[co-authors: Matthew R. Levy*, Mark D. Pihlstrom*, Kathy L. Osborn*, Ryan R. Woessner*, Yosbel Ibarra**, Alan Sutin**, Antonio Peña**, T.J. Gentle***]
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 United States. View the full guide.
Faegre Drinker; Greenberg Traurig, LLP; and Miller & Martin PLLC
In your jurisdiction, which sectors do venture capital funds typically invest in?
Venture capital funds invest in a wide array of sectors and industries throughout the United States. According to the National Venture Capital Association, the venture industry deployed more than USD 130 billion in U.S.-based companies during 2019. The primary sector in the U.S. venture capital landscape is software, which accounted for approximately 34% of the total capital invested by venture capital funds in 2019. Additional industries that receive significant investments from venture capital funds in the U.S. are life sciences and business products and services. During 2020, the COVID-19 pandemic has further shifted focus within the venture capital space to the pharma and biotech industry within the life sciences sector, particularly companies focused on the discovery, development and production of vaccines, antivirals, and antibacterials, as well as HealthTech, telehealth and other healthcare companies.
Do venture capital funds require any approvals before investing in your jurisdiction?
While there are no specific third-party approvals that are required for a venture capital fund to invest in the United States, many funds have an internal investment committee that will need to authorize the transaction on behalf of the fund. Additionally, both the fund and the company in which the fund is looking to invest are subject to U.S. federal and state securities laws. At the federal level, the U.S. Securities and Exchange Commission (SEC) is the primary regulatory body. In connection with a venture capital transaction, the company receiving the investment generally relies on certain registration exemptions under the rules and regulations of the SEC, including the Securities Act of 1933, to qualify the issuance of the securities to the venture capital fund. Accordingly, the venture capital fund may be required to provide certain representations to the company with respect to the fund’s ability to participate in the financing round, such as “accredited investor” and “bad actor” status. Each state also has separate “blue sky” registration requirements that may necessitate further representations by the venture capital fund in order to effectuate the investment. As a result, a venture capital fund should consult with its legal advisors prior to investing in the United States in order to understand the applicable federal and state requirements and restrictions that may apply to a particular transaction.
Are there any legal limitations to an offshore venture capital fund acquiring control or influencing the business, operations, or governance of an investee entity?
The Committee on Foreign Investment in the United States (“CFIUS”) is an interagency committee of the United States Government authorized to review certain direct or indirect foreign investments in the United States to determine if they may adversely affect U.S. national security. CFIUS may make recommendations to the U.S. President on whether to block a proposed transaction involving a foreign investor. CFIUS and the U.S. President also have authority to force the unwinding of any transaction that was subject to CFIUS jurisdiction but not reviewed. As illustrated by several recent CFIUS actions, the unwinding order can be made many years after the closing of the investment and there is no statute of limitations.
Under the Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”) and new regulations that took effect in February 2020, CFIUS now has expanded authority to review controlling and certain non-controlling foreign investments in U.S. businesses engaged in producing, designing, testing, manufacturing, fabricating, or developing “critical technologies.” In addition, a mandatory filing is now required for foreign investments in U.S. businesses that own, operate, manufacture, supply or service “critical infrastructure,” or maintain or collect sensitive personal data of U.S. citizens. Finally, certain foreign investments in real estate, including leases and concessions, located in or near areas such as military installations, ports, and airports, as defined in new CFIUS regulations, may also be subject to CFIUS jurisdiction and review. In all of these scenarios, even investments that are as small as a few percentage points can be sufficient to warrant or mandate a filing of a declaration or notice with CFIUS.
FIRRMA greatly expanded the investigation and enforcement powers of CFIUS, and CFIUS Office of Investigation staff are now actively investigating transactions that were never notified to CFIUS. Failure to file with CFIUS when a filing is mandatory can result in civil penalties up to the total value of the investment. Both the seller and investor are jointly liable for such penalties.
In addition to the CFIUS review process, there are several statutes that require information gathering and disclosure relating to foreign investment in domestic companies. The International Investment and Trade in Services Survey Act of 1976 authorizes the U.S. President to collect information on international investments and U.S. foreign trade.
The Foreign Direct Investment and International Financial Data Improvements Act of 1990 directs the Bureau of the Census and the Bureau of Economic Analysis of the Department of Commerce to exchange business data obtained under the census that is relevant to the International Investment and Trade in Services Survey Act. Many of these surveys and filings are now mandatory and companies and investors that fail to file can face civil and criminal penalties.
Would an investor be required to undertake an antitrust analysis prior to investment? When would such a requirement be triggered?
The Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the “HSR Act”) requires that certain acquisitions of equity or assets be reported to both the Department of Justice (the “DOJ”) and the Federal Trade Commission (the “FTC”) before consummation. The transaction cannot be consummated for a certain period of time following notification (typically 30 days (15 days in the case of a cash tender offer) but may be less if early termination of the waiting period is requested and granted). In instances where a proposed investment has the potential for adverse competitive effects under the antitrust laws, the DOJ or the FTC may further delay consummation while they conduct an investigation, negotiate procompetitive divestitures, or challenge the investment in federal court.
Notification to the DOJ and FTC is required under the HSR Act if: (i) either the acquiring person or the acquired person is engaged in commerce in the U.S. (the “Commerce Test”), (ii) if the parties to the transaction have total assets or net sales in excess of certain dollar thresholds (the “Size of the Parties Test”), and (iii) the acquiring person will hold voting securities or assets of the acquired person valued in excess of certain dollar thresholds (the “Size of Transaction Test”). The Size of the Parties Test and the Size of Transaction Test are subject to annual adjustment, typically in the first calendar quarter (for 2020, the Size of Parties Test is USD 18.8 million and USD 188 million, respectively, and the Size of Transaction Test is USD 94 million). In a transaction involving consideration in excess of USD 376 million (the adjusted figure for 2020), the reporting requirements of the HSR Act apply if the Commerce Test alone is met, and the Size of the Parties test is disregarded.
Each person required to provide notification under the HSR Act must submit separate notification forms and accompanying documents to both the FTC and the DOJ. Typically, notification is filed after the parties have agreed to the basic terms of the transaction and have memorialized their understanding in a letter of intent or definitive agreement. The acquiring person in the transaction is required to pay a filing fee. The filing fee ranges from USD 45,000 to USD 280,000, depending on the value of the transaction.
A civil penalty of over USD 43,000 may be imposed for each day that a person fails to substantially comply with the HSR Act.
In addition, even if an HSR filing is not required, the antitrust laws may limit the investor’s activities pre- and post-consummation to the extent the investor is an actual or potential competitor of the target company. In particular, the antitrust laws prohibit agreements between competing firms relating to competitively sensitive topics such as prices, costs, margins, business strategy, and wages. During the due diligence phase, a competitor-investor generally should not review the target company’s competitively sensitive information because having such information could facilitate collusion between competing firms. Similarly, unless the competitor-investor acquires legal control of the target company post-consummation, firewalls will need to be erected to prevent the competitor-investor from reviewing the target company’s competitively sensitive information. The competitor-investor still may be able to review high-level, aggregated information, and may be able to rely on clean teams and third parties to provide a high-level assessment regarding the potential investment or the target company’s performance.
Relatedly, the antitrust laws also prohibit so-called “interlocking directorates,” where individuals serve on the boards for competing firms. Specifically, under Section 8 of the Clayton Act, a person may not serve as a director or board-appointed officer on two or more legally separate corporations if (1) the combined capital, surplus, and undivided profits of each of the corporations exceeds an inflation-adjusted multiple of USD 10 million; (2) each corporation is engaged in whole or in part in U.S. commerce; and (3) the corporations are “by virtue of their business and location of operation, competitors, so that the elimination of competition by agreement between them would constitute a violation of any of the antitrust laws.”
What are the preferred structures for investment in venture capital deals? What are the primary drivers for each of these structures?
Venture capital funds are typically structured as limited partnerships in the U.S. In the limited partnership structure, investors contributing capital to the funds becoming limited partners. The general partner is often a corporation or other entity created specifically to manage the fund. The primary drivers for this structure include:
As long as the venture capital fund’s investors (limited partners) are not actively engaged in the management or operations of the fund, the liability of the limited partners is limited to the amount of capital contributed or agreed to be contributed; and
The losses and gains of the fund flow through to the partners, avoiding the double-taxation associated with corporations.
With respect to individual investments made by venture capital funds in portfolio companies, the venture capital funds typically receive equity securities in the form of preferred shares in exchange for their investment. Although early-stage funds may participate in “seed” stage investing which may involve simple agreements for future equity (SAFE) instruments or convertible promissory notes, most of the total dollar value of venture capital comes from institutional investors in companies that have already raised one or more rounds of seed capital.
The typical venture capital fund investment in a series stage company (e.g., Series A, Series B, etc.) will receive preferred equity for the venture capital fund’s investment. Holders of preferred shares typically have rights that are superior to holders of common stock. These rights are negotiated and vary accordingly, but will include:
A liquidation preference that is senior to the rights of the common stockholders to receive distributions of assets in the event of the company's liquidation. This is a multiple of the original investment amount and is returned to the investor before the common stockholders receive any distribution in a liquidation (before the COVID-19 coronavirus pandemic, the liquidation preference multiple for most early-stage deals was typically x1. It remains to be seen whether this will change in the future as funds seek more protections for the increased risks they may perceive in the current macroeconomic downturn). In addition to the liquidation preference, the investor may also participate in the distribution of the remaining proceeds on an as-converted-to-common-stock basis alongside the common stockholders (participating preferred stock). This participating feature can be capped at x1, x2, x3 and so on. Before the COVID-19 coronavirus pandemic, most VCs received non-participating preferred stock (where there is no participation after the liquidation preference is satisfied. Again, it remains to be seen whether this will change in the future in the current macroeconomic downturn).
Price-based anti-dilution protection (typically broad-based weighted average anti-dilution).
A seat on the company's board of directors, or the right to be present at meetings of the board of directors.
Veto rights over certain company actions, including over:
raising subsequent rounds of equity financing or debt;
amending the charter or bylaws of the company;
selling, merging or dissolving the company.
Is there any restriction on rights available to venture capital investors in public companies?
Venture capital investors are not restricted from investing in public companies per se but based on the typical venture capital fund’s investment objectives and targeted internal rate of return, venture capital funds tend to invest in companies that are in earlier stages (i.e., before a company’s initial public offering). If a venture capital fund or investor seeks to invest in a public company, the fund or investor will of course remain subject to the vast legal and regulatory framework governing public companies and their investors (e.g., Securities Exchange Act of 1934, Securities Act of 1933, etc.)
A recent trend has been for the U.S. government (more specifically, the Committee on Foreign Investment in the U.S. (CFIUS)) to look much more closely at foreign ownership of companies in sensitive industries or companies with critical technology or sensitive personal data. Such companies are often squarely within the investment focus of VC funds.
Depending on the level of non-U.S. ownership of a venture capital fund and whether non-U.S. parties manage a VC fund, transactions may require filings with the U.S. government, with the risk that the U.S. government will disapprove transactions or cause prior transactions to be unwound. In response, VC fund documents often give the fund manager/general partner a general authority to take steps to mitigate CFIUS risk. This is a developing area, with future regulatory (and political) developments likely to affect industry practices.
What protections are generally available to venture capital investors in your jurisdiction?
Venture capital investors are primarily protected through the contractual investment documentation. The principal legal documents for a venture transaction typically include:
The amended and restated certificate of incorporation of the company.
The stock purchase agreement.
The voting agreement.
The investors' rights agreement.
The right of first refusal and co-sale right agreement.
The stock purchase agreement typically includes representations and warranties by the company to the investor. However, an early-stage start-up is unlikely to have many assets, and the investors will be reluctant to pursue an action against their own portfolio company and cause its value to decrease. Instead, the representations and warranties serve to flush out diligence issues before signing, while venture capital funds can seek rescission rights and other remedies in the event of fraud.
Additional protections venture capital investors may receive include, among other things:
A liquidation preference over common shares, which helps to serve as downside protection.
A board seat or board observer rights to help oversee its investment and management.
Price-based anti-dilution protection.
Pro rata rights to help maintain its ownership percentage.
Veto rights on certain material company events and actions.
Rights of first refusal and co-sale to ensure the investor can obtain liquidity before or at the same time as the founders.
The lead investor in a venture capital financing often receives a seat on the board of directors of the investee company, and certain acts of the company may require the express consent of the venture capital fund's representative on the board of directors. In addition, the investors typically receive veto rights in the form of "protective provisions" in the amended and restated certificate of incorporation. The investors also receive information rights to help monitor their investment.
The company's founders are also typically subject to a right of first refusal and co-sale agreement, which gives the company and certain investors a right of first refusal on the founders' shares and those investors a right to co-sell their shares alongside the founders in the event the founders try to exit the company and the investors do not want to exercise their rights of first refusal. Also, the investors typically receive a preemptive right of first offer or right of first refusal on further issuances. Investors also often receive the right to veto future financings and have price-based anti-dilution rights.
Investors often have veto rights over sales of the company embodied in the protective provisions in the amended and restated certificate of incorporation. Typically, there is also a requirement for them to approve a sale for the drag-along provisions to be triggered. They can also typically exercise their co-sale rights to sell their shares in the event the founders try to sell their shares. Finally, the liquidation preferences of the investors must typically be satisfied first before any proceeds can go to the common stockholders.
Is warranty and indemnity insurance common in your jurisdiction? Are there any legal or practical challenges associated with obtaining such insurance?
Representation and warranty insurance (RWI) has become commonplace in acquisition transactions, especially in the context of auctions. Invariably, the form of purchase agreement proposed by a seller in an auction will provide that the buyer will look exclusively to RWI insurance for recourse following the closing. The effect has been to make many private company transactions functionally equivalent to public company acquisitions, subject to certain exclusions.
Private equity buyers and sellers were early adopters of RWI and have led the broad adoption of RWI. On the sell-side, RWI allows a private equity seller to distribute all of the transaction proceeds at closing without having to escrow funds for indemnity purposes. RWI avoids potentially costly indemnity disputes between sellers and buyers, so there is also no need for investment vehicles with limited lives, like private equity funds, to hold back transaction proceeds to fund future administrative and litigation expenses. Likewise, on the buy-side, RWI makes a buyer’s offer more attractive because it allows sellers to avoid indemnity escrows and to “walk away” from a transaction without continuing indemnification obligations.
Like any other insurance, RWI will only cover unanticipated and unknown losses. Accordingly, RWI does not replace due diligence or provide a full replacement for traditional concepts of indemnity. For example, RWI will not cover risks that are difficult to diligence, and RWI carriers may exclude coverage for certain risks. Common exclusions from RWI include the following: violations of anti-corruption laws (e.g., U.S. Foreign Corrupt Practices Act), certain environmental issues, certain pension liabilities, representations regarding the collectability of accounts receivable, and representations regarding forward-looking statements. If the acquisition includes subsidiaries outside of the United States, certain other matters may be excluded with respect to foreign operations, including certain tax matters and matters relating to privacy laws. Typically, policies covering non-U.S. matters also tend to be more expensive than policies that cover only U.S. operations. Carriers may also exclude or subject to higher scrutiny certain matters based on the target’s industry (e.g., products liability for manufacturers). In certain cases, such as environmental liability, RWI insurance can be combined with other commercially available insurance to provide coverage in excess of what could be obtained solely from an RWI carrier.
With several insurance providers offering RWI coverage, RWI is widely available in the U.S. market. Even on very large deals, an RWI broker may be able to “stack” coverage among several RWI carriers to provide broad coverage.
Given that private equity funds have adopted RWI for most transactions, any buyer in an auction scenario or other competitive acquisition process in the U.S. should assume that other bidders are likely to use RWI as a structure to make their bids more attractive to sellers.
What are common exit mechanisms adopted in venture capital transactions, and what, if any, are the risks or challenges associated with such exits?
In our experience, the most common exit mechanism for venture capital transactions is a sale, in most cases, to a strategic buyer (i.e., an enterprise in the same business as the target that is looking to vertically or horizontally integrate the target into its business). Although there are cases where the buyer may be another venture capital or private equity investor, strategic buyers are more likely where there is a sale of 100% of the business, and a private equity or other financial buyer is more likely in transactions where there is only a partial exit (i.e., an exit by a venture capital investor only, with management and other investors remaining in the business). As for risks, although sales processes are structured as confidential, there is always the risk that the marketplace will become aware of a potential transaction, which could create instability within an organization (e.g., employees becoming concerned), as well as with customers and competitors. Given that strategic buyers are likely to participate in any sales process, sellers should also take care to limit access to confidential information, such as customer lists, product information and strategy initiatives, to competitors participating in the sales process. Like any other exit transaction, a sales process also tends to require time and effort from the executive management team, which detracts from their time managing and operating the business.
A venture capital exit could also be structured through an initial public offering (IPO), although this is obviously a more complicated transaction (see discussion below). An IPO exit is typically only considered for larger businesses that can take advantage of being a public company (e.g., access to capital markets), while having the necessary infrastructure to support the regulatory and compliance requirements of a public company. The IPO process itself is also costly and time-consuming, requiring significant effort from the executive management team. Given the public nature of an IPO, sellers should consider their business model and the level of disclosure that will become publicly available, including to competitors. The issue of disclosure becomes especially important with respect to financial information and possible regulatory issues that would otherwise not have to be disclosed publicly. Finally, venture capital investors should make sure their investment documents allow for registration rights that permit them to cause an IPO exit or to exit through one or more secondary registrations post-IPO.
A less common form of exit is through a management buyout, where the business is sold to existing management. These transactions are less common because management would need to raise equity and/or leverage the target in order to raise sufficient funds to be competitive to alternate exit transactions. A management buyout is likely in cases where the target company, while operating successfully, may not be generating the type of valuations that would be attractive to buyers. Management buyouts are also more common in cases where the target company suffers from some risk factor, such as a regulatory hurdle or other adverse event, that makes it less likely that the company can be sold to a third party or, if it can be sold, that the valuation from a third party is likely to be less than the value proposed by management.
Do investors typically opt for a public market exit via an IPO? Are there any specific public market challenges that need to be addressed?
While acquisitions are the most common exit structures for venture capital, IPOs account for the largest driver of value in exits. According to the National Venture Capital Association, large IPOs in 2019 drove IPO exits to account for 78%, or USD 198.7 billion, of total value in 2019. However, as some recent IPO failures highlight, the path from private company to public company can be challenging for a number of reasons.
To prepare for an IPO, companies must have the proper corporate governance, systems and controls in place and, importantly, ensure that these are all functioning properly. A public company management infrastructure, including robust financial and legal departments, will also be necessary to comply with post-IPO reporting requirements and maintaining stock exchange listing standards. More than just structural in nature, these changes require that management at all levels change their mindset from being a private company to a listed company.
Additionally, a successful IPO will also require correct market timing and being able to tell an attractive story to investors – with the latter sometimes proving especially challenging. The story includes not only the company’s performance through the IPO, but also the path for continued growth and profitability.
The public nature of the IPO process also exposes companies to scrutiny, including from investors, the public, regulators or competitors, which can be especially challenging if the IPO process is ultimately unsuccessful.
**Greenberg Traurig, LLP
***Miller & Martin PLLC