The VC business modelVC’s are generally structured as limited partnerships with one or more individuals acting as the general partner and the outside investors in the fund acting as limited partners. This structure has been mirrored by funds that opt for the new LLC form of business entity where the general partner can be formed as an LLC.
Each fund has a fixed term—usually ten years. Investments are made in stages throughout the ten year period and the fund is liquidated at the end of the ten year term. The proceeds of the liquidation of the fund are generally shared among the limited partners (investors) with a carried interest (“carry”) percentage (usually twenty percent) retained by the managers—the VC partners. Rules for how the carry is shared between the partners can become sophisticated and resemble partnership agreements in that senior partners can negotiate larger percentages than junior partners. In addition to the carry, the VC partners share a management fee, usually in the region of two percent of the total fund per year. So, a $1b fund will translate into a $20m/year management fee for the VC.
In the first few years of the life of the fund, the VC will invest in a portfolio of investments, usually 10-30 startup companies. During the last few years, the VC will work towards liquidating the shareholding in those companies. The time from investment to exit for a startup company is generally expected to be around seven years, so the fund would usually like to make the bulk of its investments during the first three years so that the portfolio can be liquidated before the end of the ten year term.
The returns demanded by VC’s are relatively high. According to Bob Zider, ‘How Venture Capital Works’, Harvard Business Review
[1]: “In return for financing one to two years of a company’s start-up, venture capitalists expect a ten times return of capital over five years. Combined with the preferred position, this is very high-cost capital: a loan with a 58% annual compound interest rate that cannot be repaid”. Zider goes on to explain: “Investors in venture capital funds are typically large institutions such as pension funds, financial firms, insurance companies and university endowments—all of which put a small percentage of their total funds into high-risk investments. They expect a return of between 25% and 35% per year over the lifetime of the investment”.
Home run focusThe VC business model is based on the chance that one or more of the portfolio will hit a home run—that it will result in a huge return to the fund. This is usually achieved through a high-profile IPO. So, VC’s are heavily focused on finding the next Google or the next Cisco systems.
Under this portfolio theory model, each company in the portfolio has to be a candidate for a home run. Considering the high failure rate of portfolio companies, the VC’s focus on investments that have a potential investment return of 5x or 10x or even higher within a 5-7 year period.
Preferred stockVC’s almost always structure their investments in the form of preferred stock. Like common stock, the properties of preferred stock are prescribed in state corporation codes and the corporate articles and bylaws. Preferred stock represents an equity interest in the Corporation but it is considered a hybrid of both common stock and debt.
Preferred stock is in a junior position to debt when it comes to liquidation and bankruptcy and although preferred stockholders cannot usually force the Company into involuntary bankruptcy, VC’s can add these rights to the terms they demand in exchange for the funds they invest. However, preferred is senior to common stock—dividends to preferred holders come before payments to common stockholders and preferred holders often come out of liquidation owning the assets of the Company while the holders of common usually come away from a liquidation with nothing.
As more than 90% of venture startups end in liquidation
[2][3], the vast majority of patents and intellectual property developed by the founders ends up in the hands of the VC’s, and the founders find themselves post-liquidation with no legal claim of ownership over the ideas, inventions or intellectual property they created.
Common stock usually has advantages over preferred when it comes to declaring dividends, however preferred stock under the VC Preferred model, is convertible to common—so convertibility allows the preferred holders achieve the best of both worlds—upside potential as common stock and downside protection when treated as a creditor. Preferred acts as a second class of common stock with a liquidation preference
[4].
Preferred and common stock structure allows for differential pricing. The SEC mandates that common cannot be lower than 10% of preferred. Closer to IPO, the common should be repriced to at least 90% of the preferred share value. If the Company had only one class of stock, and the employee were issued stock at a price lower than the market rate, then the difference between the issue price and the market rate at the time of issue is taxable as unearned income. However, under the preferred/common two-tiered stock structure, the Company is able to issue common stock to employees at prices significantly lower than the price at which preferred stock is sold to investors. In addition to providing the control mechanisms the VC’s seek, there are significant tax benefits to this two tiered common/preferred stock structure.
Preference shares
Preference shares are essentially common stock with additional contractual rights provided in the stock purchase agreement. The preferred stock is issued under provisions of the Company’s articles of association and bylaws. The articles in most technology startups provide the board of directors a ‘blank check’ to create preferred stock as and when it is needed. The articles and contractual rights can be trumped by the law of the state of Delaware, or the state in which the corporation was formed. Delaware has certain statutes controlling how preference shares can be issued and the rights of the corporation and preference shareholders. VC’s are accustomed to these statutes and prefer Delaware corporations as they feel comfortable with the Delaware law in this area.
Preferential rights are contractual and strictly construed by the Delaware courts, but preferred stock also has a common stock characteristic. The question facing the court in Jedwab
[5] was whether the rights of preferred shareholders should be treated as contractual or fiduciary (as shareholders). The Jedwab court answered: ‘both’. Preference rights are contractual; ordinary stock rights are fiduciary... However, as stated in the paper by Mitchell, The Puzzling Paradox of Preferred Stock (And Why We Should Care About It)
[6], before we can apply the Jedwab rule, we must know which rights of the preferred are preferences, and thus contractual, and which are shared, and thus fiduciary.
ConvertibilityThe complex preferred stock structure is unpalatable to Wall Street investors and other investors in the public stock markets as it creates a complex capitalization structure and seriously affects the value of common stock. So, immediately prior to IPO the preferred stock converts to common, and the contractual rights of the preferred shareholders are lost. Conversion of preferred to common is normally set at 1:1. One preferred share converts to one common share, however anti-dilution provisions such as the following can adjust this conversion ratio.
The[7] Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.” Anti-dilution Provisions:
In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:
[Alternative 1: “Typical” weighted average:
CP2 = CP1 * (A+B) / (A+C)
CP2 = New Series A Conversion Price
CP1 = Series A Conversion Price in effect immediately prior to new issue
A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)
B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP1
C = Number of shares of stock issued in the subject transaction]
This form of anti-dilution is known as the ‘weighed average’. A more extreme formula is sometimes chosen called the ‘ratchet’ that essentially mandates that all future dilution resulting from the sale of additional shares is at the expense of the common shareholders, and that the VC will suffer no dilution from future rounds of funding. This is clearly a little unfair on the entrepreneurs and according to Fenwick & West publications, some form of weighted average anti-dilution protection was used in about 95%
[8] of 4Q 2006 VC financings, the same as in 3Q 2006.
Ownership structureCommon shares make up a large fraction of the Company’s outstanding shares. One study finds that, among firms about to go public, almost half the shares are in the form of common. The study finds that median VC share ownership is 53%; median founder ownership is 12%; median manager ownership is around 7%. (Because these are medians, not means, they need not add up to 100%.) The balance of the shares is owned by non-VC investors, other employees, and business partners
[9].
Participation rights
When future funds are raised by the Company, usually in new classes of preferred stock issuances, the current VC’s negotiate rights to participate in those future rounds:
Right to Participate Pro Rata in Future Rounds:
All [Major] Investors shall have a pro rata right, based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock into Common Stock and the exercise of all options outstanding under the Company’s stock plans), to participate in subsequent issuances of equity securities of the Company (excluding those issuances listed at the end of the “Anti-dilution Provisions” section of this Term Sheet and issuances in connection with acquisitions by the Company). In addition, should any [Major] Investor choose not to purchase its full pro rata share, the remaining [Major] Investors shall have the right to purchase the remaining pro rata shares.
Unlike the anti-dilution provisions that result in ‘free’ stock in the form of adjusted conversion rights, these participation rights provide the VC with the opportunity to maintain their shareholding percentage but the VC is forced to ‘pay to play’.
The no-shop term sheet provisionPrior to investing the Company, the VC’s usually present a term sheet to the entrepreneur that outlines the significant provisions of the investment such as the amount of money to be invested, the number of shares the VC will receive in exchange and the preferences they want writing into the preferred stock. The provisions of the term sheet are usually unenforceable, except for a provision that restricts the entrepreneur from shopping the term sheet to other investors, and effectively soliciting bids from other investors.
No shop/confidentiality
The Company agrees to work in good faith expeditiously towards a closing. The Company and the Founders agree that they will not, for a period of [six] weeks from the date these terms are accepted, take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company [or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company] and shall notify the Investors promptly of any inquiries by any third parties in regards to the foregoing. [In the event that the Company breaches this no-shop obligation and, prior to [________], closes any of the above-referenced transactions [without providing the Investors the opportunity to invest on the same terms as the other parties to such transaction], then the Company shall pay to the Investors $[_______] upon the closing of any such transaction as liquidated damages.] The Company will not disclose the terms of this Term Sheet to any person other than officers, members of the Board of Directors and the Company’s accountants and attorneys and other potential Investors acceptable to [_________], as lead Investor, without the written consent of the Investors.
After the term sheet is signed, the due diligence process commences and through the no-shop clause, the entrepreneur is locked in to dealing with only the one lead VC. The VC, on the other hand, is under no obligation to make the investment or to observe the provisions agreed in the term sheet. This arrangement puts the VC in an unusually powerful position, as will be discussed later.
Liquidation preference
One of the most important provisions of the VC-Preferred model is the use of liquidation preferences. This provision means that when the Company is sold, or liquidated, the preferred-holding VC takes its money out of the proceeds before sharing any of the proceeds with the common shareholders.
In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows [either 1, 2, or 3]:
1) First pay [] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. The balance of any proceeds shall be distributed to holders of Common Stock.
2) First pay [] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock on an as-converted basis.
3) First pay [] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price.]
A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise].
Essentially, the founders and other common stockholders have to stand in line behind the VC when proceeds of a sale are distributed. So, a VC investing $10m in a startup may hold preference stock representing only 20% of the outstanding stock of the Company, the other 80% representing common stock held by founders and employees. If the Company is sold for $50m, under a 1x liquidity preference, the VC will take the first $10m (1x the $10m investment) and the remaining $40m will be shared with the common stockholders, so the common shareholders would receive 80% of $40 and not 80% of $50m. Many entrepreneurs are surprised to discover the impact of liquidity preference, and are only informed by the legal counsel at the time of the acquisition.
In 2006, according to Fenwick & West, one of the most active law firms in the VC financing business, the liquidation preference for series ‘A’ financings in Silicon Valley was almost uniformly at a 1x
[10].
A liquidation preference of 1x is not too unpalatable to entrepreneurs, however, VC’s sometimes demand liquidity preferences of 3x, 5x, 7x—even as high as 12x the original purchase price.
[11] Clearly, with a liquidity preference of 5x, and an investment of $10m, the VC stands in line to receive the first $50m of the proceeds of any acquisition. The founding entrepreneurs receives nothing from common stock for any acquisition less than $50m.
Liquidity preference creates a significant discrepancy in the way VC’s and common shareholders view acquisitions, and lead to many entrepreneurs being shut out from receiving any of the proceeds when the companies they founded are sold.
The role of VC partnersThe partners in VC firms are responsible for finding new investment opportunities, sitting on the board of directors and directing the management of portfolio companies. As much as 40% of the VC partner’s time is spent prospecting for new investments
[12] and this involves reviewing business plans and listening to pitches from entrepreneurs.
So, 40% of the VC’s time is spent prospecting, and at least 20% of the partners time is spent on internal management at the VC firm, this means that no more than 40% of the venture partner’s time is available to manage his/her portfolio companies. With, say, 5 portfolio companies under the partners control, less than 5% of the partner’s time can be spent on each portfolio company. The amount of time available for each portfolio company may be considered low bearing in mind that, under the VC-Preferred model, the VC partner is effectively in control of board of directors and the management decisions for each company in his/her portfolio.
Treatment of founder’s stock
Founders stock is usually issued as vesting shares of common stock. Often a large proportion is vested by the time the VC’s gain an interest in the Company. However, to tie the founders to the Company and reduce the incentive to leave before the VC has achieved a successful exit, the VC’s sometimes eliminate the prior vesting of the founders with a legal provisions such as this example:
Founders’ Stock:
All Founders to own stock outright subject to Company right to buyback at cost. Buyback right for [__]% for first [12 months] after Closing; thereafter, right lapses in equal [monthly] increments over following [__] months.
SyndicationVC’s syndicate their investments
[13] and it is common practice for one investor to lead a round and bring in other venture capitalists to co-invest. One VC will act as the lead investor, negotiating the terms, then invite other VC’s to participate in the round. This is a significant aspect of the portfolio strategy of the VC as it enables the risk to be spread beyond the companies that the VC invests and controls directly. Through syndication, the VC is able to acquire shareholding positions in startups that are under the control of other VC’s in the syndicate.
Syndication ties the venture investors together but it requires a common, standardized, structure in the way the VC investments are made. This standardization leads to remarkable similarity in the terms sheets offered by VC’s to entrepreneurs.
The syndicates have proved to be highly profitable over the years and the larger, more successful venture investors have a legion of smaller, newer funds that are eager to co-invest in their deals. To join a syndicate, it’s in the interests of new VC’s to offer the same standardized terms as the older, established VC’s and to bring new opportunities to the established syndicates. As will be discussed in more detail, the syndication aspect of the VC preferred model provides disincentives for new VC’s to compete in a free market by offering different investment terms that may be more appealing to startup entrepreneurs. It also encourages these new-entrant VC’s to offer investment opportunities to the syndicates rather than keep them exclusively to themselves.
VC candidate selection processA traditional rule of thumb for the VC business is that for every 100 investment proposals received, 10 will be considered seriously and 1 investment will be made. These numbers have become more distorted in recent years as VC’s are bombarded with investment proposals from investors. Today, for each investment that a small VC makes, over two hundred business plans and proposals from entrepreneurs are rejected
[14]. The number of rejections is even higher for the large VC funds that attract more business plan submissions. Furthermore, many VC’s admit that they do not consider unsolicited business plans at all—they only consider plans that they receive from their favored law firms, other VC’s or trusted contacts.
After submitting the business plan through the lawyer or the appropriate channel, the entrepreneur with an attractive offering will be invited to make a presentation to the VC. The presentation takes around an hour, during which time the VC asks questions and gauges the attractiveness of the opportunity.
If the deal is attractive, it will be circulated by the VC to others in the syndicate. If approved by the partners in the VC firm and the syndicate, a successful candidate will receive a term sheet, due diligence will commence and the terms will be negotiated with the lawyer representing the entrepreneur.
Cisco Systems, before it became one of the most profitable venture investments of all time
[15], was rejected by more than 75 VC’s. Google and other hugely successful companies were rejected by several VC’s before finally raising the funding they needed to grow the business. The selection process and the criteria adopted by VC’s have been criticized as being somewhat unstructured and unpredictable. However, the number of opportunities presented by entrepreneurs is so large that VC’s are usually able to assemble a profitable portfolio.
Reporting of investment results
The VC community has resisted attempts to compile or track the investment results of individual firms. The success rates for each VC are generally kept under wraps and are not available to the public.
Ever larger fundsPortfolio theory is effective at reducing the risk when the investments are split across a number of portfolio companies. The larger the portfolio, the smaller the risk from failure from any one. As a result of the successful track record some VC’s have achieved, VC funds are attracting more investment and growing larger
[16]. However, the number of partners in each firm is not growing by the same proportion. A VC partner can only sit on a handful of boards of directors, so the result of this trend is that VC’s have to make larger investments in their portfolio companies. As we will discuss elsewhere, this can lead to the VC wishing to inject more money into a startup company than the founders would choose.
Participants in the VC-Preferred ecosystemAs well as the established VC’s, there are several groups of participants in the VC-Preferred model. New VC’s are benefitting from the VC-Preferred model in that they do not have to invent a new financial instrument or establish new business practices. New VC’s simply need to follow the VC-Preferred model and the law firms and other resources are available to help them achieve this at minimal cost.
There are a handful of large law firms in Silicon Valley that are dependent upon the VC-Preferred model. They derive a large proportion of their revenues representing VC’s and VC-backed startup companies. As noted earlier, most VC’s will not consider unsolicited business plans. The law firm acts as gatekeeper for the VC screening entrepreneurs and business plans. The VC then gives the law firm business by insisting portfolio companies use the firm.
Executives such as CEO’s, CFO’s and general counsels are often repeat-players for VC’s and their syndicates. Individuals will often move from one portfolio company to another and their careers are intertwined with the VC’s with which they align.
As with law firms there are a number of recruiters, auditors, financial advisors and other service providers in the technology sector that derive their incomes from VC firms and VC-backed startups and are dependent upon the VC-Preferred model.
[1] Harvard Business Review, 1998 reprint 98611.
[2] Unfortunately, and surprisingly, there are no good figures available to measure the success rates of technology startups in Silicon Valley or elsewhere. Companies grow and launch their initial public offerings on the capital markets with great fanfare, but when they die, they normally do so quietly and outside of the public eye. By measuring the rate of company formations with the Company liquidations, most observers agree that the success rate is significantly lower than 10%. VC’s openly admit that less than 10% of the companies they fund are successful. Some of the top-tier VC’s on Sand Hill Road are revered by the investor community as they have seemingly managed to raise the success rate above 30%.
[3] Brian Headd, an economist at the SBA Office of Advocacy and author of a 2003 report on small-business closure rates admitted: “We don’t have very good firm age data” The SBA’s Office of Advocacy has convinced the Census Bureau to carry out a study of annual entry and exit rates of even the smallest businesses.
[4] See Liquidity preference below.
[5] 509 A.2d 584 (Del. Ch. 1986).
[6] 51 Bus. Law. 443.
[7] This and other provisions are extracted from VC term sheets.
[8] Source: Current Venture Financing Environment, 4Q 2006 Bay Area Venture Capital Terms Survey. Fenwick & West Publications. http://www.fenwick.com/publications/
[9] Steven N. Kaplan, Berk A. Sensoy, and Per Stromberg, “What are Firms? Evolution from Birth to Public Companies” 26 (working paper, January 2005).
[10] Financings that had participating liquidation preferences (LPs) in 4Q 2006 were 73% compared to 64% in 3Q 2006. Participating LP was uncapped in 64% of 4Q 2006 financings compared to 58% in 3Q 2006. 34 of 35 initial LP were 1X in this period. Source: Current Venture Financing Environment, 4Q 2006 Bay Area Venture Capital Terms Survey. Fenwick & West Publications. http://www.fenwick.com/publications/.
[11] The Deal.com 2002. “VC’s Reconsider Tough Terms for Entrepreneurs”.
[12] Paul Dali, partner with Dali Hook Partners, a Menlo Park VC firm. 2005.
[13] Venture capitalists often band together in groups to invest in companies. Conventional wisdom says they engage in this practice, called syndication, to better screen potential investments. More eyes, the thinking goes, yield better investments. But Raphael "Raffi" Amit, Wharton's Robert B. Goergen Professor of Entrepreneurship, says that's wrong. Venture capitalists syndicate because each one has different skills and information, so each can add value to an investment in different ways.
[14] Dr. Po Chi Wu, partner with Alameda Capital. Santa Clara 2005.
[15] Don Valentine, partner with Sequoia Capital, finally invested in Cisco and his investment has been reported to be the most profitable VC investment when measured by return on investment. Litigation ensued after the founders were forced out of the Company.
[16] Trend towards fewer but larger venture capital funds continues in US in Q2 2006.
04/08/2006. Source: AltAssets.
US venture capital firms raised $8.23bn in the second quarter of 2006, slightly down from the $8.27bn raised in the second quarter of 2005, according to Dow Jones VentureOne. The research shows a trend in recent quarters towards fewer but larger individual funds being raised.
The largest US venture fund raised this quarter was the $2.56bn Oak Investment Partners XII fund. In addition, five other funds raised this quarter were $500m or larger.
At the half year point, $11.5bn has been raised by US venture capital firms, about seven per cent more than the amount raised in the first half of 2005. The median size of funds closed to date in 2006 is $170m. In the first half of 2006 only 28 per cent of the funds that closed were smaller than $100m.
Stephen Harmston, director of global research for VentureOne, said, 'It still remains likely that 2006's fundraising will match or surpass the amount raised last year due to the significant level of interest investors have shown in this asset class of late, including interest in funds that will be closing later this year.'
