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Legal pitfalls in the fundraising process

What do venture capitalists look at when they invest in portfolio companies? Written from an entrepreneur's perspective, this article by Janine Canham and Wen Leung of CMS Cameron Mckenna helps investors to understand the considerations VCs must take into account.

Business plan

From a legal perspective, care must be taken to ensure that the contents of the business plan are accurate as VCs are likely to request entrepreneurs to warrant their accuracy at a later stage when the legal documents are signed. Moreover, in the case of financial projections, it is not unusual for VCs to request a warranty that such projections have been prepared with due care and on a reasonable basis.  If plans have been ‘over-hyped', the business plan may need to be revised to a form that can be warranted - a situation which is better avoided by getting the plan right at the outset. Therefore, business plans should be prepared with that requirement in mind.

Submission of the business plan is preferably undertaken in a discreet manner.  Mass circulation of a plan to potential investors is not advisable as it may attract fund-raising laws that make it illegal to invite subscriptions for shares unless the issuer complies with rather onerous provisions regarding the form and content of the invitation.  Mass circulation of a business plan may also undermine any efforts to seek intellectual property rights to protect an invention or computer program.  For instance, if an entrepreneur wishes to obtain a patent for an invention, he must demonstrate that his invention carries an inventive step and that the invention is new.  Mass circulation of a business plan describing the invention will remove its novelty aspect and jeopardise the chances of obtaining a patent.

The same applies to the exclusivity of the entrepreneur's idea.  If the entrepreneur sends too many business plans and is not cautious about who the recipients are, the idea may fall into unscrupulous hands and a recipient could claim the idea as his/her own and use it.

It is also important that plans are clearly marked as confidential and that the recipient undertakes to return or destroy the plan so that the entrepreneur is not regarded as having impliedly authorised the disclosure of the plan.

Due diligence

Due diligence is a key process when determining whether the investment is a sound one.  In practice, negotiation of the term sheet often proceeds in tandem with the due diligence process. As the VC is not bound to proceed with the funding, it is important that the VC (or its representatives) signs a confidentiality agreement in relation to all information provided to them.

The deal

Negotiation time frames
Companies (particularly those which have high ‘burn rates') should be wary of ‘delay tactics' or other factors which have the effect of hampering the speedy conclusion of negotiations.  Importantly, the legal documents which are intended to formalise the understandings reached between the entrepreneurs and the VCs should not contain any surprises.  Entrepreneurs should seek legal advice sooner rather than later as it easier to negotiate early drafts of documents before the process develops to a point where the entrepreneur comes under pressure to sign less satisfactory documents if the company is in need of funds to pay wages, rent and other operating costs to sustain the company. 

Term Sheet
When VCs invest their funds in new projects, they are often accountable to the investors who contribute to the VCs' funds and are therefore subject to performance expectations, which in turn drives VCs' expectations of companies which the VCs decide to fund.  Entrepreneurs should ensure that once the parties have reached an oral understanding, the main points are recorded in a term sheet.  Although the term sheet would often be subject to execution of formal documentation and would give VCs various options not to proceed (for example, if the results of the due diligence are unsatisfactory), it is nevertheless important to set the basis upon which the legal documents can be drafted. 

The term sheet should contain the basic terms of the investment, which would usually include the following:
· Conditions precedent to the investment;
· How the investee company will be operated and managed;
· Milestones and criteria for the measurement of performance;
· Ongoing liabilities and undertakings of the parties upon exit (e.g. share escrow restrictions);
· Non-compete clauses;
· The effect of future funding and how existing equity shares are preserved through anti-dilutory protections;
· Key personnel to be employed by the investee company.

VC Involvement
In broad terms, the main areas in which VCs become involved with an investee company are:
1. Equity participation
VCs usually hold shares in the investee company which provides the VCs with their return (assuming the investee company is successful). The aim of VC financing is to achieve capital growth and it is expected that entrepreneurs surrender a sizeable share of equity (particularly in start-up companies).  When exiting the company - usually through an initial public offering or by selling their shares to a third party - VCs expect to sell their shares at an increased value. 

Equity participation is also a means to retain some control over the way the company runs its business.  The shares would usually confer voting rights, thus giving VCs ‘negative control' powers to prevent excessive borrowing or selling of assets for instance, unless the VCs give their written consent first

2. Board participation
VCs normally expect to have a board seat in order to exert some control over the company and to monitor the company's performance.  However, as VCs tend to take a minority stake, they do not usually seek day to day control of the business.  VCs also expect to have ‘negative control' powers at the board level by way of veto rights over certain important policy and management decisions (such as the appointment of new directors, changes in the nature of the company's business, major expenditure to be undertaken by the company etc.). While board representation serves to give VCs protection by means of participation on the board, often the contribution of VCs is not purely financial and may comprise the contribution of ‘non-financial' resources in the form of management expertise, contacts etc.  In some cases, this may be crucial to the company and it is therefore important that entrepreneurs ensure that VCs are bound to give enough time and support to the company. 

3. Management powers
Normally, VCs expect to have rights to monitor their investment by appointing a non-executive director (or board observer).  These are minimum protections which any VC will expect. In addition, it is common to find defined mechanisms (e.g. committees, regular management accounts and other financial information) to ensure that VCs are kept informed about the company.  It is important though that entrepreneurs do not agree to provide excessive information which is costly and time-consuming to produce.  Thus, the entrepreneur should only agree to provide regular financial information which is not unduly excessive.

4. Control over exits
VCs often seek defined exit routes. These should be clearly discussed and agreed at the outset. For example, an entrepreneur would not want to be subject to undue pressure from VCs to ‘go public' merely to enable VCs to realise their investment. Therefore, the circumstances in which the company is required to undertake an initial public offering should be clearly set out.

Another exit strategy is the redemption of the VCs' shares at the option of the VC.  Before agreeing to such a right, entrepreneurs should consider whether this would unduly restrict their ability to secure further funding from other investors, as these investors would want their funds to be channelled into the company's business rather than applied to pay off an equity investor. 

Warranties & Representations
The entrepreneur should be careful with the warranties they give to investors. Often, the warranties are expressed to be subject to matters disclosed to the VC. These qualifications would be set out in a disclosure letter which the entrepreneur should pay close attention to in order to minimise the entrepreneur's exposure to warranty claims.  As outlined previously, particular care should be taken in preparing a business plan which is in a form that the entrepreneur can warrant.

Legal Documents
Usually, the documents are based on the term sheet and are prepared by the VC's lawyers.  Entrepreneurs should ensure that these documents do not differ substantially from the understanding they have reached with the VC. Such differences can be minimised if a comprehensive term sheet is prepared at the outset.  It is also crucial to have these documents carefully reviewed before they are signed and to obtain independent legal advice because you may otherwise find yourself signing away your rights, such that all your hard work in building up a company will profit only the VC.

© CMS Cameron McKenna 2000
 

CMS Cameron McKenna is a major international law firm with offices in 21 jurisdictions including Hong Kong and Beijing.  The firm's website can be visited at www.cmck.com.