Key Concepts in Negotiating Venture Capital Financing 

     

Identifying the right venture capital partner and securing financing represent major achievements for a growth-stage company. Before the transaction is finalized, however, management faces an additional hurdle: negotiating the terms of the venture capital financing.

The key concepts involved in the negotiations are outlined below. The terms and conditions of the proposed investment are usually presented in a term sheet.

The valuation of the company is critical because it governs the percentage of equity relinquished in return for the investment capital. Valuation is usually expressed in “pre-money” terms, before injection of the venture capital funds. It is typically based on industry comparable valuations and recent transactions. Management should prepare a strong case for maximizing the value placed on their business.

The total investment and timing of cash inflows are also important. The release of funds may be staggered over time and payments may be tied to the accomplishment of set milestones. No funds will be released before the due diligence process is completed, which can take up to 45 days. During this period, the venture capital provider will insist on an exclusivity period when the company will be prohibited from accepting an alternative financing proposal.

Venture capital providers usually receive preferred stock in return for their investment. The main characteristic of preferred stock is that it has priority over common stock (usually owned by company founders) in the event of a company liquidation or sale. This provides downside protection for the venture capital provider. The provisions of the preferred stock may also include the right to accrue dividends, which become payable when the company is profitable, and the right to convert the preferred stock to common stock to profit from upside potential if the business is successful.

Stock owned by company founders and management may include vesting provisions, whereby the right to ownership accrues over time. This aligns management interests with those of investors.

Venture capitalists also negotiate for anti-dilution provisions to protect their position if later financing rounds place a lower value on the company. This puts an investor in a previous round in the same position as if they had invested at the lower price of the subsequent valuation. They also usually require pre-emptive rights for future equity offerings so they have the option to maintain their percentage ownership through additional investment.

Venture capital investors will want to occupy or appoint a set number of board positions. They may also seek the right to add to or change the incumbent management team and specify the terms of management employment contracts. Restrictions may also be placed on the actions that management can take without venture capitalist approval, such as raising additional capital or divesting assets. Investors will also takes measures to ensure that all intellectual property rights reside with the company and not employees.

Preparedness, knowledge and leverage are the keys to successful negotiation and a company should engage experienced legal representation to ensure the most favorable outcome. Do not underestimate the implications of the financing terms on the future success of the business and the future wealth of the company founders.

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