Talk the VC Talk
Michael Neuvirth [email protected] September 28, 1999
Israel's Business Arena
=C2=A9 Copyright 1999, Globes Publishers Ltd.
-----------------------------------------------
All start-ups face a major problem when it comes to early stage investmen=
t.
They have to make crucial decisions that are relevant only for the distan=
t
future. Therefore, in conducting negotiations with potential investors,
start-ups must always bear in mind the entire process they have embarked
upon =E2=80=93 and ensure that the current investment will not prove an o=
bstacle at
some future stage.
Although the legal structure and process of venture capital investments w=
ill
vary from one company to another, depending upon the company's existing
legal structure, its goals, and the investors' requirements, there are
typical issues and terms that arise in most cases. Today, Enable begins =
a
serious of columns that will highlight some of these issues and terms, an=
d
the main milestones of the process.
Inital Disadvantage
Negotiations with venture capitalists to establish the basic investment
terms are typically done directly by the principals without attorneys
present. The venture capitalists have the advantage of experience, and
understand the various terms. The management team of the start-up usually
lacks such familiarity with the important investment terms, and without
preparation and some coaching, will often be in no position to appreciate
their significance.
Term Sheet
The financing process, from the legal point of view, typically begins wit=
h
negotiation and drafting of the term sheet. Therefore, entrepreneurs must
understand what a term sheet is all about and its role in the investment
process. The term sheet is the initial document, which sets forth, in
outline, the major terms and conditions on the basis of which the investm=
ent
is to be pursued. Although the term sheet may take a variety of forms, it=
is
intended to accomplish the following purposes:
To reflect the agreed valuation of the business and to quantify the propo=
sed
allocation of that value between the entrepreneurs and investors.
To summarize key financial and legal terms of the transaction which will
serve as the basis for preparing definitive legal documents.
To impose enforceable legal obligations upon the parties =E2=80=93 like p=
rohibiting
negotiations with other parties pending the completion of the transaction
(no shop, or standstill).
Most importantly, the term sheet should be used by the venture capitalist=
to
make sure that the concerns of the entrepreneurs =E2=80=93 which if not a=
ddressed
will turn into "deal killers" - are resolved. This includes issues like
composition of the board of directors, terms of employment for the
entrepreneurs, and relocation of the company and/or of the entrepreneur.
Some Key Terms
The terms of investments differ from one case to another. However, there =
are
common provisions, and examples of some typical provisions are discussed
below:
Registration Rights - These rights allow investors to force the company t=
o
register the investors=E2=80=99 shares for sale to the public at the exch=
ange
commissions. Such rights afford the investors liquidity by enabling them =
to
sell their shares to the public.
Registration Rights may be granted in two forms:
(i) Demand Registration Rights, which enable the investors to force the
company to register their shares for sale to the public at any time; and
(ii) Piggyback Rights, - which allow investors to "piggyback" their share=
s
in a public offering conducted at the initiative of the company.
The significance of Registration Rights may be overlooked at the financin=
g
stage, but they may prove to be highly cumbersome later on, particularly =
in
the case of Demand Registration Rights. This is due to the fact that a
demand for registration may be instigated at a time which is not favorabl=
e
to the company. Such process when forced on the company may be substantia=
lly
detrimental. The costs involved are considerably high, and the registrati=
on
process is time consuming =E2=80=93 especially for the management team.
Pre-Emptive Rights - These entitle the investors to a right of first refu=
sal
with respect to any issuance of shares in the company, subject to the
conditions agreed upon. In this manner, the investor is afforded some
protection against dilution.
Right of First Refusal - Entitles the investors or other shareholders to =
a
right of first refusal to purchase shares being transferred by other
shareholders in the company.
Warrants - These are options granted by the company to third parties, or
members of the company, for the issuance of shares in the company, under
certain conditions and at pre-determined price. Warrants may be granted t=
o
existing shareholders, others advancing bridge loans to the company, or t=
o
investors who actually purchase shares from the company, in which case th=
e
warrants are issued as part of a "package".
Participating Preferred Shares - In many instances, investors, especially
capital venture investors, may require to be issued participating preferr=
ed
shares. Such shares normally carry preferences and rights that are not
attributable to other shares, such as a preference in distributing the
company=E2=80=99s assets in certain events (the company=E2=80=99s liquida=
tion or sale). It
may well be that rights allocated to investors will be granted to holders=
of
Preferred Shares. It is often the case that in a particular company there
will exist more that one class of Preferred Shares, in which case each cl=
ass
may have different rights and preferences or different ranking with respe=
ct
to particular rights and preferences.
About the author
Michael Neuvirth is Director of Corporate Finance and Strategic Planning =
at
Foresight Business and Financial Consulting Ltd. www.foresight.co.il He =
has
over 12 years experience in the high-tech business arena, and has develop=
ed
business and strategic plans that have helped a wide-spectrum of high-tec=
h
companies raise the investment they needed. He has also written extensive=
ly
about the subject. Michael was formerly an intellectual property lawyer i=
n
the US, and is a member of Phi Beta Kappa.