One of the bigger surprises in the history of the Committee on Foreign Investment in the United States (CFIUS) began to unfold in May 2023, when CFIUS posted a new Q&A on the FAQ section of the CFIUS website. The FAQ effectively announced a seemingly technical change to its understanding of the definition of “completion date,” triggering an avalanche of law firm advisories, some questioning the intent and/or wisdom of the new definition.

Two months later, it is clear CFIUS intends to enforce the change seemingly sought through the issuance of that FAQ—we’re aware of many private CFIUS communications warning of such enforcement. That, in turn, may create significant obstacles for precisely the entities CFIUS is apparently trying to protect—start-ups in “critical technology” sectors trying to raise enough capital to become successful commercial enterprises.

Why is this surprising? Both CFIUS and the investing community had previously seemed to agree on a prior interpretation of its rules. The prior interpretation enabled “two-step” investments into critical technology companies. Such investments usually involved a first-stage investment in which the foreign investor would obtain a small amount of equity and no rights of access to or control over the business. After CFIUS was given the chance to approve or condition the deal, the investor would take more equity and perhaps some more active rights, such as a board observer.

This model permitted venture-backed companies to draw on the full range of investors when seeking rapid capitalization—i.e., foreign and domestic—while still letting CFIUS weigh in prior to any foreign investor obtaining substantive rights. Rapid capitalization is critical for start-ups because fundraising requires the sale of equity, and companies often are hesitant to sell equity until it becomes necessary to continue operations. The venture investing community and CFIUS discussed these concerns when the CFIUS rules were written, and CFIUS indicated that it had no intention of breaking the venture model. Indeed, the published version of the rules appears to endorse this two-step investment structure in the preamble, as part of the discussion of comments considered by CFIUS.

In what practical way does the FAQ alter the “completion date”? The FAQ seeks to re-define the “completion date” of a transaction as the date on which any equity transfers to a foreign investor. This is in contrast to the definition understood by practitioners prior to the issuance of the FAQ. The previous consensus understanding, grounded on the language of the rule and accompanying preamble, was that the key date was the date on which certain rights transferred (e.g., a board seat or access to certain technical information). The FAQ changes the key date from the rights transfer date to the date on which any equity is acquired by a non-U.S. investor.

Why does this undermine fundraising efforts of critical technology companies? Most mandatory CFIUS filings are mandatory because the U.S. company receiving an investment is involved with “critical technology.” In such a mandatory filing case, the filing must be made at least 30 days prior to the transaction completion date. As noted above, on the prior understanding of completion date, keyed to the transfer of key rights, deferring those rights until after CFIUS clearance had been a common method to ensure that a U.S. start-up could obtain capital quickly while still complying with the mandatory filing timing rules, i.e., filing 30 days prior to deal completion. The mandatory CFIUS filing could be made after the injection of capital, with the investor’s rights deferred for however long the CFIUS process might last (often many months). This is no longer an option, according to the CFIUS FAQ.

Now, when a U.S. critical technology company seeks to raise capital by packaging together investments from many investors (which is common), many foreign investors will have to sit on the sidelines because the deal cannot be closed quickly with an obligatory CFIUS process standing in the way. That increases the cost of capital for many cash-starved businesses.

Isn’t the idea of the rules that it’s totally appropriate to be more worried about “critical technology”? Certainly, that’s one of the areas where Congress clearly is suggesting that CFIUS should pay more attention. But for independent commercial reasons, it’s a difficult time to be a critical technology company. Many such companies build the kinds of capital-intensive hardware devices—semiconductors, batteries, aircraft, etc.—that have the most difficult time fundraising. Venture investors see more obvious ROI in funding companies with less overhead because all their work is in the cloud—enterprise software, artificial intelligence, blockchain products, etc. Because most “critical technologies”—more particularly, those not eligible for CFIUS’s filing exceptions—deal in atoms rather than bits, they need to cast a wide net in finding funding. Slowing down their ability to fundraise makes it that much less likely that such companies will succeed, especially in the current difficult venture investing environment.

Well, isn’t that the price to be paid for protecting against potentially worrisome investors? Here’s the kicker: the vast majority of investments structured with deferred rights are from friendly countries, commonly European investors. In the current geopolitical environment, investors from China or Russia generally do not use this deferred rights strategy because they understand that they might not get the rights for which they bargained. If a Chinese investor pays $10 million for a board seat and 10 percent stake in a U.S. business but defers the board seat until CFIUS clears the investment, there is a significant chance that CFIUS will not permit the Chinese investor to receive that board seat. So deferring rights in this manner is largely a strategy for investors from allied countries, as those investors generally have been confident of ultimately obtaining CFIUS clearance.

Now, however, the new definition of “completion date” in the FAQ almost surely will cause many investors from allied countries to have to take a pass on investments that would trigger a mandatory CFIUS filing, because the investor will be unable to invest in a manner that ensures compliance with the CFIUS timing rules.

So, what does this mean for a company building, say, a new battery system that’s getting started today? First, it means that the start-up will be more likely to strive to avoid becoming a critical technology company. For example, one way that companies become critical technology companies is by doing business with the U.S. military as a maker of ITAR-controlled (military) specific products. Today’s new start-up battery company, however, will have to think twice about working with the U.S. military, as it may close off their practical ability to access a significant chunk of the capital markets in a timely manner.

Second, it means that if our hypothetical hot new battery company has a portable founder—someone with relationships in several countries where he or she can draw on engineering talent —that founder simply won’t start the company in the United States. We’ve already had that conversation with multiple companies who’ve made the decision that they won’t enter the U.S. market or draw on U.S. talent until they feel their business is large enough to tolerate the delays inherent in being regulated by CFIUS. Each time that happens, the U.S. loses another critical technology company.

So, if I have a critical technology company that has a critical need for capital today, and foreign investors are the only interested parties, do I have options? Importantly, the new CFIUS approach to "completion date" set forth in the FAQ considers that date to be "the earliest date upon which the foreign person acquired any of the equity interest." This interpretation rules out a two-step closing with a small, passive equity investment, but leaves open the possibility of a two-step closing in which the first stage is a convertible debt instrument, or of a debt-based bridge loan followed by an initial equity investment. Neither of those structures involves the conveyance of "any of the equity interest" at the first step. However, that approach is not without risk. In the FAQ, CFIUS specifically flags its authority to determine that a "contingent equity interest," like a convertible note, is appropriately considered an equity interest under certain circumstances. Any structure that grants too much power to the investor to convert the first-step debt instrument into equity, therefore, may be determined by CFIUS to violate its new approach to two-step investments.

Anything else that is surprising about this FAQ? The fact that CFIUS has sought to change, via a website FAQ, a key definition set by regulation—a definition that CFIUS practitioners have relied upon for years to structure deals with deferred rights—counts as another surprise. Courts that have found FAQs and similar informal guidance insufficient to override regulations (in part because of due process concerns) might also be surprised. However, maybe surprise there is unwarranted—see our “Betwixt and Between” piece explaining that CFIUS is not a typical rule-bound regulator.

Does this really count as “one of the bigger surprises in CFIUS history?” OK, it’s not a surprise on the level of The Sixth Sense. But it does suggest the current edition of CFIUS may love surprise twists, and may have more in store going forward…