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Venture Capital
Deal Structures vary from
investment to investment but most venture capital deals are
structured using the same concepts, many of which are described in
detail throughout this book. The following provides a summary of a
typical venture capital deal structure where the investor purchases
less than a controlling interest in a growing privately held
company.
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Investment Security. Venture
investors usually prefer using convertible preferred stock or
convertible debentures when investing in privately held
companies. These securities give them preferences over other
stockholders and are typically convertible, at the investor’s
option, into common stock. Usually, conversion is mandatory when
the company goes public. See: Common Stock, Convertible
Debentures, Convertible Preferred Stock, Convertible Securities,
Fully Diluted, Preferred Stock Umbrellas.
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Pricing and Valuation. The
amount invested and the number of shares of common stock into
which an investor’s security is convertible determines, in the
common parlance of the industry, the value of the company
receiving the investment. Investors often phrase their
investment proposals in terms of purchasing a percentage of a
company’s fully diluted stock ownership for a given amount of
money. For example, a term sheet may express that the investor
will invest $2 Million to purchase 1 Million shares of
convertible preferred stock which is to be convertible into 1
Million shares of common stock representing 25% of the company’s
fully diluted capital stock, after investment. This would price
the deal, in terms of company valuation, at $6 million pre-money
and $8 million post-money. See: Discounted Cash Flow, Fully
Diluted, Post-Money Valuation, Pre-Money Valuation, Pricing,
Valuation.
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Full Disclosure. The
financing agreements prepared by venture capital investors are
detailed and include extensive representations by the company
and, sometimes, individual management members respecting all
aspects of the company’s operations. Ten to twenty pages of
single spaced representations accompanied by an extensive
disclosure schedule elaborating on the representations are not
unusual. See: Boilerplate, Due Diligence, Reps and
Warranties.
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Liquidation and Dividend
Preferences. Investors usually build into the securities
they purchase preferences that entitle them to receive a
predetermined amount (typically their investment amount plus a
predetermined return) before other shareholders in the event the
company is liquidated. These same securities typically entitle
the investor to receive dividends before dividends are issued to
holders of common stock. See: Convertible Preferred Stock,
Participating Preferred, Negative Covenants.
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Investor Stock Redemptions.
Investor preferred stock is frequently subject to one or both of
two types of redemptions. The first requires the company,
usually after a fixed period of time and at the direction of the
investor, to redeem (i.e. repurchase) the investor’s preferred
stock at a fixed price. The other entitles the company to
require the investor to either redeem his preferred stock or
convert into common stock, usually after a fixed period of time.
The first provides a mechanism for an investor to liquidate his
investment in a company that is not meeting expectations. The
second enables management to release the company from some
investor preferences (many of which are contained in the terms
of the preferred security) by forcing the investor to redeem or
convert into common stock. See: Calls, Puts.
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Conversion Rights. The
investors’ right to convert preferred stock into common stock is
usually coupled with the company’s right to require conversion
in the event of an initial public offering or, less frequently,
sale of the company. The conversion price is usually equal to
the purchase price of the preferred stock but is subject to
downward revision (resulting in giving the investor more common
shares upon conversion of the preferred shares) after a
subsequent sale of stock by the company at lower prices. See:
Convertible Securities.
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Antidilution Rights.
Antidilution rights entitle investors to receive extra shares of
common stock when they convert their preferred stock into
common stock if a company sells stock for lower prices after the
investors’ purchase or if their has been another diluting event,
such as a stock split. The mechanism for creating this right is
a charter obligation to reduce the conversion price ratio used
to determine the number of shares of common stock into which the
preferred stock will convert. Ratchet antidilution rights
provide investors with the most extra shares by reducing the
conversion price to the lower sale price given to other
investors. Weighted average antidilution provisions reduce the
conversion price less by using a formula that factors in the
number of shares sold at the lower price as well as the lower
price. See: Antidilution Provisions, Dilution (Percentage),
Ratchets, Weighted Average Antidilution.
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Voting Rights. Investor
voting rights preferences usually include the right to elect one
or more representatives to the company’s board of directors and
to approve certain types of actions such as the amendment of the
company’s charter, the sale of the business, or the issuance of
new or preferential securities. Sometimes the voting preferences
extend to other matters as well. See: Shareholders’
Agreements, Voting Agreements, Voting Trusts.
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Participation and Information
Rights. The voting rights negotiated by venture investors
are frequently supplemented with rights to participate in
developing or approving the company’s business plan, to
participate in certain board of director committees, and to
receive regular financial reports from company management.
Rights to approve certain types of major transactions or changes
in company direction are also common. Venture investors who do
not join a company’s board of directors often request a separate
agreement giving them rights to attend board meetings and confer
with management. See: Control, Negative Covenants, Operating
Covenants, Reports and Records, Voting Agreements.
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Preemptive Rights and First
Refusals. Preferred stock investors frequently require the
preemptive right to buy stock in future rounds of company
fundings, typically to the extent needed to preserve their
ownership percentage. These rights are usually supplemented with
first refusal agreements that entitle them to purchase shares
sold by management, frequently at the price management
negotiates with a willing outside buyer. See: First Refusal
Rights (Company), First Refusal Rights (Shareholder), Liquidity
Agreements, Preemptive Rights.
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Co-Sale Rights. Investor
co-sale agreements entitle investors to include some of their
shares of stock in a sale of stock conducted by a company
manager or founder. The purpose of the agreement is to provide
the investor with some protection against a sell out by the
company’s management. See: Co-Sale Rights, Liquidity
Agreements.
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Vesting Agreements. Sometimes
investors negotiate to make the shares of the founders and
management subject to future vesting so that they will forfeit
shares if they leave the company before the vesting periods
expire. See: Unvested Stock, Vested Stock, Vesting Schedules,
Vesting Stock Grants.
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Registration Rights. Venture
investors typically negotiate agreements that entitle them to
require the company to register their shares for resale to the
public. The purpose of the agreements is to provide the investor
with a mechanism to liquidate his shares. Investors usually
require two types of registrations rights - demand rights that
entitle them to force the company to register their shares and
piggyback rights that entitle them to include their shares in a
stock registration initiated by the company. Management
employees typically do not obtain registration rights and the
rights granted to outside investors are usually carefully
limited. See: Demand Rights, Piggyback Rights, Registration
Rights.
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Management Noncompetes.
Founders and management are usually required to enter into
agreements that require their full time attention to the
company’s business and protect its trade secrets. These
agreements typically also prevent the founders and managers from
going into competition with the company. When combined with the
vesting agreements described above, these agreements can provide
powerful incentives to keep management from leaving the business
to engage in competitive enterprises. See: Employment
Contracts, Noncompete Agreements.
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Information Property Agreements.
All company employees are usually required to sign
confidentiality and proprietary rights agreements as a condition
to the closing of a venture financing. Many companies already
have these agreements in place to protect the company’s trade
secrets and insure the company’s rights to inventions created by
company employees. These agreements frequently include
provisions preventing employees from soliciting customers or
other employees away from the company. See: Confidentiality
Agreements, Patents, Secrecy Agreements, Think Capital.
See the Deal entry for a
description of the documents used to complete a sale of stock to a
venture capital fund. See also: Deal, Financing Agreements,
Structure. |
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