As an entrepreneur or principal of a small business, particularly a start-up company, you have probably pursued or considered pursuing funding from a variety of sources, including debt financing, equity financing from friends and family or “angel” investors, and equity financing from a venture capital (“VC”) firm. This article focuses on the myriad aspects, both positive and negative, of the VC funding alternative.

An understanding of a VC investor’s motives is important in determining whether to pursue VC funding for your business. Generally, investors consider VC funds to be more risky “alternative investments” in a balanced investment portfolio. The VC funds must demonstrate an ability to generate high returns (both in absolute dollars as well as how quickly that return is realized) in order to attract investors, and, in turn, will look to your company to help them realize these returns.

VC funding can be very difficult for businesses to attract and secure. In general, VC firms are extremely selective when reviewing prospective portfolio companies, and are looking for businesses that can generate returns on investment of at least 30%. Under current market conditions, VC firms are also favoring investments in more mature businesses rather than early stage companies. A VC firm might review 50 to 100 portfolio companies for each one that it selects. As a result, there is an attitude among many businesses that they are among the lucky few to get as far as the negotiating process. Notwithstanding the difficulty in attracting VC funding, it may be more available to your company in the current financial climate than traditional bank financing or other forms of equity financing.

When considering a term sheet from a VC fund, you should ask about the fund’s current position in relation to its overall “life cycle.” Most funds have a ten year life, at the end of which they are liquidated. Thus, when most funds make investments in portfolio companies, they have exit strategies of three to seven years in order to satisfy their investors return expectations. These exit strategies include selling your company or an initial public offering. If this timeline differs from your goals for your company, VC funding may not be appropriate for your business. In addition, a VC fund that is at the beginning of its life cycle may reserve considerable sums for potential future financings for your company, often at rates of 2:1 or 3:1. The fund’s current position in relation to its overall “life cycle” will indicate to you whether the fund will be able to continue to support your company in future financing rounds as your business grows and prospers.

Many VC firms will have experience in your industry, and can provide extremely valuable advice and guidance. This support can help you avoid costly mistakes, can accelerate the life cycle of your business and can help you seize opportunities that you may not have been prepared to seize on your own. Directors or officers that join your firm at the behest of the VC investor may bring operating or technical experience that your company lacks, and may bring ideas and help develop your business plan. VC firms can also bring a wealth of contacts, including potential customers, other investors, investment banks and acquirors. VCs can provide entrepreneurs with opportunities that would never present themselves otherwise. Such opportunities can bring wealth and success to a company and its owners that may never come without VC funding.

There are many variants of the basic deal structure, but regardless of the specifics, the goal is always the same: provide the VC firm with downside protection as well as significant upside and an opportunity for additional investment if the company is a winner. VC funds most often invest in convertible preferred stock. These securities offer the VC fund the best of both worlds: equity, which will entitle the fund to its portion of the returns if your company is successful, as well as the right to receive distributions before the holders of common shares in your company, which resembles debt.

By accepting VC funding, you will be ceding significant control to the VC fund. VC investors will want to place at least one representative on your board of directors in order to manage the investment. Other common terms that VC funds seek when financing a business are:

(i) liquidation and merger provisions that will permit the VC firm to demand a cash payment at the time of merger, which can make the potential merger much less attractive to a potential partner or can prevent the deal outright;

(ii) disproportional voting rights regarding key decisions, such as the sale of the company or the timing of the company’s initial public offering;

(iii) antidilution provisions such as “full ratchets” that can permit the VC fund to convert all of its securities to common shares at the lowest share price that your company subsequently offers;

(iv) redemption rights (allowing the VC to require the company to “buy them out” after a period of time or upon the happening of certain events);

(v) provisions that give the VC fund the right to put additional money into the company;

(vi) provisions that allow the VC firm, together with other stockholders, to force a sale of the company (a “drag along”) and

(vii) provisions in your employment contract (which the VC firm will likely require you to sign) including non-competition and non-solicitation clauses that can impair your ability to find work if you leave the company, share forfeiture provisions if you leave the company prior to a stated time, and restrictions on your ability to sell or redeem your shares.

Although the aforementioned terms are common in VC transactions (and are becoming more common even in “angel” investing), it is important to note that each transaction is unique, largely because each VC firm may demand different terms under different circumstances and because each business has a different amount of leverage it brings to the transaction. In general, businesses will be able to negotiate better terms if they are already profitable or have a sought-after product or service, and have experienced, skilled management. Companies with management that has a proven track record of successfully building and selling a business are particularly desirable to VC firms. Alternatively, companies with unproven management that are several years from bringing their product or service to the market will have less bargaining power. Before undertaking discussions with a VC fund, you and your company should honestly evaluate where you fall within this range, as it can help you prepare for the negotiation process.

Finally, before accepting VC funding, you should conduct your own “diligence” investigation on the VC firm:

  • Speak with the CEOs of other portfolio companies in which the VC firm has invested (including CEOs who have either been fired or involved in an unsuccessful venture). Typically, the VC firm’s website lists the companies. Find out how the VC firm is to work with, and whether the relationship is a benefit or a burden, after the honeymoon is over.
  • Identify who will serve on your Board from the VC firm, and what that person’s position is within the VC firm. How many other Boards does that person sit on (how much time will they actually have to focus on your business)?
  • Does the VC who will sit on your Board have relevant experience in your industry segment? Does he or she have operating experience (have they walked in your shoes)?