Venture Capital Financing

Although the political headlines of many states seem to indicate taxes might be on the rise, it appears that Indiana's state government might not be following suit, at least not when it comes to investments made in certain early stage Indiana companies. Indiana State Representatives Jerry Torr (District 39), Kathy Heuer (District 83) and Rebecca Kubacki (District 22) introduced House Bill No. 1008, which proposes certain pro-investment changes to Indiana's Venture Capital Investment Tax Credit legislation. House Bill No. 1008 was approved by the Indiana House of Representatives on February 17, 2011 and was then referred to the Indiana Senate where it is being sponsored by Brandt Hershman (District 7), Luke Kenley (District 20), and Jim Arnold (District 8).

Read the entire article about House Bill No. 1008 authored by Ice Miller attorney Bo Ramsey.

A proposed rule has been introduced by the U.S. Securities and Exchange Commission to exempt advisers of venture capital funds and other funds with less than $150 million in private fund assets under management from the registration requirements of the Investment Advisers Act of 1940 that were enacted in connection with the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Without this exemption in place, as of July 21, 2011, all advisers of private fund assets regardless of size would be required to be registered under and comply with the Investor Advisers Act of 1940.

Read the entire alert on the proposed exemption rule.

During the financial crisis, private equity, mezzanine and venture capital firms have spent a lot of time "cleaning house."  The financial crisis has made cheap debt less available and thus private equity and other firms are not able to complete deals with the huge leverage ratios that existed prior to the crisis.  So, they have taken a close, hard look at existing investments in order to determine which could be saved and have allocated resources appropriately.  

This sort of review has included, from a legal perspective, review of debt covenants and commercial contracts.  The firms have wanted to determine which of their portfolio companies are in danger of violating a financial covenant or failing to perform under a critical contract. 

Recent reviews have also included analyses of potential exit strategies in a down economy.  The potential strategies include the traditional options of bankruptcy, sale and IPO.  IPO's have been down sharply until very recently, so this option has not been given much consideration.  Sales have continued, but with valuations low, this is often not a favored option.  Bankruptcy is, as always, fraught with difficulties as firms consider the opposition of creditors as well as the value of their secured positions, if any.

Throughout the financial crisis, distressed investing has continued.  With the credit markets tight, private equity and other firms have taken some opportunities to fund companies that have not been able to get credit in the traditional credit markets.  These efforts persist, and the firms continue to focus sharply on the fundamentals of these companies in order to protect their investments. 

The two key documents for a new LLC are:

• Articles of organization
• Operating agreement

The articles of organization are filed with the secretary of state.  They contain some very basic information about your LLC, including its name and whether it is managed by a manager or managers.  If the articles do not say that the LLC is managed by a manager or managers, then it is automatically deemed to be managed by the members.  Articles of organization are required to include much less information than is required to be included in the articles of incorporation for a corporation. 

LLCs are also required to have an operating agreement.  The operating agreement does not have to be written.  It can be oral, but a written agreement is better for a number of reasons, including just as evidence of what the agreement of the members actually is.  Because there are fewer statutory formalities around the operation of LLCs than there are with respect to corporations, the operating agreement is a good place to memorialize the members' agreement with respect to the operation and management of the company. 

Matters that are addressed in a written operating agreement include the following: 

• the process for calling and holding members' meetings;
• the powers of the manager or managers and process for holding meetings;
• duties of officers and the process for appointment and removal of officers by the board;
• limitations on members' ability to transfer their ownership interests;
• repurchase rights  on a member's death, permanent disability, termination for cause or resignation from employment with the company;
• preemptive, co-sale, tag-along and other rights (these concepts are discussed in the context of corporations in the previous blog post "I'm Raising Raising Venture Capital for My Company and I Can't Understand Half the Jargon They are Using. Can You Help?");
• governance (for example, the agreement may require that significant management decisions require the consent of some or all of the members or the managers);
• allocation and distribution of the company's income; and
• miscellaneous (restrictions on competition, treatment of confidential information and dissolution of the company).

The three key documents for a new corporation are:

• Articles of incorporation
• Bylaws
• Shareholders' agreement (optional)

The articles of incorporation are filed with the secretary of state of the state in which you are forming your corporation. They contain some basic information about your corporation, such as its formal name, its registered agent for service of process, the number of authorized shares and the rights and preferences of any preferred shares.

Most states require a corporation to have bylaws. The bylaws generally set forth the following information: 

• the process for holding shareholders' meetings;
• the powers of the board of directors and process for holding board meetings;
• duties of officers and the process for appointment and removal of officers by the board.

A shareholders' agreement is not required by law but is often a good idea. It is an agreement between the shareholders of the company that governs the rights of the shareholders. A shareholders' agreement typically limits if and how a shareholder of the company may transfer his or her shares of stock. It may also contain the following provisions:

• Repurchase rights. Repurchase rights typically require the owners or the company to purchase a shareholder's shares in certain circumstances, such as death or permanent disability. A shareholders' agreement also will often require a shareholder to sell his or her shares of stock to the company or the other owners if the shareholder is fired for cause, voluntarily resigns or the breaches the shareholders' agreement.

• Preemptive, co-sale, tag-along and other rights. A shareholders' agreement may also provide for preemptive rights, rights of first refusal, tag-along rights/co-sale rights and/or drag-along rights. These concepts are discussed in the below blog post "I'm raising venture capital for my company and I can't understand half the jaron they are using. Can you help?"

• Corporate governance. A shareholders' agreement generally governs the manner in which the day-to-day operations of the company will be managed. For example, the agreement may require that significant management decisions require the consent of some or all of the shareholders or the board of directors. A shareholders' agreement may also establish the means by which the directors are to be elected.   

• Miscellaneous. Other matters that may be addressed in a shareholders' agreement include restrictions on competition, treatment of confidential information and dissolution of the company.

Many terms of art are used in venture capital transactions that can be difficult to understand. Most of them relate to key issues that may be points of negotiation in your venture capital transaction. Below are a few of the common terms of art used in venture capital transactions and their common meanings:

• Conversion: Conversion refers to the conversion of shares of preferred stock into shares of common stock. Conversion provisions can be optional or mandatory. An optional conversion is when a shareholder has the option to convert its shares of preferred stock to shares of common stock at any time or when certain events happen. A mandatory conversion requires that all shares of preferred stock be converted into shares of common stock upon the occurrence of a certain event, such as consent of the majority of the holders of the preferred stock or a public offering. In a venture capital transaction, the typical negotiation points regarding conversion provisions, in addition to those mentioned under "Anti-dilution", are the events that trigger mandatory conversion, such as a public offering, and the dollar threshold that the event must reach before the conversion is mandatory.
• Anti-dilution: Anti-dilution provisions allow a preferred shareholder to keep the same or a similar ownership percentage in the company when the company sells more stock. This may be accomplished by giving the shareholder preemptive rights (see the definition below). Other terms that you may hear in conjunction with anti-dilution are weighted average and full ratchet. These are two methods for adjusting downward the conversion price per share of stock issued to the preferred shareholder when additional shares of stock are issued to new investors at a price lower than the price the preferred shareholder paid. In other words, if a preferred shareholder purchased its shares for $1.00 per share, and is able to convert its preferred shares into common shares at a deemed $1.00 per common share, the anti-dilution provisions may operate to make that conversion price lower, allowing the preferred shareholder to convert its preferred shares into a larger number of common shares. In a venture capital transaction, a typical negotiation point regarding anti-dilution provisions is whether a weighted average or full ratchet formula is used. A weighted average formula is currently the most common, but there are a number of ways a weighted average formula can be calculated.
• Preemptive rights: Preemptive rights are the rights of a shareholder to purchase its pro rata portion of any new shares of stock issued by the company at the same price and on the same terms as the new shares are being offered to new investors. A preemptive right, if exercised by the shareholder, allows the shareholder to retain its ownership percentage in the company. In a venture capital transaction, the typical negotiation points regarding preemptive rights are (i) who will receive the preemptive rights, such as the venture capital investors, major shareholders or all shareholders and (ii) what issuances are exempt from the preemptive rights.
• Right of first refusal: A right of first refusal gives each shareholder or certain specified shareholders the right to purchase its pro rata portion of shares offered by another shareholder to a third party, on the same terms. The company may have the first right of refusal and the shareholders may have a secondary right of refusal if the company elects not to purchase the shares. In a venture capital transaction, the typical negotiation points regarding rights of first refusal are (i) who is subject to the right of first refusal (i.e., who must offer their shares to the company and/or other shareholders prior to selling to a third party), (ii) who will receive the benefit of the right of first refusal, such as the venture capital investors, major shareholders or all shareholders and (iii) what transfers are exempt from the right of first refusal.
• Tag-along rights/Co-sale rights: Generally, a tag-along right is a protective provision for a minority shareholder. It allows a minority shareholder to sell its pro rata portion of shares of stock along with a selling significant shareholder. This right is often combined with the right of first refusal to allow a shareholder who does not exercise its right of first refusal to sell its pro rata portion with the selling shareholder, on the same terms and conditions. In a venture capital transaction, the typical negotiation points regarding tag-along rights are the same as those for rights of first refusal.
• Drag-along rights: Drag-along rights allows a defined group of shareholders (usually a single shareholder or group of shareholders who own a majority of the company) to require the remaining shareholders to sell their shares of stock in, and/or consent to, a transaction approved by the defined group, such as a sale of the assets of the company or a sale of all of the shares of stock of the company. In a venture capital transaction, the typical negotiation points regarding drag-along rights are (i) who are the shareholders that can initiate the transaction, and (ii) the percentage threshold of such shareholders that must approve (i.e. a majority, two-thirds, etc.).
• Redemption: Redemption happens when the company buys shares back from the investor. Redemption can be mandatory or optional on the part of the company or the shareholders. Generally, the redemption cannot occur before a certain date, such as five years after the first sale of the series of preferred stock, and must be approved by a certain percentage of the shareholders (i.e. a majority, two-thirds, etc.). This is designed the protect the venture capital investors' return on the transaction but also provides the company with some comfort that, absent special circumstances, it will not be required to come up with the cash to redeem prior to the agreed-upon date. There may be more specific negotiated redemption provisions that relate to the occurrence or non-occurrence of certain events by agreed upon dates. For example, if the venture capital is being used primarily to finance a construction project, there may be deadlines that have to be met in order to avoid mandatory redemption. In addition, the company may negotiate provisions that allow the company to redeem at its option after certain time periods have passed or certain events have occurred. In a venture capital transaction, the typical negotiation points regarding redemption provisions are (i) whether and under what circumstances redemption is required or allowed , (ii) the price for which each share is redeemable (e.g., the original purchase price plus accrued dividends or the greater of the original purchase price plus accrued dividends and the fair market value), (iii) the first date on which a redemption may be requested and (iv) the percentage of shareholders that is required to effect a redemption.
• PIK preferred: "PIK" stands for "paid-in-kind". This means that the dividends on PIK preferred are paid in the form of additional shares of preferred stock. In other words, rather than accruing dividends that must be paid in cash now or in the future, the preferred shareholder is deemed to own additional shares. The calculation of the number of PIK preferred shares issued in connection with any particular dividend is a point of negotiation between the parties.

As we all know, we are in a recession.  In these difficult economic times, everyone is wondering where we can find money to help start or grow our businesses.  It seems that everyone is holding their money close to the vest.  In reality, however, there are many different places where a company can obtain equity or debt financing to help its business.  The key is understanding what type of money is available.

Traditionally, the first place to find money when starting a new business is from family and friends.  Obviously, investments from family and friends are made in large part upon the relationship you have with those individuals, but you need to be careful to comply with federal and state securities laws.  This usually means that you want to make sure you investors are accredited investors and that you conduct your private offering in compliance with an exemption under Regulation D  of the federal securities laws.  There are limits on the number of investors and the amount of financing a company can receive in order to fall within one of the many exemptions.  Family and friends are still providing capital during the recession, however the amounts that can be raised from family and friends have diminished as individual investment and savings accounts took a beating from the drop in the equity markets over the last year.

If you do not have close friends or families with the available cash to invest in your business, "Angel investors" can be and are a still a great source of capital.  Angel investors are high net worth individuals that can provide large tranches of capital through equity or convertible debt investments.  Typically, angel capital is the second round of capital that start-up companies and businesses receive and can provide capital in the range of $500,000 to $2,000,000 depending on the needs of the company and the willingness of the "angels" to invest.  Although angel investors are more selective in these economic times, angels are still investing and are looking for the right opportunities and the right companies.  Once again, when raising money from angels, you need to comply with federal and state securities laws and structure your offering to comply with on the private offering exemptions.

Venture funding is another source of capital that can be very advantageous for start-up companies.  Venture funding comes at a price.  Generally, venture capital firms will require a seat on the board, veto rights on major decisions such as additional financing and sale of the company, and a high return on their invested capital.  There are numerous venture capitalists looking to deploy money right now.  They are more selective in these economic times, but the venture capital firms typically do have the money to invest.  Venture funding is one of the key types of financing that provides the necessary capital infusion to allow a company to take the next step.

Private equity capital is generally available for more mature companies that are looking to expand and grow.  Private equity investments can take a variety of forms and generally involve a buy-out or a purchase of a majority equity interest in a company.  As with venture funding, there are numerous private equity funds with millions of dollars to deploy right now.

Traditional debt financing from institutional banks is available to companies as well.  The credit markets have suffered through the banking crisis and the recession, but the current administration's policies have encouraged banks to loosen the reigns to start lending money again.  It remains to be seen whether that will work.  A bank will generally require security interest the company's assets including inventory, real estate and/or accounts receivables, pledge of stock or a personal guaranty.  Bank financing will also require meeting certain financial covenants.

A venture capital firm usually wants to receive "participating preferred" stock.  The term describes rights that can become important in liquidation and, sometimes, dividends.

If the company liquidates, participating preferred stockholders will have an advantage over common stockholders.  First, the preferred status means that the company must pay a specified amount to the holders of the preferred stock before any holders of common stock receive any money.  That preferred amount (called a liquidation preference) may be measured in relation to the preferred stockholders' initial investment plus accrued and unpaid dividends but may be more than that.  When the preferred stock is participating preferred, the holders of the preferred stock will share the remaining pot of cash along with the common stockholders, in addition to the liquidation preference already received.  This means that less money will be available for the holders of common stock.

Participating preferred stock also sometimes (but less often) participates in dividends.  This participation is in addition to the normal preference for dividends that generally accrue on preferred stock.  If and when the company's board of directors decides that the company will distribute dividends to its stockholders, holders of participating preferred stock have priority over holders of common stock with respect to accrued and unpaid dividends.  Plus, they may also "participate" with the common stockholders in the same manner as they participate with the common stockholders with respect to liquidation.

Venture capital firms generally demand a number of rights to protect their investments.

Venture capitalists usually receive shares of preferred stock when they invest in a company, while the founders and other initial investors hold common stock.  Of course, if you raise successive rounds from venture capital firms, you will likely end up with several different series of preferred stock with different rights and preferences.  Preferred stock has certain advantages over common stock, particularly dividend and liquidation preferences.  This means that if the company decides to distribute dividends to its stockholders, or sell its assets and distribute the proceeds to its stockholders, the holders of preferred stock will have priority over the common stockholders.  They will be entitled to receive some portion (or even all) of the dividend or sale proceeds before any of the common stockholders receive any money at all.

Preferred stock will probably have better voting rights as compared to common stock.  For example, the company will have to get approval from the holders of a certain percentage of the preferred shares to take major corporate actions, such as approval of the annual budget, amendment of articles or bylaws, liquidation of the company, creation of a new class of securities with rights equal to or better than the preferred stock, sale of the company or acquisition of another company.  This structure lets the venture capital firm have a say in decisions that will have a large impact on the company.

The venture capital firm will also likely demand representation on the company's board of directors.  The number of members will vary depending on the current structure of the company and the amount of capital invested by the venture capitalists, but at least one, and often more than one, spot on the board will probably be reserved for members elected or appointed by the venture capital firm.

Also, venture capital investors will want information and reports about the company so it can track its investment.  For example, the company will likely have to deliver its quarterly and annual unaudited financial statements.  Many venture capital firms will demand audited financial statements, which can be a significant expense for the company.  Plus, venture capital investors will expect some other rights, such as the right to force the company to register its common shares with the Securities and Exchange Commission under some circumstances or to participate in any registration initiated by the company (registration rights), the option to purchase shares of stock of the company that other stockholders want to sell (right of first refusal), the right to purchase any new shares issued by the company (preemptive rights) and an adjustment of the conversion to common stock price in the event the company sells stock at a lower valuation (anti-dilution protection).

Looking at all of the ownership and control pieces likely to be obtained by a venture firm, it will probably end up exercising a lot of control over the company.  Such is the price of venture capital.  However a venture capital firm will probably allow the day-to-day operations of the company to continue to be handled by the business people.

The following blog was posted by Kristine Danz, a partner at Ice Miller LLP.

We can now officially relegate 2008 to the records books.  Wall Street took a beating unlike anything we've seen since the 1930s, we witnessed a historical presidential election and a bailout of an unfathomable magnitude.  Main Street felt the pinch as well with unemployment on the rise.  So what awaits us in 2009?

By all accounts, we're looking at a rough first quarter.  According to a survey by the National Venture Capital Association (NCVA), U.S. venture capitalists are forecasting a difficult 2009 for, "the country's economy, the capital markets, and the venture industry as the global financial crisis takes its toll on the entrepreneurial system." Other highlights, or rather lowlights include:

• Continued slowdown in the number of IPOs;
• Limited investments in seed and early stage investments;
• Difficulty in securing funding for newer companies;
• Declining returns for VCs.

And now for the good news.  Investments in clean technology, life sciences and biotechnology are expected to grow and debt markets will likely improve.

Like they say in the news business, we don't make the news, we just report it.

IN Partners, LLC announced today the initial closing of MidPoint Food&Ag Fund, L.P. and MidPoint Food & Ag Co-Investment Fund, L.P. for a total of $27.8 million in the aggregate.

IN Partners is an Indianapolis-based venture capital firm specializing in the agribusiness sector.  MidPoint is IN Partners’ inaugural fund.  MidPoint’s investment focus is in six specific areas of food and agriculture: (1) biobased products and processes; (2) human wellness; (3) food safety; (4) animal health; (5) environmental technologies; and (6) production technologies.

Read the IN Partners press release.

As Associated Press business writer Michael Liedtke observed in his October 20, 2008 article Feeling Financial Squeeze, VCs Curtail Investments, “Although a drought hasn't set in yet, it's looking inevitable as the ripple effects of a worldwide financial crisis rattle venture capitalists.”

According to data released by Thomson Reuters, PricewaterhouseCoopers and the National Venture Capital Association, venture capital investments have recently experienced the largest decline since spring of 2003 following the dot com bust.

Many venture capital firms are advising the management teams of their portfolio investments to revise their short-term business plans to reduce costs by laying off staff and trimming budgetary spending in expectation of a worsening recession.

Although venture capital investments have experienced the largest drop off in the last decade, there is a silver lining in the form of a rising interest in biotechnology and alternative energy.  As stated by Terry Kosdrosky in Private Equity Has Toolkit to Ease Troubled Market, “Political leaders and the public are hungry for renewable sources of energy that will lessen the country's dependence on foreign oil and cut down on pollution.”

Venture capital and private equity funds have followed the emerging trend of new companies seeking to stake a founding interest in these industries.  For example, Liedtke cites statistics supporting a 21 percent increase in venture capital investments in biotech startups from last year, while alternative energy, was close behind with a 17 percent increase.

In addition to venture capital opportunities in the U.S. biotechnology and alternative energy industries, Kosdrosky also points to growing opportunities overseas, stating “With growth stunted in the U.S., many private equity firms are looking to put their money to work in growing markets such as China and India.”

The current financial climate has forced venture capitalists to focus their resources on existing investments rather than taking on new challenges.  What does all this mean?  Despite the downturn in the global economy, opportunities for lucrative venture capital investment still exist, albeit in new forms and perhaps in sectors not previously considered.  As blogger Seth Levine wrote in his October 22, 2008 post of VC Adventure, “Be flexible. Seek outside input. Be introspective. Stop and consider what you're learning and if it effects key assumptions behind your business idea. Tweak what you're doing.  Repeat.”

Dr. Homer L. Pearce's remarks during Ice Miller's recent life science distinguished speaker's series highlight the importance of sufficient research funding for success in the war on cancer.  Research and development costs associated with identifying pharmaceutical solutions are particularly daunting and, given the time to market and current patent protection periods, sometimes commercially unjustifiable.

As a result of the targeted efforts of many, including the Indiana Economic Development Corporation and BioCrossroads, among others, Indiana's unique contribution to the national life science sector is becoming increasingly recognized - not only in terms of its many research institutions, major pharma companies and contract service providers, but also with respect to availability of funding.  In 2006, according to PricewaterhouseCoopers, Indiana ranked 21^st in the nation for venture capital investments in the life science sector.

According to the S&P-2006, Purdue and Indiana University currently have $200 million in academic life science funding commitments and graduate 10,000 science and engineering students each year.  Both institutions are developing innovative diagnostic equipment and pharmaceutical protocols that, with appropriate funding, can bring life saving treatments to market.  The financial needs of Indiana's innovators have not gone unnoticed by public and private financial sources that are positioned to fund such developments. 

In 2008, we should expect to see further growth in Indiana's life science community as our state's leading research scientists build on the efforts of past scientific contributors to develop cutting-edge technologies and as funding sources become increasingly available both locally and nationally.