Venture Capital Structures

Overview of typical terms and value expectations

I recently gave a short training session on venture economics and structures with a friend who is a partner at a venture capital firm. Here are some of the topics discussed:

Table of Contents

• Pre-money valuation is the value placed on the company prior to the investment.

• The post-money valuation is the pre-money valuation plus the cash invested.

• Calculate the VC's ownership percentage by dividing the investment amount by the post-money valuation.

The VC makes a $5M investment in a company worth $5M pre-money. The post-money value will be $10M. The VC will own 50% of the business = $5M invested / ($5M pre-money + $5M invested). Note that VCs tend to talk in terms of post-money since that determines their stake in the business.

VCs tend to insist on preferred stock rather than common stock for several reasons:

• preferred shares have seniority over common shares if the company sells or is liquidated and it comes down to distributing the returns.

• a company can create multiple classes of preferred shares, each with special rights. When you see references to Series A, B, C, etc. classes of preferred shares, these indicate the rounds of funding.

• VCs typically preserve the right to convert their preferred shares into common stock should that provide a better economic return.

Liquidation preferences mean that in the event of liquidation, the investor receives money before anyone else. Note that a company that undergoes multiple funding rounds can face multiple tiers of liquidation preferences. It is not uncommon for liquidation preferences of previous investors to be renegotiated during a new round of funding, or leading up to a sale of the business.

The liquidation multiple determines whether the investor simply gets back their investment, or if they get a multiple of the investment amount.

i. The VC invests $5M at a 1x multiple at a $10M post-money valuation.
ii. If the business sells for $8M, the VC would keep their preferred shares and with their 1x liquidation preference, they would receive $5M. The common shareholders would receive the remaining $3M.
iii. On the other hand, if the business sells for $20M, the VC would be much better off converting to common (at which point liquidation preferences disappear) and receiving $10M (50% of the $20M).

In the above example, the preferred share structure enables the VC to choose whether they want their holdings to look like a debt instrument (pay me back at a pre-determined multiple of my investment) or an equity instrument (I own X% of the company and will get X% of the pie).

Participating preferred allows the venture capitalist to get BOTH a liquidation preference AND convert into common to participate as an equity holder. Some object to this as "double-dipping" and there is a rich debate among some of the venture blogs as to the pros and cons of this structure. Many participating preferred structures specify that this feature is only applicable to an M&A event or liquidation -- in the case of an IPO, VC preferred shares are converted to common.

i. VC makes a $5M Series A investment at $10M post with 1x preference
ii. Company sells for $20M
iii. Series A investors will receive $5M from their 1x preference AND they receive $7.5M from their 50% share of the remaining $15M

Participation caps (also called kick-out feature) establish a threshold at which point the participation feature disappears. This threshold can be a multiple of return on investment or a dollar amount.

i. 3x cap on a $5M Series A investment at $10M post with 1x preference
ii. Once the VC's returns reach $15M in liquidation preference, they can no longer reap the reward of their conversion to common. Typically, they have the option to convert to common from the start, neutralizing their liquidation preference and thus removing the cap. The below chart demonstrates this visually.

Continuing with our last example (3x cap on a $5M investment at $10M post with 1x preference), the below chart shows the returns that both the VC and the common shareholders would receive upon the sale of the business. Total Exit Value is the sale price. The yellow bar is the return to common shareholders. As you can see, if the business sells for less than or equal to $5M, the common shareholders see nothing. If the business sells for $25M, then the preferred shareholders get $5M from their preference and $10M from their 50% common stock equity ownership. Once above $25M, the cap kicks in and the VC receives no additional returns. However, if the company sells for more than $30M, then it makes economic sense for the VC to convert to common at the start and simply take their share (50%) of the total.

Conversion into Common Shares

The typical conversion calculation (from preferred into common) is as follows:
= (total liquidation preference + accumulated dividends) / conversion price

The conversion price is the original purchase price, adjusted for splits, plus any adjustments for anti-dilution clauses.

Anti-Dilution Clauses are intended to protect the VC from dilution during "down" rounds (rounds at a lower valuation). There are two main types of anti-dilution methods:

• Ratchet: lowers VC's per-share price to new share price being offered (tends to be highly dilutive to common shareholders)

• Weighted Average: reprices VC's shares by taking into account their number of shares and the number of new, lower-priced shares. There are two methods:
  i.  Broad-based anti-dilution method: investor’s shares are repriced to the weighted average of their shares and the new down-round shares, using the fully-dilutive weighted average shares (better for the common shareholders)
  ii.  Narrow-based anti-dilution method: calculates the weighted average only using current common shares outstanding (better for the VC)

Voting Rights

What is IRR?

Bio of the Author:

Living in New York City, Giff Constable is currently an investment banker with Broadview, a Division of Jefferies, working with companies in enterprise software, IT services and BPO. In his entrepreneurial life, he served as Vice President of Business Development for Opus360 Corporation (New York, NY), a 350-person software company, where he focused on partnerships, strategic direction, and product design. Prior to Opus360, Mr. Constable was CEO and co-founder of Ithority Corporation (San Francisco, CA), which was acquired by Opus360. He has worked for VC-backed enterprise software startups, Envive Corporation (Mountain View, CA) and Trilogy Software (Austin, TX), in marketing and sales. Mr. Constable received a B.A. from Princeton University.

© 2001 Giff Constable. Giff Constable can be reached at theeditor - at - constable.net