Deal Structuring & Negotiation

After the business plan presentation the VCs are likely to ask you for additional information and  clarify points which in their view will have an important bearing on their decision to invest. The preliminary negotiations at this point will be concerned with the valuation of business, the ownership stake the VC would like to take in the venture, what financing structure will be used to put the money in the business and other issues relating to the management and functioning of the venture. The agreement on these issues will be summarised in the Commitment Letter which the VCs will issue to the venture.

You will definitely need professional advisors at this stage, as the financing instruments and the legal documentation can be quite complex.

Valuation Of Business

The elements that go into the making of the valuation decision of VCs are :

  • The stage of Investment - the earlier the stage, the lower the valuation. As your company grows it would develop a track record of success which will be indicative of less risk and you are more likely to succeed then, in contrast to the time when your business was at the seed stage.
  • Risk Profile - the higher the risk, the lower the valuation. Several things encompass risk, including technology risk, completeness of management team, and number of competitors.
  • The Scale of Opportunity - the possible financial success your company can achieve in the future will determine the possible value that VCs will place on the company at the time of investing. A company that can reach $1 billion in revenue should command a higher valuation than a similar opportunity that can reach $200 million.

An academic explanation of  the value of your company is the present value of all future cash flows discounted back at the required rate of return, usually called a discounted cash flow analysis. While this valuation methodology is technically correct, sophisticated valuation methods are useless in raising your first round of Venture Capital.

Venture Capitalists are concerned with getting above average returns to compensate them for the risk they are willing to take. Seed and early stage investors expect a return of 10 times their original investment, while later stage investors target 3 to 5 times their original investment. Your valuation should consider these return requirements and exit opportunities.

When considering an investment, Venture Capitalists talk about "pre-money" and "post-money" valuations. Say,  that your company is raising $2 million for  one-third (33 1/3%) of the company, the post-money valuation is $6 million ($2 million divided by 33 1/3 %). The "pre-money" valuation is $6 million less the $2 million raised, or $4 million.

Venture Capitalists focus on pre-money valuations, or the valuation of the company prior to a new round of venture funding. This valuation allows for better comparability across companies without regard for the amount of capital being raised.

Comparing your business to a comparable business with similar elements can give you insight into your valuation. Ideally, you should find companies with similar growth opportunities, risk profiles, and investment stage. You must seek advice from professional advisors such as lawyers and accountants who have assisted entrepreneurs in raising Venture Capital. You should also talk to entrepreneurs in venture-backed companies to get more insight into prevalent practices in valuing companies.

VC firms think in terms of a target overall return from their investments. Generally return refers to the annual internal rate of return (IRR), and is calculated over the life of the investment. The overall return takes into account capital redemption (in case of preference shares and debt), possible capital gains (through a total exit or sale of shares), and income through fees and dividends. The returns required will depend on the perceived risk of the investment - the higher the risk, the higher the return that will be sought - and it will vary considerably according to the sector and stage of the business. As a rough guide, the average return required will exceed 30% to 50% per annum.

Ownership Issues

The percentage of equity varies and depends on the amount of money provided in relation to the value of the business and the  returns expected from the investment. The percentage of equity can range from 10 % in the case of an established, profitable company to as much as 80% or 90% for seed stage projects or turnaround financing. Mostly, however, the VCs do not want to take more than 30% to 50% as they know that the management team, which is what they are really investing in, should have an incentive to be able to produce sustained business growth.

Financing Structure

There are various ways in which the deal can be financed and these are open to negotiation. The Venture Capital firm will put forward a proposed structure for consideration by you and your advisers, which will be tailored to meet the company's needs. The Venture Capital firm may also offer to provide more finance than just pure equity capital, such as debt or mezzanine finance. In any case, should additional capital be required, with a Venture Capital firm on board, other forms of finance are often easier to raise.

The  proposed structure may include a combination of ordinary shares, preference shares and loans. The preference shares and loans can be convertible, which means that on the happening of certain agreed events the said instruments will convert into the equity of the company.

Management & Control Issues

The other issues which you would need to consider and agree upon before the financing is in place are :

  • Whatever percentage of the shares you sell, the day-to-day operations will remain the responsibility of the management. The VC would like to be involved in the strategic decisions that may change the basic product/ market character of the company and any major investment decisions that may impact the financial resources of the company. They will therefore require at least one position on the Board of Directors of the company. In the initial rounds of financing, the founder may be in a position to retain control. But with subsequent rounds of financing, with each investor wanting a position on the Board, this may not be possible.
  • VCs  also want to be in a position to be able to protect their money in case the business does not do well or the management reneges on  any of its fiduciary obligations or is not able to meet the targets or milestones that have been agreed upon. They, therefore include protective covenants in their equity financing agreements to permit them to take control and appoint new management in such cases.
  • How many votes are to be ascribed to the Venture Capital fund's shares?
  • The level of warranties and indemnities provided by the directors ?
  • Whether there is to be a one-off fee for completing the deal and how much would it be  ?
  • Who will bear the costs of the external due diligence process?