09/30/1997
Counselors to Rising Start-Ups
Practioners on both coasts discuss new technologies, IPOs on the Web and changes in SEC and IRS regulations
The following is an excerpt from an electronic panel discussion among seven venture capital practitioners that took place on the Law Journal EXTRA! Web site. Law Journal EXTRA! is an online service for the legal community from the publishers of The National Law Journal.
NLJ: How does the increased use of the World Wide Web for initial public offerings change the relationship between venture capital investors and start-up companies?
Timothy Tomlinson (partner at Palo Alto, California's Tomlinson Zisko Morosoli & Maser L.L.P., specializing in electronic commerce and Internet security-related corporate and business matters): Recent legislation and no-action positions enabling Internet public and private offerings and secondary market bulletin boards have loosened restrictions at the federal level on electronic capital raising. This enhanced ability to bring entrepreneurs into contact with additional and nontraditional sources of financing has had an effect on the venture capitalist relationship with start-up companies.
We are seeing venture capitalists more aggressively market themselves as providing investment banking types of services. Venture capitalists have begun emphasizing their skills as business and financial advisors with a view towards entering into long-term advisory relationships with their start-up clients, much in the same way traditional investment banking firms have historically operated.
Eric C. Jensen (partner at Menlo Park, California's Cooley Godward LLP, representing emerging high-technology companies, venture capital funds and investment banks): I don't believe that it will significantly change relationships. The question seems to assume that venture capitalists are needed in order to enable a company to do an IPS. While venture investors add credibility and most have excellent contacts with investment bankers, a strong company can very easily gain the attention of investment bankers on its own. While the Web may enable easier sales of stock to individuals, I have not seen evidence that it will change the buying behavior of institutions (i.e., Fidelity, etc.). Such institutions continue to rely upon the screen provided by investment bankers, IPO road shows and one-on-one meetings with the principals of companies. Since institutions buy most of the stock in an IPO, I believe most companies with a good story will continue to go public in the traditional way. I believe the Web is more important in the after-market, as a means to update all investors.
Martin H. Levenglick (partner at New York's O'Sullivan Graev & Karabell L.L.P., representing companies and investors, particularly in information technology, online and new media fields in venture capital, corporate finance and mergers-and-acquisitions transactions): I don't think it will have any particular effect on such relationships. My sense is that the availability of SEC filings, such as prospectuses, on the Web may enhance the perceived cachet of certain "hot" Internet companies with the trade, but will have little impact on actual investors in a particular company or, more importantly, potential investors in a public offering. Of course, whether or not a company chooses to make its prospectus available on the Web, Edgar filings are available on the Web from the SEC, but viewing these documents in ASCII text is not a pretty site.
Craig W. Johnson (chairman of Menlo Park, California's Venture Law Group, representing public and private deal-intensive technology growth companies): Use of the World Wide Web for IPOs will have a larger effect on service providers related to the process than venture capital firms. For example, printing and distribution costs for the prospectus may be significantly reduced as distribution via the Web becomes more acceptable. I also expect more drafting will be done "on line" rather than in all hands meetings as Web-based collaboration and video conferencing tools become more available. Use of the Web for IPOs raises many new legal questions.
NLJ: With respect to new technology companies, how can venture capital investors obtain sufficient comfort that a given company's portfolio actually includes all necessary rights in the technology that the company purports to own, and that competitors do not have rights in the same technology?
Leslie E. Davis (partner at Boston's Testa, Hurwitz & Thibeault L.L.P. in the business practice group, concentrating in business, corporate and securities law with emphasis on biotechnology, medical technology, managed health care and finance industries): Absolute certainty is not possible, especially if patentable technology is involved. Third parties may have unpublished applications on file. In addition, many patent claims are so broad that it is not clear exactly what is covered or if the patent will be enforceable.
When considering making an investment in a technology company, investors should look at two primary lines of inquiry: Misappropriation and infringement…A related question [venture capitalists] often look at is whether there is competitive technology that reduces the value of the technology in question, now matter how well protected.
Mr Jensen: Through use of expert consultants and legal due diligence, venture capitalists can gain a large degree of comfort that a start-up's technology has not been stolen from another company, and that it is believed to be unique and proprietary. Absolute assurance is impossible, particularly in the patent area. The existence of patent applications by competitors are usually not known and final conclusions regarding infringement will be made by a court many years down the road. Taking the risk is one justification for the returns earned by venture capitalists.
Mr. Tomlinson: The ultimate security for the venture capitalist is a complete technology audit. Such an audit could run $15,000 to $25,000 and up in legal fees. This is not often cost justified, and the start-up is usually leery of this process. To be practical, an investor needs to look at a subset of a complete audit information.
At a minimum employee technology assignments must be in place; licenses of third party technology must be broad enough to permit the company to execute its business plan; and some review of employee obligations to prior employers should be made.
Mr. Johnson: Venture capital firms often use patent counsel to do patent searches of a new company's technology, particular in patent-intensive areas such as biotechnology. As for trade secrets, know-how and other rights, investor counsel is responsible for confirming that each employee has signed a nondisclosure and assignment of inventions agreement confirming that the employee has not taken and will not use any proprietary information of a former employer and for obtaining appropriate representations from the company about ownership of technology. In cases where the investor has particular concerns (such as where the team worked together at a prior employer developing a similar product), investor counsel will usually conduct personal interviews with each key company employee to probe further into the accuracy of the company's representations about ownership of technology.
NLJ: Are there risk factors that are particularly pertinent to start-up companies?
Ms. Davis: The quality and experience of management is key, both for credibility with potential investors and for managing the risks. A particular risk for start-ups is that a founder or key employee may be subject to a noncompetition or other restrictive agreement with a prior employer.
Joseph W. Bartlett (partner in the New York office of San Francisco's Morrison & Foerster L.L.P., specializing in alternative finance and venture capital, particularly for high-technology companies; author of numerous articles and books on venture capital): Of course, there are risk factors particularly pertinent to start-up companies, including the fact that they are start-up companies. However, it is clear from the case law establishing the "bespeaks caution" defense and the Securities Reform Act that a boilerplate risk factor section is not the answer. The risk factors must be specific to the particular nature of the start-up.
Jacqueline A. Daunt (corporate partner at Palo Alto, California's Fenwick & West L.L.P., representing domestic and international high-technology clients in venture financings, acquisitions, partnering and licensing transactions): Market risks. Does anyone really want the product at a price that will make the company profitable? Development risks. Can we really solve this technological problem in the relevant window of opportunity? Business model risks. Do we know how to create a workable business model, where the company gets paid for the value customers perceive they are receiving? Competition risks. Does the other guy get a better idea on how to solve the problem, execute better and more efficiently, is better capitalized, which allows them to "buy" market share by low margins on the front end? Management risks. Is the guy who can invent an innovative technological solution the same guy who can build a profitable public company? If not, how do you transition the new CEO without losing the creative visionary founder?
NLJ: When representing a start-up technology company at its inception, how should the company and its founder be counseled regarding:
a) capitalization issues? . . .
Mr Jensen: I encourage my clients to use stock and stock options in lieu of cash compensation for employees, consultants and directors. Founders need to understand that it is necessary to provide others with a stake in "their company" in order to build value. Use of Rule 701 for employees issuances and Rule 506 for issuances to investors . . . allows a start-up to provide the necessary equity without violating federal securities laws. I counsel founders to provide full disclosure to investors of the many risks involved. Since successful entrepreneurs focus on upside, not risks, this exercise generally requires some effort.
Ms. Daunt: Issue common stock to service providers (employees, contractors, etc.) under a plan that qualifies for federal securities exemption provided by Rule 701 and a California state qualification exemption under 25102(o). To qualify, you have to abide by the legal requirements. Do it.
Issue preferred stock to outside investors under a private placement exemption (4(2) or Reg D at the federal level and 25012(f) at the California state level). To do so means that investors need to be rich or sophisticated. Do not take money from widows unless they are your family members. Even then, think twice. Failure to abide by the securities laws means that instead of getting an equity investment, the investor may have made you a demand loan, which the individual entrepreneur may have to back from his or her personal bank account. Its not worth the risk.
Mr. Levenglick: Companies and their founders must be made sensitive to the fact that issuances of equity, whether to each other, to "friends and family" or to any other person or entity, are subject both to the federal securities laws and to applicable state securities or blue-sky laws and an exemption from registration needs to be available before going forward on such issuances. Clearly, the company should be made aware of the notion of "accredited investors" under Regulation D when considering potential third party investors. The company should be advised to implement at an early state a typical employee stock option plan that is carefully monitored and in which option grants are properly documented, as the preferred vehicle for issuing equity to employees. Often, the failure to focus on the applicability of the securities laws in the early stages of a company's capitalization will later become an issue of some magnitude and complexity when institutional fundraising is sought or the company is attempting to "go public".
NLJ: . . . b) clients' internal arrangements?
Mr. Jensen: Typically my clients provide in their bylaws that in the event a holder of common stock wishes to transfer his stock to a third party, the company has the right to purchase such shares on the same terms as offered to the third party. In most cases this does not apply to the preferred stock purchased by venture capital investors. I believe this right helps keep stock in the hands of persons friendly to the company.
Ms. Daunt: High-tech start-ups don't usually have buy-sell agreements, designed to buy out deadlocked founders. The venture capitalists generally "control" the company and the company retains the right to repurchase "unvested" stock from any terminated founder a the original purchase price. These companies all reserve "rights of first refusal" that allow the company to buy back stock at a price offered by an outside purchaser. Companies view their common stock as a competitive advantage in retaining employees, not as a means for outsiders to make a pre-IPO investment in the company. A few companies (10-15 percent) still reserve the right to repurchase "vested" stock on termination of employment. The concern is employee mobility. The companies don't wan the ex-employee working a competitor to get financial information on its operating results.
Mr. Levenglick: [T]he founders and their company should be made aware of the importance of keeping stock "in the family" in the event of the early departure of a founder from involvement in the business. As equity is the principal form of currency utilized by young companies to attract, compensate and retain highly qualified personnel, the concept of "vesting," which requires individuals to remain in the employ of a company for a period of time (usually years) to earn full rights to their equity, is a very important component of equity issuances to key employees in young companies (while true "founders" will often expect their initial equity to be fully invested at inception as compensation for their having come up with the idea behind the company and having provided the early "sweat" to build it).
NLJ: . . . c) valuation of company?
Ms. Daunt: Start-up valuations are a "black art." The venture capitalists look at the idea, the market, and the management team and make a guess as to what its prospects are. If they look good enough, the venture capitalists will pay what it takes to get in the deal. There are companies that get a $3 million pre-money valuation, without a business plan or a product prototype. Of course. . . lots of companies . . . don't get funded at all.
Control (in the sense of majority stock ownership) does not seem to be the controlling factor. As a practical matter, the "golden rule" applies: he who has the gold rules. Companies need capital and those who provide them with the necessary capital set the rules even if the venture capitalists don't have a majority of the stock after the first round. There will be a second round and the entrepreneur needs the venture capitalists on board.
Venture deals are done with preferred stock in Silicon Valley. The liquidation preference allows the company to sell its common stock to its employees at a discount from the price paid by the venture capitalist for the preferred stock. The liquidation preference allows the VCs to argue for a bigger cut of acquisition consideration if the company is sold. Everybody benefits. The SEC is getting tough on the "cheap stock" issue for the Internet start-ups, however. We are counseling that companies get more appraisals of common stock to justify their pricing.
Mr. Levenglick: The issue of valuation is fundamental to the fundraising process, of course, in that valuation will be determinative of how much equity of the company has to be sold to achieve a particular level of capital. Whether a company is prepared to sell "control" to investors, or is indeed able to retain for its founders a majority stake in the company, will be tied directly to valuation. Whether investors are acquiring a majority or minority interest in a company will dictate the appropriateness of a number of terms and conditions, such as voting arrangement for directorships, tag-along or co-sale rights, protective provisions or covenants requiring special class voting for organic (sale of company, etc.) changes as well as other material actions or transactions by a company, among a host of other considerations.
NLJ: "Pay to play" or "participating anti-dilution" clauses have become common as a term in venture capital financings, intended to motivate investors to continue to invest in the portfolio company in subsequent rounds of financing. Should the investors be required to participate in just a "down-round" (i.e., at a lower price than the price at which they invested) or at any price? Has there been concrete experience to suggest that such clauses actually work in practice to get investors to invest when they would otherwise choose not to?
Mr. Johnson: Pay to play is a way to try to hold a syndicate of venture funds together in later "down" rounds of financing. If an investor refuses to participate in a lower priced later finance round, that investor loses its antidilution protection with respect to earlier rounds of investment (thus being doubly diluted by the down round). As venture funds have become larger in recent years, fewer deals are being syndicated since the venture fund may want the entire investment for itself. Thus, pay to play is less common today than it was 10 years ago. A bigger concern of many smaller venture investors (reflective of a six year bull market) is not to be shut out of subsequent "up" rounds. Thus, "rights to maintain percentage interest" have become much more common in venture financings. I believe pay to play rarely changes an investor's mind about participating in a later round, which may account for its diminished use.
Ms. Daunt: I really like pay-to-play provisions. Why should an investor who refuses to support the company when they need capital in a "down" round be entitled to gross up the number of shares they have in the company? It hurts the company, it hurts those investors who do continue to provide support (by diluting their percentage interest in the company) and requires greater option grants to continuing employees (also causing greater dilution). I don't know if it actually changes the investor's behavior, but not letting them benefit from the dilutive offering is the right result. I don't think that pay-to-play provisions make sense except in the "down" round context.
NLJ: Do you think the current efforts to reform the Securities Act (e.g., relaxation of Regulation D general solicitation requirements and the "test the water" rules) will have a significant impact on venture capital financing?
Ms. Davis: We do not foresee much impact on traditional investing by venture capital funds. However, relaxing these rules (e.g., for private offerings to qualified investors who have been pre-screened via an Internet-based intermediary service) may facilitate access to early stage "angel" financing.
Mr. Bartlett: I don't think of it as having a significant impact. Venture rounds usually do not have much to do with the general solicitation requirements. Rule 506 offerings in fact go out, without general solicitation, to the "usual suspects," without the necessity of some from of cold calling or letter writing.
Mr. Levenglick: I think this will help diminish the sensitivity and concern that companies in fundraising mode have about participating, and sometimes even attending, investor conferences.
NLJ: To what extend to your fund clients use limited liability companies as investment vehicles? What are the reasons, if any, not to organize a privately held vehicle as an L.L.C.?
Mr. Jensen: Typically venture funds have been organized as limited partnerships. The general partner of such partnership has in the past been another limited partnership, with the individual venture capitalists serving as general partners of such partnership. Use of this second tier partnership allows the venture capitalists to add or remove persons and to separately allocate profits without changing the venture fund agreement. Most new venture funds have replaced the upper-tier partnership with a limited liability company, allowing the venture capitalists partnership tax treatment with limited liability. However, some investors in venture funds want the venture capitalist to remain liable for obligations, particularly if the economic deal requires that distributions be repaid if certain returns are not achieved.
Ms. Daunt: A venture-backed company wants to be a corporation. You cannot do employee equity plans in an L.L.C. without a lot of expense and hassle.
Mr. Bartlett: There are several reasons not to organize a privately held vehicle as an L.L.C. The technical reasons have to do with the investors in the venture fund - - if they are pension or endowment funds worried about unincorporated business taxable income or offshore entities worried about income effectively connected to a trade or a business in the United States. Further, some states impose tax, there is an issue under the New York unincorporated business tax, standards of governance vary from state to state, etc.
Mr. Levenglick: Many of our fund clients shy away from investing in L.L.C.s (if they have tax-exempt investors or pension fund investors as limited partners in their fund) because of restrictions imposed under their partnership against incurring unrelated business taxable income (UBTI). In such instance, the fund will require that the L.L.C. roil-up into a C corporation pre-financing. However, as a general proposition, L.L.C.s are becoming more popular due to: (i) new flexibility in achieving "pass thru" status due to the "check the box" rules and (ii) the obvious tax savings associated with the pass-thru vehicle, including the avoidance of double-taxation in an exit accomplished through a sale of assets transaction, and current utilization of R&D losses.
NLJ: What do you tell your clients about choice of entity now that the IRS has promulgated new check-the-box rules?
Ms. Davis: Until all of the states have adopted check-the-box, we are generally advising clients forming L.L.C.s or partnerships to satisfy the old four-factor federal classification rule. Clients organized as L.L.C.s or partnerships with operations, or taxable owners, located in states that do not respect check-the-box could be in for an unfortunate surprise if they rely solely on the new federal rule, and state tax authorities nonetheless treat their entity as an association taxable as a corporation. California, for instance, has its own set of entity classification regulations based on the old four-factor test, and has indicated that it does not intend to adopt check-the-box.
Mr. Jensen: Until the check-the-box IRS regulations are adopted by California and other states in which venture funds operate, we are not advising clients to follow the new provisions. Despite the flexibility provided by the regulations, for start-ups expecting venture funding, the C corporation structure is still generally the best structure. First, the flow-through of start-up losses provided by a partnership-like entity is not of great value to most founders. In addition, the tax-exempt investors in venture funds do not want the unrelated business taxable income that is generated by operating profits of a start-up company formed as a partnership.
NLJ: How would you describe the typical investment being made by venture capital funds? Are they using convertible preferred? Do they take control immediately or only upon default? If convertible preferred is used, is conversion permissible at any time? What about redemption rights? Can the companies pay dividends "in kind"?
Mr. Bartlett: The implication of [the] question. . . is that term sheets are getting standardized. I agree. Convertible preferred is the norm. It does not usually entail immediate control because the golden rule. . . usually gives the VCs enough control to make sure the founders behave themselves. The term sheet in my treatise talks about events of default and control shifts; but again, that is not necessarily an item the VCs bargain for heavily. Conversion of a convertible preferred is permissible at any time; it is, in fact, required on the eve of an IPO. The preferred is usually redeemable at the option of the holder after five years, which somewhat compromises its treatment on the balance sheet. Therefore, some venture funds like to use a preferred which is not technically redeemable at the holder's option but which starts to pay real dividends at very high rates after five years, which in turn induces the company either to arrange a liquidity event or call the preferred. The preferred. . . is so-called exploding preferred, the idea being to move the founders off the dime if a liquidity or exit event is not occurring with sufficient rapidity.
Mr. Johnson: In the 1970s the most common form of venture investment was common stock or convertible subordinated debt. Starting in the 1980s the most popular investment vehicle became convertible preferred stock. Investors figured out that burdening a company's balance sheet with debt was not very useful (restricting the company's ability to borrow) and changed to preferred stock when competition for employees heated up and investors wanted to offer lower priced common stock to key employees to attract and retain them. Redemption clauses are rarely used, since if a company is successful enough to redeem its stock at cost (pass the legal tests protecting creditors), the investors feel their stock is worth more than cost. If investors are willing to take their money back, the company usually can't satisfy the legal tests. Dividends are usually paid only "when, as and if" declared by the Board of Directors. In 22 years of venture capital practice I have had only one private company actually pay dividends.