Friday, January 23, 2009

The Flora and Fauna of Venture Capital

I have found that many entrepreneurs are confused by the differences between the various flavors of angel and venture capital. This is not surprising since the categories used are overlapping and are often used inconsistently by different investors. However, there are some broad generalizations that can be drawn – typically based on the timing of the proposed investment and the typical purpose of the investment in the company’s lifecycle. Depending on the timing, you can also draw some basic conclusions as to the type of investor that will be involved and, in each category, generalizations can be made as to the type of security the company will sell and the magnitude of return the investor will seek.

The earliest stages of investment are usually characterized as seed rounds, proof of concept investments or angel investments. These investments usually do not occur until after the investor has tapped out his friends and family (in what is often characterized as the “friends and family” round). The money invested is intended to allow the founders of the company to do their initial research, to complete the initial programming or to apply for the initial patent(s). Companies at this stage usually do not have a saleable product and do not have very many employees, other than the founders/inventors. The investors are almost always NOT traditional venture capital funds. Rather, they consist of wealthy individuals or groups of individuals that are willing to invest their own money and take the extreme risk involved in making equity investments into companies that often only have a good idea. Alternatively, the investor may be a government or university funded incubator that was established to help entrepreneurs or scientists get their ideas off of the ground. In this stage, the amount of the investment is typically relatively small – e.g. $100,000 to $500,000, seldom more than $1,000,000 in total. Also, the investor usually takes common stock in the company – the same stock that the founders get. Alternatively, the investor will take a convertible note that allows them to have the protection of debt at the beginning and also allows them to convert at the valuation established by later investors. Investments at this stage are extremely risky and are subject to significant dilution when new investors come in during later stages. Consequently, angel investors look for returns of at least 10x their initial investment, and sometimes as high as 20x or 30x their initial investment.

The next stage of investment in a typical company’s life cycle is early stage venture capital. This type of investment usually is not available to a company until it has a proven product and a business plan. However, it is not necessary that a company be profitable or even be producing its product. The funds the company raises will be used to mass manufacture the product, market the product, build a sales force and further develop the product. For this investment, the company will be able to attract early stage venture capitalists. These venture capitalists often have smaller funds which are more suited to making the relatively smaller sized investments found at this stage of a company’s life. In this stage, the amount invested is typically in the $1,000,000 to $5,000,000 range. The early stage venture capitalist will almost always be investing in Series A preferred stock of the Company. This security will be superior to the common stock held by the founders and any angels and will typically come with dividend rights, liquidation preferences, some form of anti-dilution rights and a right of first refusal on stock sales by the founders and angels. Sometimes it may also come with pre-emptive rights, redemption rights and drag along rights and other rights and preferences. The venture capitalists at this stage will look for returns of at least 5x their initial investment and would gladly accept higher returns.

There may be multiple additional rounds of equity financing after the Series A round. These types of funding are often called growth capital or mezzanine financing. Usually, the company will either be close to profitability or will have a clear path to profitability and the funds are meant to allow the company to expand its sales force and marketing efforts and ramp up its revenue growth. The money may also be used to develop additional products or to research expansion ideas. These investments are usually made by the larger size venture capital funds and the amount invested can range from $1,000,000 to $25,000,000 or higher – depending on the company and the market opportunity. The investment will typically be made for additional rounds of preferred stock – for example, Series B or Series C preferred stock – and each successive round will generally having superior rights and preferences to the prior rounds. Venture capitalists at this stage of investment may still look for 5x investment returns, but depending on the opportunity and the trajectory of the company, will often settle for 2x or 3x returns.

Occasionally, a company in the growth phase of its life cycle, or that is on the cusp of the growth phase, will raise bridge capital. This is typically debt that “bridges” the gap in funding between rounds of venture capital financing. Usually, it takes the form of a convertible note that will automatically convert into the next round of preferred stock, sometimes at a discount. The lender may be an existing investor in the company or it may be a new venture capital fund that is contemplating making the follow on round.

Another type of financing that is available to companies in their growth phase is venture debt. This is a loan from a bank that is often securitized by the company’s accounts receivable, inventory or equipment. The venture lender will take warrants in the company to help increase its return on the loan. Typically, these lenders seek combined returns in the 12 to 18% range.

The final type of financing that a company may seek can be characterized as acquisition or buyout capital. This type of capital is used to purchase the assets or stock of other businesses that will then be adsorbed into or added onto the company. The investor may be the company’s existing venture capitalists or it may be a private equity fund that is building out a platform in the company’s industry. In the later case, the investment may come with a right to purchase the company outright in the future. This type of financing also occurs when a company’s venture capitalists start planning their exit strategy. By putting together the right pieces it may make the company more attractive as an acquisition candidate or perhaps more eligible for an IPO.

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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.