Venture Capital Financing
Companies that have burned through what cash friends and family have been willing to provide, and still can’t get a bank loan, turn to strangers for money. These strangers go by many names, one being “venture capitalists”.
Venture capitalists provide money when other sources are not available. Most venture capital financing goes to companies in a narrow band of industries: technology, information services, life science and telecommunications. Because so many start-up ventures fail, venture capital tends to adopt a collective mentality, flocking toward those deals and industries that are perceived to have the greatest chance of a quick and profitable exit.
A common requirement for venture capital is a founder or CEO who has had previous successful experience with venture capital money. Also, venture capital tends to favor companies that are already far along in the development process and need funding to get a product to market. Finally, venture capital needs to see that projected revenues will accelerate very quickly, like a hockey stick, once product development and launch are complete. New ventures in mature industries with slower growth prospects, no matter the brilliant the business plan, are not a target of venture capital investors.
Once a decision is made to provide venture capital financing, the venture capitalist typically prepares a term sheet for the investment, setting out the principal terms of the transaction. The term sheet is later reflected in formal legal documents. Whatever negotiations transpire between the company and the venture capitalist occur as the term sheet is circulated.
Venture Capital Term Sheets
The following provisions are typically covered in venture capital term sheets:
1. Fixing the “pre-money” value of the company in order to determine how much equity the new investors will receive. For example, if the company has a pre-money value of $3 million and the venture capitalist provides $1 million of capital, the company will be worth $4 million after the investment, and the venture capital will receive shares equal to 25% of the outstanding stock.
2. Defining the terms of the security the venture capitalist will receive—generally preferred stock. The term sheet will spell out the rights and preferences of the preferred stock, such as dividends (often payable in more shares of preferred stock), liquidation preference, conversion rights (how the preferred stock is converted into common stock), and anti-dilution protection (in case the common stock is split or additional shares of common stock are issued at a price that is less than the conversion price of the preferred stock).
3. Actions that require the consent of the preferred stock voting separately as a class, such as a merger or sale of the company, amending the terms of the preferred and the issuing securities with rights senior to those of the preferred. Generally, the approval of the venture capitalist will be required in order to undertake any significant event.
4. A right to demand that the company file a registration statement with the Securities and Exchange Commission covering the stock so that it can be sold in the public markets. Also, the right to participate in any registration statements filed by the company on behalf of other investors.
5. The right to elect one or more members to the board of directors.
6. Who will serve as CEO and chief technology officer of the company.
7. How much stock management will own, generally through incentive stock options, including lock up provisions prohibiting the sale or transfer of such stock except in connection with a transaction in which all shareholders participate.
8. Rights of first refusal and preemptive rights with respect to new shares offered by the company.
9. The right of the investors to participate in any sale of stock by the original founders of the company.
Venture capital generally comes in stages. Each round of capital is designed to get the company to the next stage of development. As the stages proceed, different venture capitalists may become involved, as the industry has firms that specialize in different stages of development.
