New England Biz Law Update
While many dedicated corporate sponsored venture funds have disappeared (at least for now), strategic corporate co-invests in venture deals remain a staple of the biotech, IT and telecom venture investment sectors. In-house counsel for the strategic corporate investor needs to be tuned-in to the likelihood that the venture capital funds may have very different interests from those of his or her company.
These are deals where a company makes a strategic investment as a part of a broader venture capital round. The investment is made side-by-side with a venture capital fund (VC) or syndicate of VCs leading the investment. Typically, the lead investor in the VC syndicate establishes the principal deal terms in the form of a term sheet and then negotiates the details of the transaction on behalf of that syndicate.
Assuming that each of the investors (including the strategic corporate investor) will be purchasing the same security at the same price with substantially identical deal terms (at least on their face) – why shouldn’t in-house counsel to a strategic corporate investor feel comfortable in just following the lead of its VC co-investors?
Aligned Interests?
The fact is that pure financial investors (like VCs) may have very different interests and competing agendas from those of the strategic corporate investor.
For example, VCs are an internal-rate-of-return driven species. While strategic corporate investor’s clearly want a good return on their investment, they are typically in the deal based in part on other motivations, such as instant access to intellectual property.
VCs are built to support (financially) a portfolio company down the road through several rounds of financing, while the strategic corporate investor is often a one-time investor, not interested in pouring more money into this portfolio company in later rounds of financing. They will typically hard-wire in their strategic relationship at the time of the initial investment.
Subsequent rounds of financing and later issued securities – especially in so-called down rounds – can often be detrimental to stockholders participating exclusively in earlier rounds of financing. This is not a big concern if you are playing in the subsequent round, but it is a potential big concern if you are not around for future financing.
VCs are a clubby bunch that tend to run in packs – co-investing in numerous deals – and generally stick together. This could leave the strategic corporate investor on the outside looking in for major decisions. Decisions based on past and future relationships rather than upon the merits of a particular deal involving a portfolio company are always a worry.
Transactions between the various portfolio companies of one or more VCs are not unusual (for instance combining complimentary portfolio companies). These types of transactions have obvious conflicts for those not involved with the other company in question.
A critical analytical step for any in-house counsel to take in connection with a strategic investment in a venture round is to fully understand his or her company’s business motives in making this particular investment.
Is this a pure financial play? If so, your interests may well be closely aligned with those of the VCs.
Is there a preferred vendor/customer/supplier relationship sought? Is there an R&D/joint development of IP/access to technology/establish standards component?
Only after these motivators are fully dissected and appropriately weighted, will in-house counsel be in a position to evaluate the proposed deal terms.
Deal Term Landmines
Assume that the deal terms as between the prospective portfolio company and the investors will in fact be negotiated by the lead investor and will treat all investors substantially the same. Nonetheless, there are still any number of areas where these terms will require careful attention by the strategic investor.
You have to carefully watch for the following.
Intra-Investor Governance
The real action for a strategic investor is not so much in the deal terms as between the portfolio company and the investors, but rather in the intra-investor governance terms. These are the various provisions of the certificate of incorporation and the investment contracts that govern how the investor group makes decisions. Amendments to the investment documents and waivers of specific provisions thereunder are frequently overlooked even though they can be critically important down the road.
What percentage of the investors (typically established as some percentage of the outstanding class of securities) can waive or amend provisions of the investment documents? This can only be analyzed with a cap chart in front of you where you will actually see which single investor or groupings of investors hold negative or affirmative control over a particular amendment or waiver. These percentages may vary as among the documents and even as among various specific deal terms. In-house counsel needs to carefully review and analyze this to fully understand who can and can’t change the deal terms everyone just agreed to.
Are there certain provisions that can’t be changed without unanimous approval, such as what the security is entitled to receive upon a sale of the company?
You need to decide what level of tolerance you have for waivers and amendments. Do you want a unilateral veto over any waivers/amendments – maybe not realistic unless the strategic investment is a very large percentage of the financing.
Do you want any other investors to have unilateral control over waivers and amendments? What are the likely voting blocks?
Next, assuming you do not have the leverage to extract a unilateral veto, you need to decide if there are certain provisions in the investment documents that you really don’t want changed without some higher standard being met – such as a waiver of anti-dilution rights or issuance of senior securities in later rounds of financings. Again, this needs to be carefully calculated based upon the cap chart and the players involved in the investment syndicate.
Recommendations
Here are several baseline protections that in-house counsel should consider in any strategic venture investment.
If you don’t want waivers/amendments without your consent, make sure the waiver/amendment provisions reflect that.
Even if a unilateral veto on waiver/amendments is not possible, make sure that you can’t be singled out for adverse treatment in an amendment/waiver effected by the requisite percentage.
Obtain a covenant from the company and the investors that you will not be subject to a pay-to- play provision.
Obtain board observer rights, but avoid serving on the board even if available because there are too many potential conflict and liability issues for most strategic investors.
Make sure information rights are available to you as an investor and that they are adequate to address your own internal reporting and other needs (but beware of SEC reporting requirements if you are a reporting company).
Last but not least, make certain that any special strategic deals are reflected and documented prior to the investment.
While VCs and those providing strategic venture investments will have similar, aligned interests in many respects, there are several critical areas where that will likely not be the case. In-house counsel must be alert to those areas where their interests will be misaligned with those of the VCs and ensure that protections for his or her company are put in place at the right time.
Christopher W. Nelson is a partner in the private equity and technology company practices groups of Edwards & Angell, LLP, a national law firm with more than 300 attorneys that focuses on financial services, private equity and technology. He may be reached at: [email protected].
