Venture capital investment in the United States: market and regulatory overview

A Q&A guide to venture capital law in the United States.

The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.

To compare answers across multiple jurisdictions visit the Venture Capital Country Q&A Tool.

This Q&A is part of the global guide to venture capital. For a full list of jurisdictional Q&As visit

Jeffrey Estes, Benedict Kwon and Michael Brown, Stradling Yocca Carlson and Rauth, P.C.

Market overview

1. What are the main characteristics of the venture capital market in your jurisdiction?

Venture capital and private equity

Venture capital (VC) is high risk money provided to start-up ventures and emerging growth private companies which demonstrate significant growth potential. VC is an illiquid investment, with the end goal of reaping a substantial profit through the sale of a private company or an initial public offering (IPO). A VC fund purchases preferred stock or debt securities convertible into equity, and routinely takes an active role in the direction of the private business by becoming a member of a board of directors, as well as advising and/or mentoring the entrepreneurs running the business. The VC fund and the other investors are provided certain economic and voting rights, privileges and preferences.

Private equity (PE) is often used to refer to investments in mature companies. There are three main reasons why these investments are sought: an enterprise may need capital to expand, it may be performing poorly, or its founder may be looking to exit. In any of those scenarios the PE firm is fulfilling the capital needs of an enterprise, or perhaps it is supplying enough equity capital to serve as a base for borrowing the remainder from traditional lenders. While a PE firm generally invests in private companies, PE firms may also purchase securities of public corporations, and often engage in a wide-variety of deal structures, including leveraged buyouts and other control transactions.

Sources of funding

Many entrepreneurial ventures start with funding from friends and family. These investments typically range from a few hundred to a few hundred thousand US dollars.

Angel investors are high net-worth individuals who invest their own funds in exchange for equity shares of start-ups. Angel investors are frequently successful former entrepreneurs and retired businessmen who desire to assist early stage ventures and have the financial capacity to make high risk investments. Angel investors regularly organise themselves into groups or networks to invest collectively. Angel groups meet regularly to review business proposals, share information and pool investment capital, as well as to provide advice to their portfolio companies. When angels partner with early stage VCs, those financings typically range from a few hundred thousand US dollars to US$2 million.

VC funds are pooled investment vehicles from third-party sources that are used to invest in emerging growth companies. VC funds typically employ individuals with technology backgrounds, business training and/or deep industry experience that understand a particular stage of a company's life-cycle and/or a business sector. These funds typically specialise in a particular technology or industry because the VC fund partner must understand a company's business in order to advise it.

Government grants are also a source of funding, particularly for companies in the life sciences and clean technology sectors.

Strategic investors also offer additional funding alternatives for all stages of development. They are typically established companies in the same field that invest in the development of complementary products or services.

Types of company

VC funds generally seek to invest in companies that are developing novel technologies or innovative business models. VC funds invest in a wide variety of industries, including healthcare services, clean technology, consumer products and services, and life sciences, but are perhaps best known for investing in technology companies such as hardware, software, internet, and communication/social media. Companies in these sectors are favoured because they have the potential to generate high commercial returns with relatively modest capital commitments over a short period of time.

While VC funds are best known for investing in certain industries, enterprises outside of the traditional high-technology spectrum can also gain VC fund support. Global brands including Federal Express, Starbucks Corporation and The Home Depot were all started with VC funds, due in part to innovative business models and the potential for significant growth.

Market trends

According to data from Thomson Reuters, in 2014, venture capitalists invested US$48.3 billion in 4,356 published deals in the US. As stated in the PricewaterhouseCoopers MoneyTree™ Report and echoed by the National Venture Capital Association these statistics represent an increase of 61% in US dollars and a 4% jump in deals over the previous year.

Most industries experienced an increase in investment in 2014, but the software industry was the single largest investment sector for the year, with a 77% increase over 2013 to US$19.8 billion. The life sciences sector (biotech and medical devices) was next, accounting for 18% of all VC US dollars in 2014.

In terms of stages of development, seed stage companies appeared to be falling further out of favour. Only 192 seed stage companies were funded in 2014, representing the lowest number since 2002. That sector attracted 1% of US dollars and 4% of deals with an average seed stage round of US$3.7 million.

Early stage deals represented US$15.8 billion or half of the deals in 2014. These 2,165 transactions attracted 33% of US dollars with an average deal at US$7.3 million, up notably from 2013.

Expansion stage companies attracted 41% of US dollars and 27% of deals in 2014. Overall, there was US$19.8 billion going into 1,156 deals. The average expansion stage deal size was US$17.1 million.

US$12 billion was invested into 843 later stage deals, a 35% increase in US dollars and a 6% decrease in deals for the year. Later stage companies attracted 25% of the US dollars invested and 19% of deals in 2014. The average size of a later stage deal rose to US$14.3 million.

2. Are there any recent or proposed regulatory changes affecting the venture capital industry?

In April 2012, Congress passed the Jumpstart Our Business Startups Act (JOBS Act), which required the US Securities and Exchange Commission (SEC) to write rules and issue studies on capital formation, disclosure and registration requirements.

In order to implement section 201(a) of the JOBS Act, on 10 July 2013, the SEC adopted amendments to Rule 506 of Regulation D under the Securities Act of 1933 (Regulation D). These amendments permit companies to engage in general solicitation or general advertising in offering and selling securities pursuant to Rule 506, so long as all of the purchasers of the securities are accredited investors and the company takes reasonable steps to verify that such purchasers are accredited investors. The new rules were codified as a new Rule 506(c) under Regulation D.

In conjunction with the lifting on the long-established ban on general solicitation in certain circumstances, the SEC on the same day in July 2013 issued a number of proposed amendments to Regulation D. Form D and Rule 156 under the Securities Act enable it to gain more information about private placements and market practices relying on Rule 506 offerings. The SEC has not yet codified these new rules.

On the same day in July 2013, the SEC also adopted rules that disqualify felons and other bad actors from participating in securities offerings relying on Rule 506, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). These rules require portfolio companies to investigate the background of significant investors, management and members of the board of directors.

On 23 October 2013, the SEC also issued rule proposals under the JOBS Act to permit companies to offer and sell securities through crowdfunding. Crowdfunding involves the sale of small amounts of equity to many individuals, often through the internet. The JOBS Act created an exemption under the securities laws to allow securities to be legally sold through crowdfunding, and established the foundation for a regulatory structure to govern it.

As required by the JOBS Act, on 18 December 2013 the SEC also issued proposed rules to increase access to capital for smaller companies through amendments to Regulation A. Regulation A is an existing, seldom used exemption from registration for small offerings of securities. The amendments now allow companies to offer and sell up to US$50 million of securities through Regulation A within a 12-month period.


Tax incentive schemes

3. What tax incentive or other schemes exist to encourage investment in venture capital companies? At whom are the schemes directed? What conditions must be met?

Qualified small business stock

Perhaps the most popular tax provision available to emerging growth companies is the qualified small business stock (QSBS) exclusion (section 1202, US Internal Revenue Code). Under this provision, investors are permitted to exclude a percentage of the gains on the sale of QSBS that is held for more than five years. This percentage was temporarily increased to 75% for QSBS acquired from 18 February 2009 to 27 September 2010, and to 100% for QSBS acquired from 28 September 2010 to 31 December 2014. The exclusion returned to the 50% level for stock issued after 31 December 2014.

QSBS is generally defined as shares that are issued by an active qualified small business, that are acquired by the investors directly from the corporation that issues these shares. A qualified small business is generally defined as a C-corporation whose aggregate gross assets do not exceed US$50 million before and immediately following the QSBS offering. The corporation must also be engaged in one or more qualified businesses, with both:

  • No more than 10% of its assets consisting of stock or securities of other corporations.

  • At least 80% of its assets involved in the active conduct of one or more qualified businesses, during substantially all the time the investor holds the stock.


Funding sources

4. From what sources do venture capital funds typically receive funding?

VC funds raise capital from high net-worth individuals and large institutional investors, such as:

  • Corporations.

  • University endowments.

  • Insurance companies.

  • Pension plans.

  • Charitable organisations.

  • Sovereign wealth funds.


Fund structuring

5. Can the structure of the venture capital fund affect how investments are made?

VC funds are in most cases structured as limited partnerships, with the general partner serving as the fund manager and as investment adviser to the portfolio companies of the VC fund. The general partner is an entity through which the fund managers make management, disposition and other realisation decisions related to the VC fund's investments and business affairs.

Although less frequent, VC funds can be set up as limited liability companies (LLCs), in which case the fund's managers, or an entity controlled by the fund's managers, are the managers of the LLC.

On formation, VC funds admit a number of investors as limited partners (in the context of limited partnerships) or members (in the context of LLCs). The limited partners are typically sophisticated investors such as:

  • Public and private pension funds.

  • Endowments established by universities or other charitable organisations.

  • Corporations.

  • Insurance companies.

  • High net-worth individuals or investment entities established by such persons.

Most VC funds receive a significant amount of their funding from tax-exempt organisations.

Both partnerships and LLCs are pass-through entities for US tax purposes. This means income from investments is not taxed at the entity level but passes through to the underlying investors. Pension funds and similar organisations are generally exempt from taxation on dividends and on capital gains they receive, but not on pass-through business income. Due to this pass-through entity structure, investors in the funds may be subject to US tax on the income of the fund, if the VC fund were to invest in other pass-through entities (such as an operating partnership or LLC).

To avoid these pass-through tax complications, VC funds generally do not invest in pass-through entities, investing instead in C-corporations, which are taxed at the entity level for US federal tax purposes. To avoid several related pass-through tax complications, VC funds are often expressly prohibited from investing in pass-through entities under the terms of their investment agreements.

6. Do venture capital funds typically invest with other funds?

VC funds frequently partner with other VC funds to invest in a portfolio company. To limit risk, VC funds are generally constrained from investing a large percentage of the fund in a single company. Therefore, VC funds may syndicate and invest alongside a distinct VC fund, with each taking a certain percentage of a particular investment round, rather than one fund exclusively investing in a company. In addition, companies will often require more capital to obtain business milestones than a single VC fund is willing or permitted to invest. As a result, companies may require capital from additional funds in subsequent rounds of financing.

In subsequent investment rounds, new funds will often invest alongside those that invested in previous rounds. Not only does this limit risk and decrease the need for large amounts of capital to be invested by insiders, but it also avoids inherent conflicts of interest by providing an outside, independent assessment of the value of the shares.

7. What legal structure(s) are most commonly used as vehicles for venture capital funds?

VC funds are typically structured as limited partnerships (see Question 5). The general partners serve as the fund managers and limited partners contribute capital to the partnership.

Although used less frequently, VC funds may also be set up as LLCs. In these cases fund managers become managers of the LLC and investors become members with limited rights. While many VC firms are formed in Delaware, some take advantage of the favourable tax treatment that can be gained by forming in certain international jurisdictions. A foreign vehicle, such as a Cayman Islands entity, may be attractive to non-US investors and tax exempt investors.


Investment objectives

8. What are the most common investment objectives of venture capital funds?

When a VC fund invests in a portfolio company, it usually reserves three or four times that first investment for additional financings, with the goal of getting the company to reach a liquidity event during the life of the VC fund. VC funds generally seek liquidity from a portfolio company through an acquisition or IPO.

The time frame in which a fund seeks to exit its investment depends on the industry in which it is investing. For example, a VC fund focused on medical devices typically has a longer period of maturation for its portfolio companies than a VC fund targeting software as a service. In general, a VC fund anticipates an eight to 12 year window for the life of the fund.


Fund regulation and licensing

9. Do a venture capital fund's promoter, manager and principals require licences?

Before the signing of the Dodd-Frank Act, most VC fund managers avoided registration under the Investment Advisers Act 1940 (Advisers Act), by relying on the private investment adviser exemption.

Under the Private Fund Investment Advisers Registration Act 2010, which is part of the Dodd-Frank Act, VC managers are now expected to rely on an exemption for private fund managers that provide advice solely to one or more VC funds.

On 22 June 2011, the SEC approved final rules to define VC funds. Their intent was to distinguish them from hedge funds and PE funds.

A VC fund is a private fund that meets the following requirements:

  • The fund represents itself as pursuing a VC strategy.

  • The fund holds no more than 20% (measured immediately following any investment) of the fund's total capital commitments in non-qualifying investments (non-qualifying basket). Qualifying investments generally consist of:

    • originally issued equity securities in qualifying portfolio companies; and

    • short-term holdings, such as cash and cash equivalents of US treasuries with a remaining maturity of 60 days or less and shares of registered money market funds. The value of all short term holdings is excluded from determining the percentage of fund non-qualifying and qualifying investments.

  • The fund cannot leverage its investments in excess of 15% of the fund's aggregate commitments.

  • The fund documents must provide for limited withdrawal rights for investors.

The final adopted VC exemption fixes the non-qualifying basket as no more than 20% of capital commitments for fund investments in non-qualifying investments.

Existing VC funds are exempted as long as a fund's first closing was before 31 December 2010 and no new capital commitments are made to the fund after 21 July 2011. This VC fund exemption can be used by both US and non-US advisers as long as all the private funds managed by the adviser are VC funds and otherwise meet the criteria of the exemption (or the grandfathering provision).

The Private Fund Investment Advisers Registration Act also imposes increased recordkeeping and reporting obligations for both registered and certain unregistered advisers. Even advisers that can meet the VC exemption or other exemptions from registration are required to file and regularly update reports with state regulatory agencies and/or the SEC.

10. Are venture capital funds regulated as investment companies or otherwise and, if so, what are the consequences? Are there any exemptions?

VC funds are formed and operated to avoid regulation under the Investment Company Act 1940. To accomplish this, VC funds usually strive to meet one of the following exemptions from registration under the Investment Company Act for an issuer:

  • Whose outstanding securities (other than short-term paper) are beneficially owned by no more than 100 persons, and which is not making, and does not presently propose to make, a public offering of its securities.

  • Whose outstanding securities are owned exclusively by persons who, at the time of acquisition of the securities, are qualified purchasers, and which is not making, and does not at that time propose to make, a public offering of the securities. Qualified purchaser means any of the following:

    • any natural person who owns no less than US$5 million in investments, as defined by the SEC;

    • any company that owns no less than US$5 million in investments and that is owned directly or indirectly by or for two or more natural persons who are related as family;

    • any trust that is not covered by the second bullet point above, and that was not formed for the specific purpose of acquiring the securities offered (and the trustee or other person authorised to make decisions relating to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in the first, second or fourth bullet point in this list); or

    • any person, acting for its own account or the accounts of other qualified purchasers who, in the aggregate, owns and invests on a discretionary basis no less than US$25 million in investments.

VC funds almost always need to rely on the private placement exemptions of Regulation D to offer and sell their securities, since the funds do not make registered offerings of their securities. As such, investors in VC funds are expected to meet the "accredited investor" definition of Regulation D.

11. How is the relationship between investor and fund governed? What protections do investors in the fund typically seek?

The partnership agreement (or, in the case of an LLC, the LLC operating agreement) governs the relationship between the VC fund and its investors. The agreement usually contains provisions that do the following:

  • Restrict the types of investments that the VC fund can make, for example limiting the:

    • percentage of the fund that can be invested in any one portfolio company;

    • ability of the VC fund to invest in pass-through entities; and

    • types of companies and/or industries in which the fund can invest.

  • Govern the management fees (typically 2% to 2.5% of total capital commitments), carried interest (often 15% to 20% of profits), and other compensation payable to the general partner.

  • Set performance goals (or hurdle rates) for the limited partner that must be achieved before the general partner can receive carried interest payment.

  • Prohibits self-dealing transactions.

  • Set the term of the partnership.

  • Provide for transfer of partnership interests and contingencies for defaults by a limited partner in meeting its capital commitments.


Interests in investee companies

12. What form of interest do venture capital funds take in an investee company?

VC funds typically purchase preferred stock in portfolio companies. Occasionally, VC fund investors purchase convertible promissory notes, which may be issued in a very early-stage investment or used to bridge the portfolio company to its next equity financing. At the next equity financing, the notes typically convert into the next round of preferred stock purchased by the new investors in the equity financing round. Such notes may be issued with a discounted conversion price, as well as interest, to give the bridge investors a reward for investing at a more risky time for the company. Sometimes, the VC funds also receive warrants to purchase company shares in connection with their investment.

These investment structures allow the VC fund to convert to common stock or exercise the warrants and purchase additional company shares, in each case at the same valuation as at the time of the initial investment (and after which the company's valuation has presumably increased), typically in connection with a liquidity event.


Valuing and investigating investee companies

13. How do venture capital funds value an investee company?

Venture capital funds typically evaluate the:

  • Management team (namely, the track record and education of the executives).

  • Business model.

  • Technology (the technology should be sufficiently unique and proprietary to exclude competitors from entering).

  • Fit to the fund's objectives and/or expertise.

  • Value-added potential for the firm.

  • Present and future capital needs.

In emerging growth companies, traditional indications of value are not readily available. Investors often estimate a hypothetical future terminable value for the company several years in the future and then discount backwards, using:

  • Projected cash flows until the exit.

  • Exit valuation.

  • A discount factor to account for the unusual risks involved.

  • The multiple rounds of financing required until the exit.

14. What investigations do venture capital funds carry out on potential investee companies?

A VC fund will review the business plan and conduct initial due diligence on the business of the company, including:

  • A review of the management team qualifications.

  • The market for the product.

  • The business plan.

  • The competitive environment.

  • The financial statements and projections.

After a term sheet has been signed, the VC fund conducts additional business and legal due diligence, and typically will review:

  • Corporate records and charter documents.

  • Agreements concerning securities and related stock issuances.

  • Intellectual property.

  • Material agreements with customers, suppliers, employees and contractors.

  • Disputes and potential litigation.

  • Employment related questions.


Legal documentation

15. What are the principal legal documents used in a venture capital transaction?

The principal financing documents for a convertible note financing include:

  • Purchase agreement. This provides for the mechanics of the sale of the convertible promissory notes and warrants, if any, and includes representations and warranties of the parties and conditions to consummate the sale.

  • Convertible promissory note. Notes convertible into preferred stock are often used to assist the company pending the raising or closing of a subsequent round of financing.

  • Warrant. Warrants are a type of security often issued as a sweetener in a convertible note financing or in a preferred stock financing.

The principal financing documents for a preferred stock financing include:

  • Preferred stock purchase agreement. This provides for the mechanics of the sale of the securities and includes representations and warranties of the parties and conditions. In VC financings, preferred stock is typically created and sold.

  • Amended and restated certificate of incorporation. This document sets out the rights of the preferred stock being created and delineates the rights, privileges and preferences among the multiple series of classes of capital stock.

  • Investor Rights Agreement. This provides registration rights, information delivery rights, participation rights in future fundraising rounds, and certain covenants binding the company.

  • Right of First Refusal and Co-Sale Agreement. This is designed to provide the company and its investors with an opportunity to purchase stock being offered for sale by a company's founders, with an additional right to participate in sales of the company's stock by such founders and other major stockholders.

  • Voting Agreement. This is designed to require the company's stockholders to vote on certain matters, most notably the election of directors of the company, and often include "drag-along" rights which compel the parties to this agreement to vote in favour of a sale or merger of the company.

Occasionally, Investor Rights Agreements, Right of First Refusal and Co-Sale Agreements and/or the Voting Agreement are combined into one larger agreement, often called a Shareholders' Agreement.


Protection of the fund as investor

Contractual protections

16. What form of contractual protection does an investor receive on its investment in a company?

In the initial purchase agreement, the company makes certain representations and warranties to the investor. If the representations are not true, the VC fund will have a breach of contract claim.

VC funds often negotiate a number of contractual protections providing a measure of control over the portfolio company's affairs, such as a contractual right to designate one or more members of the company's board of directors. This provides the VC funds with a voice in the management of the company.

The VC funds also often negotiate a number of protective provisions in the company's certificate of incorporation or other investment documents. These protective provisions prohibit the company from taking certain actions without first obtaining the approval of the holders of a certain percentage of a class or series of stock, or of one or more specified directors (often those designated by the VC fund investors) (see Question 19). As described in more detail in Question 19, actions requiring approval involve strategic transactions or transactions that may dilute the value of the enterprise, as compared to operational questions that are typically left to the entrepreneurs.

VC funds also typically have some contractual protections relating to potential returns on their investment in the company. In addition to the protective provisions mentioned above, preferred stock purchased by VC funds generally includes a liquidation preference over all other classes of stock outstanding at the time of issuance, and may include accumulating dividend rights.

VC funds also negotiate contractual protections against the effects of dilutive issuances of securities by the portfolio company. For example, the company's charter will generally include adjustments to the conversion ratio of preferred stock, to partially offset the effect of certain stock splits, recapitalisations and combinations. In addition, the company's charter will include price-based anti-dilution protection for preferred stock, so that when a company issues a new preferred stock at a lower price than that at which the VC fund purchased its preferred stock in an earlier financing round, the VC fund will be entitled to a larger percentage of common stock than it would have otherwise been entitled.

VC funds also often negotiate a right to participate in future securities offerings of the company (Right of First Offer), thereby allowing the VC funds to mitigate the dilutive effects of such offerings. The Right of First Offer entitles a VC fund to purchase a portion of a subsequent round of financing equivalent to the fund's percentage of the company immediately prior to the round of financing. In practice, this Right of First Offer is often waived in later financing rounds when certain new VC funds seek to purchase securities, with the existing and new investors negotiating among themselves for allocations.

VC funds also typically have contractual rights to require the company to register the shares held by the funds for sale to the public.


Forms of equity interest

17. What form of equity interest does a fund commonly take (for example, preferred or ordinary shares)?

VC funds typically receive convertible preferred stock, preferred stock with warrants or short-term convertible promissory notes (see Question 12). These funds rarely receive shares of common stock. VC funds are willing to pay a premium for liquidation preferences and the other contractually negotiated rights contained in such securities.


Preferred shares

18. What rights does a fund have in its capacity as a holder of preferred shares?

Private company investments are largely illiquid. A VC fund will typically receive a return on its capital investments at a liquidity event (IPO or sale transaction). In connection with a liquidity event, the fund will expect to receive a significant upside to its investment. In an IPO, the preferred stock will convert to common stock and the common stock can be sold on the public market, typically for a premium.

In a private sale transaction, the fund will typically be entitled to receive the greater of the original investment (or some multiplier) or an amount of money the holder of preferred stock would have received had the fund converted to common stock at a liquidity event. The VC fund is normally entitled to be paid in the transaction based on the foregoing allocation before entrepreneurs, who normally hold common stock, would be entitled to any remaining proceeds.


Management control

19. What rights are commonly used to give a fund a level of management control over the activities of an investee company?

Representatives of a VC fund typically sit on the board of directors and participate in the management of a portfolio company. If it is unable to negotiate a board seat (often because there are fewer board seats than VC funds that invested, or the seats are reserved for larger funds), a fund typically negotiates for the right to send a board observer to participate in meetings in a non-voting capacity and to gain access to management.

A VC fund also typically has a right to receive financial information about the portfolio company (typically annual and quarterly, and sometimes monthly) financial reports.

Given that funds normally do not gain control of the voting stock of the company, fund managers typically negotiate certain protective provisions that require the vote of holders of preferred stock, or a certain series of preferred stock, before the portfolio company can engage in certain transactions, including but not limited to:

  • Effecting an acquisition, dissolution, reorganisation or liquidation of the company.

  • Amending the certificate of incorporation or bye-laws in a manner adverse to an outstanding class or series of preferred stock.

  • Creating securities having rights, preferences or privileges senior to or on parity with an outstanding series of preferred stock.

  • Increasing the authorised number of preferred stock, or a series of them.

  • Purchasing, redeeming or paying dividends.

  • Changing the size of the board of directors.

Additionally, the funds sometimes negotiate separate and additional rights that require the director(s) they appoint to the board to approve certain actions, giving the appointed director veto power over such actions. These protective provisions may include:

  • Changing the principal business line of the company.

  • Modifying the compensation of executive officers.

  • Entering into transactions with executive officers or other insiders of the company.


Share transfer restrictions

20. What restrictions on the transfer of shares by shareholders are commonly contained in the investment documentation?

Shares in private companies are customarily illiquid. Based on the US regulatory regime, shares of private companies cannot be transferred or sold by a shareholder unless federal and state exemptions from registration are available for the proposed transfer or sale.

In addition to the regulatory restrictions on transfer, there are often contractual restrictions negotiated among companies, VC funds, founders and other shareholders, which are contained in the investment documentation. Most commonly, these funds typically negotiate a right of first refusal on transfers of shares held by founders and other significant holders of common stock. Such right of first refusal typically entitles the company and the investors to purchase securities being transferred by the founders based on the terms offered by the third party transferee. Investors can also seek rights of first refusal with respect to transfers by holders of preferred stock, to control the composition of the shareholder base of the company.

The right of first refusal is typically coupled with a right of co-sale (or tag-along), which requires that before founders or other significant security holders may sell their securities, the investors will have an opportunity to participate in the sale on a pro rata basis, to effectively stand in the shoes of the founder or common stockholder with respect to a portion of the sale of shares. Any shares sold through the right of co-sale would be on the same terms as those under which the founder or common stockholder would sell its shares.

Most shareholders, including VC funds, are also normally subject to a lock-up in connection with an IPO. The lock-up restricts the ability of shareholders to transfer or dispose of, directly or indirectly, any shares of common stock or any securities convertible into or exercisable or exchangeable for common stock. The lock-up usually restricts such transfers for 180 days following an IPO, subject to extension to comply with certain rules applicable to investment banks.

21. What protections do the investors, as minority shareholders, have in relation to an exit by way of sale of the company?

Because VC funds normally do not gain control of the voting stock of the company, they typically negotiate certain protective provisions that require the approval of holders of preferred stock, or a certain series of preferred stock, to effect an acquisition, dissolution, reorganisation or liquidation of the company (see Question 19). Sometimes, VC funds also negotiate separate and additional rights that require the director(s) they have appointed to the board to approve this type of transaction.

Investors now commonly request drag-along rights, which compel all (or most) of the shareholders to agree to a sale transaction if a defined group of shareholders approve the sale transaction. In general, a shareholder can bring a court action to value shares in the merger, and obtain a payment from the company if the court finds that the merger consideration was insufficient. The drag-along offers the company an opportunity to prevent dissent to a sale transaction by minority stockholders, requiring stockholders who are parties to the drag-along to vote for a sale transaction, and accordingly seeks to avoid subsequent litigation to determine the fairness of the transaction and/or the fair value of the shares being sold in the transaction.


Pre-emption rights

22. Do investors typically require pre-emption rights in relation to any further issues of shares by an investee company?

Investors typically require pre-emption rights to participate in most subsequent issuances of equity securities. Such rights are often negotiated for a limited subset of the investors, so that it is easy to effect a subsequent transaction without having to offer a relatively small investor a right to participate. The right is customarily based on percentage equity ownership in the company.



23. What consents are required to approve the investment documentation?

The board of directors approves:

  • The transaction documents.

  • An amendment of the certificate of incorporation or the bye-laws.

  • Any side letters.

  • A share option plan increase.

  • Any other related agreements.

The shareholders typically approve:

  • An amendment to the certificate of incorporation or the bye-laws.

  • Any share option pool increase.

Shareholders of a corporation may also be called upon to approve a contract or transaction that involves a corporation and its directors and/or its officers, or where a contract or transaction involves a related entity.

Additionally, the shareholders often waive the Right of First Offer (see Question 16). This waiver may be coupled with a waiver of price-based anti-dilution protection in the event that the price of the subsequent security sold is lower than the price in the prior round.

If the company has a credit facility, the lender may also need to consent to the investment documentation.



24. Who covers the costs of the venture capital funds?

The company pays all costs and expenses it incurs with respect to the negotiation, execution and closing of the VC financings. The company also typically reimburses the fees and expenses of at least the law firm representing the lead VC fund in the financing, up to a pre-negotiated cap on fees.


Founder and employee incentivisation

25. In what ways are founders and employees incentivised? What are the resulting tax considerations?


Emerging growth companies use a variety of elements in creating benefits packages for founders of companies, executives and employees. Salary and related fringe-benefits provide cash compensation.

Equity participation offers an opportunity for the same individuals to participate in the long-term success of the company with the potential for a significant payment return in the event of an exit transaction. Founders of companies, executives and employees are incentivised to remain at a company for an extended period of time through the use of vesting arrangements. To be sure, equity incentives typically make up the most significant component of any start-up company's incentive compensation and benefits package.

Founders of companies are often able to purchase stock at a very low price, with the company maintaining a repurchase right over the stock that typically lapses over time (Restricted Stock).

After the company has matured past the initial start-up stage, the company may continue to issue Restricted Stock to officers, directors and/or employees. Because the value of the enterprise typically increases significantly as compared to the nascent stage enterprise, the value of the Restricted Stock issued proportionally increases as well. The enterprise likewise maintains a repurchase right over the Restricted Stock that is issued to officers, directors and/or employees, with the repurchase right lapsing over time. Once a company has matured past the initial start-up stage, Restricted Stock grants are often issued from under a stock incentive plan, albeit the tax consequences are generally identical to those issued from outside a formal plan.

Stock options are also used to incentivise employees, officers, directors, consultants, and other third-party service providers (Recipients). Stock options that qualify as incentive stock options (ISOs) (as defined in the US Internal Revenue Code) provide employees who are US taxpayers with significant tax benefits if certain holding period requirements and other specific legal obligations are met.

Non-qualified stock options are stock options that do not satisfy the federal tax law requirements for treatment as ISOs, and provide greater flexibility for companies. However, they do not provide the same significant tax benefits to US taxpayer employees.

Although Restricted Stock and stock options are the most common forms of incentives for Recipients, there are a number of other types of equity and non-equity arrangements. For instance, companies often use stock appreciation rights (SARs), restricted stock units (RSUs) and performance units. SARs entitle Recipients to receive an amount, in stock or in cash, measured by the appreciation in the stock of companies over a period of time. RSUs allow Recipients to receive shares of company stock if Recipients continue service through certain time or milestone vesting periods. Performance units provide incentive compensation to Recipients in cash or stock based on the performance of companies, as measured by a standard like cumulative growth in earnings. SARs, RSUs and performance units are becoming more common in venture-backed companies, but remain less used than Restricted Stock and stock options.

26. What protections do the investors typically seek to ensure the long-term commitment of the founders to the venture?

Granting equity incentives that vest over a period of years is the most common method used to encourage founders to commit to a long-term relationship with the company.

Typically, founders' shares are subject to a repurchase option that lapses over time and allows the company to repurchase unvested shares on termination of service. If founders' shares are not subject to vesting before the first round of financing, the VC fund can negotiate to impose vesting.

In addition, the company can put in place a carve-out plan, also called a management incentive plan, which reserves some of the proceeds of an acquisition for payment to management. In situations where the aggregate liquidation preferences exceed or nearly equal the acquisition price, preferred shareholders are paid first and the common shareholders (often management) would not realise a significant return on their equity. A carve-out plan gives management incentive to continue working towards an acquisition.

Founders and other employees are often required to sign non-compete agreements that restrict them from competing with the company and soliciting the company's customers after termination of employment.


Exit strategies

27. What forms of exit are typically used to realise a venture capital fund's investment in an unsuccessful company? What are the relative advantages and disadvantages of each?

If a portfolio company is unsuccessful, the VC fund can seek to limit losses by:

  • Selling the company at a valuation that is less than ideal.

  • Selling off company assets.

  • Liquidating the company and distributing any assets that remain after the company liabilities have been satisfied.

28. What forms of exit are typically used to realise a venture capital fund's investment in a successful company? What are the relative advantages and disadvantages of each?

For a successful portfolio company, the VC fund will seek liquidity of its investment and gains through an acquisition or IPO.

An IPO can be a good alternative if the company's business model can be sustained as a public company and if the valuation is high enough to meet the desired returns. However, an IPO is an expensive and lengthy process that involves considerable risk.

An IPO will be favourable to investors if the publicly traded share price continues to increase following the IPO. An IPO will eventually provide liquidity to the VC fund, but most of the fund's shares will not be sold in the IPO. The fund will typically hold restricted shares post-IPO, and will be locked up under federal securities laws from selling for at least six months after the IPO. Frequently, a fund will be deemed an affiliate after the IPO, further restricting the timing and volume of resales. The VC fund's registration rights (see Question 29) help to alleviate this issue, but subsequent market conditions and the company's performance can make a successful follow-on offering difficult.

In contrast, an acquisition allows the VC fund to sell its entire equity stake in one transaction. It may, however, be subject to earn-outs that pay over time or escrowed consideration, which delays the VC fund's final pay out. In addition, if the consideration is paid in shares, the fund will then hold a new equity position that may also be illiquid.

29. How can this exit strategy be built into the investment?

Funds build their exit strategy into investment documents in a number of ways. With respect to an IPO or other sale of portfolio company stock to the public, the investment documents often include a number of rights affiliated with such exits. For instance, funds often negotiate registration rights, which allow them to require the company to register shares held by the funds for sale to the public.

There are often a number of rights or restrictions that only arise in connection with a qualified IPO (an IPO that meets certain predetermined metrics) which allow VC funds more input in the size of the IPO.

Additionally, investment documents generally include protective provisions in favour of investors, which provide the funds the opportunity to exercise a considerable level of control over the type and size of any exit. VC funds may also negotiate a drag-along provision, which allows them to compel other shareholders to vote in favour of and participate in the exit transaction.


Online resources

US Securities and Exchange Commission (SEC)


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Contributor profiles

Jeffrey Estes, Shareholder

Stradling Yocca Carlson & Rauth, PC

T +1 949 725 4054
F +1 949 823 5054

Professional qualifications. California, US

Areas of practice. Venture capital, emerging growth companies; corporate partnering and IP transactions; securities offerings; mergers and acquisitions.

Non-professional qualifications. JD, University of California, Los Angeles, 2002, Corporate Law Specialization; BA, University of California, Los Angeles, 1996

Recent transactions

  • Represented Tandem Diabetes Care, Inc. (Nasdaq: TNDM), in its US$138 million initial public offering.
  • Represented Vessix Vascular in its acquisition by Boston Scientific Corporation for up to US$425 million.
  • Represented WaveTec Vision Systems, Inc. in securing US$16.5 million in venture capital financing.
  • Represented Sequent Medical, Inc. in its US$26 million Series C preferred stock offering.
  • Represented Tandem Diabetes Care, Inc. in a senior secured credit facility, US$45 million.

Languages. English

Professional associations/memberships. American Bar Association; Orange County Bar Association; Adviser to TriTech SBDC.

Benedict Kwon, Shareholder

Stradling Yocca Carlson & Rauth, PC

T +1 949 725 4165
F +1 949 823 5165

Professional qualifications. California, Illinois and Pennsylvania, US

Areas of practice. Private investment fund formation; mergers and acquisitions; taxation.

Non-professional qualifications. JD, Northwestern University School of Law, Chicago, 1999; BS, University of Illinois, Urbana-Champaign, 1994.

Languages. English, Korean

Professional associations/memberships. Chair of the American Bar Association Subcommittee on Private Equity and Venture Capital Funds; Former Vice Chair and Member of the California State Bar Committee on Partnerships and Limited Liability Companies; Member of the California Hedge Fund Association

Publications. Structuring Investments in Real Estate Funds, published in the Journal of Private Equity.

Michael Brown, Shareholder

Stradling Yocca Carlson & Rauth, PC

T +1 858 926 3007
F +1 858 926 3001

Professional qualifications. California, US

Areas of practice. Corporate law; clean technology; corporate partnering and IP transactions; mergers and acquisitions; public company representation; venture capital; life science; medical device; pharmaceuticals and biotechnology.

Non-professional qualifications. JD, University of Virginia, Charlottesville, 1996; BA, University of Washington, Seattle, 1993

Recent transactions

  • Represented Biocept, Inc. (NASDAQ: BIOC) in its US$19 million initial public offering.
  • Represented Biotech Investment Group (BIG) in its acquisition of Femta Pharmaceuticals.
  • Represented various Motorola Mobility (NYSE: MMI) senior executives in Motorola Mobility's US$12.5 billion acquisition by Google (NASDAQ: GOOG).

Languages. English

Professional associations/memberships. Board member of BIOCOM; Membership Committee of Business Executives Council; Springboard Executive Committee of CONNECT.

Publications. Four Tips for Selling Your Business, published in the Daily Transcript; How to Strengthen Your Company and Prepare for a Successful Exit, published in the Daily Transcript; Co-author of Innovative San Diego Life Sciences Companies Weather the Storm, published in the Daily Transcript.

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