The most analytical yet lean 101 text on venture capital investing I was lucky to discover so far is the exceptional MSc Thesis of Shikhir Singh at Cass Business School back in 2005, entitled as “Structuring Venture Capital Deals”.
Firstly, I’d like to highly recommend it to all of you who would like to have a good understanding on the subject, potentially targeting a VC investment in the foreseeable future, rather than just having a casual interest by scanning the twittersphere. You may read the full thesis or download its pdf via scribd at the end of this post.
And, remembering back in the engineering school, most students were avert to anything with the cost/profit/economy keywords attached, even if the math were much more easier than literally everything else they have ever tried. You’d better not replicate such an approach here, geeks can and should know the VC stuff, and it is to our very benefit to know the basics.
Moreover, I’d like to stress out some critical points and differences to the local greek legal framework that have turned out to be serious difficulties in setting up the Openfund (a more official post will follow-up, outlining the solutions we were finally able to iron out).
To start with, let me first attempt to briefly summarize the most common VC terms, as shaped out by Singh. You may also use the list below as a quick reference.
Liquidation event: An exit event for the VC (sale, merger, closing or IPO). Serves as VC’s target.
Pre-money: The value of the company prior to receiving the outside (VC) financing.
Post-money: Equal to Pre-money plus external funding received.
Option pool: Unallocated stock options, created prior to an investment for new hires so as not to require further dilution
Share Price = Premoney / (Shares Outstanding + Option Pool)
Grounds for the Term Sheet
The need for a term sheet is justified by potential conflicts of interest, Singh comes to summarize perfectly:
The goals of an entrepreneur of a company which is seeking funding are to:
1. Create a successful company
2. Get the funding necessary to create a successful company
3. Maintain maximum value and control of the company
4. Share the risks with the investors
5. Obtain the expertise and contacts that help the growth of the company
6. Obtain a reward for creating a successful company
The goals of a VC which is seeking to provide funding are to:
1. Maximize return to justify the risks and effort in funding company
2. Ensure that the company makes best use of the capital provided
3. Ensure the ability to invest in later financing rounds if it so chooses
4. Ensure the ability to liquidate their assets to match their funding cycle
5. Develop a reputation that attracts other venture opportunities
Conflicts of interest arise due to differing objectives between VCs and entrepreneurs on:
1. Split of the financial return of the company
2. Liquidation of the company
3. Control of the company
After all, it is clear that an investment negotiation is essentially a power struggle, with the VC attempting to minimize risk and maximize returns, while the entrepreneur tries to share risk and receive the investment. The provisions to be described hereafter come to address the conflicts of interest, within the investment term sheet.
Liquidation & financial split provisions
The following are the most common deal terms designed to address the conflicts that may arise regarding the liquidation and financial split of the enterprise.
Redemption Provision: Penalty clauses required by VCs to speed up a liquidation event. May include paying back initial investment or multiple of it, paying unpaid dividends, appointing committee to look for exit opportunities, or providing more board seats or other special rights to the VCs.
Redeemable Preferred Stock: Special class of stock securing priority to any cash available from a liquidation event. In case of an exit, VCs owning preferred stock get first their share -their initial investment or a multiple of it- and the common stockholders follow to divide up what is left. Preferred stock holders’ upside potential is limited in this case.
Redeemable Preferred & Common Stocks: A combination of the above, which enables the VC to get first rights to any cash available, thus making money from both the initial investment multiple and the common stock.
Convertible Preference Shares: Such shares can be converted to common stock at a predefined conversion price, at various points during the life of the company (for example, when new stock is issued or at any exit). Investors use the right to convert if the pre-specified conversion price is lower than common stock’s liquidation share price.
Participating Convertible Preference Shares: Participating convertible preference shares carry the right that in case of any liquidation event other than an IPO, the VC will get face value plus get free shares as though the VC had the convertibility option. In the case of an IPO, the VC has just the liquidation preference or the convertibility option.
Multiple Rounds Standards: When multiple rounds of financing occur, it is typical for each new investor to ask for liquidation preference over the previous investors.
Anti-Dilution Provisions: Anti dilution provision in VC contracts refers to securing that the value of a VC’s investment in a company will not be decreased in a case of a “down-round” (and it does not refer to keeping the percentage of shares steady, as anti-dilution is generally perceived). In such a case, anti-dilution clauses result in the investors getting additional shares for free, providing full or partial counterbalance to their decreased investment’s value. The right to anti-dilution clauses only applies to investors holding convertible preference shares and participating convertible preference shares. The most common anti-dilution provisions include full ratchet and weighted average provision, Singh also provides a more illustrative example.
Full Ratchet: With a full ratchet, enough new shares are issued for the investor holding the anti-dilution right, so that his investment value remains intact.
Weighted average provision: This provision stands between the full ratchet and no anti-dilution. It’s formula re-prices an earlier round by issuing enough additional shares to that round to bring its investment’s value down to the (weighted) average price of both the new and the previous round.
Pay to Play Provision: In one of the few provisions that benefits the entrepreneur over the VC, pay to play clauses require that VCs participate proportionally in future rounds or they will lose some or all of their privileges (anti-dilution rights, liquidation preferences, voting rights, preferred stock or a combination of the above).
Common provisions to address the struggle for control within the enterprise include the following:
Board Members: The board of directors is set up to protect the interests of the corporation and the equity holders. It also monitors the progress of the management team. The number of board seats a VC gains after an investment is a point of negotiation, while in new investments the board is typically expanded. The VCs can also ask for their board members to be granted special rights.
Milestone Provision: The VC usually gives or takes something if specific milestones are met or not. Milestones may include developing a prototype, getting a large customer, sales or profit targets, among others.
Class Veto Rights: VCs almost always require some veto rights, disproportionate to their shares. These may include “mergers and acquisitions, restructuring, issuing of new shares, changes to the company charter, amendments which will alter the rights of preference shares which the VC owns, annual business plans, profit distribution and employee stock options, borrowing more than a certain amount, buying assets more than a certain amount, sale of major assets, and sale of copyrights, trademarks, or intellectual property”.
Dividend Provision: VCs can request a dividend provision where the company has to pay the VCs annual dividends. The dividends can be either cumulative or non-cumulative. Usually, the value to the dividends is predetermined.
Fees: The most usual kind of fees include deal fees, annual management fees, legal fees and due diligence fees.
Lockup Provision: The time window after an IPO during which VCs and founders cannot sell their stocks, typically negotiated with the Investment Banks to ensure the owners will remain in place.
Founder Shares Vesting: This provision requires the founders to give their shares to the company, and the company will return them back over a period of time (to ensure that the founders won’t leave the company after VCs’ investment).
Drag Along Provisions: Drag along provisions give the majority of the shareholders in a particular class the right to sell the company and force the rest of the investors to sell under the same conditions offered to them. They are designed to inhibit a situation where a minority of shareholders holds a company hostage by refusing to sell.
Tag Along Provisions: This -rarely negotiable- provision ensures that if the entrepreneur gets someone to buy his shares, all the shareholders holding those rights can sell their shares to the same shareholder under the same conditions offered to the entrepreneur in proportion to their holdings.
I do believe that the above provide you with a broader view on the subject. Singh moves on to provide some quick stats on the frequency of those terms; these are not harsh VCs reprisals, but the most common or default options a VC has available, in order to secure the most basic forms of your commitment, in return of his money. And money -next to time- is the strongest expression of commitment; you have to be reasonable to ask for them, either we speak about $1 or €1M.
So, VC funding has nothing to do with donations, or gifts, if you used to think of it like that you’d better reconsider. What’s more, valuations are rather just the tip of the iceberg, you’d better ask for the full term sheet and think hard about the total value you’re carrying forward, before you speak your mind.
Finally, to put the above into the Openfund context (and I’d be really happy if you could prove me wrong), let me mention first that the only class of stock available under greek law is common stock (update: It seems that there is a kind of “preferred stock” for greek SAs, with some rather limited and predefined rights -yet I’m missing a link in english. Still, this is not the case for limited companies). I really don’t know if this occurred out of a political axiom or anything else, but I do need to mention that it invalidates most of the financial provisions deployed above. Moreover, the notion of the Board of Directors is not valid in greek limited companies (Ltd), there are just shareholders and “administrators”. There is of course another class of companies, “Anonymous companies” or “Societe Anonyme, SA”, prescribing the existence of a Board, but a minimum capital of €60k is needed for their incorporation.
If this sounds like a pretty unsolvable problem of the “good luck with this” category, you’re not that far away. But, I’m happy to report you that we have reached an elegant solution; which is of course the subject of another post…