John Delaney and Jay Rand aren’t venture capitalists, but both are keenly aware of the issues facing VCs today. They are attorneys, and, lately, VCs have been spending a lot more time sitting across the table from legal counsel-whether it’s because of a potential clawback, the threat of having their private equity data made public by state pension funds or lawsuits filed against companies where VCs sit on the board.
Delaney and Rand are partners in Morrison & Foerster’s New York office. Delaney is co-chair of the office’s technology transactions group. Rand is a member of MoFo’s corporate group. Both represent venture firms as well as venture-backed companies.
VCJ News Editor Danielle Fugazy met with Delaney and Rand at their offices on the 40-somethingeth floor of the Axa Financial building overlooking Rockefeller Center. The attorneys have a sense of humor, but on this day they were very serious in responding to questions put to them. The conversation touched on a variety of topics, including the sharp decline in Series A deals, limiting exposure in down rounds, the increase in VC litigation, how term sheets have changed and the impact of the Freedom of Information Act (FOIA) on private equity firms. The following is an edited transcript of the Q&A:
What do you say to early-stage companies that are having a hard time raising VC?
Rand: The first thing I ask every company that thinks it needs venture fund is: “Are you sure, and how do you think your company fits into the venture capital model?” I ask that because there were companies back in 99 and 2000, which may have been good businesses and may have succeeded if they didn’t take venture money. But because they raised venture money, the expectations of the companies changed, the ramp up of the business models started to match the funding rather than the natural evolution of the businesses, and they suffered as a result.
Now when companies come to me and talk about raising X number of dollars, I see what kind of a ramp up they’re looking at and what exits are feasible. Then most of the time, I start explaining why venture funding may not be the way to go. The reason? It may be a very good business, but it won’t give the kind of returns venture capitalists want to see.
Delaney: I am telling my early-stage clients not to approach VCs until they have three things: a product, customers and revenue. We’re not seeing any venture investments in this market unless those things are present. Well then, how are companies supposed to get to that stage without venture money? The old-fashioned way. The way it was done prior to 1998: beg, borrow and steal from friends and family.
Companies that have capital-intensive businesses in the early stage are floundering. What we’re seeing is that a company might be able to raise $100,000 from family and then $500,000 to $1 million from an angel. After that, companies went to a traditional VC for the $2 million Series A round, but now those funds have gravitated to $5 million rounds in later-stage companies, so there is a big gap between $100,000 and $5 million.
Rand: The $2 million round is almost as hard to do as the angel round now. There was a point when $2 million was an early-stage round, but it is hard to find players in that range.
What’s causing the disappearance of Series A rounds?
Delaney: I am seeing venture funds move toward later-stage, bigger investments in companies that are more established, which plays to the strength of larger funds (see related story, page 6). You would then think you’d see earlier stage funds moving toward making smaller investments in earlier stage companies, but that’s not really happening.
Rand: The common [exit] horizon for a company in ’99 and 2000, even for an early-stage company, was three years at the latest. In some cases companies were going from inception to IPO in 18 months or less. Horizons are back to what they had been prior to 1996, which is five years plus. Venture funds could still be looking at an exit in three years, but in order to do that the funds are going to invest in companies that are further down the pike.
You are seeing funds that were set up to be early-stage funds going into the later stage deals, but that’s because they can. Before, valuations were such that one of the reasons a fund would be raised for early-stage deals is that there would be larger hits but fewer of them because a fund can make bigger multiples with the homeruns they may get. In the current market, the thinking is those larger multiples aren’t so realistic, because looking at the valuations in a public marketplace, you can’t really sustain the kinds of multiples people were talking about two or three years ago, but you can still get quality investments by looking for companies that have revenue or are break even.
Delaney: This practice has wreaked havoc on the startup market, at least in New York. It has led to the death of the Series A round. It is very, very difficult right now for next-generation technology startups to raise the money they need to kick-start their business plan, because even the small funds are gravitating toward the later-stage deals, and at the same time the angel investors are no where to be seen.
Down rounds are common today. Having been a prior investor in a company, how can a VC coming into a down round limit its liability?
Rand: There are steps a VC can take to protect himself, but nothing is perfect. There are steps that are becoming more common, but that doesn’t mean that somewhere down the road someone won’t challenge them. First, VCs are now making sure they have the disinterested vote of the board-so the non-VC directors have approved the transaction, and the higher threshold of approval the better. You want the board to consider a bunch of factors as to whether the transaction is in the best interest of the company.
To figure out what’s in the best interest of the company, a VC can look at things like prevailing market valuations-where the company is relative to where it’s projected to be-based on comparables in the marketplace. If you can get an independent valuation, that’s great. There are some companies that are hiring valuation consultants to give valuations, but at the end of the day you are talking about something that is so hard to value in the first place, but there is probably some value in doing that.
Another important way to try to make the deal seem more candid is to offer all the current investors the right to participate in the newest round. The VCs should be given a contractual preemptive right to buy at least a pro rata share of any future financing rounds being raised. There are going to be some shareholders who don’t have that contractual right, but if you open the round and let other people participate, it helps.
Is there any legal way to avoid being part of a down round?
Rand: I have heard of situations where VCs have asked for some kind of indemnification to protect themselves against down rounds when the next round is raised, but I don’t know that that really works.
Delaney: One thing we have noticed is a greater interest among board members of private companies in obtaining directors and officers (D&O) insurance. Traditionally, many board members didn’t think of D&O insurance until an IPO, but that has certainly changed. You see venture capitalists interested in D&O pre-IPO because, frankly, you are seeing more lawsuits against companies at the private stage, and the board members are being named as defendants. Some are directly related to down rounds.
Are you finding that there are more lawsuits now than there were before, or is it that more attention is being paid to them now?
Rand: Market conditions have some bearing on that, but a more important factor is that the industry itself has changed. It used to be a closed industry where everyone knew each other. There was concern that if the LPs or companies started suing the funds, they may be blackballed. This market is different. When the whole industry expanded in the late 90s, you had a lot of new entrants on both the fund management and investor side.
On the investor side, you are seeing people come in without the historical background, and they don’t care much about the relationships. Maybe they don’t expect to be in the industry for the long run, so they are not constrained by the relationships they had prior to this down market.
You are also seeing a lot of new people on the fund management side. You had funds that went outside the parameters of what they originally set out to invest in. That has been the cause for some litigation. There are also cases where there is bad blood between funds and down-round situations. But if you want to take a 50,000-foot view of it, the lawsuits are here because some of the rules that may have applied in 1995 or 1996 don’t really apply anymore.
Delaney: When you look at the LPs that default, which causes lawsuits, they tend to be unsophisticated individual investors, as opposed to the institutional investors, who are your traditional venture capital LPs.
Rand: Some of suits are happening because LPs are under their own pressures. They have constituencies that they have to answer to. If they are private institutions, there will be some pressure to salvage (to the extent they can) some of the money invested in them.
Delaney: While it is true that there is more litigation now than historically, what’s surprising is that given how bleak the industry is, how few lawsuits have arisen. It is fair to say that typically all parties involved want to settle these disputes quietly outside of the spotlight.
Why are you surprised that there aren’t more?
Delaney: The busiest people in our firm now are the litigators and the bankruptcy lawyers. It’s well know that in a bad economy litigation increases across all industries. If you call a firm in New York, Boston or San Francisco and ask if they are seeing a lot of VC cases, I suspect they will say no. But there have been a small number of high-profile cases. I think the cases have been so high- profile because traditionally there has been so little litigation in the venture industry.
The other thing I would point out is that arbitration clauses are becoming more common. Venture capitalists have an interest in not airing their dirty laundry in public, and arbitration clauses are a good way to make sure disputes are handled quietly and confidentially. If disputes have to be argued in a courtroom, it’s hard to keep that out of the press.
Rand: One other type of litigation, which we haven’t seen yet, is what happens when you have had a washout and then the company recovers? One time a company called Atlantic sued a venture firm because it engaged in a cram-down financing. The founders were diluted heavily, and then the company had a successful exit. The founders felt the VCs made the transaction in a case of self-interest. If and when the market recovers and companies are exited, you might see more of that type of litigation. But the jury is still out on that.
What do think about LPs disclosing internal rates of return (IRRs) to the public and what are you expecting the courts to rule?
Rand: The numbers are always subject to interpretation. The gut reaction you hear from some observers in the industry is that no one really understands what IRRs are or how they should be interpreted, so it is meaningless information. I think IRRs are valuable if you are an investor and you are considering investing in a fund and you want to compare the fund against other funds to see if it is out-performing the class, just like mutual fund investors do.
Every year Consumer Reports publishes information on dozens and dozens of mutual funds in different classes and how they did relative to the norm and over a three- to five-year period. That is usable in and of itself, but if you are going to carefully evaluate a fund, you are going to take that information and do a little more digging.
You see a fund has a 30% IRR. Well, not all 30% IRRs are created equal. You could have a fund that made 10 investments-one was a success and nine were failures, but the IRR can still be good. How do you measure that against a fund that may have had more successes but the same IRR because it didn’t have one homerun? Is that an indicator that the fund will be able to do that again? It is hard to say.
I also don’t think the complaint is about releasing IRR information. The real issue is: If that information is released, what other information could potentially be released? I think the fear in the industry is for it to start getting to the next level, and funds will start having to release information about portfolio companies. That could still happen, and it can have an adverse impact on a portfolio company’s ability to raise financing.
Does the outcome of the San Jose Mercury News’ lawsuit against CalPERS have any effect on the VCs and LPs in the rest of the country?
Delaney: Venture capital agreements will almost always have a confidentiality agreement in them. However, the language will vary from agreement to agreement. It is not uncommon for a provision to have a caveat or carve out where a party receiving confidential information pursuant to the agreement has a legal obligation to disclose that information.
One question will be whether the public institutions under the confidentiality provision have a right to disclose it or whether there’s a legal obligation to do so. That answer will depend on how the confidentiality clause was drafted. Venture capitalists are concerned about the issue, so I imagine that they are paying close attention to the scope of the confidentiality agreement with limited partners, particularly when the limiteds are public institutions.
Rand: That’s a tough one because it will vary on FOIA laws from state to state.
Are you putting more confidentiality language into VC contracts now? Is there anything more that VCs can do legally to limit their liability?
Rand: At the heart of these cases is the Freedom of Information Act and where it applies. Some states have broader exceptions than others, in terms of information that is considered private or trade secret and what is an exception. Each state is different, and in some cases, the laws may trump confidentiality agreements. What you do see are more fund agreements that say their investment returns and other information are trade secrets. That is the kind of provision that you expect is being tested.
Delaney: The fund can ask that if the LP/public institution receives a FOIA request that they give prompt notice and cooperate with any actions by the fund to limit its disclosure. At a minimum, the fund will want to decide what information is going to be disclosed by the LP to make sure the LP only discloses what it is absolutely obligated to disclose.
It is possible, if given sufficient time, for the general partner to run into court and get some sort of injunction, if the general partner feels there is no legal obligation on the public institution’s part to disclose specific information. And, there is now greater attention to ensure those types of provisions are in confidentiality agreements.
Rand: You may start seeing an effort in certain states to sit down with the attorney general, or whoever handles this issue, and really start hammering out the parameters for the kind of information that can get publicly disclosed. There isn’t a lot of direct precedence for what type of information should be disclosed and what shouldn’t be.
If your client’s LP was asked to disclose IRRs or other information, what route would you advise your client to take?
Delaney: The public institution may be between a rock and a hard place if the confidentiality agreement doesn’t allow this type of disclosure. But on the other hand, the law appears to require disclosure. In that situation, presumably the public institution will comply with the law, but there could be a breach of contract claim resulting from the disclosure.
Another issue is whether a GP would want to pursue a breach of contract claim [out of fear that they may not be able to raise money in the future]. It will be interesting to see if funds are reluctant to take money from public institutions.
What is the biggest difference between doing a term negotiation now and in 1999?
Rand: The greatest difference is the success rate in deals that have gotten to a term sheet actually getting consummated. Before the downturn, better than 90% of the deals that got a term sheet got funded. The percentage is a lot lower now. It is more difficult for VCs to put syndicates together. It is unusual to find VCs investing alone, and VCs are doing much more careful diligence. It is taking longer. So the biggest change is how many deals make it to the term sheet then don’t get done.
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