Chapter 7. Practical Aspects of Raising Venture Capital

Chapter 7. Practical Aspects of Raising Venture Capital

INTRODUCTION

This chapter addresses the practical aspects of raising venture capital and the characteristics and the problems of each round of investments, starting from the contacts with the investors and ending in the receipt of the money. This chapter is aimed primarily at entrepreneurs who are raising venture capital for the first time and at others who have no experience in this field.

It is important to understand that the process of raising venture capital is complicated and that there are no guarantees of success. From among more than one million companies which are founded in the United States every year, less than 0.1% receive financing from the venture capital industry. Of every 100 business plans received by venture capital funds, fewer than five on average are seriously considered as candidates for investment and fewer than two receive financing. However, because entrepreneurs usually contact several sources of finance, approximately one-third of the companies which are initially rejected by venture capital funds ultimately find one source of financing or another. Moreover, it is usually a small number of companies from among those which receive financing from venture capital funds that generate the majority of the funds' return. As a result of the growing number of plans which are submitted to institutional investors, the process of raising capital after the initial rounds of financing could last many months and requires thorough preparations and groundwork.

Basic Terms

This section presents the basic terms with which companies raising capital need to be familiar. A more detailed discussion of the valuation of startup companies and various calculations in connection with these terms is given in Chapter 9.

Sale of Shares by Shareholders Versus Investments

The main difference between the sale of shares by shareholders (a "secondary offering")—a transaction to which the company is not a party—and raising capital for the company (i.e., importing money into the company) is that in the latter case the company allots new shares to investors (i.e., adds shares to the company's allotted share capital), against which it receives an investment, usually in cash which it can use for its business.

For example: Speed Ltd. has 3,000,000 shares that are equally divided between its two entrepreneurs. In other words, each entrepreneur holds 50% of the company's equity. If a certain entity were to buy 1,500,000 shares from one entrepreneur, the other entrepreneur would still hold 1,500,000 shares out of the 3,000,000 (50% of the company) and will not have been diluted at all. Ostensibly, the company's financial condition has not changed at all either, since no new funds were infused into the company. If, on the other hand, an investor invests money in the company, in consideration for which the company allots to him or her 1,500,000 shares, then, although each entrepreneur still retains 1,500,000 shares, these shares now constitute only one third of the company's equity. In other words, they were diluted by approximately 17%, or one third of their holdings (for an accurate calculation of the number of shares allotted in investments and the rate of dilution, see Chapter 9). However, in this case the company receives funds or other resources which it can use for its activities. This type of issuance is the most prevalent in early-stage equity private placements, since the main reason for raising capital is the need to infuse money into the company and not the entrepreneurs' desire to realize their investment.

Terms for Describing the Value of a Company

  • Share price— The price of the share is the basic parameter for calculating the value of a company. Shares are the subject of the investment transaction and they are what changes hands from the seller to the buyer or from the company to the investor. Therefore, the price per share, multiplied by the number of shares purchased, is the gauge by which the value of the transaction is measured.

  • Fully diluted— An investment in a company is usually made on a fully diluted basis. This means that the calculation of the investor's holdings is made based on the assumption that all the options and other rights to buy shares will be exercised. The dilution also often includes the equity (options) which the company intends to allot to employees. Obviously, when full dilution is assumed, the number of shares from which the investor is entitled to receive a certain percentage according to the valuation of the company is higher, and hence the number of shares the investor actually receives is also higher (for a calculation of the number of shares allotted on a fully diluted basis, see Chapter 9 on issuing stocks to investors).

  • Pre-money value— This refers to the product of the number of allotted shares before the investment multiplied by the price of the share. Alternatively, in preliminary investments this parameter serves as the standard for the degree of dilution, which is determined according to the amount of money invested.

  • Post-money value— The post-money value of the company is its pre-money value, plus the amount of money invested. For example, if Speed Ltd.'s pre-money value is $3 million and it raises $1 million from new investors, then its post-money value is $4 million.

It should be noted that the price of the share just before and after the investment remains unchanged. Speed Ltd., for example, has 3,000,000 shares before the investment. Since its pre-money value was estimated at $3 million, the price of each share was $1. The company has now received an investment of $1 million in consideration for shares. Since the share price is $1, one million additional shares were bought and allotted. The total amount of allotted shares is now 4,000,000, i.e., the new investor holds 25% of the shares: 1,000,000 out of a total of 4,000,000, with the price of each share remaining $1.