Venture Capital Investing Roadmap, Key Documents and Terms
Venture Capital Investing Roadmap, Key Documents and Terms
Typical VC/PE investment process in a nutshell
- First Meeting - Typical first conversation with a potential investor starts with a pitch presentation usually in a range of 7-30 slides. Many companies produce an additional one-pager fact sheet as a teaser to get investors interested to receive the pitch presentation and/or meet. Other forms of the first communication are common as well such as a simple introductory email and perhaps a link to a short explanatory video about the company’s main products.
- Initial Opinion - After the first meeting/interaction investors take from a few days to several weeks to form their first opinion, usually without going too deep in the details. Investors look if the case fits their investment strategy, evaluate the business model, market opportunity, the team, funding requirements and other key aspects. Investors may or may not request additional information from the company regarding the opportunity.
- Evaluation - After formulating an initial positive opinion investors start devoting more time to evaluate the opportunity. Usually investors would request additional information from the company like business development plan, financial forecasts and historical data, would talk to key partners and customers, meet with other team members and the key company managers, engage with industry experts and would look deeper in the market, competitors and other critical aspects. Usually this process takes 1-3 months while in some cases it can take a much longer period if the case is quite complex.
- Term Sheet - Once the investor has gone through deeper analysis of the opportunity and is happy with the findings the investor would usually propose to sign a Term Sheet (please see more detail on this below) which would already describe the key terms at which the investor is happy to invest into the company subject to satisfactory due diligence results and other investment completion conditions.
- Due Diligence - After signing the Term Sheet investors engage in a more formal and deep due diligence process on financial, legal and technical matters. The level and sophistication of the due diligence is dependent on the stage of the company; usually start-ups would face much less formal due diligence compared to larger and more developed companies. Usually financial and legal due diligence is outsourced to reputable third party service providers such as lawyers and audit firms.
- Closing the investment – Once due diligence is completed the shareholders of the company and the investors would sign an Investment Agreement (the key terms of an investment agreement are outlined below). Investors would require the company to adopt new Articles of Association (Statutes) that would incorporate corporate governance and investor protection principles as agreed in the Investment Agreement. Articles of Association are filed with the Enterprise Register while the Investment Agreement is not. Alongside these documents a usual set of capital increase papers would be prepared by professional lawyers to register at the Enterprise Register the equity capital increase, the issue of new shares and amendments of the Articles of Association (applies to equity investments, while no registration is required for mezzanine financing or convertible loans).
The Term Sheet
The term sheet outlines the key financial and other terms of a proposed investment such as the amount of money to be invested, the form of funding and deal structure, the valuation of the company and the key corporate governance and investor protection principles to set expectations for the final Investment Agreement. Once agreed by all parties, the Term Sheet is used as a basis for drafting the investment documents while in the meantime investors undertake due diligence of the company. Provisions of a Term Sheet are not usually legally binding except for the confidentiality clause, exclusivity on the deal for a certain period of time and agreement on who is bearing legal, due diligence and other costs. Usually the Term Sheet is signed by all shareholders of the company and the potential Investors.
The Investment Agreement,
The Investment Agreement is contract stating all the rights and responsibilities of the parties to set out the conditions for Investors to provide money to the Company. Investment Agreement is a binding contract usually fairly long and describes in detail the conditions that have to be met before the investment, process of the investment and responsibilities and warranties that parties assume after the investment. The key term of a typical Investment Agreement are summarised down below in the following section.
Key terms and concepts of the Investment Agreement and the Term Sheet
Pre-money valuation - the valuation of the company agreed by the parties that is used to calculate the purchase price of the new shares. Essentially it is an agreed value of the company just before the money is invested in the Company.
Post-money valuation - the valuation of the company immediately after the investment has been made and includes the new investment. Essentially the post-money valuation of the company is the sum of pre-money valuation and the investment amount.
Cap Table (Capitalisation Table) – is a snapshot of the shareholder structure of the company. The cap table may include convertible notes and employee stock options to reflect the ownership structure on a fully diluted basis, ie after all equity-related instruments have been converted into issued shares.
Convertible note – some early stage investors prefer structuring their investment as a loan that is converted to equity at the next round of the investment (qualifying round) with an agreed discount for the convertible note holder for taking an earlier risk. In this way parties do not have to agree to a valuation just yet. Usually investors agree on a valuation cap that is the maximum valuation at which the loan would be converted to equity.
Milestones and tranching - usually investors will split an investment in a few payments called tranches, subject to various technical and/or commercial milestones being met. In case of failure to meet a milestone investors may renegotiate the deal or refuse to transfer any subsequent tranches. Tranching is used by investors to minimise the risks in cases where the company substantially deviates from the agreed plan. Investors may use a ratchet to adjust the respective shareholdings of the investors and the founders depending on either the company's performance or the level of returns on an exit.
Conditions Precedent - a list of conditions to be satisfied before the investment is disbursed to the company. Conditions precedent may include but is not limited to adopting new articles of association, adopting certain shareholders’ decisions, signing new employment agreements with key employees, having the investor’s board nominee(s) in place, and other conditions.
Warranties – shareholders warrant that the investors are provided with complete and accurate information of the current condition of the company and its past history so that they can evaluate the company prior to investing. Usually there is a detailed list of particular warranties and the Investment Agreement sets out limits and procedures how to remedy and deal with the warranty claims.
Disclosure letter – document by the company and founding shareholders to inform investors about any exceptions or carve-outs from the warranties. Signing the disclosure letter is usually a completion condition of an investment. If a matter is referred to in the disclosure letter the investors are deemed to have notice of it and will not then be able to claim for breach of any warranty in respect of the disclosed matter(s). In some case Investor might ask founding shareholders to indemnify against some of the risks uncovered in the disclosure letter.
Veto rights – usually investors are looking for veto rights on certain decisions like new share issue, issuing share options, paying dividends, entering voluntary winding -up, buying shares in other companies, increasing remuneration of founders etc. Usually veto rights are given only to investors acquiring significant minority and may lapse at the next fundraising rounds.
Anti-dilution Rights – rights to protect the value of an investor’s stake in the company if new shares are issued in the future at a valuation which is lower than that at which the investor originally invested. This protection effects the issue of a number of new shares which the investor will receive, for no or minimal cost, to offset the dilutive effect of the new issue of cheaper shares.
Liquidation preference - special rights in the event of liquidation or exit for the investor to receive an amount of the proceeds before anyone else, usually in an amount of their investment or with some fixed annual interest.
Pre-emption Rights – where the company issues new shares, investors will require the right to maintain at least their percentage stake in the company by participating in the new offering up to the amount of its pro rata shareholding, under the same terms and conditions as other participating investors. Pre-emption rights are automatically provided under the law of Latvia.
The board and council – usually investors would require to have a representative on the board (valde) or the supervisory council (padome). Often VC/PE investors in Latvia prefer the company to create a supervisory council and take a seat on the council to avoid potential board member liabilities. Investors might look for additional non-executive council/board members who are industry experts and can help the company with their experience, contacts and advice. In many cases investor representatives and non-executive council members will form the majority of the council.
Tag Along Rights – the right assures that if a majority shareholder or shareholders sell their stake, minority holders have the right to join the deal and sell their stake on the same terms and conditions as would apply to the selling majority shareholder(s).
Drag Along Rights - the right assures that if the majority shareholder(s) or investors sell their stake, minority holders are forced to join the deal. A drag along right gives the investor the right to force the other shareholders to exit. These rights are very essential when an exit is made to a strategic investor who is willing to acquire 100% of the company. A successful exit is a primary reason why VC/PE investors invest in the first place, thus drag along rights is one of the most important rights for a typical venture investor.
Information Rights – investors require the company to provide them with a regular business update concerning its financial condition and business progress, as well as have a general right to visit the company and examine its documents and accounts. Reports are usually either monthly or quarterly and reporting templates are attached to the Investment Agreement.
Non-Compete clause - if the management team and founders were to leave the company to create or work for a competitor, this could significantly affect the company's value. Investors normally require that non-compete clauses be included in the Investment Agreement as well as in the employment agreements with particular key employees of the company.
Employee share options – investors may require to set aside 5%-15% of the company’s share capital for an employee option pool so that the company with investor consent can issue new shares/options to new and existing employees as part of their long-term motivation and remuneration.
Vesting – Usually options to employees are given with a condition that respective person will stay with the Company for agreed period of time – vesting period. If a person leaves before vesting period has lapsed, respective employee options are nullified.
Key persons – usually founding shareholders are defined as key persons in the Investment Agreement. Key persons are significant shareholders and/or important employees and if they were to leave that would have adverse effect on business operations, the value of the company and future fund-raising prospects. Therefore investors require commitment from the key persons to stay with the company for a certain period and require Good Leaver and Bad Leaver clauses (explained below) in the Investment Agreement.
Bad leaver - often is defined as a key person who resigns within a short period of time, or who breaches their terms of employment or the shareholders’ agreement. Usually bad leavers will be required to sell back their shares to other shareholders for a nominal value.
Good leaver – defined as a key person who resigns and is not a Bad Leaver. Usually a Good Leaver has either ceased to be a shareholder in the company or has stayed for an agreed period of time with the company.
Disclaimer: This is not a complete list of terms used in Term Sheets or Investment Agreements. Definition and interpretation of the terms may change from a case to case.