Venture Capital

Tom Pedreira

If you have a great idea for a business, but no money, or if you have a small company with potential for tremendous growth, but need more funding to make it happen, then you might look for venture capital (sometimes known as VC) to help turn your dreams into reality.

Venture capital is the term used to describe the money that is raised and pooled together for the specific purpose of investing in start-up or early-stage business enterprises. Venture capitalists are the people who make and manage these investments. While venture capitalists often invest their own money in their ventures, most will seek out other investors to bring together as part of a limited partnership or some other form of a pooled investment fund.

The goal of venture capitalists is to invest in companies that will dramatically increase in value and allow the investors to cash in on big capital gains. It's a risky business, because many of these companies fail. In recognition of this risk, venture capitalists have traditionally insisted on having a significant ownership interest in and control over the companies they fund.

Role of a Venture Capitalist

To increase their chances of investing in a profitable start-up, venture capitalists are continually adopting and implementing new strategies on their investments. Beyond simply contributing capital, for example, venture capitalists often want to play a strategic role in the growth and development of the companies they fund. This may include:

• Participating on a company's board of directors
• Providing advice on key issues relating to the development of the company (such as staffing, marketing, business development, supplier relationships and analyst relationships)

Pros and Cons of Venture Capital

In short, venture capitalists can make things happen for small companies that have big growth potential, which can make them a great ally in making a new business successful. Trying to secure venture capital could be a great idea if you have a fledgling business with a lot of potential for expansion, or even a great business idea but no way to fund it.

But there is a big trade off you have to recognize up front: venture capital may allow you to build a huge company with the potential for untold personal wealth, but it may come at the price of losing control over a company you founded and sacrificing your personal lifestyle in the process.

Typical Investment

What will venture capitalists look for in a company? They will want to see:

• A good idea for making money
• Founders who are willing to invest their own money in the venture
• A great business plan that reflects sound and realistic thinking
• An established or promising product and market
• Some operating history that shows promise of success

Strong management is also important, although venture capitalists often expect to provide or bring in additional management expertise.

Trade-Off for Investment

What will venture capitalists want in return for the big bucks and experience they provide?

• A large position in your company, which will dilute the founders' ownership
• Liquidation preferences, where they may get their money back at least several times over before sharing profits with other shareholders
• Seats on the board of directors and special rights that allow them to oversee management
• They'll also want an exit strategy that will allow them to cash out of the company within a relatively short period of time (typically 2 to 7 years)

Usually, venture capitalists insist on registration rights - the right to make the company register their stock for sale to the public at some point in the future. They also receive preferred stock, which is entitled to be paid before common stock if the company liquidates.

Preferred stock is often issued in series, with the first round typically being called "Series A Preferred Stock." The next round would be the "Series B" round, and so on, often going up to a "Series D" or "Series E" round before the company has a public offering or realizes some other exit strategy that allows the venture capitalists to get their money back. Profits would be distributed first to the Series A stockholders, then to the Series B and so on. In addition, the owners of each series of stock might have different rights.

Questions for Your Attorney

Before allowing a venture capitalist to make an investment in your company, talk to an experienced finance lawyer who can help you analyze the investment proposal and negotiate the terms and conditions of the investment.

Among the questions to consider asking your lawyer:

• Have you previously represented companies looking for venture capital investments?
• What red flags should I be aware of?
• Does the venture capitalist's proposal seem fair?
• How can I attract venture capital while still maintaining control over my company?
• How much do you charge for your services?

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