Most start-up and early-stage companies need financing to succeed. A major challenge is that these businesses often cannot or may not want to obtain traditional bank loans. As a result, they must turn to other methods of raising money, including venture capital. Such funding can be complicated and is often subject to federal and state law requirements. As such, companies and investors should obtain experienced legal advice regarding when and how to use venture capital financing.
What Is Venture Capital?
Venture capital is a form of financing by investors into companies, the vast majority of which are startups. It is typically for businesses that can demonstrate strong potential to grow rapidly and in the long-term. Typically, investors are looking for short and longer-term gains and often provide business guidance to companies in addition to funding, in order to maximize their returns. Transactions may be structured in different ways, but investors usually take an equity interest in the company by purchasing preferred stock, which can be later converted into common stock. Investors can be individuals, private companies, insurance companies, pension funds and foreign government-controlled investment funds.
How Should Investors Conduct a Due Diligence Check?
It is important for investors to verify certain information about the company prior to investing. An attorney should review documents related to the company’s formation, operations and corporate governance; assess its financial situation; ensure compliance with any laws; and evaluate any potential liabilities. Additionally, investors should obtain information on the management team and the business and marketing plans.
What Should Be Included in a Venture Capital Financing Contract?
Venture capital financing contracts vary but typically incorporate certain documents. These include a Term Sheet, Stock Purchase Agreement, Investor Rights Agreement, Voting Agreement and Certificate of Incorporation (as amended), among others.
There are several key terms in these documents which should be carefully drafted and reviewed by counsel. These include:
- Right of first refusal and other restrictions on transfer. The company and/or investors may have a right of first refusal before the stock can be sold to third parties. This would be among other clauses restricting certain transfers of stock or other forms of equity interest in the company.
- Right of redemption. An investor may have the right to demand that the company repurchase shares at a designated price in the event certain circumstances occur.
- Anti-dilution protection. Existing investors may be protected from dilution of the value of their shares in future rounds of financing.
- Key Person Clause. Investors may want to require that key executives/employees remain with the company in order to protect their investment.
- Restrictive covenants. The company may be prohibited from taking certain actions without approval, such as selling certain assets, paying dividends or issuing shares.
- Rules regarding major corporate transactions. The contract may outline rules regarding approval of mergers, acquisitions and other transactions and treatment of investor shares in those circumstances.
How Are Valuations Determined?
The valuation of the company has a significant impact on how much equity investors will get in exchange for their investment. The value must be determined before the company receives the next round of financing (pre-money valuation) and after receiving the capital (post-money valuation).
Pre-money valuation is determined by looking at several factors, such as cash-flow, revenue and comparisons to similar companies. However, this is the starting point as the parties will negotiate what methodology to use. Good legal guidance, as well as the assistance of a valuation firm is important in setting the pre-money valuation.
Post-money valuation typically utilizes one of two methods. The first one simply adds the amount invested to the pre-money valuation of the company. The second divides the investment amount by the number of shares received for that investment to determine a per share valuation, which is then multiplied by the number of total issued shares post-investment.
Convertible notes are a method of financing that is structured as a loan but can be converted to an equity interest in a later round of funding. These are used for companies where it is very difficult to determine a pre-money valuation. Investors in convertible notes receive assurances or warranties because of the risks involved in such financing. Note holders can often choose a cash payout option, if for whatever reason they are not interested in converting their equity interest when the time comes, or it ends up being required (i.e. in a change of control circumstance).
What Is a Leveraged Buyout?
Leveraged buyouts use borrowed money to acquire other companies. The acquired company’s profits are then used to pay off the loan. This type of transaction allows the acquiring company to avoid adverse effects on their existing business because they are not committing their own funds to the purchase. However, there are also risks to investors including a downgraded credit rating and poor performance by the acquired company.
What Is Recapitalization?
Recapitalization occurs when a business restructures its debt and equity ratio. The company exchanges one form of financing for another, such as obtaining new capital by adding more debt or equity. This may be done for a variety of reasons, including to change the value of stock before selling, reduce the level of debt and interest payments, stabilize the company’s finances, or as part of an exit strategy for owners/investors.
How Can Companies Get Venture Capital Financing?
Companies should lay a strong foundation for venture capital financing by getting legal advice regarding properly setting up their business and ensuring they comply with all laws. They also need a sound business plan, a strong management team, and experienced business, financial and legal advisors. Before seeking investors, companies should be able to demonstrate some successes and potential for a return on investment immediately as well as over the long term. They should also research investors to find ones that will be a valuable resource as the company grows to maximize the benefits on both sides.
Early-stage companies and investors can reap substantial rewards from venture capital financing. However, these transactions are complex and have substantial risks. Consulting experienced legal counsel can help ensure that the parties make well-informed decisions and structure the deal to comply with all applicable laws.
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