Guidelines for structuring venture capital investments.

• Author: TYLER III, J. ROBERT

Venture capital has become an integral part of North Carolina's economy. According to a recent report published by the Council for Entrepreneurial Development, venture investments totaling $1.99 billion were made in 168 North Carolina companies in 2000. Although some venture-backed companies have failed or are struggling after the dot-com bubble burst, many of these companies will become profitable and create long-term employment growth.

Venture capital is a professionally managed pool of capital that is raised from public and private pension funds, endowments, foundations, banks, insurance companies, corporations, wealthy families and wealthy individuals. Venture capitalists generally invest in companies with high growth potential and a realistic exit scenario within five to seven years. A typical VC investment structure will include rights and protections that are designed to allow the VCs to gain liquidity and maximize the return to their investors.

Liquidation rights

Most VCs investments are structured as convertible preferred stock with dividend and liquidation preferences. The preferred stock often will bear a fixed-rate dividend that, due to the cash constraints of early-stage companies, is not paid currently but is cumulative and becomes part of the liquidation preference upon the sale or liquidation of the company. The payment of dividends on the preferred stock will have priority over dividends on common stock. These cumulative dividend rights provide a priority minimum rate of return to the VCs.

The preferred stock will have a liquidation preference that is generally equal to the purchase price, plus accrued and unpaid dividends. This preference is designed to ensure that if the company is sold or liquidated, the VCs get their money back before the holders of the common stock, such as the founders, management or employees.

Most VCs also insist on participation rights so that they share on an equal basis with the holders of the common stock in any proceeds that remain after the payment of their liquidation preference. These liquidation rights and the right to convert the preferred stock into common stock allow the VCs to share in the upside if the company is sold.

Ownership protection

An important consideration to VCs is the percentage of the company that they own on a fully diluted basis. Fully diluted means the total number of issued shares of common stock, plus all shares of common stock which would be issued if all outstanding...