Choosing to finance your company with venture capital is a big decision that founders should not take lightly. In our experience, so many founders have wrongfully assumed that venture capital is the only way to finance their company. Often, it’s not a great fit. But, for those companies and founders that need large sums of capital to grow at extremely high rates (e.g., exponential or orders of magnitudes) in short periods of time, it can be the right plan.
If you’re going to raise money from venture capital, then you’re going to need to understand the basic terms of the deal.
Pre-Money vs. Post-Money
The terms “pre-money” and “post-money” valuations are terms that are frequently used. Essentially, pre-money and post-money valuations can refer to your company’s valuation at two different points: before and after a certain round of external funding or injection of capital.
The valuation of the company will often be one of the most important business points negotiated, as these numbers will often dictate how much of the company is being sold to investors for their investment.
Here’s a quick example: Let’s say a founder and a VC firm agree that the “pre-money” valuation of the company is $4 million. The VC firm commits to investing $1 million. Therefore, the “post-money” valuation of the Company would be $5 million (i.e., pre-money + investment amount). Implicitly, this means that the VC firm will own approximately* 20% of the company after the investment (i.e., investment amount divided by the post-money valuation). *[I say “approximately” because there are different methods of calculating the shares that parties will get, all which will have different results.]
Now, if that Founder were able to negotiate the “pre-money” valuation up to, say $5 instead, then the VC firm’s ownership would only be approximately 16.67% (and the founders would suffer less dilution).
Liquidation Preference; Participating vs. Non-Participating
The liquidation preference for a venture capitalist is a clause in the contract that dictates the amount and priority in which an investor will be paid in the event of liquidation (and the term “liquidation” typically includes as a result of the sale of the company, merger, etc.). Typically, a VC firm will request at least a 1X liquidation preference, which means, in effect, that the VC firm will be repaid their investment before other shareholders participate in liquidating distributions of the Company. If that liquidation were 2X, then the VC firm would be repaid two times their investment before other shareholders participate in liquidating distributions.
There is another concept that dovetails with the liquidation preference: participating vs. non-participating preferred shares.
Typically, a VC investment will provide that the preferred shares being purchased have the ability to convert into Common Shares. With respect to a liquidation preference, how and when a VC firm may choose to convert their preferred shares into Common Shares may be a function of whether they have participating preferred shares or non-participating preferred shares. Non-participating preferred stock will have to make a choice at liquidation: do they prefer the liquidation preference (and nothing else) or would they prefer to convert into Common Stock. Participating preferred stock does not have to make this choice and gets the best of both worlds (i.e., very VC-favorable term).
Here’s an example.
Let’s say the VC firm owns 20% of the total shares, invested $2 million, and has a 1X liquidation preference.
If the Company sold for $4M (net of debt and expenses):
• If the shares are non-participating preferred, then the VC company would choose whether it’s best to receive the $2M liquidation preference or convert into Common Stock to get their 20% of the $4M (i.e. $800K). The VC firm would choose not to convert.
• If their shares were participating, that same fund would receive the first $2M, then be able to convert their shares and take 20% of the remaining amount (i.e., 20% of $2M, or $400K). Thus, in this case the VC firm would receive a total of $2.4M.
If the Company sold for $20M (net of debt and expenses).
• If the shares are non-participating preferred, then the VC company would choose whether it’s best to receive the $2M liquidation preference or convert into Common Stock to get their 20% of the $20M (i.e. $4M). The VC firm would choose to convert and forgo their liquidation preference.
• If their shares were participating, that same fund would receive the first $2M, then be able to convert their shares and take 20% of the remaining amount (i.e., 20% of $18M, or $3.6K). Thus, in this case the VC firm would receive a total of $5.6M.
Protective Provisions & Board Composition
Despite the fact that most VC investors are coming in and purchasing less than a majority of the shares, the VC firm still cares about controlling the company. Thus, typically, the VC firm will require that (i) one or more of their appointees serve as members of the board of directors of the company and (ii) certain decisions be approved by them (either as preferred stockholders or as a special board of director).
Some of these decisions typically include major and extraordinary decisions, like raising more capital, selling substantially all of the company’s assets, entering into a merger, incurring significant debt, changing any of the terms related to the capital stock, etc.
Anti-Dilution
Typically, the VC firm that invests wants to protect themselves against the Company subsequently issuing more shares at a lower price than what the VC company paid for the shares. Thus, they create anti-dilution protections, which essentially state that, if the Company subsequently issues shares at a price per share below what the VC firm paid, then the Company will issue more shares to the VC firm to get their ownership back up to a “fair” amount.
There are two main types of anti-dilution provisions that can be included in venture capital contracts. One is referred to as “full ratchet;” this anti-dilution provision allows preferred stockholders to convert their shares into common stock at a reduced price, which allows them to multiply their shares. So, under a full ratchet, if the VC firm bought shares at $1/share and the Company subsequently issues shares at $0.25/share, then the VC firm would basically look back to their investment and re-issue shares as if the price were $0.25/share (instead of $1/share). Therefore, the VC firm’s number of shares would increase by 4X.
The full ratchet can be a harsh result. As a result, we more typically see a “weighted average” used to determine how the VC shares will be re-priced. The weighted average takes many more variables into consideration when calculating the revised share price.
Registration Rights
Investors who inject capital into a privately held company are always considering how they will achieve liquidity from their investment Often, liquidity comes through the company being acquired. But, it’s possible to achieve liquidity through making the company list its shares on a public stock exchange so that it can be sold in the market. To protect themselves against the possibility that an acquisition doesn’t come (timely), the VC firm will often negotiate registration rights (i.e., the ability to register their shares on a stock exchange for the purpose of selling them).
There are a couple of ways in which registration rights can manifest in contracts. The first method is called “piggyback” registration rights, which means that investors can have their restricted stock included in an IPO so they can have access to the wider market. Another, more aggressive registration right is the “demand” right. With this right, investors can, essentially, force the company to register with the SEC and have an initial public offering.
Redemption Rights
What if an investor simply wants out? The company’s founders are taking the business in an unsatisfactory direction or things just aren’t going as well as some had hoped. In this case, investors might want to consider exercising their redemption rights.
Redemption rights make a company obligated to buy back shares of preferred stock if the holders wish. However, it is not as simple as an investor asking for his or her money back; for redemption rights to be successfully triggered, a majority of shareholders, usually, must approve the transaction. What can be negotiated is the amount that an investor will be repaid, and in which manner (lump-sum or regular payments).
Conclusion & Contact Us
Any contract you sign on behalf of your company should be thoroughly vetted to ensure legality and fairness. This need is magnified with contracts involved with venture capital investing. Doida Law Group is ready to assist you with drafting and negotiating these deals, plus, through our flat-fee structure, we offer clients price certainty from the start. Call us today at 720-306-1001 to see if a complimentary consultation with our firm is the next best step for you and your business.