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Are you a startup company that needs funds to launch? Are you an established company in need of funds for expansion? Are you running a company stricken with huge credit lines and in dire need of funds? Whatever the reason is that you need funds for; venture capital provides you the solution to all your financial needs.
How Venture Capital Works
Investors release funds to those companies that they feel have enough potential to be successful. Venture capital firms are managed by different individuals from various fields and sometimes by the venture capitalists themselves.
Now, we know that venture capitalists release funds to companies that are in need of money to develop and advertise. What do the venture capitalists get in return for this? They get a share of the equity and a part of the ownership. Sometimes they will even settle for seats on the board of directors. It all depends on how much you need and how they give you as well as how much they want in return.
Venture capitalists are not just the ones who give out money. That is not the sole reason though for companies to approach them. It is their line of contacts as well as the reputation that comes with it that are more attractive to companies. While money is important, it is not everything in business. Your contacts; who you know are just as important a factor. If you are associated with the right venture capital firm, which has a very good address book of associates and decent network then your work is done. You have got a great deal right there itself.
The venture capitalists just do not barge into any and every business that asks for their capital. They do their homework too and they do comply with their ground rules.
Broadly, there are three things that they take into consideration.
1. First is the value system of the company who seeks funds from them. This makes them ascertain how strong the morals are and would be able to assess the core strength of the company. If this is satisfactory then the company can weather any storm. So this becomes very relevant.
2. Second is the rate of return of money invested. This is for obvious reasons. No free lunches here. You got to know how much you would get if you are investing something. This will be checked out and if satisfied then there will be confidence in the minds of the venture capitalists to invest.
3. Third, they would look for an exit option. Business is a gamble at the end of the day. You got to know when to jump ship. You got to make the provisions at the start itself. They would look for one and if they know they can sneak out unharmed when the ground slips under the feet, then they will give a confident okay to the project.
There are various jargons that are used in case of venture capital investments. There is sweat equity, which as the name suggests is all about the sweat investment. The lawyers and other professional just work without getting paid and invest with their sweat. They do this only if they have faith in the firm. Later on for their sweat investment would expect to be rewarded with huge contracts and other lucrative services.
If you need funds to just do the groundwork and develop a blueprint of the business and the venture capitalists then it is called pre-used funding. If the funds are given to develop a model product and recruit a management group then it is called self-funding.
In case, the funds are given to aid with the completion of product and the starting of marketing then it is called startup funding.
There are development funding, Mezzanine funding, expansion funding, mergers and acquisitions and a lot more jargons that is associated with venture capital.
Valuation. Valuation is the most prominent negotiating issues. Valuation is the price of the company in which the venture capitalist invests. Valuation determines what percent of the company the investor is buying for their capital.
Timing of the Investment. Many investors will commit a large amount of capital, but will contribute that capital to the companies in installments. Often, these installments are only made when pre-designated milestones are met.
Vesting of Founders' Stock. Like capital, investors often prefer that stock is given to company founders and key employees in installments. This is known as vesting.
Modifying the Management Team. Some investors insist that additional or substitute management employees be hired subsequent to their investment. This gives investors additional security that the company will execute on its business model. An important issue to negotiate with regards to modifying the management team is the amount of stock or options that will be issued to new management team members, as this will dilute the holdings of the founders.
Employment Agreements with Key Founders. Venture capitalists typically do not want companies to have employment agreements that limit the circumstances under which employees can be fired and/or set compensation and benefits levels that are too high. Other key employment agreement issues to be negotiated with venture capitalists include restrictions on post-employment activities and employee severance payments on termination.
Company Proprietary Rights. If the company has an important product with intellectual property (IP), investors will want to ensure that the company, and not a company employee, owns the IP. In addition, investors will want to ensure that new inventions be assigned to the company. To this end, investors may negotiate that all employees must sign Confidentiality and Inventions Assignment Agreements.
Exit Strategy. Investors are very focused on how they will “cash out” of their investment. In this regard, they will negotiate regarding registration rights (both demand and piggyback); rights to participate in any sale of stock by the founders (co-sale rights); and possibly a right to force the company to redeem their stock under certain conditions.
Lock-Up Rights. Venture capitalists may require a lock-up period at the term sheet stage. The “lock-up period” is typically a 30-60 day period where the investors have the exclusive right, but not the obligation, to make the investment. Investors typically conduct due diligence during this time without fear that other investors will pre-empt their opportunity to invest in the company.
Each of these issues are critical when raising venture capital, since the outcome can significantly impact the success of the venture and the wealth potential of the company founders and management team. Because venture capitalists are very knowledgeable regarding these issues, and have great skill in negotiating on them, companies who are raising venture capital should seek advisors who also have this experience and expertise.