VENTURE CAPITAL 101--WHAT IS VC FINANCING?
If you're trying to learn about something like Code Section 163(l) disallowing any deduction for interest paid or accrued including original issue discount amortization on a debt instrument under certain tests blah blah blah . . .
. . . but you don’t have an overarching system level understanding of a deal that you're involved in, then your priorities are off and you're just messing around. This is a dangerous type of subtle goofing off because you can convince yourself that it is noble to learn as much as possible. That's fine if you are genuinely interested in it. Go for it. But it's not your bread and butter.
Your job is to focus on and develop your business--be it investments or entrepreneurship and make key strategic decisions and maneuvers. All you need is a good working knowledge of the basics. Don't focus on bits of random knowledge without context. Focus on the things you're good at. Work with people. Be cooperative. Be a system level thinker.
You would be surprised at how few people think this way. I can tell you that my clients who have achieved without a doubt the most success think this way.
It is all about understanding what's going on from a big picture point of view.
I also want you to keep in mind that different industries have slightly different ways of doing things and have their own subtleties.
Texas Startups and Venture Capital
A lot of startups in Texas are focused on life sciences, clean energy tech, oil & gas, etc. These all come with their own quirks. For example, here is an article about the oil and gas industry and venture capital and includes observations from Dallas and Houston, Texas: https://www.startuplegalstuff.com/dos-donts-tips-energy-startups/
However, the fact of the matter is that most industries operate in very similar ways. So here is a comprehensive overview of what a venture capital financing deal is about from a system level, big picture point of view.
Table of Contents of Venture Capital 101
I. Basic Principles of Venture Capital
A. The meaning of venture capital
B. The goal of the VC investors
C. Venture capital funds look for an exit event in order to get their return on investment
D. VCs want to invest in C-Corps
E. There are different types of stock in a company.
F. Preferred stock can convert into common stock
II. Time Table and Sequence of Events
A. Negotiations
B. Due diligence and drafting
C. Closing
III. The Term Sheet
A. THE TERM SHEET >> Economic Terms
1. Price per share
2. Liquidation preference
3. Dividends
4. Anti-Dilution Rights
B. THE TERM SHEET >> Control Terms
1. Voting
2. Board of Directors
3. Preemptive Rights
4. Restriction on Sales
5. Drag-Along Rights
C. THE TERM SHEET >> Liquidity Terms
1. Redemption Rights
2. Registration Rights
D. THE TERM SHEET >> Management/Founder Terms
1. Vesting
2. Non-compete Agreements
3. Intellectual Property Issues
4. Employee Option Pool
IV. Documents
A. Charter Documents
B. Stock Purchase Agreement
C. Investor Rights Agreement
D. Voting Agreement
E. Right of First Refusal and Co-Sale
F. Other documents
V. Summary of Venture Capital 101
Article
I. BASIC PRINCIPLES OF VENTURE CAPITAL
I'm going to go through a few basic points and then summarize those points in this section.
A. The meaning of venture capital
Money is capital.
Venture capital is money that is invested in the early stage of a company's life where ownership shares of the company is purchased by investors and where that company is expected to grow quickly with an expectation of a high return.
This return expectation is 3 to 5+ times over a 10 year period. Venture capitalists are investors that make these types of investments through a pooling of money (via a venture capital firm/venture capital fund.)
This whole investment process in a company is called venture capital financing.
As I have mentioned before, the typical sequence for financing a company is: bootstrapping by company founders, then friends & family financing, then angel financing (in the form of convertible notes or series seed rounds), then Series A round (venture capital financing), then Series B round (VC financing), then Series C round (VC financing) and so on until an initial public offering (IPO).
Investment amounts vary but most Series A investments are for at least $1 million. The Series Seed round takes shape similar to a Series A round but the Series Seed is more simplified.
Don't get tripped up on the terminology of Series Seed, Series A, Series B whatever. They can be called anything. This is just commonly used terminology.
I am focusing this article on those Series rounds of financing--where equity is being purchased by venture capitalists.
B. The goal of the VC investors
The goal of venture capitalists is the same as any other investor's: buy assets (shares) of a company at a low price. Have the value of those shares go up over time. And then sell the shares at a high price.
The difference is that companies that the venture capitalists are investing in are private, high-growth companies with correspondingly high risk. Investors also take on a more active, rather than passive, role in the company by providing valuable advice and direction.
Investors buy ownership shares of the company alongside agreements with the company that the investors get certain rights such as how much control they have over the decisions of the company, and terms that allow the investors to manage their investment risk.
C. Venture capital funds look for an exit event in order to get their return on investment
An exit is typically a sale, merger, or acquisition of the company. The investors are looking to sell their shares of the company at some point down the line. They don’t want to own all of this stock in your startup forever. They want to cash out at some point.
I've had founders and entrepreneurs that do not fully understand this. But they need to. I've had to explain this to them. They'd want an exit too if they were investors.
The agreements that come along with the share purchase will detail that the investors will also get an X amount of money (a "liquidation preference") when there is an exit such as the company getting sold. An exit allows for investors to hopefully sell their shares for more than they paid for.
D. VCs want to invest in C-Corps
C-Corps are companies where the ownership of the company is represented by stock or shares. VCs prefer investing in C-Corps as opposed to LLCs because their structure is more in line with their own internal system.
Make sure the startup is a C-corp. If it’s not, then there are ways to fix this issue. Of course fixing something is more costly and time consuming than getting it right from the get go. I've had to fix these types of problems before. It's expensive and you might as well get it right from the beginning.
E. There are different types of stock in a company
Founders of the company, employees, consultants, etc. get COMMON stock of the company. The VC gets PREFERRED stock of the company in an investment.
When you hear the phrase “common stockholders” this means the founders, employees, consultants, etc. When you hear “the preferred stockholders” this means the investors/the VCs.
The preferred stockholders have protection, economic, and control rights above and over the common stockholders.
I've had founders be upset with this seemingly unjust thing. But founders shouldn't be disappointed by this. It’s normal and a waste of time to brood over it.
Note, however, that setting up the company with a common/preferred structure allows benefits such as stock pricing considerations for employee option purposes.
F. Preferred stock can convert into common stock
Preferred stock can convert into common stock.
This can be done at any time at the choice of the preferred stock holder. Typically, preferred stock initially converts to common stock on a 1:1 ratio. But this ratio changes depending on certain circumstances e.g. stock splits. Usually there's not much incentive for preferred stockholders to convert. However, there are times when preferred stock must convert into common stock such as in the context of an IPO.
For many matters, such as voting, stock is counted on an "as-converted basis." That means that the total number of stock is counted as if all of the preferred stock has converted to common at whatever ratio, but that the preferred stockholders don’t actually have to convert to common.
Summary of the basic principles of venture capital
VC financing is about investors investing in a private, high-growth company by buying preferred ownership shares of the company at a negotiated price. This purchase of shares comes along with certain rights for the investors. The company uses the investment amount to grow the company. The investors hope to then sell these shares in an exit after the company has grown and shares have increased in price.
Everything else is the details. Of course the details matter. Details always matter. But this is FUNDAMENTALLY what is going on with a VC financing.
II. TIME TABLE AND SEQUENCE OF EVENTS
A. Negotiations
If your company is attractive, venture capitalists will want to buy shares of your private company (invest in your company.) Negotiations between venture capitalists and the startup regarding the investment terms and details take place over the course of a number of weeks.
This stuff is technical and entrepreneurs need a lawyer to help deal with this. The startup and the VC may ultimately agree to a term sheet. This is a mostly non-binding agreement that spells out the basics of what the investment terms will be.
Note that the term sheet is the summary of key points for the real deal documents to be drafted. These final documents will have a ton of technical details and language.
The term sheet is essentially saying: the investors want to invest X amount of dollars in the startup in exchange for Y amount of stock and certain rights.
Time: Variable--a number of weeks.
B. Due diligence and drafting
After the term sheet is signed, a lot of shit happens behind the scenes by your lawyers and the investors’ lawyers. This includes: document drafting, legal due diligence, intellectual property (IP) due diligence, and a bunch of other matters. Approvals by the board of the company, stockholders, third party consents, and others must be made in order to get the deal done.
Time: 2-5 weeks.
C. Closing
At the closing, the stock certificates are delivered by the company to the investors and the funds are delivered to the company by the investors.
Time: There can be a single closing or multiple closings that take place over the course of weeks or months.
III. THE TERM SHEET
As mentioned, the term sheet is a summary of the key points of a venture capital investment deal in the company that is negotiated between the company and the investors.
The term sheet is not the actual principal deal document(s). The term sheet will provide the background for drafting the deal documents.
Most of the terms and rights spelled out in the term sheet fall under the following categories: economic terms, control terms, liquidity terms, and management terms. What follow is an explanation of the key items in a term-sheet.
I want you to have a good, basic understanding of the whole setup. If you understand these points, you will be fine.
A. THE TERM SHEET >> Economic Terms
1. Price per share
Price per share is how much the investors are going to pay for each share of the company.
Price is important, but it’s not everything. Like I said, there are a lot of rights and other issues that are important in a deal like this. More about that later, for now let's talk price.
Price per share is based on the valuation of the company, which is how much the company is worth, and the amount of stock of the company.
Valuation is a big deal and the terminology is key to understand. Pre-money valuation is what the company is worth before the investment amount is included and post-money valuation is what the company is worth with the investment amount included. Pre-money valuation + investment amount = post-money valuation.
For examples on how to calculate price per share, look at the article entitled Startup Math under Phase 3A: Financing--Fundamental Concepts.
2. Liquidation preference
If there is a liquidation event (e.g., sale of substantially all of the assets of the company, or merger, or change of ownership of more than 50% of the shares) then the preferred stockholders are entitled to receive a return on their investment before the common stockholders receive anything.
This is expressed as a multiple such as 1x, 1.5x, etc. in which case investors would receive one times or one-point-five times their investment before common shareholders receive anything. If the sale of the company is less than the valuation of the company was, that means people will lose money. It is possible that the investors will receive some or all of their liquidation preference and that the other stockholders are out of luck and will receive nothing.
What happens to the rest of the funds after the liquidation preference has been paid out to the preferred stockholders? Depends on if the preferred stock is non-participating or participating:
a. Non-participating preferred stock: this means that all of the common stockholders get the proceeds.
Remember, preferred stock can convert into common. If the stock is non-participating preferred, the preferred stockholders will choose to either receive their liquidation preference or to convert into common and share the proceeds with the rest of the common stockholders based on whatever percentage of the company they own.
Just what the hell does that mean?
If the company were sold, the preferred will have a few options as to how much they will receive. So if investors own 40% of the company, they can either receive their liquidation preference of 1x their investment amount (or 2x, or whatever liquidation preference is agreed to in the deal documents) OR they can convert to common and receive 40% of the purchase price; however if instead the investment is participating preferred stock the following happens.
b. Participating preferred stock: both common and preferred get the proceeds on an as-converted pro rata basis.
If the preferred stock is participating, then the investors will first get to receive their liquidation preference AND then receive funds on an as-converted basis to common. Some times the return on preferred stockholders proceeds are capped with a limit. This limit is expressed as a multiple of their investment.
Note: Non-participating preferred is advantageous to common stockholders.
3. Dividends
Dividends in the VC context are not a big deal and should only be allowed if, when, and in what amount the board of directors declares. Remember that VCs are going for big gains.
4. Anti-Dilution Rights
a. Price-based Anti-Dilution
Whenever more shares of the company are sold, pre-existing owners and investors of the company own less of the company than before—not in terms of actual share numbers but in terms of overall percentage of the company. Their ownership in the company gets “diluted.”
Dilution happens. Investors earlier in time understand this. What chaps their ass, however, is when subsequent investors are getting to invest in the same thing for less money than they paid.
You know when you buy something on Amazon and some time later, the same thing is selling for a cheaper price? And so you want Amazon to do something about it? Think of it like that.
Investors want protection for overpaying for their shares. The protection kicks in when subsequent investors buy shares in a financing for an amount less per share than what the investors paid for it.
In such a scenario, preferred investors will get diluted more or less depending on what formula is used to calculate the conversion price adjustment. That formula is a term that gets negotiated in a term sheet.
There is a weighted average formula (better for common shareholders) which takes into account the size and price of the new financing round and there is a full-ratchet formula (better for investors) which doesn’t really take size in account. Check the Dilution article on the left for more information about this.
b. Structural Anti-Dilution
Structural anti-dilution ensures that preferred shareholders don’t get diluted and screwed if for some reason there is a stock split or similar event.
Other economic terms: pay-to play-provisions; staggered financings
B. THE TERM SHEET >> Control Terms
1. Voting
Preferred stockholders vote on matters of the company on an as-converted basis.
They also get veto rights called protective provisions for certain events such as when the company wishes to repurchase shares from current shareholders. Protective provisions are saying that unless the preferred stockholders agree, the company doesn’t get to take a certain action.
2. Board of Directors
The board of directors make high level decisions of the company by vote. They don’t run the company on a day to day basis. That’s the job of the CEO. Board sizes vary, and investors may get to select a board number or two depending on what is agreed upon. For example, the Series A investors may get to select 1 board member on a 5 member board.
3. Preemptive Rights
These are technically a type of anti-dilution right, but they are appropriate in this control category. Preemptive rights are also called pro-rata rights or the right of first offer. When the company is doing another round of financing, investors already with the company that have these rights are allowed to purchase a pro-rata portion of these newly offered shares in order to keep their ownership percentage of the company the same as before.
4. Restriction on Sales
Also known as Right of First Refusal or Right of First Refusal On Common. Basically the company gets the first refusal right on all transfers of common stock. If the company doesn’t want to buy stock that a common stockholder is selling, then investors get the right to purchase the stock.
5. Drag-Along Rights
If a certain percentage of preferred want the company to have a liquidation event, they can force other stockholders to agree to the liquidation event.
Other Control Terms: information rights; restrictive covenants
C. THE TERM SHEET >> Liquidity Terms
These terms are all about getting a return on the investment in the company. Investors don’t want to hold shares forever. They want to buy shares, hope they go up in value, and then sell them later for a return.
1. Redemption Rights
Preferred shares may be subject to redemption (i.e. the company is forced to buy back the shares from the investors) if there hasn’t been some type of other liquidity event. Basically, the investors weren’t able to make money on the deal and so want out. These redemption rights typically don’t kick in until 5, 7 years.
2. Registration Rights
Shares must be registered in certain circumstances with the Securities Exchange Commission particularly in the context of selling shares to the public. Investors can sometimes require the company to register shares so that the investors can sell shares to the public. There are a number of registration rights such as demand rights, piggyback rights, and S-3 rights. Don’t worry about these right now.
Other Liquidity terms: co-sale, tag-along rights; IPO shares purchase
D. THE TERM SHEET >> Management/Founder Terms
1. Vesting
Vesting is important in not getting screwed—both for co-founders and investors.
Stock vesting is a mechanism where shares slowly vest to founders. The way this is set up is that stock is given to the founders at the beginning of starting the company, but the company has a right to repurchase the shares from the founder if the founder leaves the company.
Over time, the company has the right to repurchase less and less stock. In other words, the shares become vested to the founder over time and less shares are at risk of forfeiture.
A vesting system encourages entrepreneurs to stick around with the company in order to get all of their stock and not just flee with a ton of stock.
The most common vesting schedule is a 1 year cliff and monthly vesting after that for a total vesting schedule of 4 years. That means that only after a year does any stock vest (25% of the stock.) After the 1 year cliff, the rest of the stock vests on a monthly basis for the next 3 years.
There are some tax issues here. File an 83(b) election early on with the IRS. The IRS may deem that every time more stock gets vested to you over the course of the four years, you are receiving stock (and they will tax you on it.) An 83(b) election allows you to say that you received all your stock up front at the beginning. Why does any of this matter? Because all of the stocks’ value up front at the beginning should be a lot less than the stocks’ value spread over 4 years.
The vesting time table can be accelerated depending on certain events. If the company is acquired, then the amount of stock to be vested can be partially or completely accelerated and the founder can own all of the stock outright before the 4 years (or however long) time period is up. This is called single trigger acceleration. With double acceleration, there would need to be two events that combine in order to vest any stock (typically an acquisition in conjunction with a termination.)
2. Non-compete Agreements
Founders may have to be a party to a non-compete agreement. These agreements make sure that an individual agrees to not start a similar job or company in competition with the company. There are some enforceability issues with non-compete agreements. Many states require that non-competes must be limited in geographical scope and length of time.
3. Intellectual Property Issues
Make sure that all IP ownership for IP created before the company is started is transferred over to the company and also that there is an Invention Assignment Agreement that makes it clear to employees and consultants that IP they create for the company actually belongs to the company.
4. Employee Option Pool
Startups don’t have much cash to pay their employees. So they give employees stock options to purchase common stock later at a certain set price. The company sets aside a certain reserve pool of shares for this purpose (typically 10-20%.)
A practical effect of the option pool is that the pool size weighs down on the common shareholders and not the VCs. For example the employee option pool is set to 10%. VCs buy 30% of the company. Common shareholders will have 60% of the company. But all else being the same deal, if the option pool is set to 20%, then the VCs will still get 30% of the company and the common stockholders will have 50% of the company. So the burden falls on the common stockholders. Common stockholders have an incentive to keep the option pool size low.
Other management/founder terms: Restriction on Founders’ Activities
IV. DOCUMENTS
The term sheet will be the template for the actual, finalized documents. The finalized documents will contain a lot of legalese. Here is a list of the final documents:
A. Charter Documents: This is the official document that was used to create the company with the Secretary of State (e.g. Certificate of Formation, Articles of Incorporation). It will need to be amended in a financing.
B. Stock Purchase Agreement: This is the agreement between the company and the investors that details the purchase of the stock (what type, quantity, etc.) by the investors.
C. Investor Rights Agreement: A contract between the company and the investors that contains registration rights and other rights (such as rights to financial information.)
D. Voting Agreement: This is an agreement that details voting--primarily in the context of the board composition.
E. Right of First Refusal and Co-Sale: This agreement details what happens when a founder or management wants to sell stock to a third party. Usually the founder/management has to offer to sell the stock to the company first. If the company refuses, then the offer to buy goes to the investors. This agreement can also allow for the investors to sell a portion of stock alongside the founder/management.
F. Other documents: There will also be other supplementary documents such as a Management Rights Letter, Legal Opinion Letter, and Indemnification Agreement
V. SUMMARY OF VENTURE CAPITAL 101
A. Fundamentals. Get an overarching SYSTEM LEVEL, fundamental understanding of a venture capital financing deal. VC financing is financing in young, high-growth companies. The investors are hoping to invest in the company while at the same time protecting their investment, giving guidance to the company, and then exiting the company (where they will see a return on their investment.)
B. Stock. Investors purchase preferred stock. Founders and others in the company have common stock. Preferred stock can convert into common stock. Preferred stock has rights and privileges above the common stock. All of the negotiations, discussions etc. center around this purchase of preferred stock. That's what's really going on here. All existing stockholders will get diluted to varying degrees after the purchase.
C. Negotiation of terms. Investors negotiate terms with the startup company that detail what the stock purchase will look like, e.g., what kinds of rights the investors will get alongside the stock. The result will be a term sheet that gives an overview of those items.
D. The term sheet. The term sheet will have terms regarding certain categories. These categories are the economic terms, the control terms, liquidity terms, and management terms.
E. Important terms. Most of the important terms of the term sheet will be concerned with the money/finances of the deal as well as control of the company. Founders and the company need to make sure that these important terms are reasonable.
F. Events in a Nutshell
1. Investors Come In:
Investors wish to work with the company on negotiating a valuation and other terms for an investment in the company.
2. Investors agree with the company on economic and control terms:
The money/economics of the deal have to be right for the investor. They want to buy shares of the company at a low price. They want a liquidation preference. The investors want their share price to increase over time and they look for an exit (e.g., a sale of the company where they can offload their shares)
They also want control of the company in order to protect their investment and in order to help guide the company in terms of business strategies.
3. The investors agree with the company on certain other terms:
These other terms are used to protect the investors' position as shareholders in the company and to manage the risk of their investment.
4. The investors buy preferred stock of the company and become part-owners of the company:
These shares are purchased according to the terms agreed upon (types of terms are detailed further below in this article.)
The investors get added to the cap table. The company continues growing and operating.
And there you have it. Use the other venture capital financing articles on the sidebar to polish up on any details and get recommendations. Then go for it. Make your deal happen.