The Financing Process with a Venture Capital Firm

January 2008

INTRODUCTION

 

In the normal development of a business, there comes a time when leaders must consider various possible financing modes to accelerate their growth. One of these financing modes is that offered by venture capital corporations (VCCs). In Quebec alone, venture capital investments exceeded $600 million in 2006. [1] This demonstrates the importance of this industry for the development of Quebec companies.

In Quebec, there are several VCCs such as: Fonds de solidarité FTQ, Fondaction CSN, Desjardins Venture Capital, BDC, Novacap and many others. These corporations differ from banks in many ways. However, it should be noted that their financial products generally take the form of equity or quasi-equity without collateral (shares, debenture, stock options, subordinated debt) and that the return sought by these corporations is higher than that of traditional banks because of the higher risk of their financial tools.

This article summarizes the process that a company typically has to deal with in the context of a venture capital venture in Quebec.

1.    Seeking Financing

A business can find venture capital financing in several ways:
• it may be approached by a VCC;
• it may itself approach a VCC;
• it may retain the services of an intermediary specialized in financing.

But regardless of how the contact is made, it is important that the company be well prepared to demonstrate to the VCC that it has a strong growth potential. To do this, it is important, if not essential, to have in hand the following tools.

•  a sound business plan;
•  realistic (and above all, not too optimistic) financial forecasts;
•  historical financial statements for the past 3 years (and it would be better to have a good profit history, except of course for start-up or R & D companies);
•  presentation of a competent management team;
•  data on the market targeted by the company.

If these documents are crucial, contact with the VCC should not be overlooked. In fact, the person who will transmit this information to the VCC must be able to gain the confidence of its representatives. Therefore, having a strong CFO on your team can prove very helpful. Otherwise, it may be useful to hire an intermediary (business banker) who is familiar with the requirements of VCCs and who will be able to guide you.

2.       THE CONFIDENTIALITY AGREEMENT

Given the sensitivity of the information you will need to provide to the VCC (financial statements, forecasts, marketing plan, etc.), it would be wise to require they sign Confidentiality Agreement stipulating that the information transmitted by the company will remain confidential and will not find its way in the hands of a competitor.

Serious VCCs are familiar with such agreements. They often have their own formulas prepared by their own legal advisors. Negotiating terms may then be difficult. Consequently, it is prudent for the company to have a lawyer review this confidentiality agreement before signing it.

3.       EXCHANGE OF INFORMATION

Once the confidentiality agreement has been signed, the business owner will send the required information to the VCC, essentially as summarized above (business plan, financial forecasts, historical financial statements, etc.). At this stage, two rules must be respected:

• transmitting information that is always strictly accurate;
• not transmit over-optimistic financial forecasts

Failure to comply with these rules can cause you to lose the confidence of VCC analysts who receive the information.

4.       The Letter of Intent

The VCC may offer you to submit a letter of intent (or letter of interest) confirming its intention to submit an offer of investment to you. This letter generally does not have any real legal significance on the part of the company in that the latter does not undertake anything other than to study your request for investment. This letter can also be useful, for example, to show your bankers the steps taken to obtain an equity investment and thus negotiate new bank credits with them.

On the other hand, you may be asked to countersign this letter since it will often state that the company will not negotiate the requested financing with another company for a given period of time. You are free to accept this commitment, which is often accompanied by a penalty for non-compliance. But some VCCs may refuse to continue discussions if this letter is not countersigned.

5.       The Letter of Offer

Once the information has been completed, the VCC may at this stage refuse your request, or on the contrary, submit you an offer of financing. In the latter case, two offers are possible:

• the conditional offer to the decision-making bodies;
• the offer already approved by the decision-making bodies

Some VCCs will wait until your file is approved by their decision-making committee before submitting an offer, while others will wait to have an agreement signed with your company before submitting your investment file to their decision-making committee.

In both cases, these offers will normally be subject to certain conditions such as, but not limited to:

•  conducting a due diligence review;
•  signing a unanimous agreement between the shareholders of the company on terms satisfactory to the VCC;
•  payment of transaction costs (often referred to as "commitment costs") and which often represent between 1 and 3% of the amount of the investment.

Several other preconditions may be added depending on the context. For example, if the capital corporation estimates that the company's operating margin is insufficient to support the expected growth, it may require the company to obtain an increase in its margin before disbursing its investment. Also, the principal executives of the company may be required to sign employment contracts.

The letter of offer will often be accompanied by annexes which may, for example, summarize the main legal clauses that will govern the relationship between the company and the VCC. It is obviously essential to be advised by a lawyer specializing in this type of financing before signing the offer in question.

6.       The Due Diligence

The due diligent review process then begins. For the VCC, this step is a thorough business study of the company. For example, the VCC will verify the following:

• value of agreements signed with the principal customers of the company:
• terms and conditions of the company’s bank loans;
• accounting systems
• legal proceedings against the company;
• protection of the company's intellectual property;
• employment contracts of the main employees of the company;
• insurance coverage of the company.

Again, it is worth recalling that the company must be extremely rigorous in providing accurate information as it is on the basis of that information that the VCC will or will not make its investment. Moreover, the VCC will generally require the signature of a "Representations and Guarantees" form by the principal executive of the company as a guarantee that all the information transmitted therein is accurate. In the event of omissions or inaccurate information on an important issue, legal proceedings may be initiated by the VCC.

7.       Closing the transaction

If the diligent review is positive, then comes the time to prepare closing documents for the transaction (often referred to as "closing"). At this stage, the main players will be the legal advisors and the experience of your legal advisor in this type of transaction is essential.

Depending on the type of investment chosen by the parties, the documents will vary. Such documents may comprise of :

•  the subscription agreement;
•  the unanimous shareholders agreement;
•  the debenture;
•  the subscription options.

It should be kept in mind that the representatives of VCCs have some leeway to negotiate these documents despite the fact that they will generally tell you otherwise. But everything is a matter of skill and negotiation strategy. Avoid getting the VCC to break off negotiations for lack of a satisfactory deal.

This step sometimes takes place without any problems but frequently it can prove to be long and difficult when one is not well prepared or ill-advised. It is therefore necessary to set clear objectives and establish an effective negotiating strategy.

CONCLUSION

The financing provided by VCCs may be very helpful to ensure faster business growth. On the other hand, the process is relatively long and complex and is full of traps for the ill-prepared business owner. It can take several months between the first meeting with the venture capital representative and the closing of the transaction. Good preparation can significantly reduce these delays and even make the difference between a refusal and an investment offer.

This is why it is important to be accompanied throughout this process by competent advisors who will help you avoid the pitfalls in which an ill-advised company will inevitably fall.

(Our experts can accompany you if you are seeking financing from a Canadian or foreign VCC, since they have all previously worked for large VCCs).

François St-Arnaud © 2008

François St-Arnaud, avocat
(450) 641-8861 poste 222