Negotiating Venture Capital Transactions
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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies and investors. The information on this page should not be construed as legal advice. |
For the entrepreneur, founder, or management, finding an interested investor is just the first step in a venture capital transaction. Whether the company has informally discussed the potential of involving investors, or is going through a formal VC round, many of the same factors of negotiation will apply. The two sides are working towards the same goal, but have unique interests which will need to be balanced in order to close the deal.
Negotiating and structuring the deal is done by the exchange of term sheets, which are short documents detailing the proposed terms of the agreement. If the terms sheets are agreed upon, the parties move into drafting the final agreement to close the deal. Below are several factors that investors and founders may focus their attention on. There are other terms that are included in the term sheets, but often they require choosing a desired mechanism, rather that potentially deal-breaking differences.
Valuation
The most fundamental negotiations will be regarding valuation of the business. Business valuation in venture capital transactions are usually calculated by discounted cash flow (DCF) plus the residual value of the company. DCF counts the projected cash flow (revenue minus costs) for the years the plan consists of (i.e. until the exit plan). The figures are then discounted to represent a present value. The following issues are negotiated in the valuation:
- Revenue and costs projections - Investors will not accept revenue projections that are not consistent with other similar business models of the same industry. Even if the projections are based on similar businesses, the company will need to make the case for why this model will be replicated.
- Residual value of the company - If acquisition is the exit plan, companies and investors will look to acquisition prices of similar companies and make arguments for or against using those figures for comparison. The prices are usually a multiple of EBITDA which varies in different industries. The acquisition price will factor in the projected earnings of the present company. If IPOs are the exit plan, companies and investors will use projected earnings times the P/E ratio of similar publicly traded companies. Again, arguments for and against using certain companies and projected earnings may be made on both sides.
- Discounting - The ROI percentage used to discount the future cash flow to a present value has a huge impact on the resulting value. The amount of time until liquidation is a key component, because of the high percentages used. The percentage is the available percentage of risk free debt (which these days doesn't amount to much) plus the risk premium of venture investing. The resulting percentages are going to be high (40%+ for seed round financing). The premiums decrease for companies with revenue seeking later round financing. Companies should be prepared to make an argument for a lower risk premium, and convince the investors they will be able to accomplish the plan in the amount of time stated.
Business valuation comes from the founders first, in the form of their business and financial plans submitted to the investors. The next valuation comes from the investors, which, if they are VC firms, is a fraction of what the founders valued their business at. For this reason, most people in the startup world will advise companies to inflate their business valuation to achieve the actual amount they want.
Control
Aside from valuation, control is often the biggest issue for founders. After giving birth to an idea, and nurturing it to a stage that investors are interested, the entrepreneur does not necessarily want to give up operational control to the investor, who may have no experience in the field. On the other hand, the investor is not likely to contribute their capital to the venture without any power to intervene in the entrepreneur’s affairs, who may have no experience in business management.
- Board Composition - Assuming the company is a corporation, the entrepreneur and the investor might both want control of the board of directors. If they cannot come to an agreement, they may resort to selecting an equal number of directors, with an additional director of mutual selection, or through some selection procedure.
- Unanimous Decisions - No matter how the board is comprised, both sides may want to include actions that require a unanimous vote of the Board to accomplish, such as mergers, acquisitions, dissolution, employee compensation, and significant contractual relationships.
Walk-aways
One thing an experienced investor may want to protect against is a walk-away by the entrepreneur. If an entrepreneur has nothing but their efforts tied into a venture, there is little deterrent from walking away if the prospects decline. Investors may want some assurance that the entrepreneur is vested in making financial gains. This will usually come in the form of a request by the investor for a good faith investment by the entrepreneur – a financial contribution to the venture. Investors may also use creative time or performance vesting shares to incentivize the entrepreneur to remain committed to the venture.
Registration Rights
One thing that investors may require that founders may be reluctant about are registration rights. This is an agreement by the company to register the investors' securities for public offering. This allows investors to liquidate their interests by reselling their securities to another party. I do not include registration rights in pre-Series A transactions, but they are fairly standard in subsequent rounds.
Redemption Rights
Redemption rights cause the company to offer to repurchase the securities after a given period of time. This is beneficial for investors to liquidate their interests if growth becomes stagnant and potentially beneficial for management if they want to retire the investors' class of stock.
Preferred Stock
Professional investment groups will most likely insist on preferred stock, which is a fixed-income security that allows the investor to exercise a conversion right, turning the preferred stock into common stock. This way, the investors receive income on a fixed schedule, notwithstanding the profitability of the company, have the right to convert to a pure equity share if the company takes off, and get preference in the event of dissolution. This is a very favorable setup for the investor, and is the standard for VC transactions. Angel investors may be wiling to use a convertible note for a pre-Series A transactions.