The Ins and Outs of a Venture Capital Investment

A venture capital fund is a professionally managed pool of capital raised from public and private pension funds, endowments, foundations, banks, insurance companies, corporations, and wealthy families and individuals.

Basics of a Venture Capital Deal

Venture capitalists (VCs) generally invest in companies with high growth potential with a realistic exit scenario within 5-7 years. A typical VC investment structure will include rights and protections designed to allow the VCs to gain liquidity and maximize the return for their investors.

The three most important aspects of a venture capital deal, known as a term sheet, are:

• Liquidation rights
• Management participation and control
• Exit rights

All About Liquidation Rights

Most venture capital investments are structured as convertible preferred stock with dividend and liquidation preferences. The preferred stock often will bear a fixed-rate dividend that, due to the cash constraints of early-stage companies, is not payable currently but is cumulative and becomes part of the liquidation preference upon a sale or liquidation of the company.

The payment of dividends on the preferred stock to the VC fund will have priority over common stock dividends. These cumulative dividend rights provide a priority minimum rate of return to the VC fund.

Liquidation Preference

The preferred stock will have a liquidation preference that generally is equal to the purchase price (or a multiple thereof), along with accrued and unpaid dividends.

This is to ensure that the VC fund gets its money back before the holders of the common stock (e.g., founders, management, and employees) if the company is sold or liquidated.

Participation Rights

Most VCs also insist on participation rights so that they share on an equal basis with the holders of the common stock in any proceeds that remain after the payment of their liquidation preference. These liquidation rights and the right to convert the preferred stock into common stock allow the VCs to share in the upside if the company is successfully sold.

Fully Diluted Ownership Percentage

An important consideration for a venture capital fund is the percentage of the company it owns on a fully diluted basis. “Fully diluted” means the total number of issued shares of common stock plus all shares of common stock that would be issued if all outstanding options, warrants, convertible preferred stock, and convertible debt were exercised or converted. This percentage is a function of the pre-money valuation of the company on which the VC fund and the company agree.

To determine the pre-money valuation, VCs analyze the projected value of the company and the percentage of this value that will provide them with their required rate of return. This analysis considers the risks to the company and the future dilution to the initial investors from anticipated follow-on investments.

How VC Funds Protect Their Ownership Percentages

VC funds protect their ownership percentages through several protection provisions, including:

• Preemptive rights
• Anti-dilution protection
• Price protection.

Preemptive Rights

Investors can maintain their percentage ownership in the company by purchasing a pro rata share of stock sold in future financing rounds.

Anti-Dilution Protection

Investors’ ownership percentages are adjusted if the company effects a stock split, stock dividend, or recapitalization.

Price Protection: Full Ratchet and Weighted Average Rachet

In the event a company issues common stock or stock or convertible preferred stock at a price below the preferred stock, VCs are protected from the risk of overpayment for stock if the pre-money valuation turns out to be too high. The conversion price is altered so VCs will be issued more shares of common stock upon conversion of their preferred stock.

• Full Ratchet: the conversion price is adjusted to the lowest price at which the company subsequently sells its stock, regardless of the number of shares the company issues at that price.
• Weighted Average Rachet: The conversion price is adjusted according to a formula that takes into account the lower issue price and the number of shares the company issues at that price.

Management Participation and Control 101

Many VC funds say they invest in management, not technology, and VCs expect the management team to operate the business without undue interference. Most investment structures provide, however, that the VCs participate in management through representation on the board of directors, affirmative and negative covenants or protective provisions, and stock transfer restrictions.

Protective Provisions Regarding Management and Control

Typical protective provisions give VC funds the right to approve amendments to the company’s certificate of incorporation and bylaws, future issuances of stock, the declaration and payment of dividends, increases in the company’s stock option pool, expenditures in excess of approved budgets, the incurrence of debt, and the sale of the company. In addition, VC funds generally require that management’s stock be subject to vesting and buy-back rights.

As long as the company is achieving its business goals and not violating the protective provisions, most VCs permit management to operate the business without substantial investor participation except at the board level.

However, VCs may negotiate the right to take control of the board of directors if the company materially fails to achieve its business plan, falls short of certain milestones, or violates any of the protective provisions.

Exit Rights

VCs must achieve liquidity to provide their investors with the requisite rate of return. Most VC funds have a limited life of 10 years, and most investments from a fund are made in the first 4 years. Therefore, investments are structured to provide liquidity within 5-7 years so that investments made in a fund’s 3rd and 4th years are liquidated as the fund winds up, and its assets are distributed to the fund’s investors.

VC’s Role in Liquidity Events

The primary liquidity events for VCs are the sale of the company, the initial public offering of the company’s stock, or the company’s redemption or repurchase of its stock.

Generally, VCs do not have a contractual right to force the company to be sold. However, the sale of the company will be subject to the approval of the VCs, and depending upon the composition of the board of directors, the VCs may be in a position to direct the sale efforts.

Registration Rights and Redemption Rights

VCs typically also have demand registration rights that theoretically give them the right to force the company to go public and register their shares. Also, VCs generally will have piggyback registration rights that give them the right to include their stock in future company registrations.

VCs also insist on redemption rights to achieve liquidity if unavailable through a sale or public offering. These are sometimes called ‘put’ rights, as in the right to put the stock back into the company. They can require the company to repurchase their stock after a period of generally 4-7 years.

The purchase price for the VCs’ stock may be based on the following:

• Liquidation preference (i.e., the purchase price plus accrued and unpaid dividends)
• The fair market value of the stock as determined by an appraiser
• The value of the stock based on a multiple of the company’s earnings

An early-stage company (particularly one that is struggling) may not be able to finance the buyout of an investor, and the redemption right may not be a practical way to gain liquidity.

However, this right gives the VCs tremendous leverage to force management to deal with their need for an exit and can result in a forced sale of the company. Also, if the VCs trigger their redemption right and the company breaches its payment obligations, the VCs may be able to take over control of the company’s board of directors.

Tag-Along and Drag-Along Rights

Other exit rights that VCs typically require are tag-along and drag-along rights.

• Tag-along rights give investors the right to include their stock in any sale of stock by management.
• Drag-along rights give investors the right to force management to sell their stock in any sale of stock by the investors.

A Venture Capitalist Should Know the Basics

VC investment terms sometimes seem onerous and complex to entrepreneurs. VC fund managers must intimately understand the terms and structure of the deal—and their many variations. As an investor in a VC fund, you don’t need to be as conversant with the terms and structures as entrepreneurs and fund managers, but it helps to know the general outline of a deal when evaluating your fund manager’s performance.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Raising Capital: Negotiating with Potential Investors 
2. Crowdfunding From the Investor’s Perspective
3. Due Diligence Before Investing

This is an updated version of an article originally published on July 22, 2019.]

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