Venture Capital Financing

Venture Capital Financing

Venture capitalists typically have strict investment criteria and specialize in very specific high-growth industries. Venture capital is a broad term, meaning investment funds, partnerships, and divisions of large corporations whose focus is on investing in emerging and promising young companies.

Venture capitalists generally take preferred stock in a corporation in exchange for their investment, and typically expect to receive certain rights regarding their investment, including the right to elect one or more directors to the corporation's Board of Directors; the right to receive financial and other corporate reports and information; priority over common shareholders; and more.

Venture capitalists generally hope to cash out in three to five years and rarely invest less than several million dollars at a time. Also in contrast with angel investors, venture capitalists often take an active role on the boards of companies in which they invest, which may result in loss of independence and control by the owners of those companies.


Stock Purchase Agreement

When a deal has been struck with venture capitalists, the terms of the venture capital investment are typically first memorialized in a Term Sheet, with full-blown legal documents subsequently embodied in a Stock Purchase Agreement. The Stock Purchase Agreement tends to be a fairly complicated document and is generally drafted by the venture capitalists' attorneys. Sample Stock Purchase Agreements are available for review and purchase at www.AllBusiness.com/forms.

The Stock Purchase Agreement typically includes the following terms

• The price of the stock to be sold and number of shares to be purchased;
• Representations and warranties of the corporation;
• Covenants of the corporation;
• Conditions to closing the deal;
• A requirement to reimburse the venture capitalists' legal fees; and
• Exhibits and any related agreements.

Finding A Venture Capital Firm

The world of venture capital firms is very small. Once you are able to tap into that world, you should be able to find the firm that best suits your corporation's needs. You should start by asking your securities lawyer and accountant. You will want to speak with any colleagues who have experience working with a venture capital firm to raise money for their own ventures. There are publications and journals for venture capitalists that should be available in any public library. Another way to find a venture capital firm is to perform a web search on www.google.com or your search engine of choice, for venture capital or venture capitalists.

Articles, additional information, and forms regarding venture capital and venture capitalists are available at www.vcexperts.com.

The Structure of a Venture Capital Investment

The Structure of a Venture Capital Investment

A typical venture capital investment is structured so that the venture capitalist gets convertible preferred stock in your company. This stock gives the venture capitalist a preference over the common shareholders in the event of a liquidation or merger.

The preferred stock is convertible into common stock at the option of the holder -- and may be automatically triggered by certain events. For example, the preferred stock would convert to common stock in the event of an initial public offering (IPO) of the company to simplify the capital structure of the company and to facilitate the IPO.

Venture capital investments are also sometimes "staged." A certain amount of money is invested right away and additional money is invested later, as certain milestones are reached. From the company's perspective, it's important that these milestones are clearly defined and reasonably obtainable.

Venture Capitalists' Rights
Venture capitalists also typically expect to receive the following rights with an investment:

• The right to elect one or more directors to the company's board of directors
• The right to receive various reports, financial statements and related information
• The right to have its stock registered for sale in a public offering at the company's cost
• The right to maintain its percentage share ownership in the company by participating in future stock offerings

The Stock Purchase Agreement
Once the company and the venture capitalist agree on the terms sheet -- a summary of the proposed terms and conditions for the investment -- the venture capitalist's attorneys usually prepare the definitive agreements reflecting the transaction.

The main agreement will be the stock purchase agreement, which typically contains the following information:

• The price of stock to be sold and the number of shares to be purchased
• Representations and warranties of the company
• Covenants of the company
• Conditions to closing of the deal
• A requirement to reimburse the venture capitalist's legal fees
• Exhibits and related agreements, which contain other rights for the venture capitalist
  

Representations and Warranties
Representations and warranties from the company are almost always present as part of a venture capital investment. The company is expected to represent its financial and operational condition and outlook. A breach of the company's representations and warranties can lead to a real problem for the company, giving the investor various remedies laid out in the agreement.

Representations and warranties can go on for pages, because venture capitalists want to flush out any "warts" in advance. Some of the most common representations that companies are expected to make include:

• The exact outstanding capitalization of the company
• That the company's financial statements are true and correct in all basic respects and have been prepared in accordance with generally accepted accounting procedures
• That the company has no liabilities other than those reflected in its most recent balance sheet or occurring in the ordinary course of business since the date of the last balance sheet
• That the company owns all of the assets it claims to own, without liens or encumbrances except those disclosed
• That the company's intellectual property and products don't infringe the rights of others
• That the company is in compliance with all relevant laws that govern its operations
  

In early-stage companies, venture capitalists may insist that the founders make the representations and warranties personally.

Funding your Business with Loans vs. Equity Capital

Funding your Business with Loans vs. Equity Capital

When it comes to financing a business, there are two basic types of funding: debt and equity. Loans are debt financing; you borrow money and must pay it back, with interest, within a certain timeframe. With equity funding, you raise money by selling a portion of your ownership in the company.

Debt financing
Common debt financers include banks, finance companies, credit unions, credit card companies, and private corporations. Taking out a business loan allows you to remain in the driver’s seat of your own company and not answer to investors. Getting a loan is also usually faster than searching out investors. Professional investors review thousands of investment opportunities each year, and only invest in a small fraction.

Another benefit of debt financing is that as you pay down your loan you build creditworthiness. This makes you more attractive to lenders and increases your chances of negotiating favorable loan terms in the future.

Overall, debt financing is typically cheaper than equity financing because you owe only principal, interest, and fees, and retain your full ownership stake in your company.

Equity financing
Selling equity means taking on investors and being accountable to them. Many small business owners raise equity by bringing in relatives, friends, colleagues, or customers who hope to see their businesses succeed and get a return on their investment.

Other sources of equity financing include venture capitalists, which are professional investors willing to take risks on promising new businesses. These investors include individuals with substantial net worth, corporations, and financial institutions.

Most investors do not expect an immediate return on investment during the first phase of your business; they bank on your being profitable in three to seven years. Equity investors can be passive or active. Passive investors are willing to give you capital but will play little or no part in running the company, while active investors expect to be heavily involved in the company’s operations. Personality conflicts can arise in either arrangement. Before you enter into any agreement with an investor, carefully consider whether or not you are compatible, as this person will own a portion of your business.

Equity financing is not cheap: your investors are entitled to a share of your business’s profits indefinitely. Conversely, small business owners who may have difficulty securing a traditional loan or are comfortable sharing control of their business with partners may find equity financing a mutually beneficial arrangement.

Angel Financing

Angel Financing

Angel investors are individuals who are interested in investing in early stage or start-up companies in exchange for an equity ownership interest. Angel investors are likely to invest only upon seeing a business plan for a business with clear potential for profit and growth. These investors are often willing to invest in ventures that are too risky for banks or not enough profit for venture capitalists; nevertheless, angel investors are primarily motivated by a return on their investments. Another reason it makes sense to seek out angel investors is they may be willing to invest smaller amounts of money than other financing resources such as venture capitalists, discussed below.

Angel investors can be a good source of advice, guidance, networking opportunities, and other financing resources, in addition to their own angel financing. Angel investors tend to invest in businesses they believe in, are interested in, or in which they have experience. Angel investors are also typically more interested in a business's founders and management team than other investors. Although angel investors expect to cash out of their investment at some point, they may invest for five or seven years, which is longer than many other types of investors.


Finding Angel Investors

Angel investors can be found by asking your colleagues, accountant, lawyer, and friends and family. In some communities, there are specific angel networks, which networks can be found by contacting your local chamber of commerce or looking in the telephone book. Another way to find an angel investor is to perform a Web search on Google or your search engine of choice.


How Much Do Angels Invest?

Angels usually target early-stage startups and invest anywhere from $25,000 to $500,000. Angel investors often provide the seed money to get a business up and running while the founders pursue other sources of financing, such as venture capital. Anything exceeding $500,000 is considered venture capital.

Some angel investors operate as a collaborative fund. This is similar to a venture capital fund, except the number and size of investments are generally smaller.

Remember, angels don’t just invest money. Most angels invest in businesses closely related to their areas of expertise and take a significant role in the development of young companies. Often the business experience and networking opportunities angels bring to a company are just as valuable as the money they invest.

Strategic Partners vs. Financial Backers

Strategic Partners vs. Financial Backers
John Kilcullen
CEO
IDG Books Worldwide

Note: The IDG Books titles, including the popular "... For Dummies" series of books, CliffsNotes, Macmillan General Reference business books and Frommer's Travel Guides, are now owned by Wiley Publishing.

John Kilcullen peddled his idea for a series of information technology books to most of the major publishing houses before signing on with IDG as vice president of sales and developing the "For Dummies" series for IDG. Kilcullen was named CEO of a new division of IDG — IDG Books Worldwide — less than a year later. At its heydey, IDG Books employed 650 people and has revenues of $180 million.

Issue: Strategic partners vs. financial backers

Problem: If you get too involved with strategic partners, you won't retain as much equity ownership, or worse, your company and your idea won't be your own anymore.

Reality: The right strategic partner or partners can take your idea a lot further a lot faster, and make your life as CEO a lot easier. "By going with the smart money partner, you can jump-start the start-up process, especially if you are starting an inventory-intensive business such as book publishing," says Kilcullen.

Strategic partners can help your company in many ways — they can open the doors to working with the right distributors and suppliers, provide your new Web site with instant content, use their global sales force to take your company international overnight or supply you with the technological, legal or accounting help that you can't afford on your own. Sometimes, access to the right resources is worth much more than the money any financial backer could provide.

The right way to get the job done: Look for strategic partners operating within your niche that find working with smaller, independent companies refreshing. Larger companies look for strategic partners for many reasons: they want to be in a new space, but don't know how to approach it; they have new product ideas, but want to outsource them for cost reasons; they don't have the internal talent for a new type of company and don't want to do the recruiting; or, because of the way their company is currently structured, it isn't well-suited to directly leverage a new idea.

A well-developed brand, entrepreneurial ideas, passion about the customer and your product, and the ability to bring a product or service to market quickly all attract strong strategic partners.

What to watch out for: Choosing a strategic partner whose culture you don't resonate with. "IDG has a very hands-off approach. They said, 'Come to California and start a company on our nickel,' " says Kilcullen. "They found my ideas very compelling and made it clear that they trusted me. I was attracted to their global business and their corporate value set."

— Susan Smith Hendrickson