Winter 2013 Article
VENTURE CAPITAL FINANCING IN THE UNITED STATES: A LEGAL PERSPECTIVE (Summary)
Venture capital financing (VC) has been one of the main engines of the United States economy, and has substantially contributed to bringing the American economy to the current levels. The majority of companies that have achieved visibility and success over the past 20 years, especially in innovative fields, have obtained venture capital financing.
The legal structures that make up this phenomenon are guided by strict rules which are sometimes difficult for outsiders to understand. This article intends to provide non-U.S. entrepreneurs some introductory tools to understand - and perhaps take advantage of - this unique tool.
Foreign companies do not usually have access to VC financing in the United States. While it is normal that the founders of startups in this country be foreign-born persons, VC's do not normally invest in startups that are not incorporated in the United States. Indeed, American investors are not open to accept the rigid legal structures of corporations of other countries. Consider for example the obligation to replenish capital losses, a phenomenon common in certain European legislations that contradicts the logic of the typical startup, for which losses are unavoidable. More generally, venture capital players have developed and tested over time predictable legal structures. Departing from them is usually avoided because it would increase the VC investment risk.
The venture capital financing industry has developed a highly efficient machine to identify ideas and teams in which to invest. Being able to come into contact with the VC is not difficult, but requires thorough preparation. The need to develop an "elevator pitch" has become a part of Silicon Valley's myths, and signifies the importance of engaging the attention of the potential investor and communicating the value proposition of the project in a very short time.
The various stages of financing
The typical startup financing normally occurs in stages. The first stage consists of self funding from the founders ("bootstrapping"), who usually subscribe to shares of common stock for a nominal subscription price. The second stage of financing, also usually in the form of issuance of shares of common stock, is normally made up of friends and family, to be followed by angels - individuals who often have accumulated their wealth through similar investments.
The initial funding phase is not without risks. In the United States it is illegal for companies to issue securities unless the securities are registered with the appropriate regulatory authorities, or an exemption applies. It is important that all requirements to avail of the exemption be respected at the State and Federal level. Furthermore, tax problems for the founders could arise, since they could be subject to taxes on the difference between the price paid for their shares and the highest price paid by subsequent investors, if the different valuation is not supported adequately (e.g. due to the development of a business plan, progress in research and development, hiring of strategic personnel, etc.). As soon as the company seeks external financing, these first steps will be subject to a rigorous examination, and any irregularities could cause delays.
Financing of "angel investors" is often made through convertible promissory notes. The advantages are many: negotiation times are reduced, and most importantly, the company does not have to provide a valuation which, at this early stage, would necessarily be very low. The notes are usually convertible into shares of the next round of financing, at a value that will be determined at the time of such next round, and often include a substantial discount in the form of warrants (securities that give the holders the right to purchase shares from the issuer at a specific price within a certain time frame).
The Business Plan
The first step to approaching VC's is to develop a credible and professional business plan. The importance of the business plan cannot be overstated. A business plan helps the company set goals and identify the way forward for achieving them, and as such is an important tool for the entrepreneur to evaluate its goals and strategies. But more importantly, it is the way the founders can establish their credibility with potential lenders.
To approach the right VC the startup should collect information on various VC funds to assess their experience, reputation and interests. In fact, funds specialize in particular areas and may have particular preferences in relation to the size of the investment, the industry, the stage of development of the company, etc. In this phase, the company could be approached by so-called "finders", who in exchange for introductions to VC demand a percentage of the investment. The VC's do not look favorably upon this type of brokering and prefer putting "money to work" in the startup rather than enriching people not directly interested in the company's growth. Also if the finder is not registered as an investment broker, penalties could apply and the investors could even rescind their investment.
If the VC decides to proceed with the examination of the company a due diligence ensues. A high standard of disclosure must also be maintained in the early stage of the negotiations, in order to avoid affecting the valuation of the company if issues emerge at a later stage. Moreover, the securities laws anti-fraud provisions apply.
The shares issued to VC's are normally preferred shares, expressed in Series (A, B, etc.), with different valuations and terms reflecting the development stage of the company. The choice of preferred instead of common stock is due to various reasons. First, the preferred shares provide investors with a preferential treatment, thereby offering a higher return to risk capital. Second, the privileged treatment of preferred shares allows a higher valuation per share (normally 5-7 times higher) than the shares of common stock. If the company sold to investors the same shares at a price considerably higher than the subscription price of the founders, the founders would be subject to ordinary income tax on the difference between the price paid and the higher issue price. In addition, the company can offer to its employees and consultants options (options) to purchase shares at a price (which must be equal to the market value) lower than the value of the preferred shares, thereby allowing the company to attract and motivate qualified employees.
The first document, which summarizes the essential terms of the investment is the term sheet. The typical term sheet is not binding, except with respect to the obligation of confidentiality and the "no shop" clause, i.e. the exclusivity clause preventing the company, once a term sheet is signed, from negotiating with other potential investors for a certain period (typically, 2-3 months). The negotiations should be conducted with the assistance of a lawyer who has specific experience with this field, and the founders should become familiar with the typical structures of these investments. In addition, the conditions of the first round often affect subsequent financing rounds, and hence their importance goes far beyond the specific funding.
It is important to become familiar with the fundamental concepts typically contained in a term sheet, which include:
- The Company's Valuation, Price, Percentage: The typical term sheet specifies the "pre-money" valuation of the company. It is important to understand the effect that the pool of options reserved for employees and consultants, which is usually required by VC to ensure incentives to employees, has on the valuation of the founders' shares. A typical term sheet provision is "The $____ pre-money valuation includes an option pool equal to 20%of the post-financing fully diluted capitalization". The consequence of this provision is that the pool of options will only dilute the founders, and not the VC. This is also usually non-negotiable, and the only remedy is to develop a gradual hiring plan (and related option grants).
- Dividends: Normally investors in companies in this stage of development do not have expectation of dividend distributions. However, the preferential treatment of preferred shares has an important practical implication, because dividends are normally distributed to investors in case of liquidation or deemed liquidation. Formulas to determine the amount of dividends vary, and include cumulative dividend (payment of a certain percentage dividend that accumulates over time, whether or not the company approves dividends); non-cumulative dividend (payment of a certain percentage dividend that accumulates over time only if the company declares dividends). In addition, dividends to ordinary shareholders will normally only be paid after the preferred shareholders have received dividends in an amount equal to at least a certain percentage of the initial investment. Sometimes subsequent payments to holders of shares of preferred shares are made pari passu with common stock, on an as-converted basis, or up to a maximum limit.
- Liquidation Preferences: A liquidation preference is the sum due to the preferred shareholders in the event of liquidation of the company, and usually refers to a sum equal to the amount originally invested, or a multiple thereof; the remainder is then distributed to common stock holders or to common and preferred shareholders together. A sale of the company or the sale of all assets of the company is normally regarded as a liquidation (deemed liquidation). Note that it may be advantageous for the preferred shareholders to convert into shares of common stock in order to participate to distributions together with holders of common stock.
- Repurchase: In some cases, infrequent except in "down rounds" cases, preferred shares can be redeemed, and the company can be forced to buy back the shares (mandatory redemption). This allows the VC's to exit an investment if the company obtains "good enough" results but does not expect to have a liquidation event such as an acquisition. Sometimes it is provided that the company may force the repurchase the shares at the original price, plus dividends.
- Protective Provisions: Typically term sheets provide that certain acts may be adopted only with the consent of the preferred shareholders. Votes can be cast separately (voting as a class or a series) or in combination with the common stockholders ("on an as-converted basis"). It is common practice that preferred shareholders can elect a minimum number of directors. The voting rights may shift as a result of a default (voting switch).
- Conversion: Preferred shares are always convertible into shares of common stock, but if converted the preferred shares lose every privilege. Conversion can be optional (the preferred shareholder may convert at any time) or automatic. The conversion is normally required in case of a public offer at predetermined minimum values and prices (qualified IPO), dissolution of the company, and may be exercised in case of events such as a sale of the company (deemed liquidation), or upon the approval of a majority of the preferred shareholders. The conversion ratio is initially 1-1, but is modified as a consequence of the anti-dilution provisions.
- Anti-dilution: Anti-dilution protection does not take place automatically, by issuing new shares to maintain the original percentage, but through a price adjustment when the shares are converted. Anti-dilution mechanisms can be "event based", in case of stock splits, stock dividends or similar events, or "price-based", in case of issuance of shares at a lower price per share. Exclusions are negotiated to allow the company to issue shares in special cases without triggering the anti-dilution provision (for example, options to employees, or issuance in connection with strategic agreements). Another important provision is the "pay to play", according to which the investor must continue to "pay" (i.e. to participate pro-rata in future rounds of financing) to be able to play (not to lose anti-dilution protections, or be converted to common stock). Anti-dilution mechanisms can be very costly for the company. In the anti-dilution "full ratchet", if the company issues shares at a lower price, the investor has the right to receive as many shares as would have been issued if the same price had been available, regardless of the actual dilution or the number of shares sold at a lower price. More common, and less costly for the company, is the "weighted average" anti-dilution, whereby the dilutive effect of the emission at a lower price is weighted based on the number of shares issued. This can be on a broad basis, which takes into account shares issued under equity plans for employees, warrants, shares issued to strategic alliances, or similar) or narrow basis, less favorable to the company, which excludes similar issuances. These clauses are usually heavily negotiated.
- Vesting: One aspect that often the founders do not consider is that the VC's often require that the founders' shares be subject to vesting. Typically when the company grants options to its employees the options are subject to vesting. For example, after the first year of employment a quarter of the options become exercisable (vests), and the remaining options mature each month for the subsequent three-year period, provided that the employee continues working for the company, thereby incentivizing the employees and motivating them to remain with the company. VC's require a similar protection from the founders: Their shares, although already issued, are retroactively subject to vesting. This protects the founders who remain on board against the founders who leave the company at an earlier stage. Often a liquidity event triggers accelerated vesting.
- Registration rights: These clauses will require the company to register the VC shares in the case of a "qualifying initial public offer" (public offer of shares at a minimum price and a minimum total offering).
- Co-sale, Tag Along, Drag Along: These clauses provide that the founders will be required to sell their shares if the VC's decide to sell their shares; conversely, if the founders were to sell their shares, these clauses would require the VC's to also offer their shares for sale.
- Other provisions include indemnification obligation, the right to information on the business of the company, and the company's payment of the investors' legal fees up to a fixed maximum amount.
The execution of the term sheet is only the first step in a process that includes the company's due diligence on the part of the VC, the preparation and negotiation of contracts and documents, the preparation of closing deliveries (i.e. of schedules that contain exceptions to the representations and warranties in relation to the company), as well as opinions, third parties' consents, etc.
The process of obtaining VC financing is complex and inevitably involves loss of control by the founders; however, the support, experience and contacts brought by the VC often allow the company to make a leap of quality that would otherwise be unthinkable.
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