Start-up ebusiness to IPO – the price to pay for VC funding

February 10, 2008

For a fledging technology businesses, particularly online businesses, a key consideration during the early stages may be the injection of cash which very often comes in the form of venture capital funding. For a willing new investor, a key consideration is the entirety of the return package which is expected on the capital funding - not just the initial equity offered. The investor will almost always want certain rights and controls over your company as part of the price of the equity stake in addition to warranties from the directors and shareholders.

This article reviews some typical requirements of investors and the issues which arise in growing your ebusiness.

Board representation

It is an almost universal requirement for the investor to want a representative director on the board of your company. The investor director will often have considerable ebusiness experience which can be used to contribute to your company’s development. You will usually be charged an annual fee for the investor director’s services. The consent of the investor director will be needed for important decisions affecting the business of your company.

Pre-emption rights on further funding

The investor will often want a right of first refusal if a further round of funding is required for your company. There is also likely to be an adjustment mechanism for the equity stake of the investor to increase if the further funding is at a share price lower than the initial funding share price.

Return of capital

If there is a trade sale in circumstances where the value of the company has gone down, the investor may require its original investment to be repaid in full out of the sale proceeds plus a pro rata share of the sale proceeds: known as a “double dip”.

Good leaver/bad leaver

If a management shareholder is a good leaver, e.g. retires from ill health, he should expect to have to offer his shares for sale at fair market value. If the manager is a bad leaver, e.g. in breach of his employment contract, the investor may require him to sell his shares for a nominal sum.

Tag along and drag along rights

These will give the investor the right to be part of a sale proposed by another shareholder (i.e. the tag) and where an appropriate level of shareholders want to sell, e.g. 50 per cent or more, the right to require the remaining shareholders to join in the sale (i.e. the drag).

Service contract control

The investor may require all decisions on the enforcement of the directors’ service agreements to be made only by the investor director. This will include the right to decide whether to dismiss a director, at which point the good leaver/ bad leaver may come into play.

These controls represent a selection of the main requirements of investors and may be negotiable depending on the circumstances of the investment.

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