A Guide to Venture Capital Financings for Startups
By Mike Sullivan and Richard D. Harroch
Startups seeking financing often turn to venture capital (VC) firms. These firms can provide capital; strategic assistance; introductions to potential customers, partners, and employees; and much more.
Venture capital financings are not easy to obtain or close. Entrepreneurs will be better prepared to obtain venture capital financing if they understand the process, the anticipated deal terms, and the potential issues that will arise. In this article we provide an overview of venture capital financings.
1. Obtaining Venture Capital Financing
To understand the process of obtaining venture financing, it is important to know that venture capitalists typically focus their investment efforts using one or more of the following criteria:
- Specific industry sectors (software, digital media, semiconductor, mobile, SaaS, biotech, mobile devices, etc.)
- Stage of company (early-stage seed or Series A rounds, or later stage rounds with companies that have achieved meaningful revenues and traction)
- Geography (e.g., San Francisco/Silicon Valley, New York, etc.)
Before approaching a venture capitalist, try to learn whether his or her focus aligns with your company and its stage of development.
The second key point to understand is that VCs get inundated with investment opportunities, many through unsolicited emails. Almost all of those unsolicited emails are ignored. The best way to get the attention of a VC is to have a warm introduction through a trusted colleague, entrepreneur, or lawyer friendly to the VC.
A startup must have a good “elevator pitch” and a strong investor pitch deck to attract the interest of a VC. For more detailed advice on this, with a sample pitch deck, see How to Create a Great Investor Pitch Deck for Startups Seeking Financing.
Startups should also understand that the venture process can be very time consuming—just getting a meeting with a principal of a VC firm can take weeks; followed up with more meetings and conversations; followed by a presentation to all of the partners of the venture capital fund; followed by the issuance and negotiation of a term sheet, with continued due diligence; and finally the drafting and negotiation by lawyers on both sides of numerous legal documents to evidence the investment.
In the rest of this article, we discuss the key issues in negotiating and closing a venture capital round.
2. The Venture Capital Term Sheet
Most venture capital financings are initially documented by a “term sheet” prepared by the VC firm and presented to the entrepreneur. The term sheet is an important document, as it signals that the VC firm is serious about an investment and wants to proceed to finalize due diligence and prepare definitive legal investment documents. Before term sheets are issued, most VC firms will have gotten the approval of their investment committee. Term sheets are not a guarantee that a deal will be consummated, but in our experience a high percentage of term sheets that are finalized and signed result in completed financings.
The term sheet will cover all of the important facets of the financing: economic issues such as the valuation given to the company (the higher the valuation, the less dilution to the entrepreneur); control issues such as the makeup of the Board of Directors and what sorts of approval or “veto” rights the investors will enjoy; and post-closing rights of the investors, such as the right to participate in future financings and rights to get periodic financial information.
The term sheet will typically state that it is non-binding, except for certain provisions, such as confidentiality and no shop/exclusivity. Although it is not binding, the term sheet is by far the most important document to negotiate with investors—almost all of the issues that matter will be covered in the term sheet, leaving smaller issues to be resolved in the financing documents that follow. An entrepreneur should think of the term sheet as the blueprint for the relationship with his or her investor, and be sure to give it plenty of attention.
There are varying philosophies on the use and extent of term sheets. One approach is to have an abbreviated short form term sheet in which only the most important points in the deal are covered. In that way, it is argued, the principals can focus on the major issues and leave side points to the lawyers when they negotiate the definitive financing documents.
Another approach to term sheets is the long form approach, where virtually all issues that need to be negotiated are raised, so that the drafting and negotiating of the definitive documents can be quicker and easier.
The drawback of the short form approach is that it will leave many issues to be resolved at the definitive document stage, and if they are not resolved, the parties will have spent extra time and legal expense that could have been avoided if the long form approach had been taken. The advantage of the short form approach is that it will generally be easier and faster to reach a “handshake” deal (and some VCs prefer a simple short form of term sheet because they think it will be more appealing to entrepreneurs).
In the end, it is usually better for both the investors and the entrepreneur to have a long form comprehensive term sheet, which will mitigate future problems in the definitive document drafting stage.
3. Valuation of the Company
The valuation put on the business is a critical issue for both the entrepreneur and the venture capital investor. The valuation is typically referred to as the “pre-money valuation,” referring to the agreed upon value of the company before the new money/capital is invested. For example, if the investors plan to invest $5 million in a financing where the pre-money valuation is agreed to be $15 million, that means that the “post-money” valuation will be $20 million, and the investors expect to obtain 5/20, or 25%, of the company at the closing of the financing.
Valuation is negotiable and there is not one right formula or methodology to rely upon. The higher the valuation, the less dilution the entrepreneur will encounter. From the VC’s perspective, a lower valuation (resulting in a higher investor stake in the company) means the investment has more upside potential and less risk, creating a higher motivation to assist the company.
The key factors that will go into a determination of valuation include:
- The experience and past success of the founders (so-called “serial” entrepreneurs present less risk, and often command higher valuations)
- The size of the market opportunity
- The proprietary technology already developed by the company
- Any initial traction by the company (revenue, partnerships, satisfied customers, favorable publicity, etc.)
- Progress towards a minimally viable product
- The recurring revenue opportunity of the business model
- The capital efficiency of the business model (i.e., will the company need to burn through significant capital before reaching profitability?)
- Valuations of comparable companies
- Whether the company is “hot” and being pursued by other investors
- The current economic climate (valuations generally climb when the overall economy is strong, and are lower during economic slumps)
While each startup and valuation analysis is unique, the range of valuation for very early-stage rounds (often referred to as “seed” financings) is often between $1 million and $5 million. The valuation range for companies that have gotten some traction and are doing a “Series A” round is typically $5 million to $15 million.
4. Form of the Venture Capital Investment
The founders of a startup typically hold common stock in the company. Angel investors or venture capitalists will usually invest in the company in one of the following forms:
- Through a convertible promissory note. The investor is issued a note by the company, convertible into company stock in its next round of financing. The note will have a maturity date (often 12 months from the date of issuance) and will bear interest (4% to 8% is common). No valuation is set for the company at this time. The investors will usually ask for the right to convert their notes into the stock issued in the next round of financing at a discount to the price paid in the next round valuation (a 20% discount is common), sometimes with a “cap” on the valuation of the company for purposes of the conversion rate (e.g., a $10 million cap). Convertible note financings are much quicker and easier to document than the typical convertible preferred stock alternative discussed below. Convertible notes are often seen in seed rounds.
- Through a SAFE (Simple Agreement for Future Equity), first developed by Y Combinator. SAFEs are intended to be an alternative to convertible notes, but they are not debt instruments—unlike a note, a SAFE has no maturity and does not bear interest. The SAFE investor makes a cash investment in the company that converts into stock of the company in the next round of financing. Just as with notes, SAFEs can convert at discounts and/or at capped valuations. (Read a good primer on SAFEs here.) Institutional investors, such as VCs, are less likely to invest in SAFEs, but they can be useful for companies at a very early stage.
- Through a convertible preferred stock investment, with rights, preferences and privileges set forth in the company’s certificate of incorporation (sometime referred to as the “charter”) and several other financing documents. The preferred stock gives the investors a preference over common shareholders on a sale of the company. Preferred stock also has the upside potential of being able to convert to common stock of the company. Most Series A financing rounds are done as convertible preferred stock. There is a strong benefit to the company in issuing preferred stock to investors—it allows the company to issue stock options (options to buy common stock, which does not enjoy preferred preferences) to prospective employees at a significantly reduced exercise price than that paid by the investors. This can provide a meaningful incentive to attract and retain the management team and employees.
5. Vesting of Founder Stock
Venture investors will want to make sure that the founders have incentives to stay and grow the company. If the founders’ stock is not already subject to a vesting schedule, the venture investors will likely request that the founders’ shares become subject to vesting based on continued employment (and then become “earned”). Standard vesting for employees is monthly vesting over a 48-month period, with the first 12 months of vesting delayed until 12 months of service are completed, but founders can often negotiate better vesting terms.
The key issues that the founders negotiate in this regard are:
- Will the founders get vesting credit for time already served with the company?
- Will vesting be required for shares they acquired for meaningful cash investment?
- Should a vesting schedule of less than 48 months apply?
- Should a vesting schedule apply at all?
- Should vesting accelerate, in whole or in part, on termination of employment without cause, or upon a sale of the company? A form of vesting that is usually acceptable to investors is the so-called “double trigger” acceleration, where vesting accelerates if the company is acquired and if the buyer terminates the founder’s employment without cause after the acquisition.
In our experience, some vesting in early-stage startups is typically required, but the founders will usually get credit for time spent with the company, as long as a meaningful amount of equity is still subject to vesting.
6. Composition of the Board of Directors
The makeup of the Board of Directors of the company is important to venture capital investors as well as to the founders. VCs, especially if they are the “lead” investor in a round of financing, will often want the right to appoint a designated number of directors to be able to monitor their investment and have a meaningful say in the running of the business. From the founders’ perspective, they will want to maintain control of the company for as long as possible. Although circumstances vary, in general Board seat allocation usually follows share ownership, so if the investors have 25% or less of the company’s stock, they will usually accept a minority of the Board seats, and if after multiple rounds the investors own most of the company’s stock, they will often control the Board.
After a Series A financing round, typical Board scenarios might include:
- A three-person Board, with two chosen by the founders, and one chosen by the investors;
- A three-member Board, one chosen by the founders, one chosen by the investors, and one independent director mutually agreed upon; or
- A five-member Board, two chosen by the founders, two chosen by the investors, and one independent director mutually agreed upon.
In lieu of a Board seat, some investors may request Board “observer” rights, granting the investor the right to attend Board meetings in a non-voting capacity with the right to receive financial and other information provided to Board members.
The actual Board composition will be subject to negotiation, factoring in the amount invested, the number of investors, the level of control sought, and the comfort level of the founders.
7. Liquation Preference of the Preferred Stock
A “liquidation preference” refers to the amount of money the preferred investor will be entitled to receive on sale of the company or other liquidation event, before any proceeds are shared with the common stock. VCs insist on a liquidation preference to protect their investment in “downside” scenarios; for happier scenarios in which a company is sold for an amount that would generate big returns for the investors, investors can always convert to common stock.
The liquidation preference is typically expressed as a multiple of the original invested capital, usually at 1x. So in the event of a sale of the company, the investor will be entitled to receive back $1 for every $1 invested, in preference over the holders of common stock.
In situations where the company is particularly risky or the investment climate has turned adverse, investors may insist on a 1.5x, 2x, or 3x liquidation preference (this was more common during the downturns of 2001-2002 and 2008-2009).
8. Participating vs. Non-Participating Preferred
Venture investors will sometimes request that their preferred stock be “participating preferred.” This means that on a sale of the company, the preferred would first receive back its liquidation preference (typically 1x of the original investment), and then the remaining proceeds would be shared by the common and preferred according to their relative percentage share ownership.
For example, if the pre-money valuation of the company is $5 million, and the VCs invest $5 million into the company with a 1x liquidation preference, here is what the founders/common holders would receive on a $50 million sale of the company:
- If the preferred is participating, the first $5 million goes to the preferred holders, and the remaining $45 million is split 50-50 (per the percentage ownership in the company). So the founders/common would receive $22.5 million and the preferred would receive a total of $27.5 million.
- If the preferred in non-participating, the $50 million in proceeds would be split 50-50 and the founders/common would receive $25 million from the sale.
Participating preferred is relatively rare. In addition to claiming it’s “not market,” founders can try to resist participating preferred on the theory that it will hurt the Series A investors down the road if later financings also incorporate that term. If founders are forced to accept participation, they can often negotiate for the participating feature to go away if the VCs have received back some multiple (for example, 3x) of their investment.
9. Protective Provisions/Veto Rights of the Investors
After a financing is completed, venture investors will often hold a minority interest in the company. But they will typically insist on “protective provisions” (veto rights) on certain actions by the company that could adversely affect their investment or their projected return.
The types of actions where a veto right may apply include:
- Amendment of the company’s charter or bylaws to change the rights of the preferred, or to increase or decrease the authorized number of shares of preferred or common stock
- Creation of any new series or class of shares senior to, or on parity with, the preferred
- Redeeming or acquiring any shares of common, except from employees, consultants, or other service providers of the company, on terms approved by the Board
- The sale or liquidation of the company
- Incurring debt over a specified dollar amount
- Payment of dividends
- Increasing the size of the company’s Board of Directors
The most sensitive of these veto rights is the one granting the venture investors a blocking right on a sale of the company. Founders sometimes try to mitigate this veto right by arguing that it should not apply in situations where the VC receives a minimum return on its investment (often 3x-5x).
In most scenarios, the VCs and the company will work out the veto rights issues down the road. For example, if the company needs cash to continue the business, VCs will likely waive their veto rights over future financings. Abuse of veto rights by investors is rare; word spreads quickly in the venture world, and VCs know that if they are arbitrary in blocking sensible deals, it will adversely affect their reputation with future entrepreneurs.
10. Anti-Dilution Protection
It is typical for venture investors to obtain protection (called “anti-dilution” protection) against the company issuing stock at a valuation lower than the valuation represented by their investment. By far the most common is “weighted average” anti-dilution protection, which reduces the conversion price—and so, inversely, increases the conversion rate—of the preferred stock held by earlier investors if lower-priced stock is sold by the company. With weighted average anti-dilution, the more shares that are issued, and the lower the price of the shares, the greater the adjustment to the earlier preferred. Founders will want to avoid the more severe “full ratchet” anti-dilution clause, which reduces the conversion price of the existing preferred to match the price of the new stock (no matter how many shares are issued).
Investors will typically agree to specifically exempt from anti-dilution protection certain types of equity issuances, such as incentive equity for employees and other service providers, equity issued in acquiring other companies, and equity issued in connection with bank financings, real estate and equipment leases, and the like.
11. Right to Participate in Future Financings
Investors will normally receive a right to purchase more stock in connection with future equity issuances, to maintain their percentage interest in the company. These participation rights often go only to so-called “Major Investors” who own a certain amount of stock, and typically terminate on a public offering. As with anti-dilution protection, these rights are typically designed to apply only to bona fide financings, and usually are drafted not to apply to employee equity, equity issued in acquisitions, or “equity kickers” issued to lenders, landlords, or equipment lessors.
12. Stock Option Issues
Venture investors will want to ensure that the company has a stock option pool for future equity grants, typically 10% to 20% of the company’s capitalization, with later-stage companies having smaller pools. The options are used to attract and retain employees, advisors, and Board members.
VCs will almost always insist that this option pool be included as part of the pre-money valuation of the company, and it is standard to do so. However, founders should realize that any increase in the option pool will come at their expense, reducing their percentage ownership of the company. If the size of the pool becomes an issue in the term sheet negotiation, it is a good idea for the founder to produce a grounds-up “budget” for future options, estimating the options that will be needed for future hires until the next round of financing.
Venture investors will also typically expect that future option grants will be subject to a “standard” four-year vesting schedule: one year of employment required before any vesting for 25% of the options (referred to as the “cliff”), and then monthly vesting with continued employment for 36 months after the one-year cliff vesting.
13. Redemption Rights
Occasionally, VCs request a provision allowing them to cash out of their investment through a redemption feature (assuming the company has the cash). A typical redemption provision would say that the investors may, by majority vote at any time starting five years after their investment, elect to be redeemed (repurchased at their original purchase price), with payments made over a three-year period in equal installments. Redemption rights are uncommon, and even in the rare case where they are put in place, they are almost never triggered—but they can give leverage to a VC that wants liquidity.
Series A investors will not typically push for a redemption feature, knowing that such a provision may show up in future rounds of financings to the detriment of the Series A investors.
14. Information Rights
Venture investors will typically get the right to obtain certain financial information, as well as inspection rights with respect to corporate records. The term sheet will typically specify that annual, quarterly, and often monthly financial statements are to be provided, as well as an annual budget or business plan. These rights often are restricted to “Major Investors,” and are typically not a source of controversy or much negotiation.
15. Insurance Obligations
The term sheet may specify that the company will be obligated to maintain directors and officers liability insurance, covering the officers and directors of the company in connection with litigation with respect to duties they are performing for the company. The term sheet will specify the dollar amount of coverage (often $2 million to $10 million).
Venture investors occasionally also require the company to maintain “key man” life insurance policies on the lives of the key founders, policies that will provide the company with cash in the event a founder dies. The idea behind this kind of policy is that the cash generated in the event of a tragedy can give the company time to rebound and hire new talent to replace the deceased founder.
16. Rights of First Refusal/Co-Sale Rights
It is common for investors to have a right of first refusal on any stock to be sold by the founders. This will usually require the founders to first offer the shares to the company, and then to the investors (on the same terms as on the proposed sale) before they can be sold. Such a right will allow the company and the investors the opportunity to keep the founders’ shares within the existing shareholder base. Founders are usually able to negotiate exceptions from the right of first refusal, for transfers to family members or trusts for estate planning purposes, and, less often, for the sale of small (5%-15%) stakes.
The investors will also expect to get “co-sale rights” with respect to founder stock sales. This will give the investors the right to participate (on a pro rata basis) in a sale by the founders of their shares. (These rights are typically exercised when the founder has negotiated a very high price for his or her stock, too high to warrant a purchase pursuant to the right of first refusal.)
17. Drag-Along Rights
Drag-along rights give the company the right to force all shareholders to participate in and vote for a sale of the company if the sale has been approved by specified groups. For a Series A financing, the drag-along is typically triggered if approved by the Board of Directors, holders of a majority of the common stock, and holders of a majority of the preferred stock. The idea is not that one group can force another to sell, but rather that if all major constituencies of the company want to sell, all shareholders are required to participate in the sale. This prevents small shareholders from creating a roadblock to an acquisition by objecting or exercising appraisal or dissenters rights under applicable law.
In later-stage deals, drag-alongs may be structured to give the venture investors alone the right to invoke the drag-along right.
Typical issues involved in drag-along rights include:
- The percentage vote of the classes that can invoke the drag-along right (majority or supermajority)
- Limitations on representations, warranties, and covenants made by the dragged party
- The obligations of the dragged shareholders under the acquisition agreement, including covenants and indemnification obligations
Drag-along rights present a number of complicated legal and drafting considerations. But they can be important to ensure that 100% of the company can be sold without delay.
18. Registration Rights
Registration rights entitle the investor to require a company to list (“register”) its shares with the Securities and Exchange Commission SEC) in a public offering so that the investor can sell the shares. Registration rights are divided into “demand” rights and “piggyback” rights.
Demand rights require the company to pursue the registration of its shares, likely also including the shares held by the demanding shareholder. Piggyback rights give the shareholders the right to include some or all of their shares in a registration statement the company is already filing with the SEC.
As a practical matter, registration rights are seldom if ever exercised, and an early-stage startup should not waste a lot of time negotiating the terms (they will often be renegotiated anyway by later-stage investors).
19. Exclusivity/No Shop
Venture investors will usually include a binding provision in the term sheet preventing the company from entering into or negotiating with any other party regarding an investment in the company, for a designated period. This is a reasonable request, as the investors will be investing time, legal fees, and resources to complete the transaction. The company will want the exclusivity period to be as short as possible. The typical period agreed to is 30-45 days.
The investors will also ask that the company promptly notify the investor of any inquiries or proposals by third parties with respect to financings or sale of the company, and furnish the investor the terms thereof.
Venture investors will typically insist on a binding provision in the term sheet that the existence and terms of the term sheet, and the fact that negotiations are ongoing with the investors, are strictly confidential and may not be disclosed to anyone without the investors’ consent, except to the company’s directors, officers, and attorneys. The company will need to notify any party that it properly discloses the term sheet to that they are subject to the confidentiality obligation.
21. Dispute Resolution
In the unlikely event of a dispute between the company and the venture investors over the term sheet or the definitive investment documents, it is often beneficial for both the company and the venture investors to resolve the dispute through confidential binding arbitration (and not through public litigation).
Here is a sample arbitration provision for the term sheet:
“Arbitration. Any controversy, dispute, or claim arising out of or relating to this term sheet or the definitive investment documents of the parties shall be settled solely and exclusively by confidential binding arbitration in accordance with the commercial arbitration rules of JAMS, in existence at the time of the commencement of the arbitration, before one arbitrator. The arbitration shall be conducted in [City], [State]. Each party shall bear its own attorneys’ fees. Each party shall bear one-half of the arbitration fees and costs incurred through JAMS. The arbitrator shall not have the right to award punitive damages or speculative damages to either party and shall not have the power to amend this Agreement. The arbitrator shall be required to follow applicable law.”
22. Confidentiality and Invention Assignment Agreements
The term sheet will likely provide that all past, present, and future employees and consultants are subject to a Confidentiality and Invention Assignment Agreement. The purpose of this Agreement is twofold: (i) to obligate the employee or consultant to keep all confidential information of the company confidential and (ii) to ensure that any intellectual property developed by the employee or consultant will be deemed solely owned by the company.
This obligation in the term sheet is non-controversial (although it sometimes turns up in diligence that past employees or consultants who have developed key intellectual property have not signed these agreements, and that can cause significant investor concern).
23. Expenses of the Venture Investors
Term sheets will typically include a commitment from the company to reimburse the reasonable legal fees of the investors plus any due diligence or out of pocket costs incurred, payable at the closing of the transaction. This obligation is typically “capped” at a specific dollar amount, but if the deal takes longer or requires more legal work than was expected, the cap is often revised to take that into account.
24. Due Diligence by the Venture Investors
Entrepreneurs should anticipate that the venture investors will perform significant due diligence before they consummate an investment. Some of this will be done by the VCs, and some by lawyers for the VCs.
The types of diligence will include:
- Review of financial statements
- Review of financial projections and reasonableness of underlying assumptions
- Review of corporate charter, bylaws, minutes, and other corporate records
- Review of material contracts
- Review of any “related party” transactions (transactions with officers, shareholders, or directors or their affiliates)
- Review of any litigation or claims
- Review of key intellectual property
- Review of litigation, bankruptcy, or governmental proceedings involving any of the founders
- Reference checks on the founders
- Checks on social media posts of the founders
- Review of any harassment, misconduct, or discrimination claims involving any of the founders
- The capitalization structure of the company and any prior investment agreements
- Competitor analysis
- Comfort as to ownership by the company of the proprietary rights to the company’s key product and the company’s ability to protect its rights
- Confirmation that appropriate Confidentiality and Invention Assignment Agreements have been signed by all employees and consultants
Due Diligence Checklists are available online that go into greater detail.
Venture capital financing can be crucial to the success of a startup. By understanding the key issues in venture financings, entrepreneurs can increase the likelihood of a successful outcome.
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Copyright © by Richard D. Harroch. All Rights Reserved
Mike Sullivan is a partner and head of the Corporate Group in the San Francisco office of Orrick, Herrington & Sutcliffe. He focuses on representing emerging companies, entrepreneurs and angels/venture capital funds. Mike has led hundreds of financings and M&A transactions for emerging companies in a wide variety of industries, particularly in the software, satellite/space, mobile, digital media, cleantech and food/wine/spirits sectors. Mike is a contributor to Venture Capital and Public Offering Negotiation (Aspen Law & Business).
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on investing in Internet and digital media companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He was also a corporate partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, strategic alliances, and venture capital. Richard can be reached through LinkedIn.