United States

Author: | Published: 4 Jan 2001
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Before the recent volatility in the global capital markets, venture capitalists (VCs) often gave companies optimistic valuations in all rounds of financing. Deals were competitive, and VCs chased after promising start-ups. Entrepreneurs often possessed more bargaining power than the VCs over fundamental terms in an investment in a start-up company. Owing, in large part, to the turbulence in the capital markets, the valuations of companies now reflect more scepticism by VCs. In turn, the terms and conditions of venture capital investments are becoming more weighted towards VCs. Although many start-ups and their lawyers continue to point to certain customary deal terms, provisions once deemed aggressive – from an entrepreneur's or a company's perspective – are beginning to be proposed by VCs with regularity (and straight faces) in term sheets. In addition, cash-strapped companies are beginning to accept these provisions more often than some care to admit. If market conditions remain unfavourable for initial public offerings and as valuations of the public company comparables remain battered, it is expected that a more aggressive, pro-investor standard will develop in US legal documentation for venture capital deals.

The VC investors

We begin with a discussion of the types of investors in start-up and emerging-growth companies in order to understand the factors influencing their investment decisions, and the methods some of them are using to help minimize their exposure in these high-risk investments.


An angel investor, named after the theatre lover who puts up his or her own money to keep a play or musical running, usually invests modest amounts of seed money (anywhere from $25,000 to $1 million) to help establish a company. Angels typically invest in common stock of the company, but as some angels realize that the returns on their investments will not always reach heavenly heights, they are beginning to invest through debt that is convertible into equity. The debt instrument is usually convertible if and when the company consummates a significant round of equity financing. This investment structure can be advantageous both to the investor and the company. First, the difficult task of valuing the company is postponed until the next round of financing because the debt is usually convertible at the same terms and price as the equity instrument of the subsequent investor. Management may find this structure helpful because they may wish to avoid placing a low valuation on the company during the period when they are finalizing commercial relationships and establishing a corporate identity. Second, as a debt holder, the angels will have a liquidation preference over common stock holders in the event of bankruptcy.


The VCs are at the other end of the spectrum from the angel investors (and in the minds of some start-ups with unpleasant experiences, some VCs have been derogatorily referred to as "demon" investors). VCs almost always acquire preferred stock that is convertible into common stock. In mezzanine rounds of financing (a late-stage investment made in a company to help it move to an IPO), some VCs will invest through either a debt security convertible into equity, or a debt security with attached warrants.

Strategic investors

Large public companies are forming their own venture capital funds to make investments in start-up companies to secure a high rate of return on their investment or, as more likely, to obtain a peek of a start-up's key technology which may be useful to the larger company. These company VCs usually acquire preferred stock.

Key terms of a typical US venture capital investment

In light of the market volatility, we highlight below some of the terms that are beginning to be the source of intense negotiations in term sheets.

Liquidation preference

It is typical for the holders of preferred stock, upon liquidation or winding up of the company, to receive their initial investment, plus unpaid dividends, before any holders of common stock. If the holders also have a right to participate in the distribution of the remaining assets of the company after receiving their liquidation preference, the preferred stock is referred to as a participating preferred. Obviously, investors like to receive participating preferred because it gives them, in effect, a greater percentage of the company by giving them both their investment back plus their pro rata percentage of the company's equity. A sale of the company is usually considered to be deemed liquidation and triggers the same liquidation provision as an actual liquidation.

In the recent past, companies often resisted granting participating preferred stock because it gives investors the right – in the companies' minds – to double-dip because the investors receive their liquidation preference and then share in the remaining distribution. Therefore, in a liquidation or deemed liquidation, investors were forced to choose to receive either their investment plus unpaid dividends, or convert their shares of preferred stock into common stock and participate pro rata with the holders of common stock. Recently, investors have begun recognizing that their exit may be more likely, in the short term, to come in the form of a sale or merger instead of an initial public offering because of dormant capital markets. Investors also are spending more time considering their downside protection in the event of bankruptcy or liquidation. They want mechanisms in place to ensure that their last money in is the first money out. Therefore, they are pressing for, and receiving, participating preferred stock. They are able to obtain their liquidation preference and participate with the holders of common stock over any amounts distributed after payment of the liquidation preference.

Dividend Preference

It is typical for the holders of preferred stock to be paid a dividend before any dividend is paid to the holders of common stock. The dividend is usually around 8% per annum. Generally, the dividend is only paid if and when declared by the board of directors and only from legally available funds. Although investors always seek to obtain cumulative dividends, which accrue even when they are not declared and must be paid retroactively once dividends are declared (or a liquidation event or redemption occurs), many companies in the recent past have resisted such requests. Recently, more investors have been requesting this right, and companies have been granting preferred stock that receives cumulative dividends with occasionally a higher percentage return.

Anti-dilution adjustment

It is typical for preferred stock investors to ask for economic anti-dilution, which adjusts the number of shares into which the preferred stock converts if the company has a down round, meaning that the price per share is less than the price paid in an earlier round. In the recent past, the formula for determining the adjustment has been weighted average, that takes into account both the price of the cheaper stock and the number of shares issued. Recently, investors have been pressing for, and are beginning to receive, a formula considered more draconian, known as the full ratchet, which adjusts the conversion to the same price as the new stock regardless of the number of shares issued.

Veto rights

It is typical for investors in start-up and emerging growth companies not to have control over the companies because they typically do not own more than 50% of the companies' voting securities. Accordingly, investors focus on veto or blocking rights over certain actions to be taken by the company. The investors usually accomplish their goal by requiring a majority or supermajority (e.g., 66%) of the holders of preferred stock (or a particular series or class of preferred stock) to approve certain actions such as: i) selling the company; ii) authorizing or issuing any securities with rights and preferences equal with, or superior to those, of the preferred stock; iii) amending or repealing any provision of the company's organizational documents in a manner that would change adversely the rights and preferences of the preferred stock; iv) redeeming or purchasing any of the company's securities other than upon conversion of the preferred stock; or v) allowing any subsidiary to issue or sell stock except to the company or a subsidiary of the company.

Recently, the list has expanded. In addition to these actions, investors may require that some or all of the following actions need the approval of the holders of preferred stock: i) consenting to a voluntary dissolution, recapitalization, liquidation or winding up of the company; ii) changing the nature of the company's business; iii) incurring debt in excess of a fixed dollar amount; iv) entering into a contract that obligates the company to spend more than a fixed dollar amount; v) acquiring assets or securities of another company in excess of a fixed dollar amount; vi) increasing the options reserved for issuance under the option plan; vii) declaring or distributing dividends; vii) increasing or decreasing the size of the company's board of directors; or viii) entering into transactions with affiliates or related parties.

Board representation

In circumstances where there is more than one investor taking part in a financing round, it has been typical for only the lead investor to obtain representation on the board. The co-investors would need to rely on the lead investor to represent their interests. However, recently, co-investors have become more insistent that they obtain a board seat in order to exert some degree of control over the company and monitor more closely their investment. Some investors are even requiring supermajority voting on certain actions from the list above at the board level, to give them, in effect, a veto right over important matters.


It is more typical in the US than in certain European jurisdictions – because of the more liberal corporate codes allowing a company to buy back its shares – for a company to grant redemption rights. In the past, however, companies resisted giving investors a right of redemption because the companies did not want to use their precious cash to pay off an equity investor. Additionally, preferred stock with a redemption right raises various tax and accounting issues because it may be treated as debt rather than equity. Recently, investors have once again been more successful in negotiating for a redemption provision in their preferred stock. As a tradeoff, the company is often successful in limiting the right of redemption so that it cannot be exercised before the fourth or fifth year after the preferred stock is issued. The company may also be able to negotiate that it can buy back the stock in equal thirds over a three-year period. However, some investors resist such compromises and occasionally counter with a more aggressive provision – if a company is unable to redeem the preferred stock within the negotiated period, the investors have the right to force a sale or merger of the company.

Staggered closings

It is typical for the purchase or subscription agreement to allow the company to sell up to a certain amount of preferred stock in a round of financing. In the recent past, some VCs would participate in a first closing with a second closing of the same financing round within a 30, 60 or even 90-day period. VCs were usually confident that their co-investors would fund at the given time. Recently, investors have insisted that companies hold one closing with all investors funding at the same time. Few VCs now want to have sole exposure in the initial funding event.

Milestone funding

Investors are beginning to fund their investment in tranches – usually based on the achievement of certain agreed milestones – instead of wiring the full amount of the investment at closing. VCs use this mechanism to limit their exposure, to bind management to the burn rate and landmarks set out in the business plan and to remove any distraction on management with the availability of excess cash.

Side letters/warrants/clawbacks

Investors are also beginning to insist on mechanisms for the company to issue more shares, or for the VC to acquire shares or options from executives upon (or failure of) the occurrence of certain events. These mechanisms may come in the form of side letters or warrants to obtain more shares from the company, or as clawbacks to obtain shares from executives in the event that they do not achieve set objectives.


Despite volatility in the capital markets, early and mid-stage venture capital investments continue to be made at high levels in the US. The main difference from the recent past is that the terms of venture capital investments are becoming more investor friendly and the transaction terms are more varied from deal-to-deal.

Wilmer, Cutler & Pickering

2445 M Street, N.W.
Washington, D.C. 20037

Tel: 1 202 663 6000
Fax: 1 202 663 6363