Before you get involved with venture capital financing, whether as a company looking to raise financing, or as a potential investor, make sure you understand important terms and concepts that you will invariably be confronted with in a venture capital transaction. Even if your business is not at the juncture of raising financing, understanding the key terms in now as they relate to a private equity transaction will help you start to position company for an eventual financing round down the road. Accordingly, this discussion provides an overview of some of the important terms in a venture deal.
1. Venture Capital: You have heard the term thrown about, but what does it mean? Simply put, venture capital is a broad term used to describe financing provided to startups and early stage businesses as well as turn around situations. However, the manner in which the financing is provided to a company is where the many variations on potential deal structures arise. The financing can be raised through debt (i.e., a loan), equity (i.e., shares) or a combination of the two (such as a convertible loan or a loan with stock options).
2. Private Equity: Equity securities of a company that are not listed on a public market are referred to as private equity. However, the term is also liberally used to refer to any venture capital deal where the financing does not involve any purchase of shares listed, or any listing of any shares, on a public exchange (i.e., stock market).
3. Valuation: The value of the company. A simple statement, but that is the only thing simple about it. Valuation is usually one of the most important issues in any venture deal, with the company arguing for a high valuation and the investor looking to push valuation as low as possible. As an investor, you may receive a term sheet with a stated valuation for the company, however, any valuation decision should be based on your independent assessment. Further, the valuation should adjust based on information you may learn in the due diligence process.
a. Post-Money Valuation: The valuation of a company immediately after the most recent round of financing. If an investor provides $1 million in a company valued at $3 million "pre-money" (before the investment was made), the post-money valuation of the company is $4 million.
b. Pre-Money Valuation: The valuation of a company prior to the investment. This amount is determined by using various possible formulas (book value, discounted cash flow, multiple of future earnings etc.).
c. Fully Diluted Basis: All securities, including preferred stock, options and warrants, that result in additional common shares on a converted basis, are counted in calculating the total amount of shares outstanding for determining ownership or valuation.4. Common Stock: A security (stock) that evidences proportionate ownership in the company and gives the owner voting rights and proportionate right in the assets and income of the company (after all obligations of the company).
5. Preferred Stock: Like common stock, preferred stock represents proportionate ownership in the company, but stands a higher position (preferred) to common stock with respect the claims on the asserts and earnings. Preferred shares may or may not have voting rights depending on what the parties negotiate. Preferred shares generally will have a number of additional rights that common stockholders do not have, including a dividend preference and liquidation preference. There are different types of preferred stock, including:
a. Participating Preferred: giving the owner the right to additional dividends if a certain predetermined financial event occurs
b. Convertible Preferred: which convert into common stock either at the option or can occur upon an event requiring mandatory conversion to common stock
c. Cumulative Preferred/Dividend Preference: Preferred shares have a dividend preference giving the holder the right to dividends before common stock holders. Cumulative Preferred Stock gives the holder a right to dividends at a fixed rate of return, and that dividend accumulates each year until paid (before common dividends, if any). Non-cumulative preferred means if no dividends declared, then the dividend is lost (rather than accumulates until declared).
6. Liquidation Preference: Preferred shareholders will have a right to receive a payment upon a triggering event, such as the winding down of the company or a merger or acquisition. The question is what is the nature of the preference: (a) how much is paid, (b) what is the priority among different classes (common vs. preferred) and series (like Series A vs. Series B, and (c) the right, if any, of the preferred to share in any remaining amounts (i.e., along side the common shareholders).
7. Series A, etc.: Stock of a company can be divided into different series, which will occur when there is more than one round of financing. For example, if preferred (Series A) shares were already issued, and the company does another round it can call the new preferreds Series B. The other important aspect is that each Series can have different dividend, liquidation, voting and other rights.
8. Convertible Stock: Most people are aware of convertible stock or convertible rights which gives the holder of preferred shares to convert them into common stock upon a triggering event. However, the real issue is negotiating the conversion ratio/formula, for example will it be 1:1 meaning one common for one preferred or another formula where the preferred gets more than one share of common for each preferred share.
9. Anti-Dilution Protection: One of the biggest concerns of any investor in a company is that it will be diluted if the company subsequently issues more shares at a lower price. As a result, investors often demand an antidilution right, and then the question is what is the nature of that right:
a. Full Ratchet gives the shareholder the right to always retain its percentage of ownership in the company. Therefore, the shareholder is given a right to a number of shares necessary to maintain its ownership percentage in the company. While this term is very favorable for the investor, it has the effect of substantially diluting other shareholders without the right and thus the full-ratchet provision is less common.
b. Broad-Based Weighted Average results in dilution of the holder of the right, the percentage decline is tempered so as to not result in the full dilution that other shareholders will experience. The issuance of new shares at a lower price will result in a re-weighting of the average share price, and the investor with the anti-dilution protection will have a right to additional shares to lessen the effect of the new round (however, the investor will still see a reduction in its ownership percentage).
10. Tag Along/Co-Sale: The Tag Along right gives a minority shareholder the right to sell its shares upon the sale by a majority shareholder on a percentage basis. If you are a minority shareholder, this is an important right because you do not want the founders or majority to be able to exit the company without giving you a right to exit in part as well.
11. Drag Along: Means that if a set percentage of shareholders wish to sell the company's share to a third party, the other shareholders must agree and are dragged along into accepting the deal and the negotiated terms.
12. Right of First Refusal/Preemptive Right: This right can work to the benefit of the shareholder, giving it a right to buy shares on the same terms offered to a third party. It also can benefit the company, providing the company a right to purchase its shares rather than allowing a third party to buy them from an existing shareholder.
13. Right of Redemption: A right of redemption gives the holder the right to demand that the company repurchase its shares at a specified price upon the occurrence of a triggering event.
14. Registration Right: Investors with registration rights are given the right to require the company to register its restricted shares either on demand (subject to certain terms) or a piggyback right (when the company files a registration statement). For a company, allowing the demand right is not generally favored
because registration is expensive, complex and the timing may not be right for a registration.
15. Board Seats: A company seeking to raise funds should be aware that an investor may seek one or more seats on the company's board of directors.
16. Restrictive Covenants: It is common place for loans to include restrictive covenants limiting certain the company from taking certain actions while the loan is outstanding, but an investor may also ask for such rights, including limitations on spending, sale of important assets, issuing additional shares, increases in salaries and other major business decisions.
17. Non-Compete Clause: A company may want to require an investor to sign a non-compete, especially a large investor. The investor will likely push back arguing as a passive investor it is not necessary.
Above are some of the more important terms you will need to address in a venture financing transaction. Of course, the investor will take a markedly different position regarding some of the rights as the company. Therefore, as your company is moving toward the financing stage, begin considering how you will address the important rights that the investor will likely demand.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.