Venture Capital: An Overview

Posted on July 17, 2012

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“All capital is venture capital.”- Henry Goodrich[1]

Treatises, books, blogs, websites, twitter accounts and numerous social and non social media in between are devoted to venture capital, so far be it for me to put forth anything new or truly informative on the subject. Certainly, investors and business people who have worked in venture capital backed portfolio companies will learn nothing new in a three-page article. However, entrepreneurs and business people can and do mix and mingle with the venture capital world, so some generic background information is potentially helpful.

Deciding whether you participate or do not participate in venture capital is a crucial decision for entrepreneurial companies. It is a high risk/ high reward decision. Venture capital is a world full of jargon and lingo and knowing some terminology may help you decide whether you want to participate in this world (or at the very least, will let you impress your friends at the bar).[2]

All definitions are quoted directly from Advanced Private Equity Term Sheets and Series A Documents.

Venture Capital: An investment in a startup business that is perceived to have excellent growth prospects but does not have access to capital markets. Type of financing sought by early-stage companies seeking to grow rapidly.

Series A: The first round of stock offered during the seed or early stage round by a portfolio company to the venture investor or fund. This stock is convertible into common stock in certain cases such as an IPO or the sale of the company. Later rounds of preferred stock in a private company are called Series B, Series C and so on.

Participating Preferred: A preferred stock in which the holder is entitled to the stated dividend, and also to additional dividends on a specified basis upon payment of dividends to the common stockholders. The preferred stock entitles the owner to receive a predetermined sum of cash (usually the original investment plus accrued dividends) if the company is sold or has an IPO. The common stock represents additional continued ownership of the company.

Ratchet: Ratchets reduce the price at which venture capitalists can convert their debt into preferred stock, which effectively increases their percentage of equity. Often referred to as an “antidilution adjustment.”

-          Full Ratchet: The sale of a single share at a price less than the favored investors paid reduces the conversion price of the favored investors’ convertible preferred stock “to the penny.” For example, from $1.00 to 50 cents, regardless of the number of lower priced shares sold.

-          Average Weighted Ratchet:  The investor’s conversion price is reduced, and thus the number of common shares received on conversion increased, in the case of a down-round; it takes into account both: (a) the reduced price, and (b) how many shares (or rights) are issued in the dilutive financing.

Down Round: Issuance of shares at a later date and a lower price than previous investment rounds.

Registration Rights: Provisions in the investment agreement that allow investors to sell stock via the public market. Means by which one can transfer shares in compliance with the securities laws subject to Lock-Up and Market Stand-Off Agreements.

Demand Registration Rights: Contemplate that the company must initiate and pursue the registration of a public offering including, although not necessarily limited to, the share proffered by the requesting shareholder(s).

Preemptive Rights: A shareholder’s right to acquire an amount of shares in a future offering at current prices per share paid by new investors, whereby his/her percentage of ownership remains the same as before the offering.

Rights of Co- Sale: Allows investors to sell their shares or stock in the same proportions and for the same terms as the founders, managers, or other investors, should any of those parties receive an offer.

The National Venture Capital Association has helpful information as well. (See www.nvca.org for their website.) For the entrepreneur investigating whether this type of financing is the right fit, your company needs to be at the stage where it can (a) accept an investment of more than a million dollars and (b) take that investment and generate a return equal to a multiple of that initial investment. Obviously, the venture capital companies themselves are the ultimate arbiters of that decision, but if the entrepreneur cannot look himself in the mirror and answer these questions affirmatively, then you are wasting your time and other people’s time trying to obtain venture capital funding. The energy then should be exclusively focused on growing (through other funding methods) your business to a point where you can answer these questions, and that is a much more productive use of one’s time.

At this point in the discussion, the question is often asked if a venture capital route is really ever right for anyone. Usually you receive warning about the negatives of VC funding, which are numerous, and indeed, it does require a unique set of circumstance. However, the reward is great, and too often commentators are overly pessimistic about this route. Perhaps we need to focus on the wealth creation that comes from this route. Creating and having significant ownership in a large business is one of the few (if not only) ways to achieve significant wealth, and venture capital is one of the few (if not only) ways to obtain capital to fund significant and rapid growth.

Additionally, if I may be permitted a brief editorial comment about the Birmingham entrepreneurial community, I think we (companies, service providers, and investors) shoot too low. We allow mediocrity and sub par performance to be tolerated. The result of this is that we do not have the companies in the pipeline to replace the inevitable turnover and mergers of Birmingham’s larger companies. The entrepreneurial community must work hard to promote good talent and work with them so that they can build a strong foundation for their companies. Entrepreneurs need to be more realistic, and frankly, better prepared to come to market. Investors need to do more work to help companies develop into better and more fundable companies. More problematic than a dysfunctional Birmingham Board of Education or a bankrupt county, if Birmingham does not have a strong entrepreneurial economic environment, we are simply rearranging the deck chairs of the Titanic.

Mike Goodrich
Goodrich Law Firm, LLC

 


[1] This is something my grandfather told me so I know that I am in fact quoting him.  Whether my grandfather was the first to say this, I cannot swear, but until someone proves otherwise, I am going with the family bias.

[2] The VC world is full of ego and not many people will confess even the slightest degree of ignorance, but the fact of the matter is that there are probably more people in this world who do not know what they are talking about than those that do. Maybe by providing a mini glossary, I am just aggravating the problem, but ideally people can use these terms responsibly and only when necessary (i.e. when truly established VC firms are involved). From my perspective, the cavalier use of some of these terms creates superfluous work, needless complexity and a lack of understanding among the parties. If people would be more willing to ask questions, profess ignorance and accept simplicity, then the business and all of its stakeholders can probably grow faster and go further.

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