Private Equity HUB is reporting that Shanghai will allow foreign venture capital and private equity funds to register legally as local equities investment firms:

Foreign investors with a focus on Chinese equities can set up a Shanghai-registered entity with initial capital of 100 million yuan ($14.56 million) or more with the legal status of a local investment company and receive special tax treatment, according to a city government document dated Aug. 11 and obtained by Reuters on Friday.

Qualified foreign investors would include private equity funds, venture capital funds, buyout funds and hedge funds, it said.

This is another instance of Chinese cities (Beijing & Tianjin) attempting to lure more overseas investment, as there currently is a large handful of difficult regulatory obstacles for foreign investment funds wanting to transact business in China.

[Additionally, this makes the owner of venturecapitalchina.com very happy.]

Read the entire Private Equity HUB article here.

Well I guess that’s it folks. I had a fun ride. Y Combinator has “open sourced” legal documents they provide to their startups seeking funding. The documents were created by Wilson Sonsini Goodrich & Rosati, Y Combinator’s law firm.

But as of 7:39PST on August 13, there is a “glitch” with the link to the open source documents. Here is the current message you get if you click the link to the documents:

Sorry, there’s a glitch with the documents and we had to take them down. We hope to have something back soon.

I’m wonder if by “glitch with the documents” they really mean that Wilson Sonsini Goodrich & Rosati is not exactly happy with this particular open source movement.

The Rick Roll. It’s classic. Some might even call it legendary. Rick Roll your friends & family. Rick Roll your co-workers. Heck, Rick Roll me. We will all belly laugh as “Never Gonna Give You Up” blares on our computer speakers. But please don’t Rick Roll venture capital firms.

By Rick Rolling a venture capital firm, I mean don’t attempt to bait and switch or otherwise mislead venture capital firms with your startup company’s pitch. They won’t find it very funny and they have seen it all before.

Here are some common venture-capital-pitch Rick Rolls:

A flock of fancy employees are on the way. Don’t talk about all the great Google execs that are coming onboard as soon as your startup gets funding without evidence to back up your claims.

Company X is our partner. “Partner” is an ambiguous term which leads to additional ambiguous language. Don’t go on and on about how you’ve “talked” with some “key executive” at Company X and how “excited” they are to become “involved” with your startup.

Company Y will want to acquire us. Don’t speculate about your exit strategy to a venture capital firm before you get funding. First, you should be more concerned with demonstrating the greatness of your startup’s idea and your startup’s ability to implement the idea, rather than hypothesizing about an event that might happen 7 years from now. And second, the venture capital firms will have access to better speculators than yourself.

My startup is the only one with this idea! Oh really? Have you checked every garage and co-working space in the world? I’d be willing to bet 25 others have your idea. Focus on the implementation of the idea rather than its extreme novelty.

While your venture capital firm might enjoy Rick Astley (it’s hard not to like a guy who sings and dances while sporting a raincoat with clear skies overhead), they won’t like being mislead by your startup company’s pitch. They’ve been Rick Rolled enough by other entrepreneurs to see yours coming. And they’ll likely feel your startup is unworthy of funding.

For another article about how to pitch venture capitalists, click here.

As an industry, venture capital is relatively young. Yet it has been around long enough–through busts and booms–that it will not simply go away as some might have you think. Venture capital is a legitimate industry which is now being enhanced through standards and patterns. Documentation is one area that is trending towards consistency in venture capital.

In the past, a startup company’s lawyer and the venture fund’s counsel might have haggled over terms that are now perceived as boilerplate. The National Venture Capital Association (NVCA) working groups have done an outstanding job creating model Series A documents.

But if venture capital documents are becoming standardized, why are law firms charging more for venture financings?

I hear more and more remarks about how high legal fees have been for their Series A financings, from $50k, $75k, $100k and upwards. And I’ve heard from both entrepreneurs and attorneys.

Of course, each venture capital transaction is a unique deal and document drafting/negotiation is not the only legal work to be completed in a venture financing. Also, I’m not implying that the legal industry should start commoditizing its practice. But you would think that legal document standardization would lead to a reduced need for negotiation…and therefore reduced legal bills.

I thought you should know that Fred Wilson is currently posting a fantastic series about Venture Fund Economics on his wildly-popular venture capital blog, “A VC.”

So far, Fred has written about venture fund gross and net returns and how venture funds may have one deal that pays off so well that it returns the entire fund.

Learning about the entire venture capital system–and not just your direct relationships–will make you a better entrepreneur. So be sure to check out the series and Fred’s blog.

When your startup company raises capital, valuation is a key question that must be tackled Rey Maualuga style. (If you are unfamiliar with “Rey Maualuga style,” click here for a Youtube example.) The two main valuation concepts in a venture capital financing are pre-money and post-money valuation.

In a venture capital transaction, the venture capital firm invests cash in the startup company in exchange for newly-issued (preferred) stock. The startup company’s value immediately before the funding is called “pre-money valuation” while the startup company’s value immediately after the transaction is called “post-money valuation.” (Technically, pre-money and post-money are more about price than a startup company’s valuation.)

Pre-money Valuation and Post-money Valuation Equations

(1) Pre-money Valuation = Post-money valuation - Venture Capital Investment

(2) Post-money Valuation = Venture Capital Investment/Venture Capital Ownership Percentage

You can determine share price by the following equation:

(3) Share Price = Pre-money Valuation/Number of Pre-money shares.

You can determine how many shares to issue the venture capital firm by this equation:

(4) New Shares Issued = Venture Capital Investment/Share Price

Pre-money Valuation and Post-money Valuation Examples

Example 1

Let’s say Google’s new venture fund comes to you and offers to invest $3MM into your startup for 30% of the company. Plugging the numbers into equation (2), we get:

Post-money valuation = $3MM/.30 = $10MM

Thus, to calculate pre-money valuation, we use equation (1) as we now know the post-money valuation and the investment amount:

Pre-money valuation = $10MM - $3MM = $7MM

Example 2

Now let’s say a venture capital firm offers your startup company a $4MM investment at a $6MM pre-money. To determine how much your startup would give up in exchange for the $4MM, we use equation (1) and get:

$6MM = Post-money valuation - $4MM, and solving for Post-money valuation (Post-money = Pre-money + Investment) gives us $10MM

Next, we use equation (2) to find the Venture Capital firm’s percentage:

$10MM = $4MM/Venture Capital Firm Ownership Percentage (VCFOP), solving for VCFOP (VCFOP = $4MM/$10MM) we get 40%.

The Wall Street Journal, Yahoo, and VentureBeat are reporting this morning that Google is currently putting the pieces together to launch an internal venture capital arm.

This isn’t the first time rumors have swirled about Google launching a venture capital fund, but the speculation is increasing based upon Google’s hiring of William Maris, a former web hosting entrepreneur, to (allegedly) set up the venture capital arm. Another thought is that Google is planning to launch the venture capital fund to coincide with the release of its Android mobile platform–and therefore Google would be targeting the telecom sector.

While Google surely brings the name factor to any business or service it plans to launch, it will be interesting to see if Google can pull it off. Google has been an acquirer of companies in the past, but Google’s biggest obstacle will be whether it can give their portfolio companies the requisite time and attention to develop the startup. There are a lot of private venture firms that already do.

Read the WSJ article here. Read the Yahoo article here. Read the VentureBeat article here.

Choosing a startup’s legal entity can be a frustrating experience for the entrepreneur. Who has time to deal with the LLC, S-Corp, C-Corp, LP, GP, LLP & LLLP when you’re already buried with things like CSS, RoR, AJAX, PYTHON, PHP & ASP? Thankfully, if your startup is absolutely determined to raise venture capital, there’s only one viable legal entity decision your startup can make–the Corporation.

Does this include S Corporations?

No. While the S Corporation structure is a popular choice for entrepreneurs and other small businesses, it comes with regulatory limitations that do not make it a feasible vehicle for raising venture capital. The three main regulatory limitations are:

• S Corporations may only have one class of stock;
• S Corporation stockholders must be natural persons (except for some extremely limited circumstances); and
• S Corporations can not have more than 100 stockholders.

The one class of stock requirement is fatal to a venture capital investment since venture capital firms will demand preferred stock in return for their investment. Also, most venture capital firms are organized as limited partnerships and less frequently as LLCs–but both legal entity types aren’t “natural persons.” And finally, as your startup grows, the 100 stockholder maximum comes into play once your startup begins issuing stock and stock options to employees.

Thus, the C Corporation will be the only type of corporation viable for a venture capital investment.

Why not an LLC?

While the LLC is also a common startup vehicle, the C Corporation wins hands down when it comes to raising venture capital. The following 4 reasons explain why:

1. Pass Through Entity

While the pass through feature (income/losses are passed down to the shareholders rather than dealt with at the entity level) of LLCs are desirable to most entrepreneurs, venture capital funds do not find pass through taxation to be a similarly desirable feature. The venture capital firm does not want the accounting and tax matters of a funded venture to be passed down to the firm, and thereby be attributed to the venture capital firm’s tax exempt and foreign limited partners. Such a scenario could create unrelated business taxable income (UBTI) issues or have their foreign investors be deemed “doing business” in the United States and thus have to file a U.S. tax return.

2. Transferability

The membership interests of an LLC are typically not freely transferable by state statute. This makes the LLC a lousy entity for one of venture capital’s exit strategies: the IPO. (Not that IPOs for venture backed companies are hot at the moment.)

3. Predictability

Started in the late 1980s and only made more popular in the last decade or so, LLCs are a relatively new type of legal entity. Thus, there just isn’t a well developed set of laws and regulations for LLCs. Corporations, on the other hand, provide a larger degree of predictability with regards to corporate governance and stockholder rights.

4. The Venture Capital Firm’s Organizational Documents

Primarily due to the reasons outlined above, many venture capital funds will have specific provisions in their own organizational documents that prohibit them from making a venture capital investment in an LLC, or any other legal structure than a C Corporation. Thus, if your startup is absolutely against being a C Corporation, you could be declined by the venture capital firm regardless of how spectacular your startup is.

The Conclusion

The C Corporation is a venture capital firm’s clear-cut choice for the type of entity in which to place their investment. When the to-be-venture-funded startup is a C Corporation, various administrative and other burdens are minimized for the venture capital firm, which allows them (and their capital) to focus on developing the startup company’s business.

I’ve been seeing nothing but doom and gloom articles recently: Our banks are going to fail, it will cost $200 to fill our cars with gas, and we’re all going to get kidney stones. And similar depressing articles have been en vogue regarding the venture capital industry.

But like a needle in a haystack, I found an uplifting article (dated today!) regarding the venture capital industry. A Businessweek article entitled What Capital Crunch? explains why the Silicon Valley is not experiencing a capital crunch. Here’s a key excerpt:

Some 71 venture capital funds raised $9.1 billion in the second quarter of 2008, up 3% from the year-ago quarter, according to a survey released July 14 by Thomson Reuters (TRI) and the National Venture Capital Assn. Investments in information technology, life sciences, and environmental technologies continue to drive the market. As the venture capital market becomes more global, Asia is emerging as an attractive location for investments.

The latest numbers signal that big investors are confident in the long-term future of the venture capital business. There does seem to be a flight to quality, however. The number of funds raised in the quarter fell 14%, down from 83 in the year-ago period.

Thus, I’m pretty sure I’ll use my mattress as an ATM and get kidney stones before the VC industry dies. Gas prices on the other hand…

Most startups issue only common stock. But sometimes a startup will encounter a situation, such as raising capital, where having more than one class of stock is beneficial (or required). When startup companies raise capital through the issuance of stock, they typically issue “preferred stock” to their investors.

Definition of Preferred Stock

Preferred stock is a class of stock that provides certain economic and control rights and protections not given to the holders of a startup’s common stock (the founders usually hold the common stock). Hence this class of stock is “preferred.”

Typical economic rights of preferred stock include a liquidation preference, anti-dilution protection, and conversion rights. Control rights deal with a host of voting issues and electing the board of directors.

Which Investors Receive Preferred Stock?

Preferred stock is most commonly issued when a startup undergoes a large financing, such as one with a venture capital fund. Angel investors and the friends & family round may sometimes receive preferred stock. Keep in mind there is no bright-line rule when it comes to angels and the f&f round.

Other than the Capital Raised, Does the Startup Benefit from the Issuance of Preferred Stock?

It sure does. Since preferred stock comes with economic and control rights and protections, common stock typically gets a lower valuation for the purposes of stock option grants or share issuances to the corporation’s employees. Employees can generally exercise their common stock options at a lower price than the price of the preferred stock. Thus, employees may feel as though they are receiving some sweat equity for their contribution to the corporation.