Having a brilliant idea for a business is one thing – but getting it successfully funded is another. Venture capitalist firms are a viable but intimidating option for many start-up businesses. This Legal Kitz blog will help explain what a venture capitalist (VC) is, and walk you through the process of successfully being funded by a venture capitalist.
What is a venture capitalist?
A VC is a professional investor who takes a share in a business, with the prediction that the business can grow rapidly and enormously. Venture capitalists will often find and support a business if it has been successful so far, and if they believe that the product or service has great earning potential for the future. They will actively be involved in the business, usually by joining the board, to have a say in the company’s direction and to protect their investment.
While venture capital firms are listed online, the most promising method for receiving funding is to get recommended by a business advisor, lawyer, accountant, or other industry source.
How can you get venture capitalists to fund your business?
1. Determine your funding need
Venture capitalists are usually interested in funding companies who intend to grow big and generate massive profits. If a business’ goal is to be successful on a small scale, venture capital firms will usually not be interested in putting forward funding.
If a start-up company is intending to grow as large as they reasonably can, it is best to have a series of investment plans depending on how much the company is able to raise from venture capitalists or other sources. This amount of money is determined by several factors, such as:
- How much capital is needed for the business;
- The current stage of the business; and
- Valuation and dilution preference.
2. Determine your business valuation
Research and financial models can be used to calculate a business’ valuation. If the company is already established with sales and revenue, the most common methods of determining business valuations include:
- Net asset valuation; which involves adding up the value of assets on the balance sheet and subtracting long-term debt. Venture capitalists usually do not prefer this method, as they are more interested in future cash flows.
- Profit multiples uses a multiple of the company’s annual profit, which is usually earnings before interest, depreciation and amortization (EBITDA). This can be highly speculative.
- Discounted cash flow uses projections for future cash flow and discounts them using interest rates to come up with a value. This method is also highly speculative.
These traditional methods usually aren’t effective. Instead, the real value of the business is ultimately whatever the market will pay for it, which is the most important element to venture capitalists.
3. Prepare documents to impress venture capitalists
In front of a venture capitalist, you will need the following documents to give them a well-rounded view of your company and earnings potential:
- An elevator pitch, which should be brief and easily understandable by someone with no special industry knowledge.
- An executive summary, which is a one to two page summary of the business, including elements of the pitch and an overview of the most important technical details from the business plan.
- A presentation/pitch deck, which is a story-telling slide show which presents the highlights of the plan including visuals, charts, and pictures of the products.
- It also important not to bring a non-disclosure agreement (NDA), as most venture capitalists will refuse to sign it. It creates too many difficulties, especially when hearing pitches from similar businesses.
4. Learn the capitalisation table
Investors will need to know what they are receiving, and if anything may potentially dilute their investment. A capitalisation table identifies the owners of a company, how much they own, and what kind of shares. This tracks authorised vs issued stock, granted options vs the reserve options pool, and other unvested rights.
5. Negotiate your term sheets
A venture capitalist will present the business with a term sheet, which contains the full terms of the deal. Every item is important, with nuances which can drastically alter the business’ rights or the true value of the deal. It is very important for a lawyer to review the term sheet and be involved in the negotiations. This can include items like:
- Valuation,
- Investor rights,
- Board seats,
- Option pool,
- Voting rights,
- Liquidation preferences,
- Founder vesting schedules,
- Founder revesting of shares,
- Veto rights,
- Preferred stock, and
- Convertible notes.
The most common economic issues which are negotiated include:
- The pre-money valuation, which is the value of the company before investment funds have been added,
- The post-money valuation, which is the pre-money plus the new investment,
- The investment type, which is usually in the form of a convertible preferred stock,
- The stock option pool, which is a right given to the holder to buy shares at a predetermined price.
The most common major aspects of company control which are negotiated include:
- Liquidation preferences, which allows investors to receive some money back in the event the business is sold,
- Antidilution protection, which protects investors from raising additional money later at a lower valuation and having their value reduced,
- Board seats, which is the number of board seats and overall size of the board. The more seats the investors have, the more control they will have for decisions which require board approval.
- Protection provisions, where investors will want protective rights to control specific business activities.
- Expenses, where businesses are often expected to pay back the costs incurred by the venture capital firm to execute the deal.
6. Prepare for due diligence
The venture capitalist will require an exhaustive review of the business, including financial statements, business structure, facilities, and key employees. There will be key questions to answer, which may include the market and the competition, product development plans, sales and marketing plans, etc.
To help this go as smoothly as possible, here are a few tips:
- Create a virtual data room or file sharing service, where investors can access and return to documents in an organised way;
- Be proactive and identify each person at the venture capital firm that the company will be interacting with and what they’ll need;
- Maintain your own tracking system and keep a checklist of what has been sent, to who, and when.
7. Close the deal
Once everything has been negotiated and due diligence has been passed, there will be many legal documents prepared and reviewed by attorneys for both parties. The most common closing documents include:
- An investment agreement, which describes all material terms and conditions, including financials, forecasts and other historical information.
- A stock purchase agreement, which is the legal sale of shares to investors and details the purchase prices, closing date, shares to be issued, representation, and warranties.
- An amendment to the bylaws, which is a new class of stock and documents of all of the shareholder rights negotiated in the term sheet,
- A voting agreement, which contains any rights of first refusal to buy new shares, stock transfer restrictions, and the requirement for common shareholders to elect the venture capitalist to the board of directors,
- An indemnification agreement, to hold harmless the board and investors should a third party sue the company.
Legal advice
It can be difficult to understand the process of venture capitalist funding. You don’t have to do it alone! If you would like to speak to one of our friendly staff here at Legal Kitz, we offer a FREE 30-minute initial consultation with one of our experienced business specialists. If you are starting up a business, check out our sister company Business Kitz for high quality legal document templates!