Typical Venture Capital Contracts and Agreements
Common v. Preferred Shares
With venture capital’s checkered past, that includes changing market conditions, a fickle regulatory environment, and extreme uncertainty in entrepreneurial investments, it is no wonder that venture capitalists have craved control wherever possible. This control has manifested itself in in what is collectively referred to as venture capital contracts.
By controlling the venture, the venture capitalist is provided a “tight leash” on entrepreneurs, including various mechanisms to discipline errant entrepreneurs, including the ability to fire or demote a managing entrepreneur with little difficulty.
The relationship between a VC and its portfolio company lasts about five years on average and over this period the contractual relationships is exposed to innumerable risks and uncertainties. Venture capitalist almost always have the bargaining advantage over the enthusiastic entrepreneur which they use to dictate contract terms, ultimately giving themselves more control in the deal.
In most venture backed start-ups, the capital structure of the company consists of common and preferred stock. Common shares are usually issued to the entrepreneur, management team, and critical employees.
Preferred stock that is convertible into common stock is almost without exception issued to venture capitalists and angel investors. This prevalent use of preferred stock in venture backed firms stands in stark contrast to preferred stock’s use in publicly traded corporations, which is very minimal.*
This structure has two main purposes, first it addresses the standard contracting concerns mentioned above and second it is the most tax advantageous. In a successful venture backed company the management and the employees will receive both compensatory return, in the form of a paycheck and investment return, in the form of capital gains. There is a obviously a strong tax preference for investment return because compensatory return is generally taxed earlier than investment return and at the rate for ordinary income, which is usually much higher than that for capital gains.
Therefore the holders of equity prefer smaller compensation and a larger stake in ownership, with the hope that that ownership will be worth significantly more in the future. The other reason preferred stock is so pervasive is because it gives the entrepreneur control through the use of select contractual provisions.
In the next post I discuss how and why control of the Board of Directors is critical. And as Donald Trump has shown us so is the power to appoint. Click here for the next article in the series.
This article was written by Curtis Roberts, the founder of The Founder's Attorney.
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* “Venture capital investments are structured to ensure that the venture capitalists are paid before founders and employees. When venture capitalists invest, they typically demand preferred shares that accrue a yearly dividend of about eight percent. The dividend goes unpaid until the company is sold. In a sale, the original amount and the interest all come due. It must be paid out before the common shares, which are typically held by the founders and other employees.” Carsanaro v. Bloodhound Technologies, Inc., 65 A.3d 618, 627–28 (Del. Ch. 2013)
** “94.5% of funding rounds used convertible preferred stock.” Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 Harv. L. Rev. 874, 875 (2003).
*** Only roughly ten percent of public companies in S&P have an outstanding class of convertible preferred stock. See above.