ATTRACTING VENTURE CAPITAL FUNDING: Understanding Venture Capitalists' Needs and Objectives by Daniel H. Aronson 1 Venture capital investing has evolved into more of an art than a science, and more of a journey than a destination. Venture capital, although the term implies great risk, is really simply an equity investment by a professionally managed investment fund in a closely-held business believed to be promising and high-growth and that is expected to produce a high-return exit within the investor's time horizon. For the fund-seeking business owner, obtaining venture capital funding is a challenge of the highest order, which can only be overcome by the right combination of company attributes (e.g., proven management talent, proprietary products or services or other competitive advantages, demonstrable growth and market potential and substantial potential exit valuation), investor appetite (and the "right fit" with the investor, in terms of size of investment, market/industry preference, geography and stage or maturity preference) and timing (in many cases, dictated or influenced by luck). Venture capital funding, for many years now, has been the driving force behind highly innovative people and businesses that couldn t attract traditional lenders or investors. Just as a business manager must actively and continuously seek to understand the wants and needs of target customers, so too should the fund-seeking business owner endeavor to gain an appreciation of the perspective, goals and objectives of potential investors. Armed with a solid understanding, owners and managers can save time, energy and resources; plan for and anticipate investor needs (including regarding ultimate exit/liquidity); and more effectively consider, structure and negotiate the investment transaction and surrounding agreements to meet owner goals. There are four principal objectives that influence the approach and behavior of a venture capitalist ( VC ) in the investment transaction process. The mating dance, due diligence process and negotiations, as well as the structure and attributes of the investment itself, largely flow from and are dictated by the VC s implementation and treatment of these objectives (and resolution of related issues): Maximizing the Upside (and potential investment returns) 1 Copyright Daniel H. Aronson 2012 - All rights reserved. Daniel H. Aronson (Daronson@bergersingerman.com) is a Partner and Group Leader of the Corporate, Securities and M&A Practice at Berger Singerman LLP (www.bergersingerman.com), a Florida-based business law firm. With more than 25 years of experience, Mr. Aronson counsels public and private companies, and their boards, senior management and significant investors and owners, regarding mergers and acquisitions, public and private securities offerings, sophisticated capital markets transactions, general corporate and governance matters and international business transactions. The views expressed herein are solely those of the author (and not his partners, colleagues or clients). This article which is based on more extensive discussion included in the author's book, Venture Capital: A Practical Guidebook for Business Owners, Managers and Advisors (RR Donnelley Publications, Fifth Edition, 2011) is intended solely as an educational introduction to the topic addressed. It is not designed to provide, and does not constitute or include, legal, tax or professional advice on any matter, and should not be relied upon for that purpose.
Protecting the "Downside" (and risks associated with the investment) Monitoring and Influencing Progress and Development (through governance, voting and control mechanisms) Pursuing and Effecting "Exit" Strategies and Liquidity A. Maximizing the Upside (and potential investment returns) 1. Return on Investment. Venture capital firms are typically organized as funds, with the management of the fund (its general partner) serving in a fiduciary capacity to the fund s limited partner investors (and with the managers typically also putting their own capital in play). VC funds seek deal flow in the form of investments in portfolio companies on an investment-byinvestment basis, which can be sold or liquidated over a defined time horizon at (hoped-for) exceptional rates of return. Put simply, VC funds are in the business of realizing a net return on investment (ROI) across their portfolio of investments, at substantially higher return levels than other alternatives limited partners could choose to invest in, including from competing venture funds. These returns are necessary to justify the risks and indefinite periods of illiquidity inherent in investing in immature, high-growth private companies and to cover the firm s operating expenses and override incentive compensation. By achieving exceptional rates of return, VC funds ensure their survival and success in the life-cycle of fundraising, investment, building/ramping, and liquidity (via executing on an exit strategy) and harvesting returns. 2. Selection & Due Diligence. VCs look at hundreds of deals a year; before they determine to commit resources to a potential transaction, they typically (a) review, in considerable detail, the business plan, financials and projections, (b) check the company and its management out through background checks and discussions with local contacts (e.g., attorneys, accountants, bankers, management of other portfolio companies, etc.), (c) based upon internal estimates regarding the target company's plans, the growth potential for the company's products/services and the market for such products/services, prepare their own projection model regarding the anticipated growth of the company and expected exit/return values, and (d) conduct an initial level of due diligence (e.g., interviews with management, review of financial and operational information and material documents, technology and intellectual property diligence, tour of facilities, etc.). If the target company passes these tests, the transaction is forwarded to the VC's investment committee for review and approval. 3. VC Fund's Directive and Incentives. VC funds are typically organized as limited partnerships: the management and investment professionals of the VC fund collectively serve as the fund's general partner, while the investors in the fund become limited partners. Limited partners usually contribute 99% of the capital in exchange for the right to 80% of the net realized gains. The general partner's 20% of net realized gains interest (also known as its "carry" or carried interest ) creates a powerful incentive to maximize the value of the fund's investments and ultimate return on investment. 4. Right Sizing the Investment. While owners and managers will have their own views as to the amount of investment capital required or appropriate at a given stage of development, the VC will apply its independent analysis and perspective (as well as its fund requirements or protocols) to assess and determine the right amount of funding, and capital resources, the
company will need to fund its short- and medium-term growth and development plans, to remove or significantly reduce risks and to fund contingencies. This capital (and capital resource) planning has been critical in recent years when follow-on investors have been difficult, and sometimes impossible, to attract when needed. 5. Timing. As the saying goes, "timing is everything." In no area is this more true than in venture capital investing. The VC seeks to make its investment at the appropriate and most opportune stage in the company s life cycle. In other words, over an investment horizon of two to five years, the company must be able to achieve the growth and execute upon an exit strategy necessary for the VC to liquidate some or all of its investment and realize its desired rate of return for its VC fund investors. 6. Budgets, Plans and Projections. VCs must be able to chart and track the business s course through growth, development, operational milestones, customer and revenue traction, profitability and ultimate exit. This is essential for mapping the company s progress and evaluating capital needs and exit opportunities. In order to achieve this, the VC will study and ultimately embrace the company s strategy, growth plan and related budget, and construct a detailed, justifiable and reasonably obtainable set of operating and financial projections, typically covering three to five years. This analysis may result in a company not making the cut because it is too early (or, sometimes, too late) to capture the desired or optimal growth in value. The VC s objective will be to invest in the company prior to a significant increase in value, typically through the achievement of one or more substantial development milestones and/or ramping up of customers, revenues or profits, or the timely presentation into a robust exit market. 7. Management Depth, Right People and Right Incentives. Most VCs subscribe and cling to the view that they do not invest in companies, technologies or products, they invest in people. After all, it is the people - management and key personnel - who make it all happen. Since these persons (particularly in early stage ventures) are often entrepreneurs, a challenge for the VC is, consistent with its own objectives, to craft and oversee an incentive structure in which (i) the VC supports and does not interfere with the proper functioning of managers and operation of the business, and (ii) management is provided with market-appropriate pay and meaningful financial rewards and incentives aligned with the VC s interests (creating a win-win scenario). The VC will also devote attention to ensuring that the management team has the right players, and sufficient depth, to take the business to the next level. Retention and restrictive covenant agreements are also typically discussed and implemented at the VC transaction closing. 8. Customary Structure and Documents. Over time, VC transactions have developed and evolved customary styles and forms, including extensive (sometimes believed onerous) due diligence and documentation to ensure that the VC s key objectives are analyzed, addressed, agreed to and implemented. Fund-seeking business owners genuinely interested in VC funding must be willing to consider and work with what has become market and customary (and often VC fund-required) structures, documents and provisions. These include convertible preferred stock, with preferences, dividends, conversion rights, liquidation rights and other superior economic features; anti-dilution protections; preemptive purchase rights and limitations on stock transfers; registration, co-sale, drag-along and other exit-related provisions; board membership, information and voting rights; management oversight, budgeting and periodic reporting
requirements; and special governance (including consent, veto and information) rights and provisions. B. Protecting the "Downside" (and risks associated with the investment) Given the substantial risk and illiquid nature of VC investments, no amount of due diligence or financial modeling, or attention to structure and protective provisions, can protect a VC from the occasional failure and/or disappointing investment. In fact, the inherent risk of failure and the difficulty of achieving resounding success is often what makes the investment attractive in the first instance. Notwithstanding this, certain structural mechanisms and protective terms have evolved and become customary to help VCs obtain maximum protection of their capital investments in portfolio companies (whether the company underperforms, goes sideways, or fails). For the uninitiated, the documents served up by the VC s counsel will appear overly lengthy, onerous and unfair. However, these documents and many of the provisions they include have become rather customary and, in many cases, the company will have few (if any) other places to go for equity funding of like amount or at this stage in its development. As a general proposition, market investment documents contain terms favorable to investors (and, from an independent, outside perspective, the risk of non-performance, failure or inability to realize a return on investment is very real). Some of the often-utilized structural protections and protective terms (guarding the "downside") include: Convertible Preferred Equity (and surrounding provisions) - with economic, control and other rights not given to holders of common stock (who are typically founders, employees and prior round investors) Liquidation preference (and participating preferred ) provisions, providing the VC investor(s) with a preferred return upon a liquidation or deemed liquidation (typically, merger, sale of all/substantially all assets, and majority change of ownership) of the company Anti-dilution price protections Board and preferred stockholder veto rights (often also referred to as protective provisions ) on issues impacting the rights or value of the preferred stock or concerning actions resulting in a change in direction, variation from budget, increased borrowings, changes in senior management or auditors, etc. Redemption (or put ) right - where the VC investor(s) have the right to require the company to repurchase their preferred securities at a specified price and terms if the company has not closed a sale, initial public offering or other specified liquidity event within a specified number of years Grant, vesting, exercise and other restrictions included in employee incentive compensation plans and option and restricted stock grants C. Monitoring and Influencing Progress and Development (through governance and control mechanisms) Anytime a business proposes to add a new significant equity owner, a thoughtful,
transparent discussion should take place concerning the game plan and related timeline for the company's use of the investment proceeds, achievement of key milestones (e.g., key management hires, customer penetration, revenue and profitability hurdles, regulatory approvals, product prototype(s), and product testing/validation), organic and external growth, and ultimate liquidity or exit. And, as part of this, issues concerning the governance of the business - who will have a seat at the table (board membership), and what say or veto rights will the owner constituencies have over key issues, in good and not-so-good times - will need to be considered and addressed. Founders, managers and other insiders initial concern regarding these issues (sometimes expressed as a loss of control ) is often exaggerated and unfounded. Venture capitalists, as a general rule, have no desire to run, or get intricately involved in, the day-to-day operations of the company (so long as it is proceeding in accordance with the agreed plan). However, VCs can be expected to insist upon (1) being kept informed and current concerning the business, management, competitive position, growth (internal and via acquisitions), capital resources, financial condition and results of operations of the company, and (2) ensuring that the company stays on, or ahead of, the agreed plan (consistent with the related agreed budget). Each venture capitalist will implement a report, information exchange and communications regime and process - typically centered around monthly reports, fairly frequent board meetings and the budgeting process - to satisfy its needs. To the delight of most portfolio companies, VCs function as true value added partners, bringing investment, financial and other expertise, experience, contacts, encouragement, and proven success to and for the benefit of the company. D. Pursuing and Effecting Exit Strategies and Liquidity As noted above, VC funds are in the business of investing their capital to realize exceptional internal rates of return. These returns are created, and only realized, if and when some measure of liquidity - the ability to sell for or otherwise receive cash - attaches to the VC s investment (and securities it received) in the portfolio company. Liquidity, in turn, is the function of the company availing itself (typically, with the VC s guidance, input and sometimes control) of one or more exit strategies. Exit transactions, like other major developmental milestones, have many facets, present many challenges and can require months, even years, of thoughtful and iterative positioning, planning and preparations. Strategies providing liquidity include the following: Sale of the Business. The prevailing exit strategy of choice, particularly given recent and current market conditions, is the outright sale of the business, whether through merger, consolidation, sale of stock or sale of assets. Preparations for and control over the decision to sell the company (and the timing of any such decision) are key, so the VC investor will require a say, if not control or veto rights, regarding this decision. Control (and the resolution of governance and approval issues) at the board and/or stockholder level is also important as the sale of a company typically requires the approval of both the board and stockholders. Whether the buyer is strategic (i.e., an operating company in the same industry and/or market) or financial (e.g., a buyout or private equity fund or investment fund) can greatly influence the approach, due diligence requirements, timing, negotiation, documentation and terms and conditions of a sell-side transaction. Given the importance of a properly timed and executed sale exit, VCs often from shortly after the investment closing - prompt and discipline their portfolio companies to implement a strategy of developing the corporate platform, instilling
budget and financial discipline, improving and adding to the management team, ramping up sales and financial performance, and achieving other milestones all in contemplation of the company s sale. Accordingly, the game plan will incorporate these tasks and milestones (and management s incentive compensation may, in some measure, be dependent on achieving them). Control over the decision to sell the company (and possible drag-along rights) will be a key area of focus here. Company insiders can expect the VC investor(s) to require a say in, if not control or veto rights over, these decisions. Initial Public Offering. An initial public offering ( IPO ) is the first underwritten public offer and sale of shares of the company s common stock (typically) to a large and diverse group of institutional and individual (retail) investors. An IPO transaction will not be appropriate for most VC-backed companies, and involves very extensive preparations, issue resolution, buildouts, audits and filings, and very substantial costs. This highly regulated process typically results in the shares being listed or quoted on a recognized exchange (e.g., the New York Stock Exchange or NASDAQ Stock Market) and a free-trading market for the registered shares. It also results in various stringent and ongoing reporting, disclosure and other obligations of the company and its officers, directors and significant stockholders. Depending on market conditions and other factors (such as negotiated rights and requirements imposed by underwriters), shares owned by founders, management, VCs and other insiders may also be registered and sold in the IPO, but typically such sales are limited (and subject to market standoff agreements). Registration rights and similar contractual provisions are designed to permit the VC to control or influence the share registration process, and to permit registration and sale of its investment interest first, before the founders and other insiders and common stockholders. Demand rights, piggy-back rights, S-3 rights, offering expense provisions and various limitations and exclusions are all the subject of discussion and negotiation (and these rights and provisions, which can be both time-consuming and expensive to the company if exercised, have become of increasing importance as the IPO market stabilizes and proceeds to some stage of normalcy). Other Exits and Pathways to Liquidity. The most prominent, sought after and successful exit strategies have been discussed above. Of course, a VC could also sell all or part of its investment position in the company to another VC, private equity fund or other third party. This doesn t happen often and may be a sign of trouble (or of a fund nearing its termination date). Partial liquidity can also be gained through a recapitalization, dividends, and stock repurchases, but (again) these are not usually viewed as preferred exits. Finally, where there are assets of value (and indebtedness and other priority claims don t exceed that value), liquidity can be obtained through a liquidation, wind-up and distribution of assets. Put simply, if the company s outright sale or initial public offering cannot be accomplished after diligent effort within the planned time horizon (plus some reasonable extension), then the VC s liquidity options become limited, and Plan B considerations kick in. Remember, given its preferred position, advantageous rights and the other attributes of its investment, if the VC s position is not good, the position of the founders, previous owners, managers and other insiders will usually be worse. This scenario triggers a new, often complex and troublesome, phase for the business and its owners: regroup and reset expectations, reconfiguring and recapitalizing, (possibly) identifying new capital and investors (and dealing
with their demands and terms), and of course execution challenges. In seeking venture capital, fund-seeking business owners and managers should take the time to understand and consider the venture capitalist's perspective, needs and objectives. This will increase your chances of success, a "good fit" with your new VC partners and ultimately a smooth and successful exit transaction.