This post is the ninth installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the previous post about Venture Capital Financing here.
When an entrepreneur has determined that venture capital financing is right for their company, the next step is to begin pitching venture capital (VC) firms to raise the necessary funds. Pitching is the process of presenting your idea and company to potential investors, and asking for a certain amount of money in exchange for a certain percentage of your company. Pitching is not a legal matter, so in this blog we will skip the discussion on pitching and focus on the most important elements of the early negotiations with VCs.
When a VC firm progresses from tire-kicking to serious investment discussions, the first step is negotiating a term sheet. A term sheet is the basic document that outlines the major terms of the venture financing, such as the size of the investment, what percent of the company is being purchased, who gets a seat on the board of directors, and who gets paid first on a liquidity event. Let’s dive in to these areas a little deeper to give you a sense of what to look for when negotiating with a venture capital firm.
Price: Pre and post-money valuation
First, let’s take a look at arguably the most important term in a financing, the valuation of a company. The basic point of a valuation is to determine what percentage of the company a certain investment is worth. For example, if you are seeking a $10 million investment for 25 percent of your company, the total value of the company should be $40 million.
However, be careful when venture capitalists talk about “valuation,” as this term has two meanings in the venture capital space. There is the pre-money valuation, and then there is the post-money valuation. Pre-money valuation is the value of the company today, before any money is invested. Post-money valuation is the value of the company after the new investment.
It is imperative that the entrepreneur understand the difference, and which measure is being used. If you think VCs are offering you an investment based on a pre-money valuation, when they are under the assumption the valuation is post-money, you might end up selling a much larger chunk of your company than planned, for much less money.
Let’s return to our example above where $10 million is being invested at a $40 million valuation. If the $40 million valuation is pre-money, that puts the post-money value at $50 million, meaning the VC is investing $10 million for a 20 percent interest in the company.
On the flip side, consider how this changes if the $10 million investment is based on a $40 million post-money valuation. Now, that same $10 million investment gets the venture capitalist’s 25 percent instead of 20 percent – a huge difference. As you can see, clarifying whether a valuation is pre-money or post-money is essential when negotiating with VCs.
Control of the company: Who gets a seat on the Board of Directors?
Another heavily negotiated point in a venture financing is who gets a seat on the Board of Directors, a.k.a. the group of individuals that controls a corporation. (Note: VCs prefer to invest in corporations, although LLC investment is becoming more common). The primary function of the Board of Directors is to determine the high-level direction of the company and to hire/fire the CEO.
In an effort to protect their investment, VCs will almost always demand at least one board seat, if not more, and will use it to monitor your performance as CEO. If a company raises multiple rounds of venture financing with different investors or VC firms, each new major investor will likely want a seat on the board as well. Therefore, it is important to remain aware of the evolving composition of the board. If three out of five board members are allies, your position as CEO is safe; if only two out of five like you, then you might be sitting on the sidelines while VCs replace you as CEO.
When a founder is fired as CEO of their own company, they become a simple shareholder and retain only the right to vote their shares like any other shareholder (unless the new CEO gives them a new job within the company). This not only hurts the ego, but it also removes your ability to influence the long-term direction of the company. It is extremely important to consider the ramifications of giving up board seats to your company when raising venture financing.
Liquidation preference: Who gets paid first?
One of the most significant benefits to preferred shares is a contractual right called a “liquidation preference.” This is, in the most general sense, a right for the preferred shareholders to get paid before the common shareholders get paid. Typically, the liquidation preference will guarantee the venture capitalist gets their full investment repaid before the common owners get anything. Guaranteeing repayment of initial investment is called a 1x liquidation preference (sometimes VCs negotiate even higher, such as a 2x or 5x, although these are less common). If the company sells for less than the size of the VC investment, the owners will end up with nothing.
For example, let’s say that a venture capitalist purchased 25 percent of a company for $5 million and was able to get a 1x liquidation preference. This means that upon a liquidity event, the VC must be paid $5 million off the top, before any money can be distributed to the common stock holders. If the company’s fortunes go south and ends up selling for $5 million dollars or less, the founders of the company will get nothing.
To take this example further, let’s assume the VC was able to get a 2x liquidation preference. This means that the company has to sell for more than $10 million or the founders will get absolutely nothing!
As you can see, attracting VCs willing to invest in your company is just the first step in completing a successful venture financing. You must also make sure to be clear on whether the investment is based on a pre or post-money valuation. Further, you will need to carefully consider whether you are ready to give up seats on your board of directors. Finally, you must think hard on what kind of liquidation preference you are willing to sacrifice to a venture capitalist, as it could result in you losing any chance of enjoying a return on your hard work. When negotiating with a venture capitalist, you need a business attorney.
Check back in next month as we explore exits, or the ways that a business owner typically cashes out their hard work and investment into their company.
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