Beware Of Due Diligence Slips And Falls When Raising Venture Capital

Wednesday, May 24, 2006

Benjamin Nelson, Hughes & Luce, Dallas, TX, http://

Abstracted from: Representations, Warranties And Legal Due Diligence In Venture Financings

Insights: Corporate & Securities Law Advisor
Vol. 20, No. 2, Pgs. 7-12

The venture capital approach.
Due diligence in venture financings is not like the process for other transactions. It is shaped by expectations of simplicity, efficiency, and speed. In attorney Benjamin Nelson’s experience, the principals in venture capital funds generally expect legal fees to be low. They will negotiate valuation, control, and liquidation preferences when putting together the term sheet but often do not wish to spend significant resources negotiating other terms. This affects the scope of the representations, warranties, and legal due diligence. Because the community of venture funds is small, principals frequently work again and again with the same corporate executives. Negotiations therefore tend to be less adversarial than those in other transactions. The corporate executives care about maintaining a reputation with the venture funds, so they have an incentive to provide complete information about the company's problems.

Differences in due diligence.
VC counsel generally does not investigate every potential issue; instead, due diligence usually focuses on problems that are not easily fixed. Minimize the expense, the author advises, by relying on the company's exception schedules and by limiting due diligence checklists to a reasonable length. Do not make vague disclosures about risks that could be significant. Due diligence in a venture capital financing differs from what is appropriate for an M&A transaction. The VC process, for instance, does not need to follow the procedures required in a public offering to establish the due diligence defense under the 1933 Act. Representations, warranties, and due diligence in VC transactions are used to identify issues but not to allocate risks between the target and the venture fund. Venture funds invest with the goal of earning returns from a substantial increase in the target's value. VC investors do not want to distract company managers with a lawsuit, so they rarely sue for breach of a representation or warranty. If the company were required to pay damages as a result of a breach, its value­in which the VC fund has a significant interest­would suffer. By comparison, the acquiror in an M&A transaction is more likely to collect damages in the event of breach of a representation or warranty.

Problems with intellectual property.
Early-stage companies generally face similar intellectual-property issues. Counsel should review co-development and license agreements to ensure that the company has title to the intellectual property it has developed or it needs for its products. Contracts also may contain adverse change-in-control provisions, reminds the author. Be sure the fund principals are aware of any most-favored pricing provisions included in contracts with the company's customers. Request a representation that the target company does not use open-source software or technology. If patents are an important part of the company's intellectual-property protection, investigate whether the company is taking the steps necessary to ensure the patents' continued effectiveness. Review whether all employees and consultants have executed invention assignments and confidentiality agreements with the company.

Other problems frequent in venture transactions.
Early-stage companies frequently face a number of other corporate, tax, and securities law issues. Valuable employees may not have made timely Section 83(b) elections, the author warns, and the company may not have complied with state and federal securities laws in granting options. Ascertain that each stockholder has signed a market stand-off provision in the event of an IPO. Each should also have granted the company a right of first refusal in any stock transfer, although this is too often not the case. Review warrants to make sure that they clearly state the number of shares for which they are exercisable. If employee noncompetition agreements are important to the venture fund, counsel should ensure that such an agreement is enforceable in the applicable state. Corporate housekeeping in early-stage companies sometimes is inadequate; for example, it is important to check that the directors properly appointed all officers who are signing the VC documents. Counsel should also understand the implications of a failure to qualify to do business in any important jurisdictions.

Abstracted from Insights: Corporate & Securities Law Advisor
published by Aspen Publishers
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