Economic terms

Valuation and pricing

How is the company valuation and investors’ purchase price usually determined in venture capital transactions?

Simple agreements for future equity and convertible notes are used in early seed financings specifically to avoid setting a valuation. In priced equity rounds, venture capitals (VCs) typically look for a large enough ownership stake (for example, 33 per cent in Series A) that will still be a meaningful ownership stake upon exiting their investment after inevitable dilution from stock option grants and subsequent investments by new investors. The pre-money valuation results from arm’s-length negotiation.

Option pool

What do investors typically require for option pools or equity incentive arrangements in connection with venture capital transactions?

VCs typically require a 20 per cent post-money option pool available for new option grants following their investment. The available, unallocated pool shares are included together with pre-closing (or pre-money) shares that are divided into the agreed company valuation for purposes of determining the purchase price per share of shares sold to investors in the financing round. This is done so new investors are not immediately diluted by the available option pool negotiated into the financing round terms.

Dividends, distributions and redemptions

What are the normal provisions governing dividends, distributions, redemptions or other profit distributions in venture capital transactions? Are there any legal limits thereon in your jurisdiction?

VC investors in convertible preferred stock have senior dividends payable prior to any dividends or distributions on common stock. The preferred stock dividends may be at a stated rate (such as 6 to 8 per cent of the original purchase price per share, annually) that is paid if and when declared by the board of directors or that is cumulative and accrues at the stated rate. Cumulative dividends are then also paid on preferred stock prior to any dividends payable on common stock, or are added to liquidating distributions or redemptions.

In the event of a liquidation, dissolution or ‘deemed liquidation event’ (namely, a company sale in a change of control or asset sale), the preferred stock receive a liquidation preference amount equal to their original investment (together with any declared or accrued and unpaid dividends), before any distributions on common stock. Sometimes, later-stage preferred stock series are senior to earlier series of preferred stock, or preferred stockholders also participate pro rata together with common stock in residual distributions.

If deals include redemption privileges, preferred stockholders often can elect, by class vote, to have the company mandatorily redeem the preferred stock, usually after five years and in two to three equal annual instalments. Any declared or accrued, and unpaid, dividends are included in redemption payments. Redemption is rarely invoked and is said to be a means of forcing companies to work towards an eventual exit for investors, instead of running the company as a ‘lifestyle’ business for insiders.

Company sales and liquidations

How are venture capital investments treated in portfolio company sales or liquidations?

VCs often participate through their board representatives or observers in deliberations over whether to liquidate or put companies up for sale or in responding to acquisition bids. They nearly always have a separate preferred class or later-stage preferred series vote on liquidating or selling the company. Their preferred stock liquidation preference, as well as any participating preferred rights, lets them recoup their original investment amount before other stockholders receive proceeds, but also participate in any greater proceeds they would receive as common stockholders (by converting to common stock). Finally, VCs often have drag-along rights to cause voting agreement parties to vote for mergers or asset sales, thereby enabling the company exit, subject to standard selling stockholder conditions.

Anti-dilution protection

What anti-dilution protections are typically built into the terms of venture capital securities?

VC convertible preferred stock normally converts initially on a one-for-one basis into common stock at a conversion price equal to their original purchase price. But if the company effects a stock dividend, reverse stock split or similar recapitalisation, the conversion price is adjusted upwards or downwards proportionately to the change to each share of common stock. The conversion price is also normally adjusted for dilutive issuances, most commonly on a ‘broad-based weighted average’ basis factoring in the number and original issuance prices of different classes and series of stock to arrive at a lower blended average conversion price, or more rarely on a ‘narrow-based weighted average’ basis (only factoring in outstanding stock or preferred stock) or ‘full-ratchet’ basis (lowering the conversion price to the dilutive issuance price). This price protection protects against economic dilution from lower-priced share issuances, but has standard exceptions for conversion shares, option grants and other commercial issuances not undertaken primarily for financing purposes.

Future investments

What pre-emptive or pro rata investment rights do venture capital investors usually receive?

VCs usually have pre-emptive rights of first offer (sometimes referred to colloquially as ‘pro rata rights’) to purchase shares in new financings to maintain their voting or fully diluted ownership percentages. These rights are usually limited to major investors having a minimum number of shares high enough to merit that right, and participating investors exercising their rights usually have a limited period in which to gobble up declining investors’ potential allotments. These rights have exceptions similar to that for price-based anti-dilution adjustments.

Insider sales

What rights do venture capital investors normally have over insider sales of securities of portfolio companies?

Major investors have rights of first refusal (ROFR) and co-sale rights over such sales. The founders and key insiders are usually subject to these rights, though some investors want all 1 per cent or greater common stockholders to be bound. The company normally has a first ROFR, followed by the major investors’ ROFR on a pro rata basis among major investors or co-sale right to sell shares alongside the insider on a pro rata basis for the total shares sold. These ensure investor control over new equity holders of the company, but are burdens on insider share resales.