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.

• Investment Security. Venture investors usually purchase convertible preferred stock or convertible debentures from a company. These securities give them preferences over the other stockholders of the company 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.

• Pricing and Valuation. The amount invested and the number of shares of common stock into which an investor’s security is convertible determines the price, or value, of 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 deal’s 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 $8 Million pre-money and $10 Million post-money. See: Discounted Cash Flow, Fully Diluted, Post-Money Valuation, Pre-Money Valuation, Pricing, Valuation.

• 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 are not unusual. See: Boilerplate, Due Diligence, Reps and Warranties.

• 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.

• 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.

• Conversion Rights. The investor’s right to convert his 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.

• Antidilution Rights. Antidilution rights typically entitle the investor to additional shares of common stock on conversion of the investor’s convertible preferred stock when the conversion occurs after diluting events such as stock splits and stock dividends. Most antidilution provisions also entitle the investor to additional shares on conversion if the company later sells stock at a price lower than the investor’s price. Ratchets, which are less common, provide investors with the most protection by lowering their 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.

• Voting Rights. Investor voting rights preferences usually include the right to elect a representative 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.

• 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. Venture investors who do not join a company’s board of directors will 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.

• 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, usually at the price management negotiates with a willing outside buyer. See: First Refusal Rights (Company), First Refusal Rights (Shareholder), Liquidity Agreements, Preemptive Rights.

• Co-Sale Rights. Investor co-sale agreements entitle investors to include some of their shares of stock in a sale of stock made 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.

• 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 employment of the company before the vesting periods expire. See: Unvested Stock, Vested Stock, Vesting Schedules, Vesting Stock Grants.

• 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. See: Demand Rights, Piggyback Rights, Registration Rights.

• Management Noncompetes. Founders and management are usually required to enter into agreements with the company that require their full time attention to the company’s business, protect its trade secrets and prevent the founders and managers from going into competition with the company. See: Employment Contracts, Noncompete Agreements.

• Information Property Agreements. All company employees are usually required to sign agreements as a condition to the closing of a venture financing which protect the company’s intellectual property and require the employee to keep the company’s secrets confidential. See: Confidentiality Agreements, Patents, Secrecy Agreements, Think Capital.