In this final installment, we follow venture capital investments into startup companies.
Throughout this series, we have provided insight into how the venture capital process works from a financial perspective – essentially, where venture capital money comes from and how it moves through the venture capital system.
In this final article, we will follow the money and the ways that venture capitalists (VC) invest in startup companies.
After a VC decides to invest in a company, they prepare a “term sheet,” a legal document that lists all the financial and legal terms of the investment. The terms include the type of security to be purchased (in exchange for the investment), pre-money valuation, the price, the liquidation preferences and other details.
Type of Security
VC investments are ultimately intended to be equity investments, which means the VC investors will purchase stock in the company. However, some VC investments, especially for very early-stage companies, may be notes, or debt instruments, that will later convert to equity once a future equity investment is made. A relatively new innovation in early-stage investment is “SAFE,” which stands for “Simple Agreement for Future Equity.”
Pre-money and post-money valuation
The pre-money and post-money valuations are determined by these formulas:
1) Pre-money valuation plus investment amount equals post-money valuation and,
2) investment amount divided by post-money valuation equals ownership percentage.
Investors in startup companies (including VCs) will determine the investment amount and target ownership percentage and, using the above formulas, will calculate the pre-money and post-money valuations.
The price of a VC investment may be the total amount invested (in return for a certain percentage of the startup company) or the stock price. The stock price is the post-money valuation divided by total number of shares in the company.
In the event of a low-value company sale, merger or bankruptcy of a startup company, the VC’s investment is returned prior to proceeds being distributed to the common stockholders in the company. This is known as a liquidation preference and the type of stock covered by this liquidation preference is known as Preferred Stock.
When all the terms of an investment have been agreed upon and approved by the VC and the startup company’s board of directors and stockholders, the actual legal documents are then signed and the money is sent via wire transfer from the VC fund to the startup company’s checking account. The money will be used to achieve milestones that increase the value of the company.
When do the VCs get their money back? Not through dividends, as venture-backed companies rarely pay dividends to stockholders. When VCs make an investment they agree to not sell their stock until there is a liquidity event, such as a sale, merger or initial public offering. After a liquidity event, the money is returned to the VC based on the number of shares and the price per share of the stock.
Luis Vasquez has 15 years’ experience in the startup and venture capital space. He has worked with a startup, a VC firm, a venture development organization and a venture studio/venture firm. He is now UCI Beall Applied Innovation’s Associate Director of Venture Capital Collaboration.