Venture Capital Financing Issues Explained

This excellent and comprehensive article [from White & Lee, LLP] provides a detailed overview of the process and issues that arise in venture capital financings - typically for technology-based emerging growth companies. For more on this topic from the venture capitalist point of view, see this great series of articles from Brad Feld.

The principle issues discussed in the White & Lee article include the following:

1. Creation of the Securities.
2. Liquidation Preference.
3. Dividend Rights
4. Redemption Rights.
5. Conversion Rights.
6. Antidilution Protection.
7. Investor Protective Rights
8. Board Seats
9. Representations and Warranties
10. Registration Rights
11. Preemptive Rights of First Refusal
12. Co-Sale Rights.

Some of the many highlights in the article include:

"It is the rare company that can fund its needs internally... Companies that are able to operate without outside sources of capital typically choose this path so as (a) not to give up management control and equity share to the investors, (b) control the rate of growth of the company, (c) focus on goals other than making money (though pursuing personal goals and making money are not necessarily mutually exclusive), and (d) delay or avoid altogether a liquidity event such as an IPO, merger or acquisition. Further, the companies that can fund operations internally typically have low capital requirements - and fully established services or product lines within a short period of formation. Most companies, however, must fund operations in private financings until they mature...

Private companies are almost always valued on the present value of future cash flows during a growth/maturity period of from 3 to 5 years. Venture investors typically apply one of several forms of discounted cash flow analysis to formulate a range of acceptable company valuations. These valuations rest on investor assumptions on product introduction, market growth, earnings and capital market multipliers that will applied to earnings. Management should have its own analysis of these factors, and discuss these considerations with the investors in order that both sides may feel comfortable with the value that has been established. Once company value is set, the investors' equity participation is easily determined as the ratio of the aggregate investment to the accepted value of the Company..."

The paper concludes:

"The resolution of the issues described in this paper depends almost entirely on the attractiveness of the Company to the investment community. Concessions on the terms of investment will not cause the investment to be made if the Company is not sound - as evidenced by its business plans, its identification and approach to the market - and other factors considered in the valuation of the Company. Once the Company has generated serious investor interest, then these issues become important...Ultimately, all parties must be satisfied with the terms of the investment in order to avoid future misunderstandings."