The following is an excerpt of Chapter 2 of the forthcoming Second Edition of Sheehan Phinney Bass + Green's booklet "Raising Capital for the Emerging Business." Excerpts of the other chapters of the booklet will appear in future editions of Good Company. Hard copies of the full booklet will be available by request to info@sheehan.com and the booklet will also be available through the Firm's website at www.sheehan.com.
Once an emerging business has developed and commenced marketing a product, and if that product has the potential to achieve rapid growth in revenues and profits, managers will often seek a professional venture capital investment in order to fuel that growth. Venture capital funds are typically organized to infuse substantial amounts of capital into an emerging business with exciting growth prospects, to help manage that growth, and to position the business for an initial public offering or a sale at an advantageous value. But while a typical venture capital investment can benefit many types of emerging businesses, it may or may not be right for any particular business. For example, the demands that venture capital investors make on a business may be excessive or inappropriate for a business with good, but not explosive, growth prospects. Also, venture capitalists are typically very assertive about their opinions and rights, and may be quick to dismiss managers who they perceive as not focused on their goals. Managers of an emerging business should carefully consider their willingness and ability to work very closely with demanding venture capitalists.
Who are the Venture Capitalists?
Unlike angel investors, venture capitalists typically manage money raised from others, chiefly institutional investors, like pension and hedge funds, and high net worth individuals. As a result, venture capitalists take a much more instrumental view of an investment in an emerging business. They typically aim to provide overall returns to their investors in the range of 30-50% and to return their capital to investors between 5 and 10 years after the inception of a fund. In order to offset the many investments which the venture capitalists expect will ultimately fail or prove marginal, they expect to realize very high returns from their investments that prove successful.
Approaching Venture Capitalists
Before making first contact with a venture capitalist, a manager of an emerging business should make sure that he or she is making the right proposition to the investor. A venture capitalist will immediately assess the strength and track record of the management team, which should be fully identified and committed to the business. The venture capitalist will also immediately want to review a well thought-through business plan, which shows how he or she can achieve high returns in a liquidity event in a 3-5 year time horizon. The business plan should make clear how the emerging business already has and expects to exploit a highly-profitable product or service in a way that other businesses will not be able to challenge or replicate. The business plan should provide a comprehensive vision of how the business will grow, and it should be specific enough to convince the venture capitalist that the plan is achievable. If the manager is not able to present these elements, then he or she is well-advised to defer contacting a venture capitalist. Venture capitalists are typically flooded with business plans, and a misstep could easily ruin the venture capitalist's initial impression of the emerging business. Perhaps even more than in the rest of life, first impressions with venture capitalists are all-important.
Timing a Venture Capital Investment
Ideally, the managers of an emerging business should always look well into the future regarding the company's needs for capital. The process of lining up a venture capital investment is often quite long—many months—and the consequences of running out of funds at a critical stage in the company's development are obviously dire. What is more, some venture capitalists will, consciously or not, offer less attractive investment terms to an emerging business that they know has few alternatives and urgently needs funds. Management should work to close the venture capital investment well in advance of depleting the company's funds.
The Due Diligence Process
In these times, the due diligence process which is followed by most venture capitalists, incorporates a number of phases over several months. If he or she has a positive impression, the next step may be to talk to others in the industry or outside experts, to assess the prospects for successfully realizing the business plan. If indications are positive, and if the emerging business is lucky, the venture capitalist may offer a term sheet representing its investment proposal.
After a term sheet has been agreed-to, the venture capitalist will typically involve its lawyers in the due diligence process, who will conduct a thorough review of the emerging business' capital structure, corporate records, agreements, intellectual property rights, litigation risks, and any other relevant information. This process will typically run for several weeks, while the lawyers also prepare investment documents.
Managers of an emerging business should respond to due diligence inquiries with a maximum degree of candor. Although venture capitalists want to hear that the emerging business is highly likely to be successful, they will almost always become aware of bad news if it exists. We believe it is far better to be candid about bad news early in the due diligence process rather than later, since bad news which is surfaced late in the process can lead to a renegotiation of the deal or its abandonment.
Investment Terms
The terms under which a venture capital investor makes its investment are vitally important, even if they appear couched in "legalese." Many of the terms go directly to the heart of how the business will be managed, whether management can be dismissed and whether and how much of the proceeds of a sale of the emerging business the managers and existing investors will be able to keep. However, in most cases, the scope for negotiating investment terms is quite limited. If an emerging business has several venture capital firms interested in it, then it may be able to play one off against another to improve the terms on offer. Outside of that type of situation, the emerging business may only have the power to nibble around the edges of the terms offered. Perhaps the most important tool that the managers of an emerging business have to negotiate investment terms is a spreadsheet showing the pro forma distribution of proceeds after a potential sale of the company at several price levels. If the mangers can show the venture capitalists that they have little practical economic reward except in the case of a runaway success of the company, they may be able to argue that the venture capitalist should scale back some of its economic rights.
The discussion about investment terms usually begins with a consideration of how much capital the emerging business needs to raise the business to the next level of success. Once this figure has been determined, the venture capitalist will apply its expected rate of return over a period of years until an expected liquidity event and arrive at a targeted value of its stake in the company. The rate of return will frequently exceed 30 or 40%, to compensate the venture capitalist for the risk borne during the life of the investment. The percentage interest in the company upon making the investment will usually correspond with the percentage interest in the company as of the time of the expected liquidity event necessary to yield the desired rate of return.
Venture capitalists almost always take a class of stock known as preferred stock. In fact, preferred stock is a defining characteristic of venture capitalists. Debt instruments are generally the tools of mezzanine investors, who generally invest in different types of companies than venture capitalists. Occasionally, an investor calling him- or herself a venture capitalist will offer to invest through a debt instrument, but such an investment should be approached with caution by the emerging business. While debt capital will pay the bills as well as equity capital, it is usually unrealistic for an emerging company to be able to service debt in the amounts that are proposed as investment capital. Outside of bridge loan situations, debt instruments should be avoided by emerging businesses.
Preferred stock derives its name from the priority return (also known as a preference) that its holders have to the proceeds in any liquidity event, particularly a sale of the company. Preferred stock holders will typically be entitled to receive the amount invested, increased by the specified percentage rate of interest, before common stock holders are entitled to receive any of the proceeds. Preferred stock is almost invariably bundled with some other instrument or right which entitles the venture capitalist to participate in the upside potential of the sale proceeds. For example, the preferred stock may be convertible into common stock at a specified price, or the preferred stock may be automatically entitled to share in the proceeds otherwise available to the common stock holders without the necessity of conversion.[1] Venture capitalists will often ask for common stock warrants in lieu of or in addition to any such conversion privilege, to further enhance their potential return.
In order to protect their preferred stock rights and to impose controls on management of the emerging business, venture capitalists will invariably insist on a set of "blocking" rights. That is, the charter and shareholder agreement provisions will include various items the adoption of which requires the venture capitalists' consent. These blocking rights will depend on the venture capitalist's style and the emerging business' characteristics and may include the right to block management compensation above specified levels, the payment of dividends, transactions with insiders, and extraordinary transactions, such as acquisitions and mergers. Often, venture capitalists will ask for the right to take an enhanced role in management in the event of negative operating results, such as additional board seats and the power to veto specific management decisions. Although these blocking rights may seem onerous to management of an emerging business, they are almost always a part of taking a venture capital investment.
Exit Strategies and Realities
Venture capitalists will seldom invest in an emerging business without a plausible exit strategy, which is usually a sale to another company or occasionally an initial public offering.[2] Venture capital funds, like other investment funds, feel a strong need to show a tangible return for their investors. Most venture capitalists in these times will plan to exit an investment in an emerging business in three to five years. Because no organized market exists to buy the shares of private companies, and because securities law restrictions generally prohibit the resale of privately placed securities unless a specific exemption is available under the securities laws,[3] the venture capitalist's exit strategy is typically very pointed with respect to the emerging business. That is, the venture capitalist will ask for rights under the charter and/or the stockholder agreement to either cause the company to redeem his or her shares after a specified period at an agreed-upon price, or to compel the company to sell itself under certain circumstances. Often, this type of arrangement is contained in a stockholder agreement, under the provisions of which the venture capital investors have the right to cause other parties to the agreement to sell their shares to a third party along with the venture capital investors. This type of arrangement is known as a "drag-along." The venture capitalist's goal is often not to actually exercise these rights, since the emerging business might not have ready access to sufficient cash and might not be able to advantageously sell itself at a time preferable to the venture capitalist, but instead to incent the managers of the emerging business to be on the lookout for potential transactions. These liquidation provisions should be negotiated with extreme caution by management because they so directly affect the ownership and investment return of all other investors.
The Role of Counsel
While venture capital investment terms have undergone a degree of standardization over the last decade, it is still essential for an emerging business to retain experienced counsel to guide it through the many legal and business issues involved in a venture capital investment. Counsel can help an emerging business position itself for such an investment by cleaning up charter documents and shareholder agreements, negotiate the investment terms that may be negotiable, obtain approval of existing shareholders to the venture capital investment, prepare disclosure documents for the investment and close the investment in an efficient and timely manner. Experienced counsel can also provide valuable advice to the manager of an emerging business on how some issues with the investment terms are likely to play-out over time and impact the parties' long-term interests.
[1] Preferred stock which is entitled to a preferred return plus a share of the residual proceeds available to the common stock holders is known as "double-dip" preferred.
[2] Viewed in a historical context, the large number of early-stage and mid-stage companies which were able to go public in the late 1990s must be considered an aberration. Although many of these companies' stock prices rose dramatically in the immediate aftermath of their IPO, the longer-term performance of many of those stocks has been disappointing. After various regulatory investigations and private litigation, it is now clear that much of the investor demand that drove many "hot" IPOs was artificially induced by questionable analyst reports, broker manipulation and day-trader exuberance. The author is of the view that the various factors which fueled the IPO boom are unlikely to recur, at least to the same degree, due to various regulatory changes and other reforms.
[3]Under SEC Rule 144, privately-placed securities may be freely resold without legal restrictions after a two-year holding period. However, since the venture capital investor will typically qualify as an "affiliate" for securities law purposes, it may have an independent duty to register any resale of securities, even after the Rule 144 holding period has expired.
|
