The Terms and Structure to Expect for Venture Capital Funding

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If you need Venture Capital, having a clear understanding of the typical structure and terms behind VC funding will for sure help the effectiveness of your search to find these funds. I will discuss in the article the various structures and terms you can expect from a Venture Capital firm.

Investment Objectives

I have written previous articles with more details on the Investment Objectives. Consult the Fund’s Website and Prospectus for their Investment Objective to determine if your deal strictly matches the Fund’s criteria.

Make an Investor Profile

Obtain additional information on the Venture Capital Firm from industry contacts and its portfolio companies.

Structure Complexity

Often structured as purchases of Convertible Preferred Stock, with grants and contractual right. Negotiation of terms mostly occurs at the Term Sheet Phase and often leaves open the need for future funding as circumstance dictates.

Costs

Travel, Due Diligence, Commitment Fee, Legal, Accounting and Consulting. It adds up!

Financial Statement, Cash Flow, Accounting and Tax Impact

it is good to keep in mind that the earlier the stage of a company, the higher the risk, both perceived and in reality. So the pay back on the investment must be high in relationship to the start up company’s assets. Therefore, the harvesting objective is a company sale or a buy out at a valuation that is much higher. Weigh out carefully how the VC investment will directly and indirectly influence your growth, well being and exit strategy. There are many impacts to consider!

Types of Securities

Most common are Common Stock, Convertible Preferred Stock and Convertible Debt Structures. Convertible Preferred Stock and Convertible Debt are often preferred forms of securities.  Convertible Preferred allows a lower valuation of the underlying Common Stock, giving rise to inexpensive Employee Stock Option Incentive Plans. There are other accounting advantages and equity negotiation advantages to a lower valuation of Common Stock:  ie. Capital Gains Tax Implications, Equity Participation, etc

Convertible Preferred Stock

It is convertible into Common Stock per agreed on Ratios, subject to adjustment for Stock Splits, Reverse Stock Splits, Dividends, etc. Voting Power is equivalent to the number of Common Stock in which it can be converted.

Liquidation Preference

Preferred stock receives all liquidation proceeds up to the original sales price of the Preferred Stock, after which the remaining liquidation proceeds are shared among Common and Preferred Stock Holders as per agreement. Usually no mandatory dividends or sinking fund arrangement. Understand Permissive redemption.

Typical VC Constraints on a Company

  • Company Valuation
  • Equity Dilution
  • Amount Invested at a time
  • Board Representation

Anti-Dilution Protection

  • Price-Based:  If the value of a Company fails to achieve expected levels in subsequent financing rounds, investors can seek an increase in the amount of equity for their investment.
  • Adjustment triggered by a later on valuation of say less than 100-120% of the prior valuation.
  • Try to negotiate a less aggressive Anti-Dilution provision such as a Weighted Average Adjustment which considers both the valuation and the equity dilution involved.
  • Avoid Price-Based Anti-Dilution Provisions that extend to more than one subsequent finance round, which creates dilution uncertainties for later investors.
  • Beware of a Ratcheted Adjustment Provision which only considers the valuation element.

Registration Rights

  • Demand Rights:  VC obtains the right to make a Company perform a Public Offering(s).
  • Piggyback Rights:  VC reserves the right to participate in Public offerings initiated by the Company or others.

Preemptive Rights

Investor has the right to purchase a Pro-Rata Portion of the Company Securities sold in subsequent offerings.

Covenants and Restrictions

  • Contractual restrictions on salaries
  • Restriction on outside business activities of principals and management
  • If the founders leave the company within a certain time period, typically two to five years, then the VC firm has the right at a stock repurchase.

Representations and Warranties

  • Company’s Valid Existence
  • Accurate Due Diligence
  • Accurate depiction of Company Organization & Ownership
  • Company in Good Standing
  • Company/ Principals have the Power & Authority to enter into the Financing transaction
  • Litigation Disclosures
  • Material Agreements, Contracts, Memorandums
  • Contractual Default Disclosures
  • Compliance with Laws, Regulations and Ordinances
  • Adequate Trade Secrets, Propriety Protections, Patent Rights, License Rights and Royalty Rights necessary for Company operations
  • Not infringing on the Rights of other Companies
  • Property Titles
  • Financial Statement Accuracy
  • Good Faith Preparation of Business Plan

Equity Investor Compensation

  • Income from Company Earnings:  either as Dividends or Drawings (ie. Partnership)
  • Capital Gains:
    • Sale of the Company
    • VC sells interest back to Company or to other Investors
  • Dividend payouts are often minimized or accumulated so Company Cash Flows aren’t badly affected
    • Retained Earnings realize a Greater Capital Gain for an Investor which can be more tax advantaged
    • A combination of Dividend and Capital Gains payouts is common, creating a balance between Company Growth and tax advantages
  • Public Offering

Best Advice

In my capacity as Business Plan Writers, I encourage you to develop a really well thought out and solid  SWOT Strategy. These documents really need to show you and your team’s competency and experience. You want the VC Firm to believe that you are capable of carrying out your plan.

For more help in the planning area, please see my article on  Write Business Plan.

About The Author – Frank Goley ~ Business Consultant ~ ABC Business Consulting

Frank Goley works in the capacity as an experienced business consultant, business turnaround consultant, business plan expert, business plan writer, business coach, small business consultant, business planner, marketing consultant, online marketing consultant, seo consultant, and business plan consultant for ABC Business Consulting. Frank is considered an expert in writing, developing and implementing business plans, business turnaround plans, funding business plans, marketing plans, strategic plans and web marketing plans. Frank offers comprehensive business consulting, business coaching, business turnaround consulting, along with web seo, web development and web marketing consulting, to small and medium size companies. Frank is the author of a business plan book, The Comprehensive Business Plan Workbook – A Step by Step Guide to Effective Business Planning, and he has over 130 published articles and e-books on business success strategies. He also writes the Business Success Strategies Blog and publishes the Business Success Newsletter.

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