Structuring Venture Capital Investments
Venture capital 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 which have a realistic exit
scenario within 5 to 7 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.
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 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 is generally equal to the purchase price, 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.
An important consideration to VCs is the percentage of
the company that they own on a fully-diluted basis. Fully-diluted
means the total number of issued shares of common stock,
plus all shares of common stock which 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 upon which the VCs and the company agree.
In determining 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.
VCs protect their ownership percentages through 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. 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 common stock regardless
of the number of shares of common 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
Many VCs state that they invest in management, not technology,
and VCs expect the management team to operate the business
without undue interference. However, most investment structures
provide that the VCs participate in management through
board of directors representation, 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 4 years. Therefore, investments
are structured to provide liquidity within 5 to 7 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 will generally 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. This gives the investors the right to require
the company to repurchase their stock after a period of
generally 4 to 7 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 upon a multiple
of the company’s earnings. An early stage company
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.
Other exit rights that VCs typical 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.
Provided by Hutchison & Mason, PLLC -- a Raleigh,
North Carolina based law firm specializing in information
technology and life science companies. This article was
originally published in the August 2001 issue of Business
North Carolina. This article was also published in the
September 2001 issue of the Triangle TechJournal.