Richardson's Growth Company Guide 5.0: Investors, Deal Structures, Legal Strategies

Richardson's Growth Company Guide -

Investors, Deal Structures, Legal Strategies

by Clinton Richardson

Smashwords Edition

Copyright 2013 Clinton Richardson

Portions first published in:

The Venture Magazine Complete Guide to Venture Capital (1987)

The Growth Company Guide (1993)

Growth Company Guide 2000 (2000)

Growth Company Guide 4.0 (2007)

Author: Clinton Richardson is a practicing attorney who advises growing companies and the investors who fund their growth. For more see About the Author at the back of this book or check out Moon Pies and Entrepreneurs at growco.com.

Cover: Design by Heather Allison. Photo shows the management team that opened the world's largest coal mine in 1923. Photo by F. L. Ratliff. To see more photos click here.

Dedication: To my entrepreneurial father and his father, who was pulled out of school in the third grade to work in a Kentucky coal mine but went on to manage the largest coal mine in the world.

Disclaimers: The information contained in this book is provided for informational purposes only and does not constitute legal, accounting, or other professional advice. If you require such expert assistance, the services of a competent professional person should be sought. From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers. We endeavor to provide accurate and up-to-date information but no guarantee is made as to the accuracy or currency of the information contained in this book.

License Notes: This ebook is licensed for your personal use only and may not be re-sold or given away to other people. If you want to share this book, please purchase a copy for each recipient.

growco.com: Follow the author's blog and find updates to this book. Ask a question or check out the video introduction.

A publication of Read Janus LLC, Atlanta, Georgia

ISBN: 978-0-9912475-1-6

Praise for Richardson's

Growth Company Guide

See what others say about the Guide series. See all quotes.

Owners and Entrepreneurs:

Terribly helpful to the first time entrepreneur.

Full of practical strategies and insight.

Direct, accurate, and straightforward.

A unique book from a veteran legal practitioner.

"Nothing less than top notch.

Venture Investors:

Important VC investment concepts explained.

Straightforward, intelligent and useful.

Extremely helpful resource for all entrepreneurs.

Soup-to-nuts perspective on the essential and subtle deal characteristics that can make or break a deal.

Business Publications:

Full of tips and strategies.

Explains just about every concept that should be known to the entrepreneur.

Heavy on content.

La bible du venture capital.

Investment Bankers:

Best, most thorough, objective, plain-English, corporate finance guide for business owners on the market.

Required reading for our new analysts.

Business Advisors:

Levels the playing field for companies receiving venture capital.

Used frequently by myself and the professional staff of our premier technology incubator.

Far and away the most important read for an entrepreneur who wants to grow their business.

Many sound, practical business and legal strategies.

My reference of choice for my many business plan students and clients.

Did you know?

~ The first Guide was published in 1987 as The Venture Magazine Complete Guide to Venture Capital.

~ The Soviet Union's Economic Ministry acquired cases of the Guide during Glasnost.

~ The second edition Growth Company Guide was published on the Internet in 1996.

~ IPO.com selected the Guide as its official venture guide in 2000.

~ TechJournal South published the fourth edition of the Guide in 2007.

See all quotes. Links to the video introduction, the blog, and the website.

CONTENTS

Introduction

Part 1: Venture Basics

Introduction to private company investing

Before the deal: Common business structures

Why investors buy non-control positions in private companies

Challenges private company investors face

Challenges growing companies face

Pricing the deal

Structuring investments in private companies

Part 2: Terms and Concepts

All Entries Listing

Illustrative Entries Listing

Listings by Subject Matter:

~ Starting Out

~ Building a Plan

~ Seeking Investors

~ Selling Securities

~ Negotiating a Deal

~ Pricing a Deal

~ Structuring a Deal

~ People and IP

~ Exits and IPOs

~ Being an Angel Investor

Part 3: Series A Stock Purchase Agreement

Comments About the Book

About the Author

INTRODUCTION

Links to video introduction, blog, and website.

Welcome to the fifth edition of a time-honored resource. In your hands is the latest, updated and expanded edition of a unique business book. For two decades, prior editions of the Growth Company Guide have helped thousands of entrepreneurs and investors grow and finance successful companies.

Authoritative, practical and accessible. Presenting authoritative, practical content in an accessible format, the Guide 5.0 helps business owners successfully navigate critical business challenges. A full overview of the equity investment process is provided. Strategies for attracting investors, structuring deals, retaining key people, and protecting and commercializing technology are explored.

And the source? The author is an attorney who has worked with entrepreneurs for decades, served on the boards of venture backed companies, and advised venture firms and angel investors.

Widely acclaimed by knowledgeable readers. First published in 1987 as The Venture Magazine Complete Guide to Venture Capital and later updated and expanded as The Growth Company Guide series, this resource has received critical acclaim from business managers, investors, business school professors, new business incubators and enterprise web sites.

Readers have hailed the series for its breadth of practical content, readability and ease of use. The series has been called everything from highly valuable to top notch to full of tips and strategies by leading enterprise resources and publishers. One French reviewer went so far as to declare the Guide to be la bible du venture capital. The web resource of a leading enterprise leadership foundation noted that the Guide series explains just about every concept that should be known to you, the entrepreneur.

Case quantities of the Guide have been purchased by prominent venture capital funds to train new associates and by a Moscow-based enterprise development agency to explain enterprise-building concepts to a new generation of Russian entrepreneurs. Business schools have assigned the text in their entrepreneurial business programs. Technology incubators use it to teach entrepreneurs.

Legal, accounting and business advisors use the book to help them advise their growing clients. Buyers of the Guide work around the world, from Silicon Valley to Boston to Moscow to Singapore.

Practical business and legal strategies. The Guide 5.0 answers the questions most frequently asked by owners and operators of growing companies as they search for funding, negotiate financing terms, and address other critical issues. It's 250+ strategy-packed entries describe the types of investors who invest in private companies, methods companies use to attract these investors, and ways to evaluate funding proposals. They include strategies for negotiating with investors and methods for valuing privately held businesses. They discuss ways to protect and license technology and how to structure strategic partnerships and joint ventures. Using stock and other non-cash considerations to attract and retain key employees is also discussed.

Unique, both-sides perspective. The Guide 5.0 is not written by a venture capitalist, who may be biased toward protecting investors, or by an entrepreneur, whose experience may be limited to a few businesses. Rather, it is written by an attorney who grew up in the home of an entrepreneur and who has broad practical experience representing both growing companies and venture capital investors. For more 30 years, the author has represented growing companies, entrepreneurs, venture capitalists, individual investors, investment bankers, lenders, and executives in a wide array of legal and business issues faced by growing companies as they finance their expansion, deal with acquisitions and divestitures, survive shrinking equity markets, conduct securities offerings, borrow money, attract and retain key employees, structure equity and non-equity compensation packages, protect and exploit intellectual property, address company governance, and deal with contracts and other business matters.

A real-time resource. The Guide 5.0 is designed to be a real-time resource for busy entrepreneurs and executives. It’s A to Z, key-word format helps readers get directly to the information they want.

For example, if a reader wants to know how venture capitalists price their investments, he can find out by simply turning to the entry entitled Pricing. There he will find a discussion of how investors evaluate and price investments in growing companies. The entry also suggests strategies for negotiating with investors and cross-references the reader to a discussion of the principal alternative pricing method contained in the Discounted Cash Flow entry. That's just one example. There are many throughout the book. We hope you find this resource useful as you build your business or invest in a promising company.

- Clinton Richardson

PART 1: VENTURE BASICS

(Return to Contents)

Introduction to private company investing. If you are reading this you probably invest in private companies, are starting or growing a business that will need outside capital or you advise those who invest in or grow companies. You might also be a student taking a course on entrepreneurial finance or someone thinking about starting or investing in a new business.

You have come to the right place. In your hands is a resource designed to help you succeed in your venture investing, your capital raise, and your other growth company challenges.

Numerous business schools have assigned editions of the Growth Company Guide to their students. Venture funds have made them required reading for newly hired fund managers and many business owners and operators have extolled their usefulness. Even Russia’s economic ministry purchased copies of the second edition Guide after Glasnost to train a new generation of entrepreneurs.

What you will find this in Part 1 is an overview of common business structures, a discussion of why investors buy non-control positions in private companies, and a review of the challenges investors face when they invest in private companies. This part also explores the challenges growing companies face when they look for capital and cut deals to protect and expand their businesses. Its concluding sections describe how investments in private companies are priced and structured. All of the discussions in Part 1 are cross linked to the more detailed entries contained in Part 2.

Before the deal: Common business structures. The primary business structures in the U.S. are corporations, limited liability companies and partnerships. Each form of entity has its own characteristics that distinguish it from the others, principally in the areas of taxation, management structure, and owner liability.

For the most part, operating companies that build or design products or provide services are structured as corporations or limited liability companies. Real estate or project businesses are frequently structured as limited liability companies or limited partnerships. See: Corporations, Limited Partnerships, LLCs (Limited Liability Companies), S Corporations.

Ownership interests in the different company types have different names and are evidenced differently. In a corporation, the owners are called stockholders or shareholders and receive stock for their investment. If a corporation has issued a total of 1.0 million shares of capital stock, a shareholder (who can be an individual or an entity) holding 100,000 shares owns 10% of the corporation. If the corporation issues more shares to new shareholders later on, the number of shares owned by the existing shareholder does not change, but the percentage of his ownership interest will decrease. See: Dilution, Fully Diluted. See also: Percentage and Value Dilution Comparison.

A corporation can issue a variety of securities to accomplish different purposes. Stock comes in two broad categories: common and preferred. Preferred stock (and sometimes common stock) can further be divided into various series or classes, each having different characteristics, including different voting rights, dividend rights and management participation rights. Preferred stock can also be convertible into common stock. Shares of capital stock are evidenced by stock certificates. See: Common Stock, Convertible Preferred Stock, Convertible Securities, Equity, Options, Participating Preferred Stock, Preferred Stock, Preferred Stock Umbrellas.

Companies can also issue debt instruments, called debentures. These, like preferred stock, can be structured to be convertible into another security such as common stock. See: Convertible Debentures, Debentures, Subordinated Convertible Debentures, Subordinated Debt, Warrants.

Ownership interests in a limited liability company are generally called membership interests but can, at the option of the company, be designated as shares or units. The owners of limited liability companies are called members. Although limited liability companies may issue certificates to document their membership interests, many do not. Instead, the membership interests are typically memorialized in the company’s operating agreement. The ownership interests can be stated in terms of percentage ownership or divided into shares or units. See: Corporations, LLCs (Limited Liability Companies).

Ownership interests in partnerships, called partnership interests, are similar to ownership interests in limited liability companies and are rarely represented by certificates. Like membership interests, they are memorialized in the agreement among the partners and the partnership. There are two basic types of partnerships, general partnerships where partners are liable for obligations of the partnership and limited partnerships which have one or more general partners that are liable for partnership obligations but limited partners who are not. See: Limited Partnerships.

Other, less defined business structures and specialized versions of the preceding business structures are also possible. Some, such as joint ventures, can involve the use of one or more business structures to accomplish specific goals of the parties involved, frequently where each party has special expertise or assets to contribute to the business. See: Joint Ventures, Off Balance Sheet Financing, R&D Partnerships, Strategic Partnerships. See also: Joint Venture Checklist.

Corporations, except for specialized S corporations (which can only have certain types of shareholders), pay corporate income tax on their profits. When, and if, the corporation distributes dividends to its shareholders, the shareholders will include the dividends they receive in their personal income and pay ordinary income tax rates on the dividends. See: Corporations, S Corporations.

By contrast, unless an election is made, limited liability companies and partnerships do not pay income tax on their profits. Their profits, regardless whether they are distributed to the owners, are allocated to their owners proportionately based on their percentage ownership interests and included in their personal income. Taxes on these profits are paid by the owners.

All three entity types are governed by state business laws and their organizational documents. For corporations, the organizational documents are the company’s articles of incorporation and bylaws. Corporations must have a board of directors elected by the owner/shareholders. Sometimes, specific groups or classes of shareholders are entitled to elect representatives to the board. Directors must be individuals and do not have to be shareholders or employees. Corporations whose stock is traded on stock exchanges (but not privately-held corporations) are generally required by law to include non-employee, non-shareholder directors on their boards of directors. See: Corporate Governance, Sarbanes-Oxley.

A corporation’s board of directors has the authority to manage the affairs of the corporation, subject to any limitations specified in the company’s articles of incorporation or the bylaws. The bylaws are adopted by the shareholders and govern how many directors the board will have or how that number is determined. See: Board Committees, Board of Directors, Bylaws, Charter, Control. See also: Board Room Etiquette - Private Companies, Director’s Duties.

The daily operation of a corporation is managed by officers who are appointed by the board of directors. A corporation usually has a president, a treasurer and a secretary and other officers. Although shareholders of the corporation may, and major shareholders frequently do, get involved in the management of the corporation, shareholders do not have inherent right to participate in the active management of the corporation beyond the right to vote their shares to elect directors and approve certain major transactions. See: Control, Minority Shareholder, Shareholder Agreements, Voting Agreements. See also: Maintaining Control in Business.

In America and overseas, venture investors use sophisticated forms of stock structures, whose features can be reproduced in limited partnerships and limited liability companies, to provide major investors with rights to participate in management, receive preferences in the event of a sale or liquidation of the company, provide for methods to exit (sell their ownership) before a company directed liquidation event, and even prevent management from taking major defined actions that might be detrimental to the investor. More about this is described below. See: Anti-dilution Provisions, Calls, Convertible Debentures, Convertible Preferred Stock, Participating Preferred Stock, Preferred Stock Umbrellas, Puts, Ratchets, Venture Capital Deal Structures, Weighted Average Anti-dilution. See also: Annotated Sample Series A Stock Purchase Agreement.

The management of a limited liability company is more flexible. The company can be managed by either the members (owners) of the company or one or more designated managers. If the company is managed by managers, the company has a lot of flexibility in determining how managers are elected. Usually, they are decided by agreement among the members. Once a company has decided that it will be managed by managers, members of the company who are not managers will usually not have any right to participate in the day-to-day management of the company unless provision for such involvement is included in the company’s operating agreement. See: LLCs (Limited Liability Companies).

In limited partnerships, the general partner has the power and authority to manage the affairs of the partnership. Similar to the role of members in a manager-managed limited liability company except with regard to limited matters that the partnership agreement specifies, the limited partners do not have the right to participate in the management of the partnership. See: Limited Partnerships.

In all of the entity forms other than a general partnership (and a limited partnership with respect to the general partner), the owners of the business entity are not responsible for the liabilities of the business beyond the owners’ investment in the company. In other words, if the business suffers significant losses or incurs significant liabilities, the owners of the business may lose all of their investment in the business, but they are not personally liable to any third party for any of the business’ liabilities.

Partners in general partnerships and the general partners in limited partnerships are responsible for the entire obligations of the partnership. Because of this risk, general partnerships are not often used for operating companies.

Why investors buy non-control positions in private companies. An international industry of venture capital investors has evolved from the ability, developed over time, to structure non-control investments in privately-held companies in ways that enhance investor liquidity, participation, and knowledge while reducing investor exposure to dilution from future investors. Today, it is common for venture capital firms, corporations and individuals (sometimes called angels) to invest in private companies they do not control. See: Angels, Corporate Venture Capital, Due Diligence, Reports and Records, Stage Financing, Venture Capital Deal Structures, Venture Capitalists.

The driving motivation for independent venture capital firms is profit. Investing in rapidly growing privately-held companies can be very lucrative. For corporate investors, the motivation is often more complicated. Profit is important but other reasons, such as expanding internal research and development efforts with select investments in companies with promising technologies, can also be important. And even when profit is the driving motivation, a corporate investor may see profit opportunities through its ability to lend non-monetary resources to a company such as sales or technical support so that the venture investment takes on characteristics of a joint venture or strategic partnership. See: Joint Ventures, Licensing, R&D Partnerships, Value Added. See also: Joint Venture Checklist.

Getting started as an investor begins with internal planning and the development of clear goals and strategies for accomplishing those goals. In the private company investment arena, this involves identifying a profile for the types of companies that will advance the investor’s objectives, identifying your investment criteria and your internal decision making processes, putting together a qualified team, developing deal flow, and understanding how to structure investments to minimize risk without hindering the ability of the companies you invest in to succeed. Professionals typically engaged to assist with the effort include attorneys, accountants and investment bankers.

Attorneys who are experienced in private company investments can help investors use all of the deal structuring tools available to structure their investments wisely and help the investor determine what the range of market is with respect to many deal terms. Lawyers also help identify and analyze contracts in due diligence investigations, sometimes helping evaluate patent and intellectual property portfolios. They can frequently introduce investors to other advisors and investors. See: Lawyers.

Accountants can help with due diligence, particularly as it relates to financial disclosure and the quality of company financial reporting methods. Investment bankers assist company investors with identifying prospective investment opportunities and approaching companies about investment or acquisition. They are frequently engaged by companies before raising money from third parties. See: Brokers, CPAs (Certified Public Accountants), Investment Bankers, Underwriters.

Challenges private company investors face. The principal challenges facing the private company investor, once the investor has established its strategy, put together its team, and identified a company it would like to invest in, are challenges that are inherent in the very nature of private companies and the fact that the investor will not control company decisions after investment. In short, these are the lack of liquidity inherent in an investment for which there is no ready and active market, the inability of the investor to control management decisions after making the investment, the challenge of investigating a company that does not publicly disclose its financial or business information, and the difficulty of determining an appropriate purchase price.

~ Illiquidity and lack of control. Investments in privately-held companies are illiquid for two principal reasons: security law restrictions contained in the exemptions companies use to sell securities and the lack of a public market into which to securities can be sold. State and federal securities laws generally require investors in private placements (the predominant method of selling private company securities) to undertake not to resell those securities for a period of time. The absence of an active trading market for private company securities provides a practical limitation on the resale of private company securities.

This liquidity issue is addressed in modern venture investing structures through the inclusion of rights in the description of the securities purchased that, after a set time, entitle the investor to require the company to repurchase shares at a formula price, agreements with key management personnel that require them to permit the investor to participate in any sale of securities offered to them, and rights in the investment documents that entitle the investor class to approve any proposal to sell the company. This last right enables the investor to veto a company sale if the terms are not acceptable.

Also common in investment documents are liquidation preferences that entitle the investor to receive back its invested funds plus a set rate of return before any funds are distributed to management shareholders. This assures investors of first call on funds received in a company sale in case sufficient funds are not available from the sale to make all investors whole. Registration rights that entitle the investor to require a company to register its shares for sale on the public markets, or to participate in a company initiated public offering, also enhance the liquidity of an investor’s shares. See: Buy-Sell Agreements, Convertible Preferred Stock, Co-Sale Agreements, Demand Rights, Down Round, IPOs (Initial Public Offerings), Liquidation Preferences, Liquidity Agreements, Liquidity Events, Participating Preferred Stock, Pay-to-Play, Registration Rights.

~ Due diligence. But even if an investor deals effectively with the liquidity challenges of a private company investment, how does he or she learn enough about the company to make a reasoned decision to invest in the first place? There will be presentations, slide shows and business plans prepared by management of the prospective company in many cases and it is important to consider them closely. But investor investigations of private companies, frequently called due diligence, usually go much further. The challenge of investigating a private company for a potential investment is met in two basic ways: through a detailed investigation that is ultimately supported by extensive representations and warranties in the final investment documents and through the staging of the investment process through the use of term sheets or letters of intent. Professionals such as accountants and intellectual property lawyers often assist in evaluating the financial disclosures and the strength of the company’s intellectual property protections. See: Business Plan, Due Diligence. Market Research, Summary.

Typical process staging involves some preliminary investigations (which are often quite thorough) followed by a term sheet or letter of intent that sets forth the business terms and conditions to a proposed investment, sets expectations for completing investigations and closing documents and, frequently, requires the company to forego seeking funding from other sources for a period of time to permit the transaction to close. These term sheets are typically non-binding except for provisions respecting confidentiality and exclusivity. They are followed by additional investigation and completion of detailed purchase agreements that set forth all of the parties' agreements. See: Deal, Due Diligence, Financing Agreements, Letters of Intent, Reps and Warranties, Stage Financing, Term Sheet, Venture Capital Deal Structures.

Challenges growing companies face. Growing companies need business skills and resources to succeed. The company's growth itself creates the need for capital. Expanding inventories and building out the workforce require funding. So does product development, securing patent protections, obtaining regulatory approvals, building a sales force, implementing a marketing plan, or building and qualifying a manufacturing capability.

When rapid growth pushes a business beyond its capacity to borrow, other approaches are required. Selling stock or other ownership interests is one of the first and most common methods explored. But other avenues, such as government grants, joint ventures and product development licenses are also ways to obtain needed capital. Each can play a role in helping a private company reach its objectives. See: Angels, Deal Flow, Joint Ventures, Licensing, SBIR (Small Business Innovation Research), R&D Partnerships, STTR (Small Business Technology Transfer Program), Venture Capital.

When it comes to raising equity investment, the questions of how much, for what purpose and the company’s anticipated growth rate determine the target audience for the fund raise and the legal rules that will apply to effort. Generally, if the amount to be raised is less than $1.0 million or the company does not anticipate dramatic growth to be fueled by the cash infusion, venture capital funds are not a promising target. If it is more than $1.0 million and anticipated growth offers venture-type returns, venture funding may be possible. In the lower range, private placements to angel investors may make more sense. Sometimes corporate venture groups are worth approaching, particularly where they can add something of strategic value. See: Angels, Corporate Venture Capital, Private Placements, Venture Capital, Venture Capitalists. See also: Does Your Investor Contribute More Than Money?, Think Like a VC.

Companies selling their securities must be careful to comply with state and federal securities laws or risk exposing management and others who promote those securities to serious liability exposure. The types of investors approached, the manner in which they are approached, and the types of disclosures made to investors all impact the availability of exemptions from the general requirement that securities be registered for a public offering in order to be sold. Common practice involves structuring private offerings to comply with one or more safe harbor exemptions whenever possible. Most of these safe harbors appear in Reg D of the federal securities laws. See: Accredited Investors, Offering Memos, Private Placements, Public Offering, Reg D, Safe Harbors, SEC (Securities and Exchange Commission), 10b5.

Conducting a fundraising campaign, whether to angels or institutional investors, requires thought and planning. Enough time needs to be allocated to determine the approach, get corporate governance and accounting matters in order, prepare necessary presentation material, and provide time to identify, approach and negotiate with prospective investors. Then there is the time needed for investor due diligence and documenting the investment. One of the most common mistakes management teams make is to underestimate the time required to raise funds, leaving their companies in peril or overly constrained before fundraising in complete. This can lead to lost opportunities and lower fundraising valuations. See: Business Plan, Business Plan Format, Clubbing, Corporate Governance, Due Diligence, Investment Bankers, Negotiation, Term Sheet. See also: Mistakes I Made at a Business Plan Forum, Practical Strategies for Negotiating with Investors, Real World Conflicts in Fundraising, Think Like a VC, What Investors Want from Entrepreneurs, Writing the Business Plan.

Sometimes the need to sell securities to investors, and the attendant dilution of management’s ownership position, can be postponed by using other methods to raise funds. Government research grants provide project funding that is non-dilutive and can be obtain through directed grant proposals to funding agencies through the Small Business Innovation Research and the Small Business Technology Transfer programs. These dollars, when obtained, can be used for specified purposes related to the funded research. State and local programs designed to support the creation of jobs are also sometimes available to provide funding or tax breaks that free up cash. See: SBIR (Small Business Innovation Research), R&D Partnerships, STTR (Small Business Technology Transfer Program).

Joint ventures and business partnerships can also be used to advance specific company projects. Sometimes these take the form of development licenses or include licenses with upfront or milestone payments that fund product research or regulatory approval. Other times they take different forms. The essence of each deal is an allocation of responsibilities, management and execution that meets the needs of all parties and advances completion of the project. Careful planning and thorough documentation are a must for the successful joint venture. See: Joint Ventures, Licensing, R&D Partnerships. See also: Joint Venture Checklist.

When the circumstances dictate the need for outside capital, company managements will also be interested in evaluating the potential price they can charge for their stock and identifying professionals to help them through the process. They will also want to understand the motivations and methods of their target investors as well as anticipate the types of deal terms they will be confronted with. See: CPAs (Certified Public Accountants), Deal, Discounted Cash Flow, Investment Bankers, Lawyers, Market Price Method, Pricing, Venture Capital Deal Structures. See also: Practical Strategies for Negotiating with Investors, Real World Conflicts in Fundraising, Think Like a VC, What Investors Want from Entrepreneurs.

Pricing the deal. One critical element in all venture fundings is price. Typically, cast in the terms of company enterprise value on a fully diluted basis, higher prices mean fewer shares are issued to investors. This also means less dilution for existing shareholders and less upside for the new investors. The tension this creates highlights for company managements the need to run disciplined fundraising campaigns that can create competition among potential investors. The difficulty of commanding high valuations at early stages of company development also convinces many companies to limit amounts they raise in early rounds in the hopes of using those funds over a 12 to 18 month period to reach a new and higher valuation point for the company and then raising funds again. See: Clubbing, Fully Diluted, Valuation. See also: Practical Strategies for Negotiating with Investors, The Seven Deadly Sins of Fundraising, Think Like a VC.

Ultimately, the issue of deal price becomes a negotiation between the investor and the company over the fair market value of the company translated into price per share. In the private company investment context, with sophisticated convertible preferred securities as the common means for investing, the issue is further complicated by the structural elements inherent in the convertible security that is used that make the shares of the security more valuable than the shares of common stock owned by management. These elements include liquidation preferences, convertibility features, anti-dilution protections (which give the investor more shares of common stock on conversion if later shares are sold at lower prices), registration rights, and the management participation rights contained in most of these securities. See: Anti-dilution Provisions, Convertible Preferred Stock, Demand Rights, Liquidation Preferences, Management Agreements, Piggyback Rights, Ratchets, Registration Rights, Valuation, Weighted Average Anti-dilution. See also: Shareholder Value: Premiums, Discounts and More.

Nonetheless, and notwithstanding the many and varied methods for valuing a private company, a few methods are used frequently by investors to gauge a range of acceptable valuations. The most common of these are the discounted cash flow method and the market price method. Neither is a perfect measure of value and both need to be viewed in light of other considerations that are important to a given investor. If, for example, there is strategic value to the investment apart from the potential increase in share value – such as access to new technologies or markets for the investor – that factor might be taken into account to increase share price since value is being obtained elsewhere. Both the market price method and the discounted cash flow methods are described in Part 2. See: Discounted Cash Flow, Market Price Method, Pricing.

Structuring investments in private companies. Deal structures vary from deal to deal but most venture capital investments in private companies use the same deal tools to improve investor liquidity, value, and participation in management. The following provides a summary of the typical venture capital deal structure tools used where the investor purchases less than a controlling interest in a growing privately held company. See: Deal, Preferred Stock Umbrellas, Structure, Venture Capital Deal Structures.

~ Type ownership interest purchased. Convertible preferred stock or convertible debentures are the security of choice because they give their holders preferences over the securities held by management and are convertible, at the investor’s option, into common stock. See: Convertible Debentures, Convertible Preferred Stock, Convertible Securities, Preferred Stock Umbrellas.

~ Due diligence. The financing agreements are detailed and include extensive representations by the company and, sometimes, individual management members respecting all aspects of the company’s operations. Ten to 20 pages of single spaced representations accompanied by an extensive disclosure schedule elaborating on the representations are not unusual. See: Boilerplate, Due Diligence, Reps and Warranties.

~ Liquidation and other preferences. The securities purchased typically contain preferences that entitle them to receive a predetermined amount (typically their investment amount plus a specified return) before other shareholders in the event the company is liquidated, preferences on dividend payments, rights to elect a director representative, and negative covenants that prevent the company from taking major actions without the investor’s consent. Sometimes the investor receives the right to sell his shares to the company at a later date for a predetermined price. See: Board of Directors, Convertible Preferred Stock, Negative Covenants, Participating Preferred Stock, Puts.

~ Protection against dilution. Anti-dilution rights entitle investors to receive extra shares of common stock when they convert their preferred stock into common stock if a company sells stock for lower prices after the investors’ purchase or if there has been another dilutive event, such as a stock split. See: Anti-dilution Provisions, Dilution, Ratchets, Weighted Average Anti-dilution.

~ Share Rights. Investor voting preferences in their purchased shares usually include the right to elect one or more representatives to the company’s board of directors and to approve certain types of actions such as the amendment of the company’s charter, the sale of the business, or the issuance of new or preferential securities. Sometimes the voting preferences extend to other matters as well. In addition, investors typically require management to enter into agreements respecting management’s ownership in the company that make it expensive for management to sell its stock or leave the company. See: Negative Covenants, Shareholder Agreements, Voting Agreements, Voting Trusts.

~ Participation and Information Rights. The voting rights negotiated by venture investors are frequently supplemented with