The Structure of a Venture Capital Investment

A typical venture capital investment is structured so that the venture capitalist gets convertible preferred stock in your company. This stock gives the venture capitalist a preference over the common shareholders in the event of a liquidation or merger.

The preferred stock is convertible into common stock at the option of the holder — and may be automatically triggered by certain events. For example, the preferred stock would convert to common stock in the event of an initial public offering (IPO) of the company to simplify the capital structure of the company and to facilitate the IPO.

Venture capital investments are also sometimes “staged.” A certain amount of money is invested right away and additional money is invested later, as certain milestones are reached. From the company’s perspective, it’s important that these milestones are clearly defined and reasonably obtainable.

Venture Capitalists’ Rights

Venture capitalists also typically expect to receive the following rights with an investment:

  • The right to elect one or more directors to the company’s board of directors
  • The right to receive various reports, financial statements and related information
  • The right to have its stock registered for sale in a public offering at the company’s cost
  • The right to maintain its percentage share ownership in the company by participating in future stock offerings

The Stock Purchase Agreement

Once the company and the venture capitalist agree on the terms sheet — a summary of the proposed terms and conditions for the investment — the venture capitalist’s attorneys usually prepare the definitive agreements reflecting the transaction.

The main agreement will be the stock purchase agreement, which typically contains the following information:

  • The price of stock to be sold and the number of shares to be purchased
  • Representations and warranties of the company
  • Covenants of the company
  • Conditions to closing of the deal
  • A requirement to reimburse the venture capitalist’s legal fees
  • Exhibits and related agreements, which contain other rights for the venture capitalist

Representations and Warranties

Representations and warranties from the company are almost always present as part of a venture capital investment. The company is expected to represent its financial and operational condition and outlook. A breach of the company’s representations and warranties can lead to a real problem for the company, giving the investor various remedies laid out in the agreement.

Representations and warranties can go on for pages, because venture capitalists want to flush out any “warts” in advance. Some of the most common representations that companies are expected to make include:

  • The exact outstanding capitalization of the company
  • That the company’s financial statements are true and correct in all basic respects and have been prepared in accordance with generally accepted accounting procedures
  • That the company has no liabilities other than those reflected in its most recent balance sheet or occurring in the ordinary course of business since the date of the last balance sheet
  • That the company owns all of the assets it claims to own, without liens or encumbrances except those disclosed
  • That the company’s intellectual property and products don’t infringe the rights of others
  • That the company is in compliance with all relevant laws that govern its operations

In early-stage companies, venture capitalists may insist that the founders make the representations and warranties personally.