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.

Founder stock sales are becoming more prevalent as part of a venture financing. Of course, getting paid has always been a priority for the entrepreneur, but founder liquidity is becoming an increasing trend in the venture world. Enter Series FF Stock.

Series FF was created for those founders desiring to cash out a small part of their overall stake in their startup company at a funding (rather than waiting to go public or get acquired). Thus, the FF class provides founders with the opportunity for a more immediate return on their investment of cash, blood, sweat, and tears.

The mechanics of Series FF Stock work like this: At a very early stage in the startup company’s life, the founders are issued a very weak class of preferred stock. The issued FF shares typically come attached with the right to convert into a future round of preferred (such as a Series B) and then sell the converted shares to investors. This conversion and sale can only take place at a financing.

The issue of early founder liquidity can lead to tension between investors and founders. The investors want to keep the founders properly incentivized. In theory, letting founders cash out any of their stake may make the founders disinterested in growing the newly-funded company.

My belief is that a little bit of liquidity for founders at funding may actually benefit the venture backed company. The founders may have maxed out credit cards or have other bills they incurred in order to get to their startup to the point of funding. Even if the founders are debt-free, I don’t think founders will lose focus over a (relatively) small payday compared to an acquisition or IPO exit.

Keep in mind that if a founder converts and sells Series FF shares, the founder’s equity in the company is reduced. Therefore, if an IPO or M&A exit is in the startup’s future, selling shares early will likely be a costly move for the founder.

For more background about the origin of Series FF stock, click here.

Texas Startup Blog has a post about the lack of any IPO exits for venture backed companies this quarter. In fact, there weren’t any IPO exits this quarter which apparently hasn’t happened in 30 years. I decided to join the discussion and my comment trying to explain the lack of IPO exits is re-published below:

Like the article suggests, there are a couple different factors for the zilch IPO exits in 2Q 2008. 3 reasons for the lack of IPO exits (besides SOX stuff) are:

(1) Recent IPO exits have not done well - I think the statistic I remember from a couple months ago (NVCA presentation) was that only 28% of IPO exits (from 2007?) were trading above their IPO price.

(2) Cleantech/greentech takes a long time - Although keep in mind this, while a hot field, only comprises about 10% of funding. So there’s a bunch of capital going here the past 2 years (3.5B) that isn’t looking to exit anytime soon.

(3) Natural VC pattern - The number of first time fundings has increased every year since 2003, with 2007 being the best year post-bubble. Maybe the industry is just stuck between the not-a-lot-funded exit time/a-lot-funded early stage time?

It’s also worthwhile to look at the M&A exits, considering they have outnumbered IPO exits a little greater than 4:1 since 2004. While some of these exits were “fire sales” the quality of these exits is increasing every year. For first fundings from 1991 to 2000, M&A exists outpaced IPOs by a little more than 2:1. Currently, M&A exits are having a slow go of things. But there were still 56 M&A exits in Q1 2008.

While the venture capital market becomes increasingly global thanks in part to Europe, China, Israel, India, and Canada, the United States remains the leader in venture-backed financing. Although some American venture funds are willing to invest in foreign startups, the lion’s share of U.S. venture funds are not going overseas.

Most U.S. venture capitalists believe ROI from domestic deals will be superior to foreign ones. Investing in a foreign company exposes the U.S. venture fund to a new set of legal rules, compliance issues, and risks, leading to increased uncertainty and transaction costs for the American venture fund. Additionally, trying to replicate typical American VC terms, such as anti-dilution and redemption provisions, can be difficult to accomplish in a foreign market.

Does this mean my international (i.e., Non-U.S.) startup will be shut out from a majority of U.S. venture capital funding or from being acquired by a U.S. company?

Potentially–unless your international startup performs a Delaware Flip Transaction.

What is a “Delaware Flip Transaction?”

A Delaware Flip Transaction is the process of creating an American holding company for an international company. The end result is that the international company will be owned entirely by the new American company. Thus, the U.S. venture fund will invest in the new American company.

What are the mechanics of a Delaware Flip Transaction?

The basic mechanics of a delaware flip transaction is to create a U.S. holding company and insert it above the international company. Next, the shareholders of the international company execute a share-for-share exchange by exchanging their shares of the international company for the shares of the U.S. holding company. (Note that this share-for-share exchange may require some additional legal maneuvering depending on the jurisdiction of the international company. For example, it will likely be necessary to use a “scheme of arrangement” or other court-approved process to accomplish the exchange in the UK and other jurisdictions.)

Why Flip to Delaware?

Delaware provides the most comprehensive set of corporate law in the United States. No matter which American state the venture fund is located in, such a fund will be comfortable with require Delaware law. Additionally, foreign companies are likely most comfortable with Delaware law, as Delaware provides a good neutral ground or “playing field.”

I previously wrote a post about why you should consider incorporating in Delaware here.

Final thoughts on Delaware Flip Transactions

Even if an American venture fund is willing to invest in (or purchase) your international startup, it still may be beneficial to perform the Delaware flip transaction. The reduction of legal uncertainty and the ability to replicate typical U.S. venture capital terms should dictate an increase in valuation and could facilitate a NASDAQ or other listing (although IPO exits for venture-backed companies are not very common). Alternatively, Delaware may provide neutral ground for funding or acquisition by a non-U.S. company or fund.

And finally, there are important tax implications that may result from performing a flip transaction, thus such a deal requires both U.S. and foreign accountants.

Thus, the Delaware flip transaction may not be for every international startup looking to be funded or acquired, but it should at least be considered.

Venture Capital Firms. They won’t grant you a meeting. If you do get a meeting they won’t sign your nda. And you’ll be lucky if your startup gets any funding. Making matters worse, they could be about to commandeer federal grant money earmarked for small businesses like your startup.

Federal agencies earmark 2.5% of their research and development budgets for grants to stimulate innovation among small businesses. To qualify, your company can’t have more than 500 employees and must be independently owned and controlled (51% owned by individuals). Thus, some Venture Capital-backed firms are locked out of the Small Business Innovation Research program (”SBIR”). Using the 2.5% set aside by the federal agencies, the SBIR offers about $2 billion each year in grants to high-tech firms. Currently, these grants are handed out in three phases. The first two phases are reserved for small businesses. In the final phase, applications from entrepreneurs funded by large Venture Capitalists and other corporations are accepted.

But that may all change. The Senate is now considering legislation that would change the definition of “small” business and expand access to set-asides now reserved for independent entrepreneurs. This bill is called the Small Business Investment Expansion Act (”SBIEA”).

In the SBIEA, VCs are trying to end the rule by which the SBA counts all employees of any company affiliated with the applicant - including the Venture Capital firm and other startups in the VCs portfolio - toward the 500-employee limit. This would allow VC-backed firms to compete for grants in all three phases of the SBIR, instead of just the final phase.