Chapter 17

Venture capitala

17.1 INTRODUCTION

“Someone, somewhere, is making a product that will make your product obsolete”

—Georges F. Doriot, America’s First Institutional Venture Capitalists

Venture capital involves investing in nascent early-stage private companies and making them profitable by injecting both financial and human capital into these businesses. The capital is most commonly provided by venture capital (VC) firms, who work closely with the incumbent founder/entrepreneur, with the hope of achieving monetary success by backing only the most innovative and commercially interesting ideas.

VC raised in the U.S., the largest venture market globally, comprises only 0.2% of the GDP according to a study completed by the U.S.-focused National Venture Capital Association (NVCA). Yet, in spite of this small relative size, the economic impact of VC is disproportionally much more significant—venture investments have been credited with creating more jobs, driving more innovation, generating more revenues, and contributing more to economic growth than the equivalent capital investments in non-venture-backed firms. According to statistics produced by the NVCA, 11% of U.S. private sector jobs come from venture-backed companies and venture-backed revenue accounts for 21% of U.S. GDP. In Europe, VC firms invested more than €270bn in over 56,000 companies and venture-financed companies created 1 million new jobs between 2000 and 2004 (EVCA, 2005).

Most readers would be familiar with VC success stories; however, there are thousands of other VC success stories that are less well documented and have produced a great benefit to broader society through improved innovation, as measured by the volume and quality of new patents (Kortum and Lerner, 2000). Examples include the development of new drugs, new biotechnology devices, and other specific life-changing and life-enhancing technologies that are less well known because they do not exist under a single globally recognized brand name.

Notwithstanding many post venture successes and the prospect of further successes in the future, the VC sector is attracting less capital commitments from investors. In 2009, USD30bn capital was directed to VC, a full one fifth of the capital committed to VC at the peak of the market in 2000 (NVCA, 2010). Institutional investors such as pension funds, insurance companies, endowments, and foundations have long recognized the benefit of including VC in their portfolios. Of this group, pension funds are by far the largest provider of capital to the venture industry, accounting for 20% of all VC commitments from 1985 to the second quarter of 2010. While commitments in recent years have been affected by the global financial crisis, the average amount committed between 2005 and 2008 was USD57bn, which is still some way off the average of USD97bn between 1999 and 2001 (NVCA, 2010).

LP surveys, such as the Coller Capital Global Private Equity Barometer, document that many institutional investors that have historically committed to the VC asset class are reconsidering their allocations to this segment. The primary reason for the reconsideration in capital commitments and this investor sentiment is because the aggregated average returns produced by VC funds are underwhelming and strong-performing funds are concentrated across a very small universe of managers. Moreover, these strong-performing managers are very difficult to access as their funds seek to raise relatively modest amounts of capital and are frequently multiple times oversubscribed.

In addition to dedicated VC funds other investors who provide VC to finance early-stage businesses include angel investors and corporate venture capitalists. As discussed in Chapter 16, angel investors are those who contribute their own personal capital to seed investments prior to VC backing. Corporate venture capital, typically found in companies where research and development are critical to the business model, is provided by in-house venture corporate divisions to facilitate better innovation and growth.

17.2 WHAT IS VENTURE CAPITAL

Definition

Venture capital is early-stage equity funding provided to potentially high-growth private companies. Venture capital, commonly known in its abbreviated form as VC, generally follows after a founder’s self-funding and seed-funding stages from business angels and is used to facilitate growth, increase scale, and ultimately monetize the investment through a liquidity event. As consideration for VC funding, which is provided in cash, the investor providing the capital receives a portion of the firm’s equity. This is one reason VC investors often are heavily involved in portfolio companies, both in daily operations and as strategic advisors to the company. They can be involved in coaching, guidance, recruiting, networking; this involvement differentiates VC investors from other types of equity investors.

Individuals, VC investment firms, governments, and corporations can all be sources of early-stage funding. While no demarcation definitively separates early-stage investment stages, progression of the financing often follows a predictable pattern. Entrepreneurs typically self-fund the development of a concept, technology, or product. To attract additional investment and accompanying commercial expertise, an entrepreneur partners with a “business angel” investor, who after assessing the underlying commercial concept or product and business plan provides initial equity funding, called seed capital. This is usually when an official legal entity is formed for the business and when the entrepreneur’s idea is shaped into a marketable product. However, the product has likely not generated any revenue at this stage. Following progression at this seed capital stage and perhaps initial marketing success, the company will need additional capital for research and development, staff salaries, operations expansion, marketing and customer attraction, or other expenses—which require additional capital and business expertise beyond what a typical business angel can offer. VC fills this funding void between business angels and access to private equity, capital markets, or bank lending. VC investments are typically undertaken in several key sectors: technology, healthcare, sustainability, and communications. Each of these sectors attracts different types of VC investments and offer specific opportunities and challenges.

Historical background

In terms of the genesis of the industry, VC was an informal function until it grew and was formalized during the Second World War in the United States. The first U.S. VC fund was the American Research and Development Corporation, formed in Boston in 1946. This was a publicly traded company which invested in small firms that had developed technology for the Second World War. The first British VC fund was the International and Commercial Financial Corporation, which was founded in 1945 and later became 3i. The formalized VC concept spread across Europe and Asia, growing during the post–Second World War economy of the 1950s while focusing primarily on technology companies.

The most famous VCs post Second World War were known as the “Traitorous Eight”, a reference to eight engineers who resigned from Shockley Semiconductor Laboratory in 1957. These individuals then founded Fairchild Semiconductor with USD1.5mn in VC funding from Arthur Rock, an early and successful VC investor, and subsequently invented the first commercially practical integrated circuit. Seven of these eight individuals later left Fairchild and proceeded to found new companies. Between 1957 and 1976, at least 23 out of the 67 entrants to the semiconductor industry had at least one founder who worked for Fairchild, including Advanced Micro Devices, Intel, Teledyne, Xicor, National Semiconductor, and related entities such as Kleiner Perkins (Braun and Macdonald, 1982).

Through the 1970s, investments were primarily provided by wealthy individuals, causing the industry to develop slowly through 1974, when the Employee Retirement Income Security Act (ERISA) was revised by the U.S. Department of Labor. This allowed pension funds to invest in certain risky investments such as private companies as the “prudent man” rule outlined that risky assets should be viewed in the context of total portfolio risk rather than individual assets risk. This change caused large pools of previously unavailable capital to be directed toward VC investments. Several headline success stories during the late 1970s attracted many new entrants—VC firms and limited partners—to the industry. Returns across geographies skyrocketed during the 1995 to 2000 dotcom boom, when valuations peaked in line with market indexes due to investor focus on the internet and other technological innovations. While VC has always been impacted by the cyclicality in exit markets and limited partner commitments, VC is currently a well-developed industry in North America, Western Europe, and several Asian geographies and continues to expand and develop in emerging economies.

VC fund structure

VC funds are structured as a partnership, similarly to buyout funds. This involves passive limited partners (LPs) supplying the capital, and the general partner (GP) investing and managing the fund. The primary difference between buyout funds and VC funds is the amount of funds being managed: a VC fund will rarely exceed USD500mn due to the typically smaller deal sizes and extensive post-investment involvement by VCs in portfolio companies.

Each VC fund typically has a specific focus to differentiate itself from other VC funds given that it is very competitive to raise capital from institutional investors. The differentiating factors could be the industry or sector of the target company, the investment size, geographical location, or the development stage.

Similarly to buyout funds, most VC funds have a fixed 10-year lifetime, with potential extensions to liquidate investments. A GP may spend one year fundraising, depending on investor interest, with investors committing a fixed amount to the GP for a specific VC fund. Exceptions include most funds raised by the top VC firms, which have historically been many times oversubscribed with many investors having their requested commitments scaled back. In these situations, the fundraising period is much shorter than the industry average. The fund is initially unfunded, but investor commitments are called as suitable investments are found. After the fundraising period ends, VC funds typically spend the next 5 years sourcing and completing investments. Years 5 through 8 are spent harvesting—that is, managing the investments and improving value in portfolio companies with the main focus on preparing for an exit. The last 2 years, the exiting phase, involve exiting the investments via trade sales, IPOs, or stock buybacks. These timeframes in a fund lifecycle are subject to many factors including the GP’s track record, the team of venture professionals, and the stability of this team, market conditions, and types of investment strategy.

Relatively speaking, smaller VC funds are disadvantaged when compared with larger VC funds. First, larger funds are able to attract better talent to source, evaluate, and execute investments. This talent attraction feature often causes more favorable returns on investments through application of experienced managerial skill, which in turn attracts larger amounts of capital due to prior successes. Thus, the cycle tends to continue, with success typically breeding further success, especially since portfolio company success can be highly reliant on the VC’s managerial input. Second, smaller VC firms often lack the financial wherewithal to provide significant follow-on financing to successful companies. As larger investors step in to provide these funds, the original but smaller investors can become severely diluted. Third, smaller VC funds may lack appropriate diversification if funds are constrained to only a few core investments. While diversification is important in any portfolio, it is especially important in a VC fund’s portfolio as only a fraction of the fund’s investments will contribute very high-performance returns. Fourth, since smaller firms tend to make smaller and, therefore, more early-stage investments, these investments by definition carry additional risk. These smaller investments can be more costly to manage and tend to have higher uncertainty and longer periods before exit.

VC drivers

Today, VC ranks as an important asset class for a diversified investor although it remains minute compared with other types of asset classes. Because VC investments are high risk, only a small number of firms successfully attract VC funding. Estimates indicate that approximately 3,000 U.S. firms get VC investment each year, including 500 startups; nearly all are in the high-tech field (Shane, 2008).

The U.S. has the largest and most developed VC industry. Over the last 10 years the U.S. VC market has comprised on average 57% of the global VC market as measured by capital committed to the asset class (see Exhibit 17.1). Over the same time period, Europe comprised, on average, 20% of this capital, with the U.K. comprising the bulk of this. The rest of the world (ROW in Exhibit 17.1) comprised the remaining 23%. By sector, the VC industry in both the U.S. and U.K. directs the majority of its capital to the technology sector, including software, medical devices and equipment, and biotechnology.

Since VC is the key medium for institutional funding for startup companies, governments play a crucial role in a country’s VC activity:

• Tax rates for capital gains and carried interest have a large bearing on the level of VC investment activity.
• A stable and investment-friendly regulatory framework can encourage VC activity with policies that provide continued funding of research. Given the relatively long time horizon, VC investments are disproportionally exposed to higher risk than other similar investments.
• Pension fund regulations that allow pension funds to commit funds to the VC industry.
• A healthy exit market (public markets and appropriate incentives for larger firms to acquire smaller firms such as VC-backed companies) is also critical to the continued success in the industry.

Geographies where government policies are more conducive to VC have been able to raise more capital and invest in more new ventures. This is evidenced by the Exhibits 17.1 and 17.2, the latter shows the VC firms that have raised the largest amounts of capital in the last 10 years. Nine of the ten largest VCs reside in the U.S.

VC clusters

Another phenomenon that is unique to the VC industry is that VC firms are commonly based and operate in a few geographical areas called clusters. Broadly defined, a cluster is a local concentration of related companies that both cooperate and compete. Most clusters expand and are concentrated around geographical areas defined by high levels of education, research, and entrepreneurialism. Often, large universities or public economic development agencies will foster research of new concepts and products through business incubators, which offer resources to entrepreneurs to develop concepts or products. Entrepreneurs often work together with developers and researchers as they seek to develop and commercialize these concepts.

Geographical concentration is important to VC investors to remain involved in daily operations of portfolio companies and to have an ample source of new investment opportunities. The network of deal team participants also grows due to the number of deals being created from the incubator and the economic benefits created through the VC-investing process. The concentration of talent in time attracts more talent to support the deal team. The “spillover effect” or “ripple effect” from job creation and economic ramifications supports the additional population. The VC industry also benefits from sharing unique resources, such as intellectual property attorneys, specialized labs for biotech research, etc.

Currently, the most well-known venture clusters exist in the U.S. and are most geographically concentrated in the southern part of the San Francisco Bay area (more commonly known as Silicon Valley), Route 128 near Boston (Massachusetts), and in New York, although more recently also in Austin (Texas) and the Research Triangle in North Carolina. As evidence of this clustering effect, close to 50% of all U.S. VC-backed companies are located in San Francisco, Boston, and New York (Chen et al., 2009). Outside the U.S. these clusters exist in Israel in Tel Aviv and Herzliya and in the UK in Oxford and Cambridge. In more recent years there has been rapid expansion of VC firms in India and China, and research suggests it is set to continue. An LP survey conducted by Deloitte has suggested that an increasing number of LPs expect to shift some of their VC allocations to emerging markets (Deloitte, 2010). This is in part due to high economic growth in these regions but also because of the evolution of the VC ecosystem in these markets.

17.3 THE VC INVESTMENT PROCESS

17.3.1 Investment stages

VC can be provided through two types of financial arrangements: milestone financing (also known as full financing) or round financing. Milestone financing is where the VC firm contractually commits to providing all capital upfront, provided specific financial and non-financial hurdles (e.g., revenue hurdles, clinical test FDA approvals, licensing agreements, etc.) are met. Round financing involves the staging of capital, where a discrete and smaller pool of capital is provided for a specific stage or round of financing. In round financing the onus is on the entrepreneur to raise subsequent capital after the capital from a particular round has been exhausted. However, even within round financing the capital is provided gradually on a contingent basis, subject to specific milestones.

The reasons that capital is provided on a milestone or contingent basis are twofold. First, it gives the VC fund an exit option with respect to providing additional capital. Second, it minimizes opportunistic behavior by the entrepreneur. For the purpose of this chapter, we intend to focus more heavily on round financing given its peculiarity and prevalence in the VC industry.

The financing stages (Exhibit 17.3) will typically require multiple rounds of financing to develop and grow a company for an eventual exit. The exit is necessary for the VC fund to monetize value, which is the ultimate goal. Within the VC industry, the multiple rounds of finance can be broadly split into pre-revenue and post-revenue rounds and, then more specifically, into startup, seed, early, mid, and late-stage financing. The startup, seed, and early stages are typically pre revenue, while the mid and late stages are typically post revenue.

Startup and seed stages

The start-up and seed stages are primarily concerned with financing the initial concept or product introduced by the founder. These financings will most commonly be provided by founders, friends and family, and angel investors—not VC funds. VC funds do not typically invest in these earlier rounds because the equity requirements and resulting upside potential are too small to justify a VC firm’s resources.

Early stage

With respect to round financing, a more straightforward method of categorizing rounds is by categorizing the early stage as the A-round (or Series A). This is the first round in which a VC firm provides capital. This initial stage of financing will incur the highest level of risk as there is least visibility into potential for success.

Moreover, the amount of capital provided in the early stage tends to be smaller as the business is still unproven and, therefore, capital is supplied more cautiously. The investment at this stage is typically still pre revenue. As visibility improves and specific hurdles are achieved a VC firm comes to have more conviction in the opportunity and more capital is provided.

The amount of capital to be committed is reflective of the size of the VC fund and the number of investments the GP wants to include in a fund (the average is between 20 and 30 investments). On average, the amount of capital provided in the A-round varies between USD1mn and USD5mn, which is expected to finance the company for between 6 months to 2 years. The capital from this round is used to pay for the hiring of additional professionals, building a distribution network to execute the sales plan, and make progress on marketing the firm or product. Prior to this point of financing, the management team will already be in place and the product will be ready or close to being ready for distribution. The objective for the VC firm at the end of this stage of financing is to produce a revenue-generating firm.

Mid stage

After the A-round capital is provided, a VC firm will realize relatively early on whether there is justification for providing further follow-on capital for subsequent rounds or, alternatively, if it makes commercial sense to abandon the investment. If the initial VC firm or another investor decides to provide additional capital as needed by the company, this is termed the B-round of investing, which occurs at the mid stage. The key objective of this round of financing is to convert top-line growth into profits. Capital will typically be directed to many of the areas from the A-round but with emphasis on the areas that are more critical in reaching profitability.

Late stage

Later stage financing occurs after the A-round and B-round when a company has produced consistent sales, revenue growth, and profits and there is visibility into an exit. Exits are typically achieved through an IPO, a sale to a strategic investor, a merger with another firm, or a sale to a larger financial buyer, such as a small-sized buyout fund.

Consequently, because later stage financing is the round closest to exit, terms will have become tighter to allow for maximum monetization by later stage investors. If prospects for the firm are particularly strong a number of prior round investors will want to exercise pre-emption or right-of-first-refusal rights to allow them to provide further capital and, therefore, mitigate the possibility of being diluted before a potentially large wealth creation opportunity.

Exit stage

A VC firm also creates value through exit. The firm has the ability to influence the timing and method of exit and often has the relevant contacts to better facilitate this. Company exits in the VC industry can occur through three primary avenues:

The method for exit will depend very much on the appetite of the buyers and the macroeconomic environment at the time prior to exit. It is certainly much more difficult to exit through the public markets during more difficult trading conditions as appetite from public markets is very much reduced. It is also more challenging for VC firms to exit their investments in geographies that have less established markets for smaller cap companies.

More VC firms are looking to exit through acquisitions; historically, a greater percentage of companies have been exited through acquisition than through IPO. However, this is predicated on the acquirers wanting to acquire the business. Moreover, returns from acquisitions have historically been lower.

17.3.2 Syndications

In round financing, each round of financing will typically involve between one and two VC firms—one lead investor and one co-investor. Multiple VC firms offer multiple perspectives and increased industry contacts. Clubbing together provides incrementally more capital, distributes the undertaken risk, and provides an independent valuation. The strategic positioning of a venture-backed firm is further enhanced as there is a greater possibility that at least one VC firm decides to participate in the B-round. If there is only one VC firm that elects not to participate in the next round, first-time B-round investors may become suspicious about the prospects for the company, resulting in either no financing or a less attractive valuation if they do invest.

Naturally, there is a tradeoff in involving more than one VC firm. The tradeoff is that each VC firm will want to take some of the equity in the business and the more investors, particularly over subsequent financing rounds, the more the founder’s share of the business will be diluted. Negotiations of each party’s interests and transaction terms can become increasingly protracted and complex when involving multiple VC firms, and an equity-sharing mechanism can be equally intricate. These factors need to be balanced with the additional value derived from the VC firms involved.

The abovementioned complexity has in fact become more pronounced in recent years due to the subdued exit environment, which has resulted in more VC firms clubbing together and more rounds taking place.

It should be noted that most VC firms will not commit capital from more than one underlying VC fund. For example, the VC firm will rarely commit to the same company from VC Fund I and VC Fund II owing to obvious conflicts of interest issues centering on valuation. Investors from Fund II would be concerned that the valuation is too high and that they are being asked to subsidize losses on Fund I. Investors from Fund I would be concerned that a lot of the upside would accrue to Fund II investors due to dilution to Fund I investors. In the limited scenarios where a cross-fund investment has taken place the GPs of the VC firm would have had to engage a third-party valuation to substantiate the investment in question.

17.3.3 The due diligence process

The depth of due diligence is necessary due to the riskiness of a potential investment, recognizing that a majority of early-stage companies will fail and investment will be written off. Commonly quoted statistics indicate that 20% to 90% of portfolio companies typically fail to provide the fund’s required return. Therefore, the typical fund is highly reliant on a small number of very successful investments that may return perhaps 10× the original investment to subsidize those that fail or do not meet the required return metrics. This also may be cause a misalignment of incentives. While entrepreneurs may be looking for a likelihood of success with a smaller payoff, VC firms are looking for that huge payoff despite only a small probability of it occurring. Therefore, the due diligence process is thorough and exhaustive. Several aspects are analyzed:

Additionally, VC firms examine the rate at which a company is projected to use cash (called “cash-burn”) and the track record of the company to date. For later stage VC investments, a small company that has a healthy financial position is more attractive to an investor than a company that needs an immediate cash injection to remain solvent. Therefore, where possible, a company should initiate its proposition to VC investors when it experiences positive developments and when the financial condition is relatively healthy.

VC firms will typically favor founders who are financially committed to their firm via a sizable investment as a proportion of their wealth. This implies that the success of the company is intricately linked to their own personal success and, thus, a source of motivation. Any sign of insiders selling shares implies questionable prospects for the firm, unless a convincing financial need arises. Therefore, only in extenuating circumstances will a VC purchase a founder’s shares.

The product of this extensive due diligence is a positive or negative decision to invest in the subject company and the appropriate amount to invest. Once a VC firm decides to invest in a company, both parties need to agree on several issues. First, the firm’s pre-money, or pre-investment, valuation is important. The uncertainty of future cash flows from a new product can make this a difficult exercise. We discuss a valuation method commonly used in Section 17.3.4#. Second, both parties need to decide on the amount and terms of the investment. Third, both parties need to agree on the future strategy of the company. Fourth, both parties need to agree as to what extent the investor will be involved and have a direction in the company’s operations. These negotiations can be protracted and difficult, as the entrepreneur may be having discussions with several interested VC firms. The company must also complete its due diligence on the investor, as the arrangement represents a partnership for the future. Once complete, consideration for the cash infusion is transferred to the investors via partially equity ownership or interest, dividends, royalties, or similar payments.

17.3.4 Pre and post-money valuations

The typical techniques for valuing companies such as discounted cash flows and comparable multiples are difficult to implement for startup companies. A company looking to receive venture backing is a nascent business with limited operating history and often no revenues. The key value in an early-stage firm lies in the intangible assets—the ideas, the technology, the entrepreneur’s experience and knowledge—and the expected future value of these intangible assets. To this end, the preferred method to use is a VC method that incorporates the abovementioned factors and adjusts for the multiple rounds of VC financing. This method is presented in Chapter 10# which discusses private equity valuation.

Pre-money valuation refers to the value of the firm prior to any financing round. Post-money valuation reflects the value of the firm after the financing has been provided and is calculated by summing the pre-money valuation with the value of the financing that has been provided. The ownership stake is calculated by taking the value of the financing and dividing it by the post-money valuation:

If a VC firm decided to contribute £50,000 in return for a 50% stake in a firm, this would suggest that the value of the entire firm to the investor would be £100,000 (£50,000/0.50). The post-money valuation in this case would be £100,000 and is the representative value of the firm after the money has been injected. This would also suggest that the value of the firm prior to the £50,000 capital injection was £50,000 (£100,000 – £50,000). The VC method is most reflective of the value of a firm at the time co-inciding with capital injection. This firm would not be valued at £100,000 if the capital injection did not take place nor if the capital injection took place some time ago under different circumstances.

The next question to answer is how the VC firm decided that £50,000 for a 50% stake would be appropriate. There are several steps to arrive at these data points. First, the VC firm could decide how much it can commit to a single deal and the typical level of ownership required to be incentivized to invest. Second, the VC firm could make assumptions about the exit value, the discount rate, time to exit to arrive at the ownership percentage required given the typical equity ticket of the VC fund managed. With the inherently high level of risk in investing in early stage forms, the cost of capital for a venture capitalist can vary from 25% to 70%. This is largely because the loss rate on a single venture investment is high and the VC firm is looking to achieve an overall fund return of between 25% and 30%. Exhibit 17.4 presents the approximate target rates based on the stage.

EXHIBIT 17.4 TARGET RATES BASED ON STAGE

Stage of development	Typical target rates of return (%)
Startup	50-70
First stage	40-60
Second stage	35-50
Bridge/IPO	25-35

In reality, valuing an early-stage firm is considered to be more of an art than a precise science. While a VC firm would use discount rates and apply the various valuation assumptions as outlined above, it will become more confident in the pricing range as more deals are priced and invested in. The VC firm may also be guided by comparing valuations of similar deals recently completed in the same segment.

The way VC firms model the valuation of a venture is through a capital (cap) table. The cap table will include detailed information about the expected rounds of financing, when the capital was provided, how much was provided, in which security types, level of ownership, and the corresponding pre- and post-money valuations at each round. It allows a VC firm to model various assumptions including the holding period, level of equity ownership, exit value, expected IRR outcomes. It is the output from these cap tables which forms the basis of negotiations between a VC and the entrepreneur. This is illustrated in Exhibit 17.5.

EXHIBIT 17.5 A SAMPLE CAP TABLE

In Exhibit 17.5 we have four rounds taking place and have assumed that in each round there is only one VC firm investing. In the founder round, all of the new shares are issued to the founders and they have a 100% stake in the firm.

In the first round, the VC firm contributes USD1mn in return for 818,182 preferred ordinary shares (voting shares that have priority claim over the founder’s ordinary shares), resulting in the VC firm taking a 45% share in the business. The issue of these shares has resulted in the founder being diluted from having a 100% ownership stake to having a 55% ownership stake. However, by issuing shares in return for capital the value of the business can be calculated. The pre-money value of the business is taken by multiplying the price per share (which is calculated by the capital provided in a round divided by the number of shares issued in a round, USD1mn/818,182) by the number of shares outstanding in the prior round (1,000,000). The post-money value is the sum of the pre money and the capital provided. The methodology for the second round and third rounds is similar.

In the fourth round, the VC firm has provided USD1.7mn of which USD1.2mn comprises preferred ordinary shares and USD0.5mn comprises redeemable preferred shares. The capital from the redeemable preferred shares influences the post-money valuation; however, as this share class does not have any voting rights attached at this point in time (only once redeemed) it has no impact on the level of equity ownership in the business.

The number of shares issued in each round is arbitrary and the price per share is not the best indicator for value creation. This is because the number of shares is frequently reverse-engineered to decide on the ownership percentage given an investment amount.

To understand if valuations have been increasing, we must compare the pre-valuation price in one round with the post-valuation price in the prior round. If there is price appreciation between the pre-financing in the current round and post-financing in the prior round this demonstrates value creation. In the example above, there has been value destruction between Rounds 2 and 3—the pre-money valuation in the third round (USD2.5mn) is less than the post-money valuation from the second round (USD4.23mn).

The cap table is helpful in demonstrating how the stages of financing impact the value of the business, the level of dilution, and the increasing level of complexity that occurs over successive rounds of investment. Being aware of the valuations and dilution dynamics before negotiations commence is critical, as is understanding which security types are most conducive to protecting an investor’s interest (preferred ordinary equity).

17.4 THE VC CONTRACT

17.4.1 Security types and specific terms

An investment in an early-stage company often presents agency problems and asymmetric information. Often entrepreneurs have an information advantage over VC investors with respect to the company, while VC investors frequently have an information advantage with respect to the external environment. To mitigate against these risks, a VC firm will structure the investment contract so it specifies cash flow (how residual cash flows are split), liquidation (priority of payment), and control rights (voting rights and board rights) of the founder and the VC fund.

In each round of investment, VC firms negotiate investment terms with the previous parties—founders, CEO (if other than the founder), business angels, and the VC firms who invested in prior rounds. These negotiations are on both valuation and terms. Typically, the (frequently higher) valuation forms the basis of the discussions. However, as the new investors have the strongest position of negotiation, certain benefits accrue by way of downside protections and warrants.

The majority of capital that is provided by a VC firm is in the form of equity, usually as convertible preferred stock. Preferred equity not only gives a position that is senior to or “ahead of” the common stock if the company is sold or liquidated, getting their capital out prior to the founders, but also allows VC firms to participate in the “upside” with the common stock when the company starts to take off. This is also why the inclusion of convertible ordinary shares and warrants are a common feature together with convertible preferred stock in a financing round. Below we have outlined commonly used VC security structures and VC-specific terms that feature in the legal documentation.

Security types

• Ordinary shares (common shares)—ordinary shares confer ownership and are attached with voting rights. A capital gain is more common than dividends given the limited cash flows of early-stage businesses. Typically, it is the founders, management, and employees who own the common stock. The claims of ordinary shareholders are ranked below those of preferred shareholders. In some VC financings, there will be different classes of ordinary shares. It is not uncommon for founders to have ordinary shares that are attached with voting rights, while VC firms receive ordinary shares that are attached with different voting and board rights and sometimes even a different vesting schedule (i.e., VC stock vests immediately).
• Preferred shares—these rank ahead of ordinary shares in the capital structure and will frequently be attached with a fixed rate dividend. If the dividend cannot be paid for whatever reason it accrues and forms part of the liquidation preference (see below), ensuring that the VC firm is able to take its capital out ahead of the founders.
• Convertible shares—these allow VC firms to participate in the upside by being able to convert the shares into ordinary shares at a pre-determined conversion price. This is particularly helpful if a company is about to experience a liquidity event.
• Convertible preferred shares—these are similar to preferred shares in that they rank higher in the capital structure than ordinary shares (protect the downside) but they also allow the owner to participate in the upside by being able to convert the shares into ordinary shares at a pre-determined conversion price. Frequently, this conversion price can vary depending on underlying performance. In the event of an IPO these shares automatically convert into ordinary shares. Convertible preferred is the most common tool for VC firms to invest in companies.
• Participating preferred/Participating convertible preferred—upon liquidation, the VC fund receives the proceeds of the preferred shares and also receives additional ordinary shares.
• Warrants—a warrant can be converted into ordinary shares at a pre-agreed price. The objective of warrants is to increase upside participation.

Contract terms

• Liquidation preference—this ensures that VC is returned first in case of liquidation of the company. The liquidation preference is stated in terms of the original capital invested. It is not uncommon for some VC firms to insert terms that provide a liquidation preference that is a multiple of the original capital invested. This is particularly destructive to the founders, especially following a down-round.
• Drag-along rights—the VC firm has the right to sell the company and force the rest of the shareholders to also sell the company by dragging them along. This is dilutive to the founders if the drag-along rights are combined with a liquidation preference.
• Vesting rights—to further ensure the founder’s interests are aligned with those of the VC firm, the shareholding will often have a vesting schedule attached (i.e., shares are only awarded after a pre-agreed time period). If an entrepreneur were to leave the firm, the unvested shares would be transferred to the venture capitalist. Vesting is more common in earlier rounds, when the venture capitalist is more reliant on the entrepreneur for value creation or when information asymmetry is large (see Kaplan and Strömberg, 2001).
• Non-compete clauses—these clauses prohibit the entrepreneur from initiating a new venture in the same industry for a pre-specified period of time, were he or she to leave the current VC-backed entity.
• Anti-dilution measures—this clause protects VC firms from dilution in subsequent equity offerings. It usually comes into effect in a down-round so that the price paid by VC firms in early rounds will be adjusted according to the conversion formula. We discuss them below.

Anti-dilution ratchets

There are two types of anti-dilution adjustments: a full ratchet and weighted average ratchet. The full ratchet is the most onerous from the founder’s viewpoint. If the company issues even one share of stock at a price below the price paid by the VC investors, then the conversion price drops fully to that price. The weighted average ratchet anti-dilution adjustment is better from the founder’s viewpoint. Although the formulas used differ in some ways, the basic approach is to adjust the conversion price to the average price received by the company for stock issuances taking into account the amount of money raised at different prices. A typical formula is as follows:

where

NCP= new conversion price
OB= all outstanding shares before offering
OCP= old conversion price
New$ = amount raised in offering
OA= all outstanding shares after new offering, before the ratchet.

The ratchets are illustrated below with a realistic example. Assume that the Series A VC investor buys 300,000 shares of the company for USD2 per share when the founder owns 700,000 shares. Later, the Series B VC investor buys 100,000 shares from the company for USD1 per share. A full ratchet would give the Series A VC investor 300,000 new shares for free in order to reduce his average price per share to USD1.

Under the weighted average method, the Series A investor’s 300,000 shares are added to management’s 700,000 shares and then multiplied by USD2. The USD2,000,000 product of this calculation is then added to the USD100,000 paid by the Series B investor giving a sum of USD2,100,000. This amount is divided by the total number of shares outstanding after the second sale, 1,100,000, to give USD1.91 which becomes the new average price for the Series A investor. When divided into the USD600,000 invested by the Series A investor this yields 314,286 total shares to which the Series A investor is entitled. Thus, it is required that the company issues him or her 14,286 free shares.

We present in Exhibit 17.6 the computations for the share ownership of Series A investors after exercising their anti-dilution rights under the two types of ratchets.

EXHIBIT 17.6 SHARE OWNERSHIP COMPUTATIONS FOR A SERIES INVESTORS

Milestones

Another method that VC firms will use to ensure their capital is protected is to provide capital that is contingent on specific milestones (or hurdles), both financial and non-financial. This way the VC firm has the option to terminate or force the liquidation preference when milestones are not achieved. This provision is included in the majority of contracts and has a typical maturity of 5 years (Kaplan and Strömberg, 2001). Similarly, when a VC firm is more heavily reliant on the founder for value creation, the liquidation preference is a less effective risk mitigation mechanism and, therefore, the contract is structured so that the founder’s ownership stake is subject to vesting provisions. Typically, when asymmetric information risks are more pronounced, the entrepreneur is more likely to be subject to vesting and have his or her equity stake tied to specific performance hurdles being achieved.

17.4.2 Roles in the VC contract

The legal documentation will clearly outline the roles of the VC firm and the entrepreneur, the composition of the board, which is formed by representatives from both the VC firm and entrepreneur, and board and voting rights. In a VC deal, two main forms of documentation exist—the term sheet and the share and purchase agreement. The term sheet outlines the key terms in summarized format while the share and purchase agreement will provide additional depth with respect to these terms. The objective of these documents is to clarify the parameters of financing and how the business will be run with respect to the roles of the VC firm, the entrepreneur, and the board.

Role of the VC firm

• The VC firm is primarily focused on ensuring the likelihood of monetization is maximized.
• VC firms influence business decisions through their board representation and voting rights. In some cases VC firms may have a majority of voting rights and, therefore, they may be better positioned to influence venture-related decisions, including changes to management and whether or not to appoint an outside CEO.

Role of management

• Day-to-day management of the business and ensuring performance hurdles are achieved.

Role of the board

• The board is the governing body of the firm and will be represented by management (1–2 seats), VC professionals (1–3 seats), and outside parties (1–2 seats) which have been agreed to by both the founders and the VC firm. In early rounds, VC majority board seats are less common; however, after a number of rounds, VC majorities become more common. In some situations when the entrepreneur has not achieved certain performance metrics, VC firms may obtain full control of the board.
• The number of board members increases as additional financing rounds take place.
• Hiring and firing the management team.
• Providing strategic input to business.
• Signing off on all business-related decisions.

17.4.3 VC expertise

In contrast to mainstream providers of financial capital, who do not get involved beyond providing capital, VC firms also expect to provide human capital—providing input, through their influence, into how the venture in which they have injected capital is governed and developed. As referred to repeatedly throughout this chapter, the primary objective of the VC firm is to monetize the investment for a higher value. The probability of success is increased when the VC firm is involved in shaping the business.

Most VC firms prefer to specialize in what they do, typically either by stage and/or sector of investment. This deep level of domain expertise allows them not only to assess the merit of an opportunity relatively quickly but also provide help to the founder after an investment has been given the “green light”. This hands-on approach and continued monitoring together with their ability to professionalize a business are key elements in the value creation process.

VC firms are heavily involved in the company they have decided to back through assuming board seats, providing strategic input to the firm, providing valuable input into the development of the product or technology, using their deep networks to negotiate with buyers and suppliers, making customer introductions, professionalizing the firm through appointing professionals at both the senior management level and further down in the organization (e.g., sales and marketing professionals), creating human resource policies, and adopting stock option plans for employees to increase employee incentives. VC firms will often appoint individuals for specific roles within the firm and, in some cases, remove individuals from the firm (including the CEO, if the founders’ skills are less relevant for the firm’s next stage of development).

VC firms whose reputation precedes them, as measured by experience and past successes, have historically produced more successful exits, strengthening the argument that a VC professional is not just about providing capital to early-stage firms but also about adding value. Further evidence of this value-add is that an offer from a more successful VC firm is three times more likely to be accepted by an entrepreneur. This is because being affiliated with a successful VC firm is often more important than the valuation and quantum of capital received due to the potential for further upside in the future through working with that VC firm.

17.5 ALTERNATIVE SOURCES OF VC FINANCING

17.5.1 Corporate venture capital

Corporate venture capital (CVC) is the direct equity investing undertaken by larger established corporations into independent early-stage entities in a related line of business. CVC investing differs from traditional VC investing in that the investment is made directly into an early-stage company—not via a third-party VC firm. Additionally, CVC’s reasons for investing are strategic as well as financial. Similarly to traditional ventures, the CVC investor may offer strategic advice and other support services to the startup to help foster its development. In many cases, CVC operates alongside traditional VC as an additional source of finance for the early-stage company.

The CVC market ranges from approximately USD20bn to USD25bn annually, or an estimated 6% to 8% of the entire VC market (MacMillan et al., 2008). While CVC is primarily focused in the largest VC arenas such as biotechnology, communication, and software, it also extends to other sectors that typically are shunned by traditional VC, such as financial services.

One of the primary factors of CVC is for a corporate to gain competitive advantage by obtaining early access to a new concept or product. By becoming an investor in a promising young entity, a large corporate can monitor developments on new concepts or products and gain a first-mover advantage for any joint venture or licensing schemes. CVC also avoids costly and uncertain M&A transactions, although a corporate may subsequently acquire developed entities which are familiar through previous CVC investments. Additionally, CVC may allow entities to grow and develop what would otherwise be limited in the environment of a large, structured corporate.

The due diligence and financing process of CVC is nearly identical to that of VC, although evaluation of the strategic interests of CVC occurs concurrently. Additionally, corporations may have inside industry knowledge that may aid the due diligence evaluation of new ventures.

17.5.2 Venture lending

Venture lending is defined as debt offered by either a bank or a non-bank to any company that is still reliant on VC support. Venture debt can be secured by future cash flows or collateral; collateral-based lending can include venture leasing, receivables and inventory factoring, asset finance, and supply chain financing. The stage, size, assets, and growth of the company will dictate which type of lending is available. Additionally, venture lending may offer bridge financing between various equity rounds. For early-stage companies, venture debt can be a crucial component of the capital structure to ensure the company has an appropriate amount of cash to stay solvent. This can provide funding to sustain the company through product development and testing, marketing campaigns, or other similar phases which are necessary to expand the company.

The providers of venture debt often receive equity warrants in addition to interest payments and fees as consideration, which makes venture debt similar to mezzanine finance. This adds an equity component to the debt to compensate venture debt providers for the risk undertaken, thus resulting in a debt–equity hybrid. The warrants, which offer the holder the right but not the obligation to purchase equity at a predetermined date and price, will dilute existing shareholders, so proper structuring and consideration of the all-in cost is important.

When equity holders are considering venture debt as another source of liquidity, management must have a specific use for the funds and know how much is required. Repayment terms, tenors, covenants, collateral, and warrants differentiate venture lending from traditional bank finance.

The primary motivation to obtain venture debt instead of venture equity is to limit shareholder dilution, thereby increasing the return to existing shareholders via leverage. Venture debt may also finance certain equipment “soft costs”, such as installation, testing, and pre-delivery payments that would otherwise consume a portion of the company’s cash reserves. For companies that are almost at significant milestones, venture debt can be a resource to help fill the funding gap and, by achieving certain milestones, look more attractive to other investors and aid the company in obtaining more favorable terms.

Venture debt, however, comes at a cost to the company given the amount of risk involved. First, while returns required by providers will be less than other pure equity investors, the all-in rates from the interest, fees, and warrants will be considerably higher than commercial bank lending rates. Second, dilution will occur from the warrants, although it will likely be less than dilution of adding a pure equity investor. Third, complying with venture debt requirements can prove burdensome from an administrative perspective. Fourth, strict financial or operational covenants may restrict the activities of the business. Finally, certain types of debt can restrict access to more debt in the future.

17.6 CONCLUSION

Since its creation, the VC industry has been instrumental in creating jobs and driving economic growth and innovation. VC-backed companies have produced many products that have become household names and are now considered essential to daily life. What is particularly remarkable is the speed at which these companies have evolved from being early-stage businesses to becoming large organizations and the speed in which these companies’ new products and services have been accepted and incorporated into the mainstay of society.

The VC industry has proven its ability to add value to early-stage companies for more than 50 years, and this is demonstrated in a number of ways. First, VC funding has a successful track record in having had some level of involvement with most of the major and successful technology companies in existence today. This is due to the professional, operational, and financial expertise VC professionals offer after seeing many companies transition through the same challenges. Second, VC firms are able to take far greater risks than other funding sources and, therefore, fulfill a crucial funding gap in the market. Third, due to the early-stage nature of the typical VC-backed company, VC firms utilize strict corporate governance structures compared with non-VC-backed companies. Fourth, empirical evidence shows that VC-backed companies grow more quickly and generally bring products to market more quickly than non-VC firms (Hellmann and Puri, 2002; Strömberg, 2009).

In aggregating all of the abovementioned points, what is clear is that the VC industry will continue to be a driver of innovation globally, a powerful economic engine, and an essential asset class for institutional investors.

17.7 REFERENCES

BRAUN, E., and Macdonald, S.1982) Revolution in Miniature: The History and Impact of Semiconductor Electronics Re-Explored, Updated and Revised Second Edition, Cambridge University Press, New York.

CHEN, H., Gompers, P.A., Kovner, A., and Lerner, J.2009) “Buy local? The geography of successful and unsuccessful venture capital expansion,” NBER Working Paper No. w15102.

DELOITTE (2010) Global Trends in Venture Capital: Outlook for the Future.

EVCA (2005) Employment Contribution of Private Equity and Venture Capital in Europe.

HELLMANN, T.F., and Puri, M. (2002) “Venture capital and the professionalization of start-up firms: Empirical Evidence,” Journal of Finance, 57(1), February.

HSU, D. (2004) “What do entrepreneurs pay for venture capital affiliation,” Journal of Finance, 59(4), 1805–1844.

KAPLAN, S.N., and Strömberg, P. (2001) “Characteristics, contracts, and actions: Evidence From venture capitalist analyses,” Journal of Finance, 59(5), 2177–2210.

KORTUM, S., and Lerner, J. (2000) “Assessing the contribution of venture capital to innovation,” RAND Journal of Economics, 31(4), 674–692, Winter.

MACMILLAN, I., Roberts, E., Livada, V., and Wang, A. (2008) “Corporate venture capital seeking innovation and strategic growth,” working paper.

NVCA (2010) National Venture Capital Association Yearbook, Thomson Reuters, New York.

SHANE, S. (2008) The Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors and Policy Makers Live By, Yale University Press, New Haven, CT, p. 90.

STRöMBERG, P. (2009) “The economic and social impact of private equity in Europe: Summary of research findings,” working paper.

a This chapter has been co-authored with William Lamain (MiF, London Business School) and Rebecca Zimmerman (MiF, London Business School).