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Accredited Investor Installment 9: Venture Capital Investing

[Editor’s Note:  This is the ninth installment in a series of articles dedicated to the 95% of people in the U.S. who have never invested in a startup, a venture capital fund, a private equity fund, or a hedge fund even though they are permitted to do so and even though doing so may make sense to achieve property diversification. Read Installments #1, #2 , #3. #4, #5, #6, #7 and #8.]

An Historical Overview

The present day VC industry traces back to the creation of the VC/PE firm American Research and Development Corporation (1946) by Georges Doriot. ARD raised $3.5 million, of which $1.8 million came from nine institutional investors, including MIT, Penn, and the Rice Institute.

The industry picked up real steam in 1958, when “Venture Capital was in its infancy,” according to Mark Heesen, president of the National Venture Capital Association, “[a] significant boost was given to the industry with the passage of the Small Business Investment Act.” The passage of the Small Business Investment Act gave tax breaks to private investment companies, leading to the creation of professionally-managed VC firms by licensing private, small business investment companies (SBICs) to help entrepreneurs finance and manage their startups.

Around the same time, another pertinent legal development occurred: the Prudent Man Rule underwent a relaxation that also helped lead to an increase in venture investments. Succinctly stated, the Prudent Man Rule is the standard by which fiduciaries are judged. From 1960 to 1962, according to Hessen, 585 SBIC licenses were approved, representing $205 million committed in private money.  “The experience with SBICs demonstrated a key point – government policy has an extremely important effect on the venture capital ecosystem.”

Some examples of companies funded through early venture capital include Xerox, Intel, and American Microsystems. Changes to the Employee Retirement Income Security Act in 1979 further relaxed the Prudent Man Rule, helping to assuage fiduciaries that they would not get sued for investing in start-ups. This further opened a pathway for investing in venture capital.

Startups funded during this time include Compaq, Intel, McAfee, Hotmail, Skype and American Online which ushered in a massive time of growth of the internet age.

In the 1990’s, the “dot com” era was a boon to venture capital, providing numerous opportunities for new firms to emerge and go public and for existing firms to put financing into the seemingly endless array of Internet startups, but the bubble eventually burst, causing heavy losses across the board.

Basic Choices for Investing in VC

If you decide you are interested in investing in start-ups, you need to decide how you will do it. That is:

Structuring a VC investment in a start-up

Regardless of how you intend to invest in VC, you should have a basic understanding of how professionals, like VC firms, invest. For an excellent overview, see J. Robert Tyler’s article, titled, “The Structure of a Venture Capital Investment.

Keep in mind that the following discussion describes common- but not universal- elements of how VC funds structure their investments. Every deal is different and actual terms vary. Also, angels typically extract fewer rights than those discussed below.

Common economics

A fundamental problem with many generally available resources is that most are created for the benefit of the start-up founders and other entrepreneurs and, thus, tend to be somewhat biased in their favor.

As Tyler’s investor-focused article explains, many venture capital investments by professional VC firms 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 will have priority over common stock dividends. These cumulative dividend rights provide a priority minimum rate of return to the VCs.

The preferred stock will have a liquidation preference that generally is equal to the purchase price (or a multiple thereof), plus accrued and unpaid dividends, to ensure that the VCs get their money back before the holders of the common stock (e.g., founders, management, and employees) if the company is sold or liquidated.

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.

VCs protect their ownership percentages in three basic ways: preemptive rights, anti-dilution protection, and price protection.

  • Preemptive rights enable the investors to maintain their percentage ownership in the company by purchasing a pro rata share of stock sold in future financing rounds.
  • Anti-dilution protection adjusts the investors’ ownership percentages if the company effects a stock split, stock dividend, or recapitalization.
  • Price protection adjusts the conversion price at which the preferred stock can be converted into common stock if the company issues common stock or stock convertible into common stock at a price below the current conversion price of the preferred stock (that is, the VCs will be issued more shares of common stock upon the conversion of the preferred stock). This protects the VCs from the risk that they may have overpaid for their stock if the pre-money valuation turns out to be too high.
  • Governance rights

Most investment structures provide that the VCs participate in management through their representation on the board of directors, and through the effects of affirmative and negative covenants or protective provisions, and stock transfer restrictions. Typical protective provisions give the VCs 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, VCs 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 any of 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 or to meet certain milestones, or if the company violates any of the protective provisions.

VCs must achieve liquidity in order to provide the requisite rate of return to their investors. Most VC funds have a limited life of 10 years, and most investments from a fund are made in the first four years. Therefore, investments are structured to provide liquidity within five to seven years so that investments that are made in a fund’s third and fourth years are liquidated as the fund winds up and its assets are distributed to the fund’s investors.

The primary liquidity events for VCs are the sale of the company, an initial public offering, or the redemption or repurchase of their stock by the company.

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.

VCs typically have “demand registration rights” that 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 “put,” or “redemption rights” to achieve liquidity if it is not available through a sale or public offering. Redemption rights give an investor the right to require the company to repurchase their stock after a period of generally four to seven years. The purchase price for the VC’s stock may be based upon the liquidation preference (i.e., the purchase price, plus accrued and unpaid dividends), the fair market value of the stock as determined by an appraiser, or 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 VC investor tremendous leverage to force management to deal with the need for an exit and can result in a forced sale of the company. Also, if a VC investor triggers their redemption right and the company breaches its payment obligations, the VC investor may be able to take over control of the board of directors of the company.

Other exit rights that VCs typically require are tag-along and drag-along rights. Tag-along rights give an investor the right to include her stock in any sale of stock by management. Drag-along rights give an investor the right to force management to sell their stock in any sale of stock by the investor.

Understanding your investment in a VC Fund

If you choose to invest through a VC fund and that VC fund, in turn, invests in 20 companies (each a “portfolio company”), you generally will have no claim or interest to those 20 portfolio companies. It is no different than if you buy stock in Walt Disney: by doing so, you do not have any right to go to a Disney movie or buy Disney products for free.

So, it is critical to understand what generally accepted market terms are regarding an investor’s investment in a VC fund. In this section, we discuss this. Just keep in mind that these are guidelines only. Moreover, if you are considering investing in a not-so-well established VC fund, you may have a significant amount of leverage in negotiating terms with the fund’s sponsor.

Fees

VC industry standard, in terms of fee structure, has long been “2 and 20.” This means that the general partner (“GP”) charges: (a) an annual fee equal to 2% of assets under management plus (b) 20% of the profits of the fund (that is, after the limited partners are paid back their initial investment plus, sometimes, a preferred return, or “hurdle).

The 20% sharing of profits is called a “carried interest” and is commonly paid at the end of the life of the fund. Sometimes, however, the fund is set up to allow the sponsor/GP to earn its carry on each individual exit (that is, sale of a portfolio company) makes along the way rather than waiting until the end of the life of the fund. When this is the case, a clawback provision will provide that overpaid carry must be returned to LPs. All of this is the same in the PE context. See Section 6.6.1.

According to Fred Wilson, a NYC-based VC blogger and principal at Union Square Ventures, two times one’s investment “is the absolute low end of acceptable performance in a venture fund.” See Wilson’s AVC Blog. However, as Wilson later explained:

[A] fund has to get a lot more than $2 back on its investments to get its investors $2 back. That’s because before the investors get their money back, the fund takes a management fee. And if there are profits, the managers of the fund take a carried interest on the profits. Our fund takes 20% and that is the carried interest that most funds take. However, there are funds that charge 25% or even 30% carried interest fees. Some think the best funds charge the highest carried interest fees. Market theory would suggest that is true. But I am not sure that it is.

The good news is, if the fund doesn’t become profitable, no carried interest is paid, so, incentives are pretty well aligned, to say the least. That said, VC funds also are paid yearly management fees, regardless of performance, intended to cover overhead.

These fees vary widely but generally range from 1.5% to 2.5% per year, often ratcheting down in a fund’s later years. What this means for a good-sized fund is that salaries (which, after all, are part of overhead) to fund managers can be very good. In the words of Andreessen Horowitz investor and financial writer Chris Dixon, investors need to understand and accept that “most VCs get rich via ‘management fees’ just by showing up each day.”

For more information on how VC funds are paid, see Kate Litvak’s April, 2009 paper on the subject, Venture Capital Limited Partnership Agreements: Understanding Compensation Arrangements. (or add this link https://seraf-investor.com/compass/article/dividing-pie-how-venture-fund-economics-work-part-iii but I’m hesitant to use it because it’s another site that has a newsletter etc.)

The Limited Partnership Agreement

A Limited Partnership Agreement (LPA) is the legal document (a contract) that governs all aspects of the relationship between General Partner (GP) and the Limited Partners (LPs) in a VC fund. LP agreements in the PE context follow the same basic structure as they do in the VC context.

Most LPAs are similar to each other, with “standard” provisions.  Common standard provisions include:

Rights and duties of the Manager

Most funds are managed by the GP, whose rights and duties are spelled out clearly in a section of the LPA commonly titled, “Rights and Duties of the Manager.” A management fee is paid to the Manager for its work.

Capital contribution

This section of an LPA outlines the obligations each LP has when a “capital call” is made by the GP and outlines the remedies available to the fund if an LP fails to make a required capital contribution.

Investment policy guidelines

This section of an LPA describes a fund’s “mandate.” That is, it describes the types of investments the fund is permitted to make.

Allocation of liabilities, profits and losses

This section of an LPA governs how profits and losses are allocated among the GP and the LPs.

Distribution

This section of an LPA governs the timing of cash payments to partners.

Assignment of interests

This section of an LPA governs the rights of partners to transfer their partnership interests.

Termination and liquidation

This section of an LPA governs the winding up of a fund. Funds typically must be wound up after about 10 years.

Risk and return

  • Risk – Most start-ups fail. That is simply a fact of life. You might assume that by investing in a VC fund, managed by a VC firm, your risk can be mitigated. All else being equal, this is right, assuming you select your VC firm well. But keep in mind that, as Marc Andreessen (of Andreessen Horowitz) once famously remarked, “[i]n California, you need a license to drive a car or buy a gun, but not to be a venture capitalist.”

Venture capital continues to grow. Eric Feng noted:

From 2003 to 2011, an average of 157 new funds were raised each year. But from 2012 onward, that average rose to 223, or an impressive 42% increase.

Good fund managers, however, have immense gravitas, attract the best opportunities, and generate superior returns (in the 25+ percent Internal Rate of Return range).

Is VC for you?

Leaving aside whether you are interested in being a lone wolf angel, part of an angel group, or investing in a VC fund, the threshold question is: is VC for you?

Like any other investment class, there are excellent performers, terrible ones, and those that fall everywhere in between. We do think, however, the attention being brought to the VC space is causing many new funds, angel groups, and the like to come to the space and, consequently, people need to be more vigilant than ever in doing their due diligence before investing their money.

Further, if you are an investor who is thinking about getting active in the space for the first time, we urge you to understand that you have a lot to learn and if you do not take the time to do that you may as well to go to the nearest convenience store and buy a stack of lottery tickets.

Prudence also dictates that we should only invest in that which we understand. If some “hot” technology promises to change the world and you cannot understand the why and how behind the technology on a fundamental level, then it is probably not for you.

Finally, consider that in many ways VC is the most dangerous of all investments. Why? It is not too uncommon for a start-up to:

  • Be controlled by its own officers
  • Lack independent board members.
  • Be run by an inventor who may have no experience running a company
  • Be heavily (or even completely) reliant on a single product,
  • Have high customer concentration.

With eyes wide open, you are the only one who can decide if venture capital is right for you.

[ Editor’s Note: Check out these related webinars, which can be taken for Continuing Legal Education (CLE) credit, or simply for practical and entertaining education for business owners, Accredited Investors, and their legal and financial advisors: Raising Capital: Negotiating with Potential Investors; Due Diligence Before Investing; and Alternative Investments Part 1: Investing in Venture Capital.]

Who are ‘We’?

You will notice that throughout this series, I use the Alternative Investment Guideterm “we.” This is done to acknowledge the great editorial assistance of the Financial Poise Editorial Team. This series is based on my book The Investor’s Guide to Alternative Assets: The JOBS Act, “Accredited” Investing, and You.

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About Jonathan Friedland

Jonathan Friedland views his role as a business lawyer simply: to help clients make money at every opportunity and to protect their interests at every turn. His national practice emphasizes corporate structuring, corporate governance, counseling on day-to-day business affairs, M&A, and corporate restructuring. Most of his clients are privately owned businesses and their owners, particularly…

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