ONLINE CHAPTERS
6.3% were able to exit through an IPO or trade sale after only one VC funding round. However, the
majority (60.5%) of first-round deals proceeded to a second financing round, and then 70.0% of these
proceeded to a third round. A lower fraction of second-round companies failed (22.3% write-offs) than
during the first round, and a higher fraction (7.7%) achieved successful exit. This pattern of decreasing
failure rates and rising exit rates continues for all subsequent rounds. In other words, if your company
makes it to the third financing round, the likelihood of business failure is much reduced, and the odds of
ultimately achieving a successful exit are very high.
A distinguishing characteristic of venture capital investment contracts is their extensive and
sophisticated covenants. Some of these covenants – both positive and negative – appear in many standard
debt financing contracts. For example, venture capital contracts often contain clauses that specify
maximum acceptable leverage and dividend payout ratios, require the company to carry certain types of
business insurance and restrict the company’s ability to acquire other companies or sell assets without
prior investor approval. Other covenants occur almost exclusively in private equity investment contracts.
All of the economic, control and ownership terms of an investment proposal are detailed in a term sheet
that the venture capitalist prepares and presents to the entrepreneur.1 Ownership right agreements not only specify the distribution of ownership but also allocate board seats
and voting rights to the participating VC. Special voting rights often given to VCs include the rights
to veto major corporate actions and to remove the management team if the company fails to meet
performance goals.2 Ratchet provisions protect the venture group’s ownership rights in the event that the company sells
new equity under duress. Generally, these provisions ensure that the venture capital group’s share
values adjust so that the entrepreneur bears the penalty of selling low-priced new shares under
duress in the type of down round financing that Federal Express had to accept. For example, if the
venture fund purchased shares initially for $1 each and the startup later sells new shares at $0.50
per share, then a full ratchet provision would mandate that the venture group receive one new share
for each old share, thereby protecting the value of the VC’s initial stake. A partial ratchet adjusts
VC share ownership only in an amount that is proportional to the amount of new capital raised.
Obviously, it would not take many rounds of financing at reduced prices to completely wipe out a
management team’s ownership stake.3 Demand registration rights, participation rights and repurchase rights preserve exit opportunities for
VCs. Demand registration rights give the venture fund the right to compel the company to register
shares with the SEC for a public offering – at the company’s expense. Participation rights give
VCs the option to participate in any private share sale that the company’s managers arrange for
themselves. If a company held by the VC does not conduct an IPO or sell out to another company
within a specified time period, then repurchase rights give VCs the option to sell their shares back
to the company.4 Share option plans provide incentives for company managers in virtually all venture capital deals. As
part of these plans, the company sets aside a large pool of shares to compensate current managers for
superior performance and to attract talented new managers as the company grows.This listing of covenants is by no means comprehensive. Other common provisions describe the conditions
for additional financing and the payoffs to entrepreneurs if the VCs decide to hire new managers.
However, the most fascinating and distinguishing feature of venture capital contracts is unquestionably
their nearly total reliance on convertible securities as their investment vehicle of choice.term sheet
An investment proposal
detailing all of the economic,
control and ownership terms
- including covenants – that
is prepared and presented to
an entrepreneur by a venture
capitalist
ownership right
agreements
Agreements between venture
capital investors and portfolio-
company managers allocating
ownership stakes and voting
rights to venture capitalists
ratchet provisions
Contract terms that adjust
downward the par value of
the share venture capitalists
have purchased in a company
in case the company must sell
new shares at a lower price
than the VC originally paid
demand registration
rights
Agreements giving the venture
capitalists the right to demand
that a portfolio company’s
managers arrange for a public
offering of shares in the
company
participation rights
Agreements giving the
venture capitalists the right
to participate in any sale
of shares that a portfolio
company’s managers might
arrange for themselves
repurchase rights
Give the venture capitalists
the right to force the company
to buy back (repurchase) the
shares held by the VC
share option plans
Plans set up to provide
share options to newly
hired managers of portfolio
companies in order to give
them incentives to manage
the company to create value