United States: Venture Financing Overview

INTRODUCTION

This practice note discusses venture capital, which is an important source of money for start-up companies that do not have access to the capital markets. It covers what venture capital investors look for as well as the process of seeking and obtaining venture capital support at the various stages of a start-up's growth.

Specifically, this practice note provides an overview of when a start-up might seek venture financing and the common venture financing options, including the structure of the financing and the typical terms applied in:

  • Seed-round investments by friends/family or angels
  • The initial Series A preferred stock financing round
  • Later financing rounds such as the Series B, C, and D preferred stock rounds
  • Later-stage bridge financings

For additional information on start-up financing, see Pre-IPO Liquidity for Late Stage Start-Ups and Seed Financing Overview. For forms related to this topic, see Convertible Note (Seed-Stage Startup) and Convertible Note Financing Term Sheet (Seed-Stage Startup).

INITIAL CONSIDERATIONS ON STAGE/SIZE OF THE ROUND

Series Seed

At the early stages, many companies find it necessary to seek a small amount of seed money from friends, relatives, angels, or what are known as seed round venture capitalists. This seed money can support a fledgling company while it writes a business plan or develops a product prototype.

Series A

After the company has developed a firm business plan, it may be in a position to seek investment capital from venture capital funds. At this stage, the business plan should set a demonstrable risk-reducing milestone, such as having a working product ready for production.

In this first round of venture capital financing, the company should try to raise a sufficient amount of capital to fund product development. Given the seemingly inevitable delays in product development and the time it takes to arrange the next round of financing (at least two to six months), you should build some cushion into the amount you raise. For further information on venture capitalists, see Private Equity Industry Practice Guide.

Subsequent Rounds Series B

At the next appropriate financing window (when you feel it is appropriate to raise additional venture capital), or as the company begins to run out of cash, you may seek a second round of venture capital to start the next milestone of the company's business plan or to adapt to changed market conditions. How much control the company is able to exercise during subsequent rounds of financing depends largely on how successful it has been in managing the planned development growth with previous funding and the degree to which investment capital is available.

If the company has proven its ability to execute its business plan:

  • It should be able to raise money at a substantial premium over the first round, perhaps one and one-half to two and one-half or more times the first-round price.
  • The first-round venture investors will participate in the second-round financing, typically providing one quarter to one-half of the money in the second round.
  • A lead investor representing the new money generally will set the second-round price and its terms and conditions.

If the company has fallen measurably short of its plan:

  • Finding new investors may be more difficult and existing investors may need to fund a greater percentage of the round.
  • Since the company will be in a weaker bargaining position, it may need to raise money at a lower price than the first round, triggering antidilution protection and causing significant dilution to founders.
  • More onerous preferred stock terms are likely, including accruing dividends, ratchet-antidilution protection (discussed below), and multiple-liquidation preferences.
  • Venture capitalists may demand a change in management, a replacement of the chief executive officer (CEO), an imposition of more rigorous controls over company management, or personnel layoffs.

Series C And On

As the company continues to grow, it may seek additional rounds of venture capital to reach the next milestones of its business plan. How much capital is needed will depend on the company's current needs and goals. How much capital investors are willing to fund will depend on the strength of the company's business plan and its performance, growth, and management.

Bridge Financing

The company may consider a bridge financing when it needs a short-term loan to cover capital needs until the next preferred stock financing. For example, if the company runs out of cash before the lead investor is found, the current investors might agree to bridge the gap by extending a bridge loan that will automatically convert into the next round series of preferred stock. Under the terms of a bridge loan, investors typically receive market rate interest and a discounted conversion price, and may also receive a common stock warrant (a right to purchase common stock in the future). For a form of warrant, see Warrant. Because this type of loan will convert only at the next preferred stock financing, you should remember that the interest will continue to accrue until such time. Once the next preferred stock financing occurs, the principal and accrued interest due on the note will convert to that series of preferred stock at the discounted conversion price.

Investors Series Seed

Obtaining capital from outside investors during the early stages of a company's development may be difficult. Since only small amounts of money are usually required at this early stage, friends and family may be a realistic source of seed money. Even at the early stages, you should ensure that the company is complying with securities laws when accepting capital from friends and family members. For additional information on the securities laws related to private offerings and exemptions from registration, see Private Placements Resource Kit.

Unless a company's founders or management have had prior success as entrepreneurs or were seasoned executives in a particular space, it may be more difficult to obtain seed money from the venture capital community. For an unproven start-up, it can take six to 18 months to:

  • Build venture capital contacts
  • Educate the potential investors about the product idea
  • Convince an investor of the strength of a company's founding team

Given these difficulties, it may be easier for a start-up company to try to attract angels or advisory investors, such as a successful entrepreneur with self-generated wealth in a related industry. This type of investor will understand the merits and weaknesses of the company's business idea. More important still, these investors can be invaluable in making introductions to the venture community.

Series A

Step 1: Finding a Venture Capitalist

There are various ways to find a venture capitalist. The most common include:

  • Consulting available sources that provide basic information about venture capital firms, including published directories and Internet databases (e.g., Pratt's Guide to Venture Capital Sources and the Directory of the Western Association of Venture Capitals)
  • Securing an introduction to a venture capitalist through successful entrepreneurs who have been funded by them
  • Getting referrals from friends and professional networks (such as advisors, lawyers, and professors)

Step 2: Selecting a Venture Capitalist

Selecting the right venture capitalist can require both time and effort. Here are some tips:

  • A company may want to seek out investors who understand the industry and who know the product or market.
  • Aim to select a venture capitalist that has the depth and breadth of experience that the company may initially lack .
  • Take the time to talk to potential venture capitalists to ensure that you can work well together and develop a personal relationship.
  • Where funding is available from several venture firms, ask the CEOs of their portfolio companies about their experience with the respective venture capitalists.

If chosen correctly, venture capitalists can provide a wealth of information on management techniques, problem solving, and industry contacts. They also can offer a broader perspective on a product's market fit, as well as additional funding as the start-up company grows.

Step 3: Making a Pitch to a Venture Capitalist

Most venture capitalists are looking for a company that can be profitable and grow in revenue. They are looking for large and growing markets where there is a demonstrable need for the product the company plans to develop. Therefore, when discussing a potential investment with a venture capitalist, have a firm business plan. This business plan should include:

  • A description of the company
  • The company's location and history
  • The product(s) to be developed and the underlying technology
  • The size and growth of the market
  • Targeted customers
  • Competitors and the company's competitive advantage
  • The management team
  • Financial summaries
  • The amount and structure of the proposed financing

Venture capitalists also invest in people, which is why the strength of a start-up's management team is a crucial element in raising money. For additional information on pitches or other presentations to potential investors, see General Solicitation and Startup Capital-Raising under Rule 506 of Regulation D.

DECIDING ON THE TYPE OF VENTURE FINANCING

This section provides an overview of some of the common types of venture financings, including the structure of each financing and the typical terms that may apply.

Convertible Promissory Notes

A convertible promissory note is a debt security that converts into company equity when certain conversion events occur. Issuing a convertible promissory note can be an effective way for a company to raise capital without the cost, time, and complexity of a preferred stock financing. This method of financing is often quicker, less costly, and more attractive to start-ups than a preferred stock financing because:

  • It involves less documentation and negotiation with investors
  • It does not necessitate the control provisions investors typically receive in a preferred stock financing
  • The issuance of convertible promissory notes does not require a valuation of the company because the notes are debt securities

Keep in mind that convertible promissory notes are typically senior to other equity holders, but because they are generally unsecured, these notes are not senior to other debtors.

Once the company identifies an investor interested in providing capital in exchange for a convertible promissory note, you should prepare a term sheet outlining the agreed-upon terms of the note. Upon receiving the investment, the company would issue the convertible promissory note to the investor. Under the terms of the note, the principal and accrued interest are payable to the note holder upon the maturity date. However, the reason convertible promissory notes are particularly attractive to investors is that the note is convertible into company equity when certain conversion events occur.

Conversion

The most common conversion event is a qualified financing, which is typically an equity financing that involves a certain threshold amount of money. When a qualified financing occurs:

  • The principal and interest of each note converts into shares of the series of preferred stock sold in the qualified financing at the applicable conversion price.
  • The notes are converted at a price that is lower than the price paid by the investors purchasing shares in the qualified financing.
  • The conversion price is calculated based on either a discount rate (which is typically a percentage of the qualified financing's issue price) or a valuation cap (a cap on the pre-money valuation at which the notes may convert).
  • The conversion price equals the lowest price calculated based on the discount and the valuation cap, if the conversion terms of a note include both a discount and a valuation cap.

Additionally, a corporate transaction, such as a sale of the company, may trigger conversion of the note. Upon a corporate transaction, note holders can elect to convert their note into common stock. In the alternative, the noteholder may choose to receive the outstanding principal and accrued interest from the company.

If neither a corporate transaction nor a qualified financing occurs prior to the maturity date of the note, the noteholder may have the option of converting its note into shares of common or preferred stock, or leaving the note outstanding in order to convert the note in a later financing. For additional information on convertible promissory notes, see Understanding Convertible Debt Securities and Understanding Anti-Dilution Adjustment Formulas in Convertible Bonds.

Simple Agreements For Future Equity

Alternatively, the company may issue investors a Simple Agreement for Future Equity (SAFE) when it does not know whether it will complete a qualified financing before a promissory note would mature. The process for issuing a SAFE is similar to the process for issuing a convertible promissory note—you would issue a SAFE to the investor as a promise of repayment. A SAFE typically converts in the same manner as a convertible promissory note, but because a SAFE is not considered a debt instrument, it does not accrue any interest and it does not have a maturity date. Rather, a SAFE is left outstanding until a qualified financing or corporate transaction triggers conversion of or payment on the SAFE. When a qualified financing occurs, the SAFE is automatically converted into a number of shares of preferred stock, determined by dividing the purchase price of the SAFE by the applicable conversion price. The conversion price is calculated based on either a discount rate (which is typically a percentage of the qualified financing's issue price) or a valuation cap (a cap on the pre-money valuation at which the SAFE may convert), whichever calculation results in the greater number of shares. In a corporate transaction, the SAFE holder can typically elect to receive from the company a number of its common stock, calculated based on a pre-money valuation, or an amount in cash equal to the purchase price of the SAFE. For a discussion of SAFEs in the crowdfunding context, see Market Trends: Crowdfunding — Other Key Market Trends.

Preferred Stock Financings

Preferred stock financings are a type of equity financing. Because companies typically sell convertible preferred stock to venture investors at a substantial premium over the price charged to the founders or the seed investors, preferred stock financings can be an effective means to obtain a significant amount of capital. At a minimum, the preferred stock gives the investors a liquidation preference, which is described below, in the event the company fails or is acquired. In addition, preferred stock holders usually obtain certain other preferential rights over the holders of common stock as well as certain voting rights, each described below. From the point of view of the start-up, these preferences justify a fair market value differential between the preferred stock and the common stock. This enables the company to continue to sell common stock to its employees at a lower price than is paid by the preferred investors.

Once a lead investor for the preferred stock is identified, you will negotiate a term sheet outlining the agreed-upon terms and begin preparing the definitive financing documents, which will typically involve several drafts before the parties agree on the terms. Concurrently investors will be granted access to a data room containing information on the company's organization, capitalization, material agreements, and financial statements, so that the investors can conduct their due diligence. When the financing documents are close to final, the company will obtain any necessary board and stockholder approvals. Prior to closing, the company will file its restated charter with the secretary of state, and once the filing is complete, the parties will sign the financing documents and the investors will initiate their wires. For further information on due diligence, see Conducting Due Diligence for a Private Offering. For forms of board resolutions in this context, see Board Resolutions: Unregistered Offering of Preferred Stock (Regulation D) and Board Resolutions: Private Offering of Convertible Preferred Shares Authorization.

Prior to drafting any financing documents, the company and the lead investor in a financing will negotiate a term sheet, which typically includes the terms outlined below. For further information on terms sheets, see Understanding, Negotiating, and Drafting Term Sheets.

Pricing: How to Determine the Company's Valuation

The purchase price of a given series of preferred stock is usually based on a pre-money valuation that venture capitalists will assign the company based on the company's stage of development before giving effect to the investment.

The pre-money valuation is:

  • The price per share that the investors are offering to pay the company multiplied by
  • The outstanding stock, options, and other convertible securities, plus the option pool reserved for future employees

When discussing a pre-money valuation, remember to clarify the size of the post-financing option pool to be required by the venture capitalists. The option pool typically contains an adequate number of shares to provide for grants to service providers and employees for one year or until the next fund raise.

In theory, when determining the value of a company, investors attempt to estimate the value at some time in the future. Investors then discount that value to a present value with a desired rate of return. For example, if the investor is looking for a tenfold return in five years and the company is expected to be worth $50 million in five years, the company may be worth $5 million today. In practice, however, venture capitalists seem to estimate the amount of cash required to achieve some development milestone and equate that amount to a certain percentage of the company (fully diluted for employee shares). The best way to find out how the company is likely to be valued is to look at what valuations venture capitalists are giving to other companies at the same development stage and in the same general market area.

After the venture funding, the company's post-money valuation can be determined by adding the amount of money invested in the financing to the pre-money valuation.

Preferred Stock Preferences and Rights

In addition to the pricing terms, the term sheet for the preferred stock financing will typically include the following preferences and rights.

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