BASICS OF VENTURE CAPITAL

 

What is venture capital financing?

Venture capital financing is financing done by institutionalized investors (venture capitalists) that purchase equity in early stage companies with the expectation of high growth in the value of the company. 

Do I need a pitch deck?

A lot of investors I know don't care for a pitch deck, but a lot do. Regardless, you should have one because SOME investors or groups will want one and you should always be ready. Even if you never show any one, it actually helps you in how you think about your own project. 

What is the difference between private equity and venture capital?

Private equity is an asset class that refers to investments and debt in private companies. Venture capital is a type of private equity where the companies are younger and often risky. Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buy-out and mezzanine investing focus on investing in more mature companies. Venture capitalists also invest cash for equity. Unlike buy-out professionals, venture capitalists do not use leverage in their transactions.

What is the single biggest mistake people make in a VC deal? 

Thinking of investors as enemies.

At the same time, investors are not your friends either. They are people working together with you with a common goal. 

If you think the investors are enemies, don't get investments from them. The best companies I've seen are ones where investors and founders know that at the end of the day they are on the same team and work hard to achieve a common goal. This doesn't mean to be a pushover when it comes to dealing with your investors. Know your place and you'll be fine. 

How big does my company need to be in order to get venture capital financing?

Not very. Venture capital is for early stage companies. A good indication is what your company has already achieved financing-wise. A Series A round will usually raise about $1M. If you've raised a bit less than that from angel investors then your startup might be big enough for a Series A round. If you haven't raised anything at all, then your company is not big enough. 

Is it hard to get financing?

If your company has some or all of the qualities listed below, then no it's not hard. If your company doesn't have these qualities, then yes it is hard.

Here is what investors are looking for:

- company revenue projections that are substantial and believable; and/or
- the company is able to potentially reach a large market; and/or
- the founders/the management team is skilled and experienced

How does an investment help my company?

An investment gives your company fuel to help it grow e.g. hire more employees, fuel marketing expenses, aid in research and development. 

What is a Series A round?

A Series A round is a type of financing round. It is usually in the form of an equity purchase of around $1M by investors and takes place after the company has done a seed round (a type of early stage financing that gets the company off its feet.)  

"Series A" is just a name. It can be called Series 1 or anything else. After a Series A round, the company can do more rounds as necessary--Series B, Series C, etc. 

When is the right time to do a Series A financing?  

When your business plan calls for it.

This can be any time after you've already done a seed round that takes the shape of a convertible note or a series seed priced round. Typically those rounds will be for less than $1M. 

What are the downsides of venture capital financing?

You as a founder will get diluted. This means that you will own less of a percentage of the company than before. If you own 100% of a company and someone buys 50% of the company, then you will each own 50% of the company. You got diluted from 100% to 50%. Another downside for founders with outside investments is that you lose some element of control. You'll have to listen to what your investors are saying, you have to go to them for certain permissions, etc. 

Depending on how you do the deal, there can be other downsides as well. 

What are the upsides?

A number of investors are experienced and can offer valuable advice about how to run and grow a company. The investment amount can be instrumental in growing the company. 

I always tell my clients to look at not just the money that the investors can offer. Look at other factors: what can they offer beyond the money? What kinds of connections can they make for you? What kinds of markets do they open up? 

How can I make sure that the deal is good for my company?

Be ready to work together with your venture capitalist 

VENTURE CAPITAL INVESTORS

Who are these investors?

Wealthy individuals, groups of wealthy individuals, former entrepreneurs, people with experience in the industry, etc. 

The important thing is that these investors are what are known as accredited investors. Read Phase 3A: Financing--Fundamental Concepts for more information on that. 

What's in it for investors?

Investors are able to or they want to make money by buying shares of your company for a low price and then selling for a high price later. They can sell their shares in an exit such as an acquisition or similar. 

Where can I find investors?

Investors are everywhere. It is your job to find them. Go to events. Talk to people. See what's out there. It's a test of your own mettle to be able to find investors. 

How is a deal structured? 

A company's ownership is comprised of individual stock. The basic type of stock is common stock--of which, depending on the setup--there can be hundreds of, thousands of, millions of. Founders, employees, and a few others receive this basic common stock. The investors on the other hand purchase convertible preferred stock of the company. This type of stock has certain protections and rights above the common stock. For example, in a liquidation of the company, the preferred stock holders would receive liquidation proceeds before the common stock holders. The reason why the investors get this type of special stock is because: (1) they are putting in the money so they have the ability to say what they want; (2) for stock pricing purposes (discussed elsewhere on this site). 

Most financing deals are structured as equity priced rounds. This means that the investors will buy some amount of the company based on how much your company is worth. They will settle on a valuation of the company with you. Use that to determine how much a share of the company costs. Depending on how much they want to buy or invest, they'll purchase a certain percent of the company. 

Overly simplified example: Company Z has 1,000,000 shares of common stock that is held by the founders. Investor Y determines that it wants to invest in the company so it buys 200,000 shares of preferred stock. These are additional shares in reserve that Company Z has. Common stock holder owns 83% of the company. Investor Y owns 17% of the company. Investor Y also gets certain protections and voting rights, etc. that the others do not have. 

Investor Y will not receive returns on their investment until they can sell their shares of the company typically in an exit such as when the company gets acquired by a larger company. 

What is the difference between the different stock types?

Basic ideas

(a) You will not see all types of stock in all companies. Some companies only have common stock. Some have common and preferred. Some have multiple classes of common, multiple classes of preferred. At formation of the company, the usual setup just has common. And when a priced round financing is done such as a Series Seed Round or a Series A, then preferred stock gets authorized and comes into the picture. 

(b) Also, there may be multiple types of common stock or preferred stock. This means that within the subcategory of preferred or common that these stock have certain rights above others. It all depends on how the stock is defined in certain agreements. 

(c) In the event of a liquidation, there is a certain order that liquidation proceeds get paid out. It first goes to debt holders of the company. Loans, debts, etc. of the company have to be paid back first. Then preferred stockholders get their cut. Then common stock holders. 

Common Stock

This is your basic, bare-bones stock (representing ownership) of the common. It's what founders, employees, consultants of the company receive. In the event of a liquidation of the company, these common stockholders will receive assets of the company depending on what percentage of common stock they hold after debt of the company has been paid back to the debt-holders of the company and after any proceeds have been paid to the preferred stockholders as necessary. Common stock holders do get certain, minimal rights as dictated by state corporate law. 

Preferred Stock

Preferred stock has rights above and beyond that of common stock. This type of stock gets issued to investors in a financing deal. It has special voting rights, veto rights, and other privileges. It also has a liquidation preference. This means that in an event of liquidation, it has the right to receive certain amount of funds before funds are distributed to common stockholders. Note that debt holders are still paid out first. Preferred stock in the startup context is also convertible. This means that it can convert into common stock when the preferred stockholder wishes and it automatically converts at certain times as well. Preferred stock votes on company matters on an as-converted basis. 

Other types of stock

There are other types of stock that you may come across. For the most part you don't need to worry about them. These stock are more or less the same type of thing, just with different rights and privileges. For example Class F common stock is a type of souped up common stock that is favorable for founders. It has greater voting power than regular common stock. Another example is Series FF. This is similar to common stock except it can convert into a type of preferred stock during a financing and is sold to investors (this provides some money to the Series FF holder.) 

Don't get stuck on these types of rarer stock. The more important thing is to realize that there are certain types of stock that get privileges above other common stock. Keep your eye on regular plain ol' common and preferred. 

 

Can founders get preferred stock? 

Can they? Yes. However, when first forming the company, founders don't receive preferred stock. Founders will have common stock. Investors will have preferred stock. 

How do I know if I got a good deal? 

Two things. If the investors are people you can't work with, it's automatically a bad deal. 

Second, if it's a reasonable deal, then it's a good deal. If it's an unreasonable deal, then it's a bad deal.

Look at the table of terms and focus on the terms marked important. If your deal terms fall under what is reasonable in these important categories, then you are fine.  

What is the timeline for an investment? 

This varies greatly depending on the parties and their relationship. Some times its can be extremely quick. Sometimes it can take a number of months. Negotiations for the term sheet spelling out the major points of the investment can take a number of weeks. After the term sheet is signed due diligence (where the parties make sure that everything is in order) and the drafting of documents takes another few weeks. 

How does an investment take place?

The investors generally know how much money they can invest and/or how much of a company they want to buy. The investors working with the entrepreneurs determine a valuation of the company. This valuation is based on a number of factors including: company personnel, the industry, the revenue of the company, etc. Doing a valuation of a company is an inexact science. 

After that they use the following formula to determine share price: 

Price = pre-money valuation / number of fully diluted shares

Pre-money valuation means the value of the company without taking into consideration the to-be investment amount. Number of fully diluted shares is all the shares of the company issued and outstanding (when taken into account certain factors such as conversion.) They use this formula to determine the price of a share. 

Example: investor wants to potentially invest $1M into the company. The valuation of the company is $4M. There are 1,000,000 shares.

Price = $4,000,000 / $1,000,000

Price = $4

$1,000,000 will buy 250,000 shares for the investor. 

For more examples look at the article on this site entitled Startup Math.

Are there any securities law consequences?

Yes. Stock of a company is a type of security and thus securities laws and regulations come into play. The most important thing for you to know regarding securities regulation and financing is who you can issue stock to. 

The investors in your company must be accredited investors. In a nutshell this means that they must have certain levels of income/assets. Look at Phase 3A: Financing--Fundamental Concepts if you need more guidance on this point. 

What documents do I need?

What is dilution and how to protect from that?

Dilution means that you will own less of a percentage of the company than before. If you own 100% of a company and someone buys 50% of the company, then you will each own 50% of the company. You got diluted from 100% to 50%. The amount of shares you own does not change. If you own 2,500 shares of the company (and you are the only shareholder) and then someone comes and buys 7,500 shares from the company, that does not mean the number of shares you own changes. It just means the percentage of shares of the company overall that you have goes down. In this case it went down from 100% (you own 2,500 shares; everyone else 0) to 25% (you own 2,500 shares, everyone else 7,500) 

Other:

Fees for an Investment Deal - alludes to attached cap table
Finder’s Fee - Many VC funds have fee structures with what might be seen as “high“ management fees because they deal with high-risk levels, legal costs, fund creation fees, and other factors. With these factors absorbing most of the management fee, a VC fund must rely on carried interest to see real revenue.