An operating business investing its own venture capital (a “CVC”) is usually a large, often public technology-based company engaged in selling products, technology and/or services. Generally, CVCs aim to invest in emerging companies (referred to herein as “startups”) for a combination of reasons that usually includes a mixture of: (i) obtaining a healthy financial return; and/or (ii) attempting to create operating benefits to their businesses or enhancements to their technologies.
Specific reasons for corporate venture investing may include (i) to license or sell the CVC’s technology or to license or buy a new technology that is complementary to its own, (ii) to enter into a joint venture utilizing the startup’s technology, products or services in conjunction with its own, or (iii) to support internal initiatives by utilizing the startup’s products, services or technology. Some CVCs invest with a higher priority given to creating operating synergies than to a financial return; some with mixed goals that vary with the facts. Importantly, CVCs generally have different goals than venture capital fund investors (“FVCs”). FVCs are investment firms whose primary goal, as distinguished from CVCs, is to invest in and promote the sale of equity interests in portfolio companies for a return of capital.
This note will set forth three distinctive legal issues that are posed for CVCs and the emerging companies they invest in. These are: (i) how a CVC analyzes the decision to have its representative elected as a board member versus designated as a mere board observer; (ii) how the terms and conditions of a CVC’s investment may differ from those of FVCs; and (iii) what drives a CVC’s choice to maximize its advantage by negotiating a right of first refusal to purchase an emerging company in which it has invested.
- How does a CVC analyze the decision to have its representative elected as a board member versus designated as a mere board observer?
Pursuant to governing law, if a CVC takes a board seat, its designated representative will be voted as a director pursuant to the startup’s certificate of incorporation (sometimes referred to as the “charter”) and/or a stockholders agreement. The board of directors is charged with managing the affairs of the startup and has the right to do so pursuant to state statute and common law, and pursuant to fiduciary duties to the startup’s stockholders, specifically the duties of loyalty and care.
To protect a CVC/board representative from liabilities to third parties or other investors arising from his/her acts or omissions or those of the startup, the startup’s charter usually provides for indemnification of directors and officers pursuant to state law. In addition, it is recommended that the CVC/board representative ask that an indemnification agreement with the startup be executed to add contractual indemnification rights for him or her. More protection for the directors (and the startup) can be obtained by the startup’s purchase of a directors’ and officers’ liability insurance policy. This is usually required by investors taking board seats in a policy amount and pursuant to terms reasonably related to the circumstances.
As an alternative, the CVC’s representative may be designated as a mere board observer rather than as a board member. The advantage to this is that the observer can gain detailed insight into the business and operations of the startup while avoiding subjecting the CVC/representative to fiduciary duties. Unlike board membership, however, board observer status generally confers no decision-making authority or managerial control over the company. Since mere board observers do not exercise any form of decision-making authority over the company usually accorded to board members, it is reasonable that they should not have the associated responsibilities, i.e., fiduciary duties to stockholders. State laws generally reflect this rationale. This is often particularly important to CVCs who are concerned about limiting risk to their operations, including limiting investment risk in entities they do not control.
If the parties agree that the CVC representative will be an observer, is important that the startup and the CVC articulate to one another the rights and responsibilities of observer status. That is the main purpose of a well-drafted Board Observer Agreement. A Board Observer Agreement should make clear what the observer can and cannot do in order to maintain his or her observer status. No decision-making, vote or veto power over any matter considered by the board should be granted to the observer by the startup. Note, however, that an observer may express his or her opinion for consideration by the board and may, if the startup agrees, have information rights to receive board notices and other information made available to directors as specified in the Board Observer Agreement. Note also that the prohibition against voting and exercising decision-making authority does not prevent the CVC from having contractual rights associated with its investment without jeopardizing its status as an “observer,” if they can be negotiated with the startup. Having said that, the CVC/observer will want to avoid de facto board member status, i.e., if an ”observer” conducts him or herself as a director ordinarily would by utilizing the powers and decision making authority of a director there is some possibility that a court may treat the observer as a director with associated fiduciary duties. One major purpose of the Board Observer Agreement is to circumscribe the observer’s rights to protect the CVC from such an unexpected result.
- How do the CVC’s contract terms compare with those offered by venture capital fund investors (FVCs)?
One or more FVCs making a convertible preferred stock investment in the startup would typically invest in return for the receipt of certain terms, which may include:
(i) usually a less than 50% fully diluted equity interest with a preference in liquidation over common stock, and sometimes a participating interest;
(ii) one or two out of what is often five board of director seats;
(iii) protective governance provisions to be drafted in the certificate of incorporation giving the FVC(s) the right to approve certain key events, such as hiring a new CEO, incurring debt above a threshold amount, or issuing new equity securities that are pari passu or senior in liquidation to the preferred securities being issued;
(iv) pre-emptive rights to purchase a pro rata percentage of future securities issuances and anti-dilution rights to protect against sales of future preferred securities at a lower price per share; and
(v) the right to demand public registration of the startup’s securities, and piggyback off another’s initiation of a registration action.
CVCs may invest alone or by participating with an FVC or FVCs, and they will usually require the same terms as FVCs and will have contractual rights and obligations in proportion to their pro rata ownership.
However, when given the opportunity, a CVC may request rights affecting its own businesses in addition, such as, for example: the right to license the startup’s technology, the right to integrate that technology in the CVC’s product offering, the right to purchase the startup’s product or service, the right to sell the CVC’s product to the startup, or the right of first refusal to purchase the startup in a change-of-control transaction (each of the terms and others requested by the CVC are referred to as a “CVC Operating Term”).
The CVC’s ability to negotiate certain CVC Operating Terms from the startup will depend upon a number of factors, in particular upon who is investing. If the CVC is the only proposed source of capital, absent the presence of a competing CVC, it will have strong bargaining leverage. If the CVC invests alongside an FVC or FVCs in a secondary role, its leverage to negotiate CVC Operating Terms will usually diminish. After all, the parties will need to have complementary goals in spite of the fact that the FVC’s interests and the CVC’s interests typically are, if not in opposition, at least different. Generally, the FVC’s primary desire is to invest in the startup and to liquidate its position no more than usually five to seven years from initial investment, and to maximize the likelihood and size of the liquidity event. As discussed above, the CVC’s goals are often more complex. To the degree that the CVC’s perceived goals would divert or complicate the startup’s task of achieving the FVC’s goals, i.e., investing and liquidating upon the FVC’s timetable, then the prospect of the CVC successfully negotiating CVC Operating Terms will be diminished. Having said that, if the CVC were to propose entering into a mutually agreed to technology license with the startup as a condition to the CVC’s investment, and if doing so would facilitate the FVC’s goals as well, then a deal is achievable.
Another case where a CVC may have particular negotiating leverage with the startup is when, as an industry leader, it supplies influential third-party validation and positive affirmation of the startup’s technology, product or service. Note, however, that the CVC will not always allow the startup to publicize its strategic investment, and such CVC identification may not be desirable to the startup. However, if desirable to either party, such ability to publicize can attempt to be negotiated.
In the event that a CVC is participating in a venture capital deal controlled by an FVC or FVCs, the CVC will not generally control the class of securities issued to the FVC or FVCs. Many CVCs, in fact, will deliberately take a passive ownership stake, as long as it is convenient for the FVCs controlling the transaction to accommodate the CVC’s requests. Generally, however, it is in the earlier stage venture rounds where it is more likely to be a sole investor, or in the later rounds when its investment has the effect of rescuing a troubled startup, that a CVC has a heightened opportunity to negotiate CVC Operating Terms. Among the most important CVC Operating Terms that a CVC may want is a right of first refusal to purchase control of the startup before third parties have the ability to do so.
- What drives the CVC’s choice to maximize its advantage by negotiating a right of first refusal to purchase an emerging company in which it has invested?
A right of first refusal to purchase the startup before any other third party (“ROFR”) is often made a condition of a CVC’s investment when the opportunity arises. This condition complicates things for the startup, its board of directors, and for any FVCs that may be investors or potential investors, because a grant of the ROFR generally impedes and complicates the company’s auction in a sale process (usually organized by an investment banker), thereby making it harder to widely offer the startup for sale to competing bidders in an attempt to increase the sale price. Here’s why:
The ROFR usually requires establishment of a time period after notice by the startup to the CVC of an offer by a third party to purchase a controlling interest in the startup, during which period the CVC will often require the exclusive right to negotiate a sale and prepare to make an offer to purchase, after having the right to review such third-party offer to purchase, along with related documents. The longer the exclusivity period during which the CVC and the selling startup must negotiate, the harder it is to keep potential third-party bidders interested. In addition, the terms of the ROFR may give the CVC the non-exclusive right to negotiate even after the exclusivity period lapses. All this complicates an auction process to generate a third-party offer.
A CVC may legitimately want the ROFR and may in fact invest for the purpose of receiving it for understandable reasons. It may want to invest great effort with an investor to co-develop technology; it may want to share confidential information with the startup; it may want to enter into other joint activities with the startup to which it attaches great continuing value. It is therefore reasonable, from its standpoint, to want to protect its investment by asking for a ROFR up front.
There exists a more benign variant on the ROFR that gives the CVC a “right of first offer,” or “ROFO.” In this case, the startup can notify the CVC that it intends to sell and can grant the CVC the right to make an offer to purchase from the CVC before soliciting the same from third parties. The existence of the ROFO, without additional restrictions, does not adversely affect the potential auction process to the degree of a ROFR, and is therefore less restrictive in its effect on the process.
Note that selling a controlling interest to the CVC, which prior to the sale has maintained that a director’s seat is an “interested party” transaction under applicable state law, deserves close scrutiny by the startup’s board of directors, and calls into play corporate governance issues that are beyond the scope of this note.
There is no question that the existence of a ROFR (and less so a ROFO) will create complexities for the selling startup. It interrupts the natural competition that is the market-based result and benefit of an open and free auction process. Arguably, it discourages third-party bidders from participating in a sale because it is drafted precisely for the purpose of favoring one party, the CVC, over all others. Conversely, if the CVC fails to exercise the ROFR, or does exercise but fails to close, the selling startup is left to explain to interested third parties why the CVC (who had invested all along and presumably has a high level of knowledge about the startup) never closed the deal.
The aforementioned questions make investing FVCs leery of a grant of ROFRs to a CVC, and will cause them to try to negotiate the ROFR out. Having said that, the ROFR term can be extremely helpful to the CVC in transactions where it invests alone or comes to the rescue of a troubled startup. In those situations, the ROFR is a frequent tool that a CVC uses to enhance its ability to influence the startup’s sale prospects.
Three take-aways from the questions presented are:
- Whether a CVC’s representative takes a board seat or becomes an observer depends on the circumstances. However, if FVCs control the class of stock in which the parties are investing in any event, a CVC should think twice before insisting on a board seat versus an observer’s seat.
- A CVC’s ability to successfully implement CVC Operating Terms will depend upon (i) the receptivity of the startup and (ii) the degree to which the CVC has negotiating leverage, which is often strongest (x) when the CVC is the only investor and/or there are no FVCs investing; or (y) if FVCs are investing, when the CVC Operating Terms are helpful and necessary to attaining the goals of such FVC(s).
- A ROFR, when granted to a CVC, is a powerful tool to allow the CVC an advantage in the ultimate sale of the startup. If the startup has some negotiating leverage, however, before agreeing, it should balance: (i) the need for and advantages of investment by the CVC with (ii) the degree of impingement upon a free sale process caused by the ROFR under the circumstances presented.