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Developments in the venture capital industry

Trends in venture capital and private equity investments in Dutch companies during 2001 were similar to those in the US and the UK. Although some companies reported major transactions and impressive valuations, many internet-related or other technology companies suffered from lower valuations. Marco de Lignie and Herman Kaemingk of Loyens & Loeff provide an overview of frequently encountered transactional items in venture capital investment documentation and of recent Dutch tax developments relevant to the venture capital industry.

Venture capitalists were busier keeping their companies alive than aggressively hunting for new investment opportunities. Exits through initial public offerings were virtually non-existent, and trade sales suffered from major downward corrections of listed companies' stock prices and the banks' increasing caution to provide acquisition financing facilities to purchasers of technology ventures. Third or even fourth financing rounds were closed at valuations low enough to trigger anti-dilution protection clauses negotiated by venture capitalists (VCs) in previous financing rounds, thereby contributing to the complexities of keeping these ventures alive in markets that were going down.

In the life sciences sector, developments were generally more positive as early-stage investors turned to funding new biotechnology and medical initiatives. Valuations in this sector were generally conservative, presumably as a side effect of the huge downturns in early-stage internet and technology ventures. However, as recently closed funds were eager to invest, later stage deals and buy-out transactions in a variety of sectors and industries received generous funding. As a result, according to figures published by the Dutch National Venture Capital Association (NVP), the total amounts of venture capital and private equity invested in the first six months of 2001 were even higher than the amounts invested in the first six months of 2000.

Venture capital investment documentation: transactional items

The terms and conditions typically negotiated for venture capital and private equity investments in The Netherlands are not fundamentally different from those commonly used in the US and the UK. This should be no surprise, as both venture capitalists and entrepreneurs are well aware of the roots and background of modern venture capital investing. Moreover, as stories of successful venture capitalists and their deals have found their ways to Dutch readers as easily as Red Herring magazine has done, there is much popular interest in the phenomena of venture capital and private equity investing. As a result, foreign investors will not have much trouble explaining why they need a double liquidation preference and narrow-based weighted average anti-dilution protection for their investments.

However, as a continental European jurisdiction with legal concepts developed under French and (later) German influence, techniques to achieve terms similar to those used overseas are sometimes slightly different. In practice, this appears not to be a serious problem, as many of the professional advisers involved in structuring, drafting and implementing the deal are experienced in dealing with American, British or other foreign clients.

Transaction documentation used in The Netherlands tends to be less comprehensive than those used in the US and the UK. This may best be explained by a combination of pragmatism and the role of general concepts of reasonableness and fairness which govern all transactions under the laws of The Netherlands and cannot be contracted out. As a result, there is no real need to agree on contractual provisions governing all kinds of unlikely situations. Also, there is a general reluctance to agree on terms that cannot easily be defended before a judge to be reasonable in the particular circumstances of this specific case, as irrespective of the text of the contracts, courts may declare unenforceable any clauses that do not meet standards of reasonableness and fairness.

That being said, we must note that litigation focussing on the enforceability of fully-fledged venture capital investment contracts is virtually non-existent, in almost all cases disputes are settled on commercial terms rather than through litigation. In assessing the pros and cons of a particular contractual provision, lawyers active in this field predominantly rely on trends in jurisprudence relating to mergers and acquisitions transactions and contracts in general.

Some caveats to take into account are the following:

• Letters of intent

Letters of intent containing clearly formulated commitments to do a particular deal may be considered to be binding agreements. An investor walking away from a deal at a late stage may risk being liable for costs incurred by the other parties and may, in extreme cases that have shaped case law in this field, even be obliged to pay to the other party the benefits that the transaction would have yielded for them.

• Milestone financing

Often used in early-stage venture financing, milestone financing allows the investor to postpone payment of parts of the amount committed until certain agreed milestones have been achieved. Clearly, this greatly boosts IRRs and reduces financial risks for the investor as the funding commitment ends as soon as a milestone is not achieved. The benefits of this type of financing also lie in the valuation: by committing a large amount of money for a reasonable stake in the company, although subject to achievement of milestones, the investor may win the deal based on the perceived high valuation of the venture. To be protected against the non-achievement of milestones, it is critical that the investor receives all shares at once, allowing future payments to be made as share premium contributions. Should milestones not be achieved, then the cost price of the shares will turn out to have been modest, resulting in a retroactive correction of the entry valuation.

• Board representation

Dutch companies have a two-tier system of management, comprising an executive board and a supervisory board. Venture capitalists typically take seats in the supervisory board. Governance clauses in investment agreements often provide for supervisory board approval being required for all kinds of management decisions, eg relating to unbudgeted investments, litigation and sale of assets. Through this system, checks and balances are implemented to secure the VC's involvement in major management decisions. This mostly works well, but may cause headaches if the company runs into financial trouble. In particular, in insolvency situations it appears to be difficult for venture capitalists holding board seats to separate the best interests of the company from the best interests of the VC. This is potentially dangerous, as Dutch company law requires that members of the supervisory board act in the best interests of the company on whose board they sit. As a result, board members in practice have fiduciary obligations towards the company, rather than towards a particular shareholder.

• Redemption

Often found in US term sheets, redemption of shares is more easily said than done as, under the influence of EU regulations, relatively many procedural requirements apply to the redemption of shares. These requirements, created for the protection of creditors' rights in case of a share buy-back by the company, often make it more attractive to replace the shares to be redeemed by large amounts of share premium that can be repaid relatively easily to the shareholder. In practice, this may involve some field work to explain the particulars to the civil law notaries; they are involved in all venture capital transactions as they have a monopoly on the incorporation of companies and the drafting of articles of association, and Dutch company law requires a deed executed by a civil law notary for the transfer or issue of shares in privately held companies.

• Anti-dilution protection

A wide variety of anti-dilution protection clauses are seen in transactions in The Netherlands. These days, as venture capital is not very much a sellers' market, it is not always considered too harsh if an investor demands full ratchet anti-dilution protection for his investment. Obviously, overall reasonableness of the contract depends on all the elements of the deal, often allowing the investor to demand substantial protective provisions if the investor has reason to argue that the pre-money valuation of the company is high. Full ratchet anti-dilution protection is one of them, although variations of weighted average protection are not uncommon either. If the investor has the power to veto any further issues of shares, he may even refrain from demanding anti-dilution protection clauses, and instead demand compensation in shares as a condition for voting in favour of a particular issue of shares. Dutch law does not allow for shares to be issued at no cost to the subscriber. The minimum amount that always has to be paid is the nominal value (or par value) of the share. This is usually a low amount (such as euro 1.00 ($0.89) or euro 0.10) but it has to be paid, even if the relevant shares are issued in the context of the application of anti-dilution protection clauses. If the investor has previously invested amounts of preferred financing into the same company, it may be possible to pay these minimum amounts through the conversion of previously paid share premium, but that is as close as we can get to ‘shares at no cost'.

TAX DEVELOPMENTS DURING 2001

Participation exemption for venture capital funds

The Dutch Supreme Court has ruled in a number of recent cases on the scope of the participation exemption. These court rulings have proved to be of great importance to Dutch venture capital funds. In summary, these cases address the question whether activities of a venture capital fund should be considered passive asset management, or investments in the course of a business enterprise. This is especially important for the application of the participation exemption (exemption for dividends and capital gains) on shares owned in: (i) foreign portfolio companies; and (ii) either domestic or foreign portfolio companies with an equity interest of less than 5 per cent. The conclusion is that the scope of the participation exemption is extended and will apply in all these situations, provided the fund is managed by a professional team and has a certain level of involvement (formally or informally) with the affairs of the portfolio company.

Changes in Dutch ruling policy

On March 30 2001, in reaction to pressure of other EU member states, the Dutch Ministry of Finance announced a new general ruling policy. In most cases, the new ruling policy will not affect rulings to be issued to Dutch holding companies. For Dutch-based venture capital companies or foreign venture capital companies investing through a Dutch holding company, there may be some relevant changes. Such changes include that a request for advance clearance should be made in the format of a so-called ATR (advance tax ruling), which includes clearance to confirm: (i) the application of the participation exemption; and (ii) the absence of a Dutch permanent establishment for foreign investors in a Dutch transparent entity.

Existing rulings with an expiration date after April 1 2001 but before December 31 2005, are automatically extended for a period ending on December 31 2005.

Collective requests by transparent foreign entities for refund of Dutch dividend tax

On May 29 2001, the Dutch Ministry of Finance published a decree dated April 24 2001, based on which hybrid entities (foreign entities that are transparent for foreign tax purposes but non-transparent for Dutch tax purposes) are allowed to file a simplified collective request for a refund of Dutch dividend withholding tax on behalf of their (ultimate) participants/beneficial owners. Such a refund is based on the relevant tax treaty. In principle, the hybrid entity is not eligible to treaty benefits. The decree allows a refund for eligible participants in the hybrid entity and provides for the conditions and formalities to satisfy to gain such a refund.

Bill on employee stock option rights released

On August 31 2001 the Dutch Ministry of Finance published its eagerly awaited legislative proposal on the tax consequences of employee stock option rights. In February 2001, two landmark decisions of the Dutch Hoge Raad (Supreme Court) caused quite some upheaval because the decisions resulted in: (i) the denial of a deduction where employee options are settled by repurchasing shares; (ii) a dividend tax liability upon repurchase (potentially as high as 33.33 per cent of the fair market value of the shares); (iii) a potential surtax liability (20 per cent); and (iv) a capital tax liability (0.55 per cent). None of these consequences had been anticipated. Although the Ministry of Finance announced temporary relief measures a month after these decisions, the bill had become necessary to permanently eliminate the ‘overkill'.

Tax proposal 2002

The Dutch government recently sent the ‘Tax Budget Proposal 2002 II - Economic infrastructure' to parliament. It concerns a package of measures that should enter into effect as of January 1 2002. One of the proposed measures is that the corporate income tax rate will be reduced by 0.5 per cent from 35 per cent to 34.5 per cent. Furthermore, an anti-abuse measure will be included in the participation exemption rules for indirectly held passive portfolio investment subsidiaries that are not resident of the EU. The measure provides that the participation exemption does not apply to a passive portfolio investment EU subsidiary if: (i) the assets of such subsidiary consist of 70 per cent or more directly or indirectly of interests in companies that are not resident of the EU; and (ii) such interests, if directly held, would not be considered participations. The passive portfolio investment EU subsidiary must be valued at fair market value annually; the resulting valuation gain is taxable. There will be a counter-proof rule.

Loyens & Loeff, Fred. Roeskestraat 100, PO box 71170, Amsterdam, 1008 BD The Netherlands, 31 20 578 5785, www.loyensloeff.com
 
© IFLR 2002

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