The Ins and Outs of a Venture Capital Investment

A venture capital fund is a professionally managed pool of capital that is raised from public and private pension funds, endowments, foundations, banks, insurance companies, corporations, and wealthy families and individuals. Venture capitalists (VCs) generally invest in companies with high growth potential with a realistic exit scenario within five to seven years. A typical VC investment structure will include rights and protections that are designed to allow the VCs to gain liquidity and maximize the return for their investors.

I will discuss the three most important aspects of a venture capital deal, known as a term sheet: (a) liquidation rights, (b) management participation and control, and (c) 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.

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. 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.

An important consideration for a venture capital fund is the percentage of the company that 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 takes into account the risks to the company and the future dilution to the initial investors from anticipated follow-on investments.

VC funds protect their ownership percentages in three 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 overpaid for their stock if the pre-money valuation turns out to be too high.

There are two common types of price protection: full ratchet and weighted average ratchet. A full ratchet adjusts the conversion price to the lowest price at which the company subsequently sells its stock, regardless of the number of shares of stock the company issues at that price. A weighted average ratchet adjusts the conversion price according to a formula that takes into account the lower issue price and the number of shares that the company issues at that price.

Management Participation and Control 101

Many VC funds day 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. 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 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.

Exit Rights

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, the initial public offering of the company’s stock, 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 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 it is not available 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 four to seven years. The purchase price for the VCs’ 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 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 board of directors of the company.

Tag-Along and Drag-Along Rights

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

VC investment terms sometimes seem onerous and complex to entrepreneurs. VC fund managers must understand the terms and structure of the deal—and their many variations—intimately. 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.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Alternative Assets Part 1: Investing in Venture Capital, Private Equity, and Hedge Funds and Raising Capital- Negotiating with Potential Investors.]