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.
Bootstrapping
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Equity Financing
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Early Sources:
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Early Sources:
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Founders Capital Savings Credit Cards Mortgage Refinancing Leasing Sales Revenue
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Friends Family "Angels" Venture Capitalists
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Later Sources:
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Later Sources:
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Lines of Credit Small Business Admin. Securitization Partnerships/Joint Ventures Banks Grants Retained Earnings
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Venture Capitalists Venture Capital Funds Corporate Venture Funds Private Equity Firms Private Placements Mezzanine Financing Investment Banks Public Markets (IPO)
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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-ŕ-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:
PREFERRED
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% |
Round 1
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35%
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Round 2
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15
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Total
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50%
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COMMON
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Founders
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30%
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Option pool
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20
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Total
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50%
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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.
___________________________________________ 1. SMB.com (Search Definitions), worldwide web.
Venture capital information links: 1. www.venturewire.com 2. www.thedeal.com 3. www.pwcmoneytree.com

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