What Venture Capitalists Want From You

Before they put money into your company, they want to be sure they can get it out. Here are some guidelines.

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It's obvious that neither party to a venture capital transaction enters into the deal without a reasonable expectation of success. But, ecause a marriage of money and people is prone to unexpected and often unpleasant developments, venture capital investors place a high priority on managing their "liquidity risk." Simply put, that means the investor will require specific, predetermined methods of recovering the venture capital invested, plus a healthy profit if all goes well, or a minimum loss in the event a business does not meet expectations or fails.

In practical terms, this means that the investor will usually demand that one of two things be present in the purchase agreement that formalizes the investment: either the right to sell his stock when he has the opportunity, or the right to assume a senior position if the company is sold or liquidated on a distressed basis.

The entrepreneur must be sympathetic to the investor's concerns about liquidity. Generally, the more ownership he wants to keep for himself, the more liquidity options he'll have to give up. But if he is sensitive about giving the investor too much control, he can offer more ownership in exchange for more flexibility.

These are some of the instruments and methods entrepreneurs and investors use to formalize the trade-offs between liquidity and control (in each instance, assume the investor seeks to acquire less than 50% ownership):

Common stock is the most frequently used instrument for purchasing ownership. It carries the right to vote on certain corporate decisions, and can pay dividends (although it rarely does in venture investments). In liquidation, common stockholders are the last to share in the assets of a corporation. If the company is successful, shares can be sold through a registered public offering, or can be sold to the public without registration under Rule 144 (a Securities and Exchange Commission stipulation that an investment must be held for two years before limited public sales can begin). Investors will insist that registration rights accompany common stock sold in private transactions.

Convertible preferred stock (convertible into common) may carry terms that include access to internal financial data as well as provisions for controls, such as a majority position on the board of directors, should certain financial tests not be met. Investor liquidity is enhanced by such strong covenants, which make the instrument appealing to other investors.

Subordinated debt (either convertible or with warrants) is used when the investor wants the security and yield of a debt instrument but the company does not want to restrict its ability to borrow from banks. If subordinated debt does not dominate the capital structure, it will be viewed as equity by senior lenders. This instrument gives the venture capitalist more options than does a straight equity position. If the company defaults on the loan, the investor can accelerate repayment; if the company cannot repay, the venture capitalist (now a creditor) has strong leverage to influence management decisions. Because the holding period under Rule 144 does not begin until warrants are exercised, from a liquidity stand-point convertible debt is generally elected over debt with warrants.

Of the three instruments, the one that appears most attractive for both the purchaser and the issuer is preferred stock. On the one hand, it is equity, and provides a sound base for the company's future growth, and on the other, if properly structured, preferred stock can contain rights virtually equivalent to those in a debt contract, assuring the venture capitalist of liquidation flexibility or the ability to influence key management decisions.

There are many trade-offs to be considered in choosing the appropriate instrument -- an investor may be willing to give up the yield and security of debt to purchase more equity, for example.

In addition to these instruments and the provisions that may accompany them, there are a number of other considerations to the liquidity preferences of investors. Among them:

Registration rights, which provide the investor a way to get liquidity if the company is successful and can attract a public market for its stock. In essence, such rights can force the company to file a statement with the SEC as the initial step toward a public offering. Important issues to be negotiated here include (1) the dollar size of the offering, (2) the number of shares an investor can sell, (3) piggyback rights (the right to participate in other company registrations), and (4) the precedence of certain investors' shares if the size of the offering is reduced.

Rights to approve a merger or the sale of additional stock, which work to control dilution and improve liquidity.

Sinking funds, commitments to set aside money to be used to retire a financial obligation, can be applied to both preferred stock and debt. If a company fails to make a sinking fund payment, it will be in default, and investors can then gain greater control.

Default may allow the investor to set in motion a program to improve his liquidity. In most cases, such an event cannot force an immediate sale, but may entail such internal measures as cutting back operating levels to preserve cash, or external actions such as recapitalizing the company, soliciting a buyer, or raising additional funds.

Each situation will have its unique characteristics, too diverse to list here. But a common understanding of the rights to be negotiated in the purchase agreement and of the trade-offs between financing with debt or equity will help forge a strong and mutually rewarding relationship.

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