What investors want

By Jim Jasaitis

What are the basic choices?

Venture capital investments can take a number of forms. The principal choice is whether to make an equity or a debt/SAFE investment.

Equity investments. An equity investment is an ownership interest in a company. Although equity investments can be redeemable (repaid over time), they generally are not subject to mandatory repayment. Rather, the idea of an equity investment is that the investment will result in (i) dividends from the profits of the company and, more importantly, (ii) appreciation in value from the growth of the business.
Debt / SAFE investments. Debt and SAFE (Simple Agreement for Future Equity) investments do not give the investor an ownership interest in the entity; rather the investor is treated as a creditor and investment is treated like a “loan” to the entity, i.e., it is repaid over time and earns interest at a specified rate. While similar to debt instruments, SAFEs typically (though not always) do not have a set “maturity date” and are not required to accrue interest. Debt instruments frequently are called notes (if they are unsecured and represent short- to medium-term obligations), debentures (if they are unsecured and represent longer-term obligations) and bonds (if they are secured). Interest paid with respect to debt is deductible by the company and constitutes taxable income for the investor/lender.
1. Debt investments can be combined with equity investments by the use of warrants, or by making the debt convertible into equity. Warrants give an investor the right to acquire stock in the company at some future point, at a price that is fixed at the time of issuance.
2. Non-convertible debt investments are not used as frequently as convertible debt instruments and equity investments because non-convertible debt is expected to be repaid, and thus the investor can be precluded from reaping the ultimate benefits of a business that is extremely successful. Meanwhile, unsuccessful ventures will be unable to repay the loans, and thus, a debt investment in a start-up is only incrementally less risky than an equity investment. Thus, venture investors typically prefer equity investments and convertible debt investments, through which they can reap the full benefits when the venture business hits the proverbial home run. Additionally, debt (as opposed to equity) on the venture’s balance sheet also may make it more difficult for the company to obtain future financing.
3. The ultimate return on debt investments may also be limited by usury laws, which limit the amount of interest a lender can charge a borrower. This is in contrast to equity investments that can pay unlimited dividends (provided that there is legally available capital to make such payments). It is also more difficult for debt investors to become involved in the company’s management. Indeed, debt investors who become involved in management may face “lender liability” and other similar claims if the business turns sour and the lender/investor seeks to collect its debt.
4. Non-convertible debt instruments are more often used in more mature financings, where the business entity is already making a profit but needs additional capital to grow to the point where it is ready to go public. In such a case, a venture capitalist might choose a non-convertible debt investment, which will be likely to generate fixed income. In these cases, the owners of the entity (i.e., the entrepreneurs and the initial venture capitalists) are generally unwilling to sell a significant piece of the equity in the business. However, even in these cases, venture capitalists frequently will negotiate for warrants or some similar equity feature to enhance their potential return on investment.
5. Debt investments also raise questions concerning repayment priority. Generally, venture investors will be requested to explicitly subordinate their investment to other indebtedness of the company. Subordination provisions can be quite complex, and the level of subordination of the venture capitalist’s debt generally is highly negotiated. Notwithstanding any subordination scheme, the venture investor’s debt investment claim will be paid before any distribution or dividend is paid to an owner of an equity investment.
  1. Complete subordination. Complete subordination exists when the subordinated debt does not receive any payments until all debt of the entity is paid in full. Typically, in venture investments, complete subordination is given only by the entrepreneurs.
  2. Contingent, subsequent or inchoate subordination. This kind of subordination usually allows the debt-holder some kind of priority in payment until a future event such as insolvency or bankruptcy in which the entity is in default of all of its obligations. Following such default by the entity, the venture investor will receive payment only to the extent that the senior indebtedness is paid in full but will always be paid before the assets of the entity are divided among the equity holders.

Common stock

Common stock is the most basic form of investment instrument. Common stockholders have no preference over any other stockholders with respect to distributions of assets or liquidation, or with respect to payment of dividends.

Common stock rights. In general, common stockholders have the right to vote for directors and approve certain significant corporate actions, such as a merger or a sale of substantially all of the company’s assets. If common stockholders desire to retain a greater degree of control over the business, the governing document can require that certain other actions (such as the incurrence of significant amounts of debt or a change in the nature of the business) must also receive stockholder approval. The rights of common stock may frequently be limited (although not eliminated) by the company’s issuance of preferred stock.
Multiple classes of common stock. More than one class of common stock may be used by corporations to differentiate various rights, including voting rights, among varying owners of common stock. For example, one class may have one vote per share, while another class may have two votes per share. C Corporations (but not S Corporations) may also grant different dividend and redemption rights to different classes of common stock. Therefore, the discussion of voting, dividend and the other rights (other than liquidation rights) of preferred stock can be equally applicable to a designated class of common stock.

Preferred stock

Preferred stock is any stock of the corporation other than common stock that possesses certain preferences to that of the common stock. In general, venture capital investors will invest in preferred stock, as preferred stock permits venture capitalists to structure more freely to what extent (and in what priority) they will participate in profits, future appreciation and management of the company.

Conversion rights. Typically, preferred stock is convertible into common stock. The right to convert the preferred stock is attractive because common stock is generally the vehicle for a company’s initial public offering (IPO) and, therefore, provides an “exit strategy” for the venture investor.
1. Optional vs. Mandatory Conversion. Preferred stock can be convertible at the option of the investor and/or mandatorily upon the occurrence of certain events. Events that will frequently give rise to a mandatory conversion include:
  1. an IPO, in which event the special protection afforded the venture investor will be less necessary and the existence of such rights will depress the price of the company’s common stock following the public offering.
  2. the optional conversion of a large percentage of the outstanding shares of the class of preferred stock or the written agreement of the holders of that percentage of the outstanding shares to optionally convert.
2. Antidilution protection. Preferred stock will typically be convertible into common stock, as the venture investor typically believes that the purchase price of the investment can be measured by the venture investor’s total ownership interest in the company. To ensure that a venture capitalist receives the benefit of the bargain, even if conversion to common stock occurs significantly later than the initial investment, convertible preferred stock typically contains antidilution protection. Antidilution provisions typically enable the holder of preferred stock to receive additional sharesin the event that additional shares, options to acquire additional shares or other convertible securities are issued or sold by the company.
  1. An example. A venture capitalist invests US$10,000 to purchase 100 shares of preferred stock, each share of which converts into 10 shares of common stock. Prior to the investment, the company had total assets of US$10,000 and there were 1,000 shares of common stock outstanding. In effect, the venture capitalist has agreed to pay US$10,000 for 1,000 shares of common stock. Thus, for the US$10,000 investment the venture capitalist initially purchased 50 percent of a company with a total capitalization of US$20,000.
    1. If the company does a two for one split in its common stock, there will be 2,000 shares of common stock outstanding. Thus, for the venture capitalist to maintain an ownership percentage, each share of the venture capitalist’s preferred stock must convert into 20 shares of common stock.
    2. If, on the day after the venture capitalist invests US$10,000, the company sells an additional 1,000 shares of common stock but receives only US$5,000 for these shares, the total capitalization of the entity will be US$25,000. Now, however, instead of owning 50 percent of a company with a total capitalization of US$20,000, the investor owns 33.33 percent of a company with a total capitalization of US$25,000 and the investment is now worth US$8,333.33. Although little in the company has changed, the investor has, in effect, lost US$1,666.67.
    3. Similarly, the investor would be deprived of the benefit of the bargain if, on the day after the US$10,000 investment, the company repurchased 500 shares of its common stock for US$7,500 or if it paid a dividend to the common stockholders that was not shared with the venture investor as if the investor had converted the preferred stock to common stock immediately prior to the repurchase or dividend.
  2. Methods of antidilution protection. There are several ways in which documents can be structured to protect the “ownership bargain” struck by a venture capitalist.
    1. Full ratchet protection. In full ratchet protection, if any equity interests are sold at a price below the price at which the venture investor initially agreed to convert to common stock, then the conversion price is adjusted downward to equal the price per share at which the additional stock was issued. Therefore, full ratchet protection gives the venture capitalist the same business deal as the new investor (who is paying less for the stock). Looking at the example in (i)(B), above, each share of the venture capitalist’s preferred stock would convert into 20 shares of common stock, so that, in effect, the venture investor pays the same price as the new investor (i.e., US$.50 per share of common stock). The adjustment would be the same even if the new investor had purchased only one share at US$.50. This formula can be quite tough on the holders of common stock, who (i) at the beginning of the transactions (assuming our example) had 100 percent of the shares of a company with US$10,000 of capital, then (ii) following the transaction with the venture capitalist, effectively owned 50 percent of the shares of a company with US$20,000 of capital, but now (iii) following the sale to the new investor, effectively own 25 percent of a company with US$25,000 of capital. Meanwhile the venture capitalist recognizes a windfall—moving from 50 percent of a company with US$20,000 of capital to 50 percent of a company with US$25,000 of capital.
    2. Weighted average adjustments. A more evenhanded (and common) method of protecting against dilutive issuances of additional stock is the weighted average method. In weighted average protection, the sale of stock below the conversion price will adjust the conversion price downward based on a weighted average reflecting the number of shares being sold and the price per share at which the additional stock was issued. The formula used to make the adjustment is complex, but the goal is to ensure that the venture capitalist’s investment will maintain its value (not necessarily the ownership percentage), as the adjustment is based both on the price and the number of shares issued to new investors. Using our example, under the weighted average adjustment, the venture investor’s 100 shares of preferred stock would convert into 1,333.33 shares of common stock, thus giving the venture investor a 40 percent interest in a company with US$25,000 of capital (i.e., an interest worth US$10,000). Weighted average adjustments can also be made for issuances that are at lower than the price paid by the venture capitalist and/or at a price lower than the fair market value of the stock at the time of issuance. Adjusting for issuances at lower than fair market value protects a venture capitalist against cheap issuances, which, after the value of its stock has appreciated, would reallocate some of its gain to a new investor.
    3. Dilution based upon percentage ownership. If a venture capitalist, such as the one in our example, desires to always own 50 percent of the stock in the company, the antidilution provision can be drafted to maintain this percentage ownership. This type of provision would be useful if the goal of the venture investor is to maintain a certain level of control over the enterprise. However, from the standpoint of a common stock investor in a successful company, percentage antidilution can be quite punitive, as the ownership interest in the company will be doubly diluted by future equity financings, even if those financings are at values well in excess of the value at which the venture capitalist originally invested. This form of antidilution protection is uncommon.
  3. Excepted issuances. It is typical that certain issuances of cheap stock should not lead to an antidilution adjustment, as such issuances benefit the company, and thus the venture investor should not use the antidilution provisions to deter such issuances. Frequently, for example, grants of shares of stock and/or options to employees, to lessors in lease financings or to sellers in acquisition transactions are deemed not to be new issuances for the purposes of the antidilution provisions of preferred stock.
Voting rights. Preferred stock can have many different levels of voting rights, depending on what role the venture investor wants to play in the business. Preferred stock can be given the right to vote on some or all matters, and can be given veto power over certain actions. It can vote on an “as converted” basis (in essence treating it as common stock for voting purposes) or it can vote as a class on certain matters.
1. Right to elect board members. If a venture investor desires to have a certain level of representation on the company’s board of directors, the company’s charter can specify that the holders of the class of preferred stock that the investor buys have a right to elect one or more directors. The same result can also be accomplished if all of the holders of stock agree, in a stockholders’ agreement, to vote in favor of one or more persons designated by the venture capitalist to serve on the company’s board of directors.
  1. If the venture capitalist does not have the right to elect a majority of the directors from the outset, frequently the venture investor will be given that right to elect a majority if the investment does not perform as planned. If a venture company has not met certain quantitative (e.g., failing to achieve a certain profit or maintain a certain net worth) and/ or qualitative (e.g., failure to open a specified number of stores, failure to bring a product to market in a specified time period and failure to obtain patents or trademarks necessary for the company’s growth) performance criteria, the venture investors might want such a right.
2. Veto rights. Generally, a venture investor will want to ensure that certain significant corporate changes are not undertaken without the venture investor’s consent. Thus, the entity’s governing documents frequently will provide that the entity may not take any such action without the approval of the holders of a class of preferred stock, voting as a class. Actions with respect to which a venture investor might want veto rights include:
  1. amendment of the company’s certificate of incorporation and/or bylaws in a manner that could be detrimental to the interests of the venture investor.
  2. issuance or sale of stock that has superior rights to or rights on parity with, the stock held by the venture investor.
  3. entry into an agreement that restricts the payment of dividends or any mandatory redemption of the investor’s stock.
  4. merger or sale of all or substantially all of the company’s assets.
  5. a dissolution of the company.
  6. incurrence of indebtedness over a certain threshold amount.
  7. a substantial change in the nature of the company’s business.
  8. going public.
  9. significant capital expenditures.
  10. key licensing transactions.
  11. the hiring or firing of key executives.
  12. significant acquisitions and dispositions.
3. Supermajority provisions. If the venture investor is not the only holder of the class of preferred stock being issued, consideration should also be given to what percentage of the class will be necessary to approve certain actions. Frequently, if one or two other venture capitalists own a majority of the class, notwithstanding that there are a larger number of holders of stock in that class, the vote of a supermajority (e.g., 66-2/3 percent or 75 percent) may be required so that more than just the one or two large holders must agree to certain significant corporate actions.
4. Common stockholder veto rights. If the preferred stock would constitute a majority of the outstanding stock on a fully diluted basis or if the common stockholders have ceded control of the board to the investors, the holders of common stock may request certain veto rights of their own. Ultimately, this permits the common stockholders to be “equal partners” at the bargaining table. Venture capitalists will often resist providing these rights to common stockholders, arguing that such rights give the common stockholders an ability to “hold the preferred stockholders hostage” with respect to key decisions, forcing the preferred stockholders to effectively renegotiate their rights and preferences after they have put their money at risk.
Dividend rights. Preferred stock frequently contains provisions that either (i) provide for dividends to be paid at a specified rate or (ii) grant the preferred stock a preference to dividends, such that dividends are paid to the holders of preferred stock before any dividends are paid to the holders of common stock.
1. Legal restrictions. Even if the preferred stock provides for mandatory dividends, the payment of dividends may be precluded by state corporate law, which generally only permits dividends to be paid (i) out of profits and/or (ii) from the company’s surplus, which is the amount by which its assets exceed its debts. Insolvent companies are generally prohibited from paying dividends.
2. Practical restrictions. Generally a start-up company will either not make a profit or want to reinvest profits into the business in its early years, and thus payment of dividends will direct the company’s cash flow away from the company, when such cash flow is needed to help the business develop and become profitable/ successful.
  c. Participating dividends. Participating dividends require that dividends be paid to the holders of preferred stock at the same time and at the same rate as dividends are paid to the holders of common stock.
3. Non-convertible stock. Typically, if a stock is not convertible, it will pay a specified dividend, which, if there is not sufficient available capital to make the payment, will accrue, to be paid at some later point.
4. PIK dividends. The company and the investors may agree that dividends can be payable in kind (i.e., through the issuance of additional shares of stock) rather than in cash. PIK dividends eliminate the drain of cash from the business while potentially increasing the return on the venture capitalist’s investment. However, PIK dividends can result in taxable income to the holder without the receipt of cash, and can be quite dilutive to existing stockholders.
5. Cumulative dividends. Some dividends are made cumulative, meaning that even if they are not declared, earned or paid, they continue to accumulate and will be required to be paid at some future point (potentially upon conversion or upon a liquidity event). Cumulative dividends have the effect of “growing” the amount that the company must pay to the holder of that stock before they can make payments to holders of junior securities. Cumulative dividends on certain redeemable stock could result in taxation to the holders as the dividends accumulate without distribution of cash.
Redemption. Preferred stock can be made redeemable so that, if there is legally available capital, the company must (or will have the right to) buy back some (or all) of the preferred stock at a specified price. There are several methods of calculating the redemption price, and they are frequently tied to the circumstances of the redemption. For example, the redemption price might be the initial purchase price paid by the venture investor plus (i) accrued but unpaid dividends and (ii) a potential premium over the original purchase price. Alternatively, the redemption price might be based on a fair market value calculation. Mandatory redemption at the option of the investor or pursuant to a specified schedule may trigger tax liability to the investor in years prior to redemption in a manner similar to the accrual of interest. To this extent, the venture investor will have to pay taxes on any redemption premium (including accrued dividends under certain circumstances) before such premium is actually received. If preferred stock is not convertible, it generally will contain some type of redemption provision.
Liquidation. In the event of a dissolution of the company or sale of all or substantially all of its assets, preferred stock generally is given a priority with respect to any distributions made to stockholders. The liquidation priority usually equals the purchase price of the preferred stock.
1. Participating liquidation preference. If the preferred stock is participating preferred, in addition to the liquidation preference, the preferred will also be treated as a common stock shareholder and will have a right to its pro rata share of proceeds distributed to all stockholders. When participating preferred stock is used, the payout is often subject to a “participation cap” that limits the investor’s return after a pre-determined hurdle is met.
2. Triggering events. Generally, liquidation rights are triggered by either the voluntary or the involuntary liquidation of the company. The parties typically also agree that certain other events, such as a sale, merger or transfers of control of the company, will be treated as a liquidation. Such provisions are common, as they prevent a change in the nature of an investor’s investment without the investor’s express consent.
3. Multiple liquidation preferences. Although currently out of vogue, venture capital investors sometimes seek so-called “multiple” liquidation preferences. This means that they must receive a multiple of their initial investment (sometimes as high as five times) before any amounts are distributed to the junior stockholders. These multiple liquidation preferences, particularly when combined with a participation feature, are often capped either at a maximum dollar amount or, more frequently, by eliminating the multiple liquidation preference in the event that the as-converted value of the preferred stock yields a sufficiently high return (i.e., the preferred stockholder gets the greater of (i) five times his original investment or (ii) the amount he would have received if he converted to common stock immediately before the liquidity event). Multiple liquidation preferences are not uncommon in so-called “down round” financings, where the value of the company has declined since the last round of financing.
Preemptive rights/rights of first refusal. Preemptive rights give investors the right to purchase all or some portion of any subsequent stock issuances by the company, so that they may maintain their percentage ownership of the company. This protects investors against dilution by the issuance of “cheap” stock, although it requires that they “put their money where their mouth is.”
1. Structure. The typical right of first refusal provision requires that a company wishing to issue securities must first offer the securities to the investors and then give the investors a specified period of time (30 days or so) to respond. In addition, investors who decide to exercise this right of first refusal will sometimes get a “second bite” by having the opportunity to buy any stock previously offered to other stockholders who also have a right of first refusal but elect not to purchase the securities to be issued.
2. “Pay-to-play” provisions. This is a provision pursuant to which an investor who does not exercise the right of first refusal in one financing will lose that right with respect to all future financings. Frequently if a right of first refusal is on a pay-to-play basis, investors who do not exercise their preemptive rights will also lose the protection of cheap stock antidilution provisions in the future (and perhaps certain other rights) as they will be viewed as having decreased their respective interest in the company’s future growth.
3. Exemptions. Like the dilution provisions, certain issuances of stock should be excluded from triggering the right of first refusal. Specifically, it is generally good policy to exempt issuances to employees as part of employee benefit plans, issuances to the public in a firm underwritten public offering and issuances to sellers in acquisition transactions.
Buy-sell rights. Investors will frequently enter into a buy-sell agreement (often called a Right of First Refusal and Co-Sale Agreement), pursuant to which the existing common stockholdersagree that if such stockholder receives an offer from a third party to buy the stockholder’s ownership interest, the common stockholder must first offer the stock to the company and then the preferred stock investors on the same terms as the third party offer before selling the stock to the “outsider.”
1. Co-Sale rights. Another option is to give the preferred stock investors a right to participate in the sale to the third party, in proportion to the number of shares held by them. This is referred to as a “co-sale right” or a “tag-along right.” Tag-along rights generally do not apply to sales by the venture investors, but rather to sales of common stock held by the entrepreneurs. These provisions limit the ability of management to leave the company without giving the venture investors an equal opportunity to exit.
2. Drag-along rights. Drag-along rights require that if the owners of a certain percentage of the outstanding stock agree to sell their stock to a third party, the other stockholders, if requested, must also sell their stock to the same person or group and on the same terms. This makes it easier for the holders of a substantial percentage of the stock to negotiate and consummate a sale of the company, if that is the exit strategy they choose to pursue.

Warrants/options

A warrant or option is a right to purchase an equity security, including preferred stock, at some point in the future. The purchase price of the warrant and the exercise price of the warrant are different. The purchase price of the warrant buys the investor the right to buy an equity interest in the company without coming up with the cash necessary to make the investment now. The exercise price is the specific price the investor will pay when, and if, the investor elects to actually buy an interest in the company. It is rare for an investor to acquire only warrants. Generally warrants are purchased to sweeten the deal for an investor who is purchasing debt and/or other forms of equity.

Antidilution protection. The number of shares and the price of shares subject to a warrant should receive antidilution protection similar to that described with respect to preferred stock (other than possibly, “price-based” antidilution protection).
Consideration. Typically, warrants can be exercised by the payment of cash or, if the venture investor owns debt securities issued by the company, the forgiveness of some or all of such debt.
Voting rights. Generally, warrants do not give the holder any voting rights.

Other rights of venture investors

There are certain other rights that venture investors will typically request to effectively monitor and participate in the venture business.

Financial statements. The company generally will have an obligation to provide the venture investor with quarterly and annual (audited) financial statements (and sometimes monthly financial statements). These normally include balance sheets, income statements, and a source and use of funds statement. The annual financials generally are required to be audited by a recognized public accounting firm approved by the venture investors. Additional information that also often is required to be delivered to an investor includes (i) information filed with federal and state regulatory agencies, (ii) notices of lawsuits and other legal proceedings and (iii) copies of all materials filed with the Securities and Exchange Commission or any stock exchange.
Budget and use of proceeds. Investors typically require an annual budget and may require that it be approved by them unless they are represented on the board. Revisions to the annual budget typically require board and/or investor approval.
Observer rights. If the venture investor is not represented on the company’s board of directors, the venture investor will typically want a right (i) to receive notice of all board meetings, and (ii) to attend such meetings as an observer (typically at the expense of the company) and to discuss matters regarding the company with the company’s executive officers and independent accountants.
Key employees. Because the entrepreneurs are often crucial to the company’s growth and development, venture capitalists may require that the company enter into employment agreements to properly incentivize the key employees to remain with the company. These agreements generally contain appropriate noncompete and nonsolicitation provisions, so that the entrepreneurs cannot leave the entity to start a competitor, leaving the venture investors with a rudderless ship, or leave the entity and then solicit/hire its employees. Furthermore, if one or more individuals are truly crucial, the venture investor may require that the company maintain key-man life insurance. Venture investors might also require that they approve any new executive officers.