.  So terminology such
as "4 on 6" signifies $4(x) of VC on $6(x) of pre-money value.  Thus, the venture
capitalist's position in post-money terms is 40% or $4(x) / $4(x) + $6(x).  Simple
enough, right?  Ah, but the plot thickens!

What are the Essential "Deal Points" of a VC Deal?

Term sheets are often used in the early stages of VC deal-making.  These term
sheets later serve as the basis for more definitive agreements.  The "wants" of both
sides are listed, e.g. what the venture capitalists want vis-à-vis what the "founder"
employees want.  VCs usually want preference, control and the quick return of their
investment. They also want to participate in any "upside" in the future while
protecting themselves against dilution of their investment.  The founders usually
want some "say so" in the reconstituted business and some stock, which is usually
in the form of options and restricted stock.  

The following essential areas will invariably be intensely negotiated:

1.        Control of the Board of Directors;
2.        Vesting of restricted stock;
3.        An option "pool;"
4.        Participating preferred stock; and
5.        Anti-dilution protection.

Control issues relative to the Board are simple enough; i.e. how many seats does
each side get on the Board?  Preferred stockholders may demand voting
characteristics for their preferred stock (PS) that are not normally associated with
PS, e.g. the right to appoint certain Board positions if goals are not met.  They
sometimes impose visitation rights on the Board, i.e. the right to attend all board
meetings.

Vesting is a bit more technical.  Restricted stock is a term of art in both VC deals and
under the tax Code.  Suffice to say that it is stock with restrictions on it.  The
restrictions generally relate to transferability.  Founder employees may be pigeon-
holed into owning this stock and surrendering it if certain financial milestones are
not met.  If it is surrendered, it is done so at "cost" and the founder-employees lose
out big time.  However, once vested, restrictions on the stock lapse, and ownership
is perpetual, i.e. buy-back, if any, becomes more feasible.  Restricted stock is
generally given for past work, but vesting is tied to future performance and length of
involvement.  

A stock option pool of authorized, but un-issued stock is allocated in order to provide
both for future growth and performance, e.g. the hiring of talent or bonuses.  Stock
appreciation rights (SAR) or tandem option rights may be sought by both the
Founder employees and new talent.

Venture capitalists will invariably take preferred stock (PS) with convertibility features,
i.e. convertible to common stock on a pro rata basis.  PS will contain preferences on
liquidation (e.g. the return of 100% of their investment right behind creditors),
redemption, as well as cumulative dividend rights. These shares will be fully
participatory, i.e. they will participate in the upside that is anticipated.  That upside
might come in terms of value that is realized when the company does an IPO, or if it
is bought by a larger competitor.  

The anti-dilution aspects of the deal involve "mechanical" assurances that Round 1
venture capitalists will retain an equal conversion ratio with subsequent round
venture capitalists, even in the eventuality of a round which takes place during less
than favorable times for the business.  

The following table demonstrates how the "moving parts" work together:

Obviously, this is a fairly simplified discussion of a very intricate area of business
finance.  A more exhaustive discussion of VC deals would assuredly include the
intricacies of stock purchase agreements, shareholder agreements, buy-sell
agreements, intellectual property assignments, covenants not to compete,
employment agreements, stock options, such security law phenomenon as
"accredited investors," private placement exemptions and securities registration,
valuation techniques, cost of capital, return on investments, breakeven analysis, as
well as various income tax provisions, e.g. Sections 351 (tax free transfers to
corporations) and 83 (restricted stock).  

It is virtually incomprehensible for founder entrepreneurs to enter into VC
negotiations without proper legal and financial representation.  It is simply an area
of business where being "penny-wise" may lead to one being "pound-foolish."  
Therefore, both founders and venture capitalists live by caveat emptor or caveat
venditor, respectively; i.e. buyer beware or seller beware.

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1.  SMB.com (Search Definitions), worldwide web.

Venture capital information links:
1. www.venturewire.com
2. www.thedeal.com
3. www.pwcmoneytree.com