Venture capital and private equity investments in the United States and abroad have been growing at unprecedented levels and have become a major component of an alternative investment universe to the public markets, primarily as a result of favorable relative long-term performance and returns as compared to public equities. These investments are generally made across four broad stages of the life cycle of a potentially high-growth company: (1) seed investments - to provide funds for research and development of a business before it has reached the start-up phase; (2) start-up investments - to provide funds for product development and marketing; (3) expansion investments - to provide funds for growth and expansion after a company's business has been established; and (4) replacement capital - to purchase shares from another investor or to refinance debt. Through these investments, an investor often will acquire an equity stake and/or security that is convertible into equity in the target company, which can range from a minority position in the company's equity to all of the target company's equity and everything in between.
This article will highlight some important legal considerations an investor should be aware of in connection with venture capital and private equity investments. Much of this article addresses legal considerations where an investor is acquiring less than all of the equity of the target company; however, several of these legal considerations also may apply in the context of a buyout transaction.
What Provisions Of A Letter Of Intent Should Be Legally Binding?
Given the pressure typically involved in getting started as quickly as possible with the due diligence and document drafting phases of a transaction, the importance of a well-crafted letter of intent can often be overlooked. The purpose of the letter of intent should be to establish a common understanding between the parties of the terms of an investment and how those terms should be reflected in the key legal documents that will memorialize the transaction. Parties sometimes fail to specify in their letter of intent whether they intend it (or some part of it) to be legally binding and enforceable. To reduce the risk of a court deciding to enforce a provision in the letter of intent that was not intended or desired to be legally binding, one of the most important provisions in a letter of intent should be to disclaim contractual, binding effect as to all but a few specifically enumerated terms, including the disclaimer itself. The terms that an investor should consider giving binding effect to (regardless of whether the transaction closes) include: allocation of expenses; exclusivity period of negotiation; an investor's access to the target's materials and information; governing law; and special remedies, such as injunctive relief.
What Laws Should Be Considered In Connection With Making An Investment?
In connection with every investment, special consideration should be given to complying with applicable federal and state securities laws, such as ensuring a valid private placement exists for newly-issued securities and compliance with tender offer regulations, if applicable. Often overlooked is the potential need to file under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, which requires a filing with the U.S. Federal Trade Commission and U.S. Department of Justice if a particular investment transaction meets certain criteria. Generally speaking, an investment of less than $50 million will not give rise to a need to submit an HSR filing. However, if a filing is required, an investor should be aware of the potential delay in closing the transaction, as there is a waiting period which could be as much as thirty days from the date of filing. The applicability of other laws that should be considered by an investor include the Investment Company Act of 1940, the Investment Advisors Act of 1940 and the Small Business Investment Act. In addition, an investor should consider whether there are any laws in the state of incorporation of the target company that may affect the investment transaction (e.g., anti-takeover provisions, stockholder voting requirements, statutory pre-emptive rights, etc.).
What Rights Should An Investor Have As A Stockholder?
The rights an investor should have as a stockholder depend, in large part, on the type of security being purchased and the nature of the investment. Investments can take the form of a majority or minority equity position in a target company, or ownership of all the equity. In the case of an investment resulting in ownership of a majority or all of the equity in a target company, the investor's control position and ability to designate the directors of the target company mitigate or eliminate the need for contractual protections for the investment. However, when an investor obtains a minority equity position in a target company, it is advisable for the investor to obtain contractual protections associated with the investment. This protection is often achieved through the purchase of preferred stock containing various rights and preferences or through a stockholders' or investors' rights agreement.
The following are some of the rights that an investor should consider: (a) voting rights - consider the right to a separate class vote, specific voting thresholds required to take certain actions, and the right to approve "significant" corporate actions that could adversely impact the economic interests of the minority stockholder (e.g., change in control transactions, amendments to the charter documents, etc.), which is commonly referred to as "veto" or "blocking" rights; (b) dividend payments - consider the amount and frequency of payments (annually, quarterly, monthly), cumulative versus non-cumulative dividend payments, and preference of payment over junior securities; (c) liquidation rights - consider the rate of return (e.g., 1x, 2x . . . 10x liquidation preference on the initial investment), events triggering the right to receive the liquidation preference, preference of payment over junior securities, and whether there is a right to participate in distributions after receipt of the liquidation preference on an as-converted basis; (d) conversion - consider what events will give rise to a conversion of the preferred stock and whether conversion should be discretionary or automatic (e.g., upon an initial public offering of the issuer); (e) anti-dilution protection - consider whether weighted-average or full-ratchet anti-dilution protection is appropriate; (f) redemption rights - consider what the redemption price should be and the trigger events for a redemption; and (g) preemptive rights - consider what types of future issuances of securities should give rise to the right of an investor to purchase a portion of the securities to maintain a proportionate ownership interest in the company.
What Rights Should An Investor Have In The Oversight Of The Company?
An investor should consider what level of participation in the management of the target company is desirable, whether through representation on the board of directors, voting rights or other similar means. The most common form of control over management is through an investor's representation on the board of directors of the target company. This will often arise from a contractual right, whether in a stockholders' agreement or the company's charter, giving the investor the right to appoint one or more persons to serve on the board of directors, and to the extent possible, should involve obtaining a contractual commitment from the holders of at least a majority of the company's voting stock to vote his, her or its shares of stock in favor of the investor's representatives. The number of representatives on the board that an investor will have the right to designate will often depend, in large part, on the size of the investment (i.e., whether the investor is acquiring a majority or minority ownership position in the company). Traditionally, the larger the size of the investment, the greater the investor's representation on the board of directors. One important consideration in this context is the inherent conflict of interest that may arise between serving as a member of the board of directors and as a representative of a significant stockholder of the target company. At the center of this potential conflict is the tension between the fiduciary duties that exist when serving on the board and the desire, as a stockholder, to maximize the economic value of an investment. Careful consideration should be given to this potential conflict so as to avoid any potential dispute with minority stockholders.
As an alternative to representation on the board of directors, an investor should consider, and may often prefer, obtaining observer rights, which provide an investor's designee with all the benefits of serving on the board other than the right to vote. Another common form of control over management is through the contractual right to vote on certain matters and to obtain information rights. This can be achieved either at the board level or the stockholder level. At the board level, an investor may require that in order for certain enumerated actions to be taken by the company, a vote of an investor's representative(s) on the board, or the vote of a certain threshold number of directors, will be required to approve the action. At the stockholder level, an investor may require that in order to take certain enumerated actions, the vote of a threshold percentage of the voting stock held by the investor will be required. Some actions that typically will require a vote at either the board or stockholder level include: the payment of dividends or the redemption or repurchase of shares; the authorization or issuance of securities that have superior rights to those held by an investor; changes to the charter documents that adversely affect the rights of an investor; any transaction that would result in a change of control or a liquidation or dissolution of the company; and the incurrence of a certain minimum amount of indebtedness outside the ordinary course of business. With respect to information rights, an investor should consider obtaining a contractual right to receive material information about the company's business (e.g., financial statements, business plans, etc.) on a regular basis.
What Exit Strategies Are Available For The Investment?
In most venture capital and private equity investments, an investor will seek to obtain as many alternatives as possible to obtain liquidity for the investment. In addition to the liquidation and redemption rights described above, a common means for liquidity is registration rights, which can take the form of demand registration rights (i.e., the ability of the investor to compel the company to register its shares with the Securities and Exchange Commission, subject to certain threshold requirements) or piggyback registration rights (i.e., the ability of the investor to "piggyback" on a registration of securities with the Securities and Exchange Commission by the company for the benefit of the company or other stockholders). An investor would be well-advised not to rely solely on registration rights as an exit strategy. An investor, particularly one with a minority ownership position in the company, should consider obtaining tag-along rights, or the right to join in the sale of the equity by another stockholder to a third party. In addition, an investor, particularly one with a majority ownership position in the company, should consider obtaining drag-along rights, or the right to force the minority stockholders to join in the sale of the company on the same price, terms, and conditions as the investor. Furthermore, an investor should attempt to limit the contractual restrictions on resales of the purchased securities.
How Can The Risk Of Exposure To Indemnifiable Losses Be Limited?
As with any investment, an investor should make certain that the definitive purchase agreement contains comprehensive representations and warranties given on behalf of the issuer about its business, financial condition and the like, and that the investor is properly indemnified for any losses associated with a breach of the representations and warranties. However, as a stockholder of the company post-closing, any indemnifiable claim against the company for a breach of representation or warranty will result in the investor indirectly shouldering part of the burden relating to the indemnifiable claim in proportion to its ownership interest in the company. As a means of mitigating losses as a result of an indemnifiable breach of the representations and warranties by the company, an investor should consider obtaining an insurance policy to cover any losses associated with such a breach. As an alternative method of limiting risk, an investor should consider obtaining the right to receive an additional number of securities without additional consideration to give the investor the same proportionate ownership interest in the company as contemplated at the time of the initial investment, after taking into account the change in the company's valuation resulting from the indemnifiable losses. Of course, there is no substitute for thorough and extensive due diligence on the target company and its business, including legal, financial and tax-related investigations.
Howard T. Spilko is a Partner and Joshua E. Davis is an Associate in the New York office of Kramer Levin Naftalis & Frankel LLP.