Financing a Startup Company Series: Venture Capital
This continues our Financing a Startup Company Series and focuses on venture capital. Venture Capital refers to professionally managed investment funds that usually have between $10MM and $1 billion to invest in early stage companies. VC funds vary widely in their investment strategy, both in terms of the industry and stage of startup companies that they will invest in. Some funds invest in very early companies, others in more developed startups. Some invest in web companies, others prefer biotech.
To attract VC funding, a company must usually have a hugely scalable business plan that involves high growth in sales. Venture Capitalists are sophisticated investors who see a lot of startups come through their doors looking for funding, and thus competition to get VC funding is tough. Each VC fund has specific company profiles that they are looking for – it pays to learn about the VCs and the types of companies in which they invest. It is important to know: 1, what industries the fund focuses on, 2, in which geographic locations they invest, 3, the stage of companies that they invest in, and 4, the size of deals that the fund will participate in.
When VCs invest, they take preferred stock that can convert to common stock if the VC so chooses. Preferred stock provides control rights over the company and gives some financial protection to VCs because in case of a liquidation or sale of the company, they will get paid out before the common stockholders. The rights that the VCs want will be spelled out in a term sheet that the VC provides to the company when the VC decides that it would like to invest. Experienced counsel can help explain the terms and their impact on your company, but some of the key terms are:
- Price Per Share – the company will usually be valued on its “pre money” valuation: the value of the company before the investment. This valuation, divided by the number of shares, gives the price per share. When determining the number of shares, negotiation sometimes occurs over which shares to include. A “Fully diluted” basis means that you include all shares that have been issued plus any issued options or warrants that could be exercised in the future (such as options issued to employees).
- Liquidation Preference – provides additional downside protection to investors in the event that the company is liquidated or acquired by allowing holders of the preference to get paid before other shareholders. A 1x liquidation preference gives investors a return of their money before anyone else is paid, a 2x preference would allow an investor to collect two times its original investment, etc.
- Participation– allow preferred stock holders to share in any distribution of proceeds from a sale of the company alongside the common stock holders.
- Anti-Dilution – encompasses several methods of protecting shareholders relative ownership of the company, at the expense of the company and future investors, in the event that there is a down round (an issuance of shares at a lower price than prior issuances).
- Conversion Rights – allow preferred stockholders to convert their shares to common stock, usually at a 1:1 ratio.
- Registration Rights – give investors the right to force a company to go public and register its shares with the SEC for sale to the public.
- Dividend Rights – give holders the right to receive cash from the company on a periodic basis. They can be cumulative (where it must be paid each year, or if not paid one year, must be paid in the future) or non-cumulative (where the stockholders only get the dividend if it is declared by the board).
- Protective Rights – give investors the right to veto certain specified actions such as selling the company, changing the terms of stock and issuing new stock.
- Voting Rights – give investors a right to vote separately to approve actions that might hurt their interests.
- Because of the variety in VC funds, it is possible to raise everything from fairly small investments of a few hundred thousand up to hundreds of millions of dollars.
- Venture Capital firms have large networks of advisors, mentors and business contacts. They can help make introductions to get quality people hired into key positions.
- Obtaining funds from a reputable VC fund is a huge mark of validation for a startup and can make it easier to attract employees, press coverage and future funding.
- VC funds will take a large equity stake in a startup, thus diluting the founders immensely. But, it is better to own 10% of a $100MM company than 80% of a $100K company.
- VC funds will often impose controls over the company’s management and take seats on the board. Although the board may have been a formality before accepting much outside funding, once a VC is on the board, it will begin to exercise more power over the corporation. While this is not necessarily a bad thing (having a seasoned VC on the board can be a huge advantage), the VCs interests in protecting and growing its investment may not always align with those of the founders.
- VC funds are very selective. Venture capitalists see a huge number of business ideas and choose to fund only the ones that they perceive to be the very best.