VENTURE CAPITAL FAQ
LIST OF QUESTIONS
Basics of Venture Capital
What is venture capital financing?
Do I need a pitch deck?
What is the difference between private equity and venture capital?
What is the single biggest mistake people make in a VC deal?
How big does my company need to be in order to get venture capital financing?
Is it hard to get financing?
How does an investment help my company?
What is a Series A round?
When is the right time to do a Series A financing?
What are the downsides of venture capital financing?
What are the upsides?
How can I make sure that the deal is good for my company?
Venture Capital Investors
Who are these investors?
What's in it for investors?
Where can I find investors?
I talked and pitched to an investor. How do I know if the investor is actually interested in my company or if the investor is just stringing me along?
Venture Capital Structure
How is a deal structured?
What is the difference between the different stock types?
Can founders get preferred stock?
How do I know if I got a good deal?
What is the timeline for an investment?
How does an investment take place?
Are there any securities law consequences?
What documents do I need?
Venture Capital Terms
What are the most important terms?
How does a financing affect prior owners?
What are preemptive rights?
How does VC financing affect the control of the company?
How does VC financing affect the economics of the company?
What is dilution and how to protect from that?
How do investors determine how much the investment is worth?
What is a venture capital financing term sheet?
What does a venture capital financing term sheet look like?
BASICS OF VENTURE CAPITAL
What is venture capital financing?
Venture capital financing is financing done by institutionalized investors (venture capitalists) that purchase equity in early stage companies with the expectation of high growth in the value of the company.
Do I need a pitch deck?
A lot of investors I know don't care for a pitch deck, but a lot do. Regardless, you should have one because SOME investors or groups will want one and you should always be ready. Even if you never show any one, it actually helps you in how you think about your own project.
What is the difference between private equity and venture capital?
Private equity is an asset class that refers to investments and debt in private companies. Venture capital is a type of private equity where the companies are younger and often risky.
What is the single biggest mistake people make in a VC deal?
Thinking of investors as enemies.
At the same time, investors are not your friends either. They are people working together with you with a common goal.
If you think the investors are enemies, don't get investments from them. The best companies I've seen are ones where investors and founders know that at the end of the day they are on the same team and work hard to achieve a common goal. This doesn't mean to be a pushover when it comes to dealing with your investors. Know your place and you'll be fine.
How big does my company need to be in order to get venture capital financing?
Not very. Venture capital is for early stage companies. A good indication is what your company has already achieved financing-wise. A Series A round will usually raise about $1M. If you've raised a bit less than that from angel investors then your startup might be big enough for a Series A round. If you haven't raised anything at all, then your company is not big enough.
Is it hard to get financing?
If your company has some or all of the qualities listed below, then no it's not hard. If your company doesn't have these qualities, then yes it is hard.
Here is what investors are looking for:
- company revenue projections that are substantial and believable; and/or
- the company is able to potentially reach a large market; and/or
- the founders/the management team is skilled and experienced
How does an investment help my company?
An investment gives your company fuel to help it grow e.g. hire more employees, fuel marketing expenses, aid in research and development.
What is a Series A round?
A Series A round is a type of financing round. It is usually in the form of an equity purchase of around $1M by investors and takes place after the company has done a seed round (a type of early stage financing that gets the company off its feet.)
"Series A" is just a name. It can be called Series 1 or anything else. After a Series A round, the company can do more rounds as necessary--Series B, Series C, etc.
When is the right time to do a Series A financing?
When your business plan calls for it.
This can be any time after you've already done a seed round that takes the shape of a convertible note or a series seed priced round. Typically those rounds will be for less than $1M.
What are the downsides of venture capital financing?
You as a founder will get diluted. This means that you will own less of a percentage of the company than before. If you own 100% of a company and someone buys 50% of the company, then you will each own 50% of the company. You got diluted from 100% to 50%. Another downside for founders with outside investments is that you lose some element of control. You'll have to listen to what your investors are saying, you have to go to them for certain permissions, etc.
Depending on how you do the deal, there can be other downsides as well.
What are the upsides?
A number of investors are experienced and can offer valuable advice about how to run and grow a company. The investment amount can be instrumental in growing the company.
I always tell my clients to look at not just the money that the investors can offer. Look at other factors: what can they offer beyond the money? What kinds of connections can they make for you? What kinds of markets do they open up?
How can I make sure that the deal is good for my company?
Be ready to work together. Read the site.
What is venture capital like in Texas?
Venture capital financing in Texas is really not much different from elsewhere. So the material covered in this article is pretty universal. You have to understand that a lot of higher dollar financings are national and global. I've had to deal with investors all over the globe--right here in Dallas, Texas and Houston, Texas. They often come to Texas for clean energy tech, oil & gas, fintech, bio & life sciences, etc. investments.
VENTURE CAPITAL INVESTORS
Who are these investors?
Wealthy individuals, groups of wealthy individuals, former entrepreneurs, people with experience in the industry, etc.
The important thing is that these investors are what are known as accredited investors. Read Phase 3A: Financing--Fundamental Concepts for more information on that.
What's in it for investors?
Investors are able to or they want to make money by buying shares of your company for a low price and then selling for a high price later. They can sell their shares in an exit such as an acquisition or similar.
Where can I find investors?
Investors are everywhere. It is your job to find them. Go to events. Talk to people. See what's out there. It's a test of your own mettle to be able to find investors.
I talked and pitched to an investor. How do I know if the investor is actually interested in my company or if the investor is just stringing me along?
How do you know if a guy or girl is interested in dating you? There are signs. It's not too different.
VENTURE CAPITAL STRUCTURE
How is a deal structured?
A company's ownership is comprised of individual stock. The basic type of stock is common stock--of which, depending on the setup--there can be hundreds of, thousands of, millions of. Founders, employees, and a few others receive this basic common stock. The investors on the other hand purchase convertible preferred stock of the company. This type of stock has certain protections and rights above the common stock. For example, in a liquidation of the company, the preferred stock holders would receive liquidation proceeds before the common stock holders. The reason why the investors get this type of special stock is because: (1) they are putting in the money so they have the ability to say what they want; (2) for stock pricing purposes (discussed elsewhere on this site).
Most financing deals are structured as equity priced rounds. This means that the investors will buy some amount of the company based on how much your company is worth. They will settle on a valuation of the company with you. Use that to determine how much a share of the company costs. Depending on how much they want to buy or invest, they'll purchase a certain percent of the company.
Overly simplified example: Company Z has 1,000,000 shares of common stock that is held by the founders. Investor Y determines that it wants to invest in the company so it buys 200,000 shares of preferred stock. These are additional shares in reserve that Company Z has. Common stock holder owns 83% of the company. Investor Y owns 17% of the company. Investor Y also gets certain protections and voting rights, etc. that the others do not have.
Investor Y will not receive returns on their investment until they can sell their shares of the company typically in an exit such as when the company gets acquired by a larger company.
What is the difference between the different stock types?
Basic ideas
(a) You will not see all types of stock in all companies. Some companies only have common stock. Some have common and preferred. Some have multiple classes of common, multiple classes of preferred. At formation of the company, the usual setup just has common. And when a priced round financing is done such as a Series Seed Round or a Series A, then preferred stock gets authorized and comes into the picture.
(b) Also, there may be multiple types of common stock or preferred stock. This means that within the subcategory of preferred or common that these stock have certain rights above others. It all depends on how the stock is defined in certain agreements.
(c) In the event of a liquidation, there is a certain order that liquidation proceeds get paid out. It first goes to debt holders of the company. Loans, debts, etc. of the company have to be paid back first. Then preferred stockholders get their cut. Then common stock holders.
Common Stock
This is your basic, bare-bones stock (representing ownership) of the common. It's what founders, employees, consultants of the company receive. In the event of a liquidation of the company, these common stockholders will receive assets of the company depending on what percentage of common stock they hold after debt of the company has been paid back to the debt-holders of the company and after any proceeds have been paid to the preferred stockholders as necessary. Common stock holders do get certain, minimal rights as dictated by state corporate law.
Preferred Stock
Preferred stock has rights above and beyond that of common stock. This type of stock gets issued to investors in a financing deal. It has special voting rights, veto rights, and other privileges. It also has a liquidation preference. This means that in an event of liquidation, it has the right to receive certain amount of funds before funds are distributed to common stockholders. Note that debt holders are still paid out first. Preferred stock in the startup context is also convertible. This means that it can convert into common stock when the preferred stockholder wishes and it automatically converts at certain times as well. Preferred stock votes on company matters on an as-converted basis.
Other types of stock
There are other types of stock that you may come across. For the most part you don't need to worry about them. These stock are more or less the same type of thing, just with different rights and privileges. For example Class F common stock is a type of souped up common stock that is favorable for founders. It has greater voting power than regular common stock. Another example is Series FF. This is similar to common stock except it can convert into a type of preferred stock during a financing and is sold to investors (this provides some money to the Series FF holder.)
Don't get stuck on these types of rarer stock. The more important thing is to realize that there are certain types of stock that get privileges above other common stock. Keep your eye on regular plain ol' common and preferred.
Can founders get preferred stock?
Can they? Yes. However, when first forming the company, founders don't receive preferred stock. Founders will have common stock. Investors will have preferred stock.
How do I know if I got a good deal?
Two things. If the investors are people you can't work with, it's automatically a bad deal.
Second, if it's a reasonable deal, then it's a good deal. If it's an unreasonable deal, then it's a bad deal.
Look at the table of terms and focus on the terms marked important. If your deal terms fall under what is reasonable in these important categories, then you are fine.
What is the timeline for an investment?
This varies greatly depending on the parties and their relationship. Some times its can be extremely quick. Some times it can take a number of months. Negotiations for the term sheet spelling out the major points of the investment can take a number of weeks. After the term sheet is signed due diligence (where the parties make sure that everything is in order) and the drafting of documents takes another few weeks.
How does an investment take place?
The investors generally know how much money they can invest and/or how much of a company they want to buy. The investors working with the entrepreneurs determine a valuation of the company. This valuation is based on a number of factors including: company personnel, the industry, the revenue of the company, etc. Doing a valuation of a company is an inexact science.
After that they use the following formula to determine share price:
Price = pre-money valuation / number of fully diluted shares
Pre-money valuation means the value of the company without taking into consideration the to-be investment amount. Number of fully diluted shares is all the shares of the company issued and outstanding (when taken into account certain factors such as conversion.) They use this formula to determine the price of a share.
Example: investor wants to potentially invest $1M into the company. The valuation of the company is $4M. There are 1,000,000 shares.
Price = $4,000,000 / $1,000,000
Price = $4
$1,000,000 will buy 250,000 shares for the investor.
For more examples look at the article on this site entitled Startup Math.
Are there any securities law consequences?
Yes. Stock of a company is a type of security and thus securities laws and regulations come into play. The most important thing for you to know regarding securities regulation and financing is who you can issue stock to.
The investors in your company must be accredited investors. In a nutshell this means that they must have certain levels of income/assets. Look at Phase 3A: Financing--Fundamental Concepts if you need more guidance on this point.
What documents do I need?
The documents that you should be concerned about regard the governance of your company. Make sure your shit is in order. This is what the investors counsel will look at prior to the financing. Make sure your charter documents are in order, your bylaws, your corporate consents, etc.
Regarding the actual financing, your lawyer working with the counsel of the investor will draw up a couple of key documents:
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). They will need to be amended in a financing.
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.
Investor Rights Agreement: a contract between the company and the investors that contains registration rights and other rights (such as rights to financial information.)
Voting Agreement: this is an agreement that details voting--primarily in the context of the board composition.
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.
Other documents:
There will also be other supplementary documents such as a Management Rights Letter, Legal Opinion Letter, and Indemnification Agreement
VENTURE CAPITAL TERMS
What are the most important terms?
All of the terms matter. But if they are reasonable, then you don't have to think about them too much.
The terms that you need to focus on and that are the most important are the following: the financing amount, share price, liquidation preference, directors, pre-emptive rights, and anti-dilution protection.
How does a financing affect prior owners?
A financing dilutes the other owners of the company (unless they have certain anti-dilution rights).
This has a couple of consequences for the diluted party:
1. They have less control (e.g. less voting power.)
2. They will get less of a payout in an event of liquidation
What are preemptive rights?
Preemptive rights are also called pro-rata rights or participation rights.
Preemptive rights generally allow a shareholder to purchase the same percentage of an upcoming round of investment as the investor current holds of the company.
It's a type of anti-dilution right and you need to pay attention to them.
How does VC financing affect the control of the company?
After investing in the company, the investor gets some control of the company. How much depends on how the term sheet negotiations play out and how much control the investor actually asserts.
The most important ways that VC financing affects control are:
1. Board control: The board makes high level decisions of the company. Investors will demand board seats.
2. Voting rights: Voting happens on an as-converted basis. This means that the preferred vote along with the common as one class all together. Preferred shareholders also get certain special protective provisions. These operate as types of veto rights.
How does VC financing affect the economics of the company?
Two primary ways: how the ownership of the company is divvied up and how much people will get paid out in an exit.
1. How the ownership of the company is divvied up: The investment will determine how much of the company the investors will own. Certain rights like anti-dilution rights will further scope how much the investors can protect that level of ownership.
2. How people will get paid out in an exit: The liquidation preference details what type of return the preferred investors will receive upon a liquidation event (e.g. merger or sale of the company).
What is dilution and how to protect from that?
Dilution means that you will own less of a percentage of the company than before. If you own 100% of a company and someone buys 50% of the company, then you will each own 50% of the company. You got diluted from 100% to 50%. The amount of shares you own does not change. If you own 2,500 shares of the company (and you are the only shareholder) and then someone comes and buys 7,500 shares from the company, that does not mean the number of shares you own changes. It just means the percentage of shares of the company overall that you have goes down. In this case it went down from 100% (you own 2,500 shares; everyone else 0) to 25% (you own 2,500 shares, everyone else 7,500)
How do investors determine how much the investment is worth?
Different investors have different methods of how they value the company. Some really go by the numbers and do different breakdowns of revenue projections, etc. Others use timing and size to get a good idea. They know that companies in a certain X industry of a certain size generally have a valuation of such and such.
What is a venture capital financing term sheet?
A term sheet is a document that is negotiated that briefly describes the key terms in a deal. It needs to be a non-binding document except for certain terms such as confidentiality. The final documents drafted after a financing can be hundreds of pages. The term sheet can be extremely short--just a few pages long.
What does a venture capital financing term sheet look like?
The term sheet is going to be divided in a number of sections with an extremely brief (about a paragraph description of the term.)
Example of a term sheet sections and terms listed:
Key Terms:
Investors - who the investors
Security - the type of stock (i.e. some type of preferred)
Price per share - the price per share the investors will pay
Valuation - the valuation of the company
Proceeds - the amount that the investors will invest
Terms of Preferred Stock:
Liquidation Preference - amount preferred will receive ahead of the common
Redemption - if the investors can force the company to buy-back the shares
Conversion - when and how the preferred stock converts into common
Automatic Conversion - when and how preferred automatically converts
Anti-dilution Provisions - what type of anti-dilution rights preferred will have
Dividends - any dividends that preferred will receive
Pay to Play - requirements for investors to purchase more shares in future rounds
Voting/Protective Provisions - details when the company needs special permission from investors
Terms of Preferred Stock Purchase Agreement:
Representations & Warranties - mentions that the Stock Purchase Agreement needs appropriate contractual terms acceptable to the investors and company
Expenses - who pays for the legal fees
Terms of Investor Rights Agreement:
Right of First Refusal - gives company the right to purchase shares if a shareholder wishes to sell those shares to a third party
Inspection and Information Rights - right to receive financial statements, etc.
Preemptive Rights - gives certain preferred shareholders right to purchase shares pro-rata in a future financing in order for that shareholder to minimize dilution
Demand Rights - right to demand that the company files certain registration statements with the SEC (a registration right)
S-3 Rights - type of registration right
Company Registration/Piggy-back Rights- right to "piggyback" registration rights on registrations of the company
Termination of registration rights - details when registration rights expire
Expenses - who bears responsibility for expenses associated with registering shares
Transfer of Rights - who the registration rights may be transferred to
Standoff Provision - restricting who can sell how much in a certain time frame after an IPO
Board - number of directors of the board and who gets to elect these directors
Founders and Employee Agreements:
Employee Pool - amount of stock reserved for employee option plans
Stock Vesting - details the vesting schedule for stock
Founder Stock Vesting - details any vesting provisions for stock that is typically currently already held by founders
Market Standoff - restrictions on when/how common shareholders can sell their stock after an IPO
Key-man Insurance - details requirements that the company acquire insurance policies for important personnel of the company
Proprietary information - requires personnel of the company to enter into certain types of confidentiality agreements, inventions agreement, and the like
Restrictions on Common Stock Transfers - limits transfer prior to shares having vested; gives right of first refusal to company on vested shares until an IPO
Co-sale Rights - gives investors right to participate in transferring of stock if founder transfers stock
Other:
Capitalization - alludes to attached cap table
Finders Fee - details any fee to any finder for the investment