Venture Capital Outline

Venture Capital

Spring 2012 / Mira Ganor

Introduction

The Lawyer’s Role

Generally

ð Hard to tell between business and legal advice

ð Occasionally you should call a bad investment

ð Must consider reputation costs when accepting representation with an early-stage company

ð Must do diligence as to entrepreneur’s financial status, status of intellectual property, non-compete agreements

Who is the client?

ð Clients need to give informed consent and lawyer needs to independently determine that he can represent all the parties he intends to

ð Many firms insist on representing only the company because founders come and go, and because the lawyer wants to keep the client after the company has an IPO

ð It is advisable for founders to have own lawyers

ð Engagement letter should resolve all of this

Ethical Issues

ð Taking stock in a client: not prohibited, as long as proper steps are taken – fair and reasonable, disclosed to client, advised of independent representation in writing

ð But, stock presents some issues, notably valuation problems, dilution, conflicts

ð Directors – not prohibited, but must consider loyalty, confidentiality, liability

ð Contingency fees – can imbalance interests

ð Deferred fees – possible but somewhat risky

ð 3 C’s: competence, capacity, conflicts

ð Cannot represent company and investor, two companies that are competing (probably)

ð Must explain to non-represented parties that you are representing the company and not them

The Venture Process

Use of Term Sheets

ð Used to put the terms of the deal on paper

ð Should disclaim contractual effect with respect to business terms but claim effect for negotiation

ð Price, consideration, structure, IP, warranties, conditions, should all be non-binding

ð Binding terms could be NDA (VC’s normally wont agree to this), right to do due diligence, exclusivity clause, termination clause, expenses

ð Disadvantages: can be found to be binding if not drafted well – Palmer (use of “shall” – binding)

ð After signing, if something is found during the diligence that is fixable you can make it a condition of the closing, or if it is more serious, you can modify the price to account for the defect

ð Non-solicitation – prevents investor from hiring away the valuable employees

ð Confidentiality – protects against disclosing negotiations in case they don’t work out / use of information found in the diligence phase

Choice of Business Entity

Business Entities in General

Sole Proprietorship

ð Individual conducts business and owns assets

ð Personal liability for all debts of business

General Partnership

ð Partners personally liable for debts of partnership

ð Default business entity

ð Partnership agreement can modify RUPA

ð Pass-through entity for tax purposes

Limited Partnership

ð Must actually file with a state

ð At least one limited and one general partner

ð Limited partner has limited liability – only up to investment – and no management or control

ð General partners get pass-through treatment, but limited partners are limited by passive-income rule

ð Can choose limited liability entity as general partner – this is the VC model

Corporation

ð Form by filing with secretary of state

ð Internal affairs doctrine – law of state of incorporation governs internal affairs of corp.

ð Limited liability for shareholders, but they have relatively little control compared to partners

ð Pays tax on corporate and person income

ð Virtually required to be a C corporation for VC

ð S Corp – pass through entity, but can only have 100 shareholders and all must be citizens or resident individuals, only one class of stock

ð Can change from S to C corp to get VC

ð Equity based compensation is the simplest

ð Can qualify for “small business stock” which gives favorable tax treatment

Limited Liability Company

ð Limited liability, pass through treatment, and owners can participate in management

ð But, very unsettled area of law, so not as widely used as you