[co-authors: Nicolas Lee, James Hutton, Jeremy Blackshaw, Glen Sauer]*
World Law Group member firms recently collaborated on a Global Venture Capital Guide that covers more than 30 jurisdictions on investment approval processes, typical investment sectors and investment structures on Venture Capital deals (and more!)
The guide does not claim to be comprehensive, and laws in this area are quickly evolving. In particular, it does not replace professional and detailed legal advice, as facts and circumstances vary on a case-by-case basis and country-specific regulations may change.
This chapter covers Australia. View the full guide.
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- In your jurisdiction, which sectors do venture capital funds typically invest in?
Venture capital funds invest across a range of sectors in Australia. The most common sectors (by aggregate funds invested) are typically:
- Services;
- Information Media and Telecommunications;
- Health Care and Social Assistance; and
- Specialty Manufacturing.
Other sectors that attract venture capital investment in Australia include:
- Agriculture, Forestry, and Fishing;
- Mining;
- Education and Training;
- Construction;
- Wholesale and Retail Trade;
- Public Administration and Safety; and
- Transport, Postal, and Warehousing.
2. Do venture capital funds require any approvals before investing in your jurisdiction?
Australia's foreign investment regime
There is no specific regime relating to venture capital investment. Australia has a foreign investment regime which applies to certain acquisitions. The Australian Government’s foreign investment regime, generally speaking, encourages foreign investment in Australia. The regime consists of the Foreign Acquisitions and Takeovers Act 1975 (Cth) (FATA), associated legislation and various regulations. The regime is also supported by Australia's Foreign Investment Policy (Policy) and around 50 guidance notes released by the Foreign Investment Review Board (FIRB), which are updated from time to time. The Australian Treasurer administers the FATA with the advice and assistance of FIRB.
Under Australia's foreign investment regime, foreign persons are required to notify FIRB of certain transactions and obtain clearance before proceeding with certain transactions. Voluntary notifications can also be made in certain circumstances.
COVID-19 related changes to foreign investment regime
As of March 29, 2020, temporary changes have been made to Australia’s foreign investment rules as a result of the COVID-19 health crisis and its anticipated economic impact with a view to regulating opportunistic foreign acquisitions. The changes include lowering monetary screening thresholds (e.g., in relation to the purchase price), which trigger a requirement to seek approval for a transaction from the Australian Treasurer through FIRB, to AUD 0.
The effect of the amended rules on inbound foreign venture capital is that nearly all transactions, including lower value seed funding rounds, currently require compliance with the FIRB approval process if a substantial interest in an Australian entity or business is proposed to be acquired by a venture capital investor which is a foreign person.
An acquisition of a substantial interest includes an acquisition of any legal or equitable interest in the shares in an Australian entity over an applicable percentage threshold. Where shares are being acquired, the typically relevant threshold is where the transaction would result in the foreign venture capital investor and its associates holding at least 20% of the actual or potential voting power attached to shares in the relevant company. Any shares held by a foreign venture capital investor from a previous funding round will be aggregated with the shares it proposes to acquire (along with its associates) in the current funding round for the purposes of the threshold.
A foreign venture capital investor which is considered a foreign government investor will require prior FIRB approval if the transaction would result in that foreign venture capital investor and its associates (in aggregate) holding at least 10% of the actual or potential voting power attached to shares in the relevant company (or potentially a lower threshold if there is an element of influence or control). This is not a material change as foreign government investors were already subject to an AUD 0 monetary screening threshold for nearly all acquisitions (including offshore acquisitions with downstream Australian subsidiaries) prior to the March 29, 2020 amendments.
A venture capital investor is a foreign government investor under Australian foreign investment rules if at least 20% of the limited partners or stakeholders of a venture capital investor are foreign government investors of a particular jurisdiction or at least 40% of the limited partners or stakeholders of a venture capital investor are foreign government investors of multiple jurisdictions (in aggregate). Tracing provisions apply to the calculation of these thresholds which have the effect that the foreign person characterization of an entity is determined by the status of the ultimate legal and beneficial interest holders (and a relatively small economic interest upstream can result in downstream venture capital entities being foreign government investors).
Prior to the changes to the rules, generally, foreign venture capital investors which were not foreign government investors only required FIRB clearance to acquire a substantial interest in an Australian entity or business where that interest is valued in excess of an applicable monetary threshold depending on the investor and/or the asset being acquired - a monetary screening threshold of AUD 275 million is generally applied to M&A deals. Higher thresholds of up to AUD 1.192 billion are applied for certain Free Trade Agreement partners, with lower thresholds for agribusiness and land entities. The monetary thresholds exempt most venture capital transactions from the requirement to seek FIRB approval.
Transaction timetables
In addition to the reduction in monetary screening threshold, FIRB has also implemented up to a six-month extension on the FIRB decision making period when an application for approval is made.
The extended decision-making period and increased case load that FIRB is now managing has altered the typical timetable for completion of venture capital funding rounds in Australia where foreign venture capital investors are participating in the round. Where typically transactions could be expected to be completed within standard 30- to 45-day exclusivity periods, the transaction documents will now often require a condition precedent to closing of receipt of FIRB approval and an elongated sunset date for satisfaction of that condition. In some cases, the parties will structure a separate, later closing for foreign VCs seeking FIRB approval such that participants that are not subject to FIRB approval may close well in advance of participants subject to FIRB approval.
Where minimum round sizes are dependent on foreign venture capital investment before participants are willing to close (particularly where foreign venture capital investors are leading a round), this can present challenges to the structuring of the transaction and requires consideration well in advance.
An urgent application may be made to FIRB requesting a faster decision where funds are required on an urgent basis by the company raising capital (for example, due to potential liquidity issues or other reasons relating to the support and protection of Australian businesses and jobs). FIRB endeavors to meet genuinely urgent commercial deadlines, though there is no guarantee of a quicker decision - an appropriate early engagement strategy can assist in this regard.
Convertible notes
The rule changes also have implications for convertible note transactions.
Where foreign venture capital investors are subject to a requirement to seek FIRB approval and seek to restructure their investment as a convertible note so that the transaction can be closed sooner and the company can have access to the funds, the right to conversion (as well as any negative controls or veto rights conferred by the notes) must strictly be conditional on receipt of FIRB clearance. This would mean that should FIRB not ultimately grant clearance to the foreign venture capital investor, there would be no ability for the notes to covert to equity and the foreign venture capital investor may have to rely solely on the redemption terms of the notes. Bespoke terms on convertible note redemptions may be necessary to facilitate this route.
Exemption certificates
One option foreign venture capital investors can explore to avoid having to comply with the FIRB approval process in relation to each individual acquisition that the foreign venture capital investor proposes to make, is to apply for an exemption certificate which allows the grantee of the certificate to undertake multiple acquisitions subject to the terms and exceptions specified in the certificate. Exemption certificates are more likely to be granted to larger venture capital funds, particularly where its limited partners or stakeholders are considered low risk foreign government investors or where the exemption relates to more passive investments in sectors or industries that are typically not considered sensitive from a national interest perspective.
In practice, FIRB’s willingness to grant broad exemption certificates has diminished during the pandemic and assessment timeframes for the granting of exemption certificates have also been pushed out. Nonetheless, exemption certificates are still worth exploring for ‘repeat customers’ looking to undertake multiple transactions in Australia.
Further changes
Since the temporary amendments on March 29, 2020, the Treasurer of Australia has announced that Australia’s foreign investment rules will be subject to a sweeping overhaul with greater focus on Australia’s national security. The Australian Federal Government is aiming to implement the new system by January 1, 2021. The particulars of the proposed reform are subject to an ongoing public consultation process and development. Until the new system is in force, the current March 29, 2020 amendments are likely to remain in place.
Wherever the final reforms land, it seems that the regime will not return to pre-COVID-19 levels of exemption and, accordingly, more transactions will be subject to the screening process than was previously the case.
- Are there any legal limitations to an offshore venture capital fund acquiring control or influencing the business, operations or governance of an investee entity?
See limitations described in relation to Australia's foreign investment regime in section 2 above.
In addition, the Corporations Act 2001 (Cth) requires that if an Australian company is a proprietary company it must have at least one director ordinarily resident in Australia and if it is a public company (which does not necessarily mean it is listed on a stock exchange), it must have at least 3 directors (2 of which must be ordinarily resident in Australia).
Where an Australian company is controlled by a foreign company there may also be additional financial reporting requirements, including preparing and lodging audited financial reports with the Australian Securities and Investments Commission (ASIC) (although exceptions exist).
- Would an investor be required to undertake an antitrust analysis prior to investment? When would such a requirement be triggered?
Australia's antitrust, competition, and trade practices regulations are predominately contained in the Competition and Consumer Act 2010 (Cth) and overseen by the Australian Competition and Consumer Commission (ACCC). Section 50 of the Competition and Consumer Act 2010 (Cth) prohibits a direct or indirect acquisition of shares or assets (including of minority stakes – as is often the case in a venture capital transaction) where the acquisition would have, or be likely to have, the effect of substantially lessening competition in any market (certain exceptions may apply).
The ACCC’s policy is to conduct a more in-depth investigation into an acquisition or investment that would result in the acquirer gaining a market share of 20% or more in an Australian market. This may be particularly relevant in the case of corporate venture funds.
Where there are concerns that an acquisition proposed to be made by a venture capital investor as part of a venture capital transaction in Australia may result in contravention of section 50, prior confirmation from the ACCC is required to be sought and the transaction documents will typically reflect that completion of the transaction is conditional on the relevant venture capital investor(s) receiving notice in writing from the ACCC stating to the effect that:
- the ACCC does not object to, or does not propose to intervene in, or does not intend to conduct a public review in relation to, or seek to prevent the acquisition by the relevant venture capital investor(s) contemplated by the transaction documents for the purposes of section 50 of the Competition and Consumer Act 2010 (Cth); or
- the ACCC does not seek to impose conditions on the acquisition by the relevant venture capital investor(s) or require undertakings from the relevant investor(s) in relation to the acquisition, other than undertakings or conditions that are reasonably satisfactory;
and that notice has not been withdrawn, revoked or amended, before completion of the transaction.
The FIRB application process described in section 2 above also involves mandatory engagement with relevant Federal Government agencies, as well as relevant State and Territory agencies. For all applications, this customarily includes engagement with the ACCC, and a letter of no objection from Australia’s Federal
Treasurer under FATA will not be given unless the ACCC has informed FIRB that there are no competition law issues in relation to the acquisition.
There are also a number of other prohibitions under the Competition and Consumer Act 2010 (Cth), including in relation to cartel conduct (price fixing, market sharing, output restrictions and bid rigging) and consumer protection matters.
- What are the preferred structures for investment in venture capital deals? What are the primary drivers for each of these structures?
Acquisition structures
In terms of acquisition structure, in Australian venture capital transactions, the two most common forms of acquisition structures used by venture capital investors to acquire an interest in a target company are:
- acquisition of convertible preference shares in the investee entity. This is typically brought about through the issue of new shares by the target company to the investor, but on occasion in a later funding round, a secondary sale of existing shares held by the founder(s) of the company may also occur; and
- acquisition of convertible notes that will convert into the class of share issued in the next qualifying funding round at a discount to the price of that round (so long as that funding round meets certain minimum requirements, including the size of the round). This is typically used as bridge financing until the next full funding round.
Variation of the above acquisition structures, as well as other bespoke structures, are also used and should be considered with regard to the circumstances and objectives in relation to the specific transaction.
Investment structures
In terms of fund structures, the Australian federal government has established a number of programs and structures that certain eligible fund managers and investors can take advantage of, with the purpose of assisting Australian early-stage companies in gaining access to capital and people skilled and experienced in the commercialization process through venture capital investment. These include:
- Early Stage Venture Capital Limited Partnerships (ESVCLP);
- Venture Capital Limited Partnerships (VCLP);
- Australian Venture Capital Fund of Funds (AFOF); and
- Pooled Development Funds (PDF),
each which may attract various tax benefits and incentives, and other advantages, and should be considered carefully at the outset by prospective venture capital funds and investors.
- Is there any restriction on rights available to venture capital investors in public companies?
In certain circumstances, once a company is admitted to listing on the ASX it will be subject to an escrow (lock-up) period on certain shareholders which prevents that shareholder from disposing of the escrowed shares for a prescribed period. In general terms, this will apply to an entity listing on ASX which does not have a track record of profitability.
The escrow is designed to prevent early shareholders from selling their shares before the market has had the opportunity to fully value, through trading, the company’s securities. If mandatory escrow does apply, securities issued to the certain persons pre-IPO will be subject to mandatory escrow.
However, certain exceptions may apply for genuine venture capital enterprises. The exceptions (the applicability of which may also be dependent on the price paid by the venture capitalist as compared to the IPO price) may result in an exemption from escrow or a reduced escrow period (typically reduced from 24 months to 12 months).
- What protections are generally available to venture capital investors in your jurisdiction?
In general, in Australia, business is conducted in a transparent, well-regulated and politically stable environment.
Venture capital investors doing business in Australia can rely on an independent and respected judiciary and legal tradition in relation to the enforcement of the commercial position and protections negotiated in transaction and governance documents in relation to a venture capital transaction.
Australia is also an arbitration-friendly jurisdiction and a signatory to the 1958 New York Convention on the Recognition and Enforcement of Arbitration Awards (New York Convention) with corresponding enacted domestic legislation. Foreign venture capital investors often opt for arbitration agreement dispute resolution clauses in the shareholders’ agreement that governs the conduct between a target company and its shareholders.
- Is warranty and indemnity insurance common in your jurisdiction? Are there any legal or practical challenges associated with obtaining such insurance?
Warranty and indemnity insurance is relatively common in Australia's private M&A market. However, warranty and indemnity insurance in Australian venture capital transactions is uncommon (particularly in earlier funding rounds).
Warranty and indemnity insurance is an uncommon option in most venture capital transactions in Australia due to factors including:
- the typical size and nature of most venture capital transactions in Australia;
- the costs associated, including the premiums, fees, and the self-insured retention or deductible;
- the typical exclusions to coverage offered in relation to most warranty and indemnity insurance products in the market;
- the general high risk/ high reward profile of venture capital transactions;
- the early-stage nature of target companies at the time of investment;
- the level of due diligence required to be undertaken by investors before insurers are willing to offer coverage on certain warranties; and
- the additional time that may be added to a transaction timetable to complete the W&I process.
Warranty and indemnity insurance is more often considered in an exit transaction.
- What are common exit mechanisms adopted in venture capital transactions, and what, if any, are the risks or challenges associated with such exits?
The most common exist mechanisms adopted in venture capital transactions in Australia are:
- an IPO (either on the Australian Securities Exchange (ASX) or a recognized foreign stock exchange);
- a sale of all of the shares in the target company to a competitor or other third-party purchaser;
- a sale of the assets and subsequent distribution and payment to shareholders of the proceeds of such sale;
- a redemption or buyback of shares held by investors by the target company; and
- less commonly, exit by way of granting an exclusive license of the target company's intellectual property rights.
The risks and challenges associated with IPO are generally considered to be greater than the other common exit mechanisms (but also present the potential for higher reward). Risks and challenges associated with an IPO include:
- satisfying the rigorous compliance process and regulatory scrutiny to qualify for public listing and issuing a disclosure document (prospectus);
- the large cost and time involved in structuring and effecting an IPO;
- in certain circumstances the pre-IPO shares of the target company may be subject to an escrow period (although as noted above exceptions may exists for genuine venture capitalists);
- in most IPOs at least some level of pre-IPO restructuring will be required;
- the price and liquidity available to venture capitalists may be subject to fluctuating market forces and conditions.
By comparison, the other common exist mechanisms are largely a matter of commercial negotiation and, typically, involve far less regulatory considerations.
- Do investors typically opt for a public market exit via an IPO? Are there any specific public market challenges that need to be addressed?
An IPO is a commonly sought and favored avenue of exit given the potential for high returns on original investment.
In order to list on the ASX the requirements of Chapters 1 and 2 of the ASX Listing Rules must be met by the company seeking to list, and a disclosure document issued. As noted above, the listing process is a complex, highly regulated, and highly scrutinized process, and the target company must meet various eligibility requirements in order to be listed.
In most IPOs at least some level of pre-IPO restructuring will be required. This may impact the current capital structure and rights of venture capital investors and specific advice will need to be sought in relation to the implication of any pre-IPO restructure.
As also noted above, in certain circumstances the pre-IPO shares of the target company may be subject to an escrow period (although exceptions may exist for genuine venture capitalists).
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