By Dave Panos, CEO and Co-founder, Pluck Corporation
Most early-stage entrepreneurs who are building successful companies will have the opportunity to raise money from a corporate partner that wants to invest for strategic reasons. You also may find that existing investors like the idea of filling out a round with a partner that has deep pockets but isn’t very sensitive to valuations. While the prospect of cozying up to a strategic investor initially sounds appealing, the implications are significant and caution is advisable.
The Dance Begins
When in the throes of explicitly raising money or developing a strategic partnership, it is fairly easy to become seduced with the idea of taking a strategic investment from a Goliath partner. Among other things, it rounds out the corporate résumé with a very nice sound bite. You may rationalize that there is some sort of transitive property that magically will make your company more valuable—if Goliath thinks it’s worth investing in, then the category matters and this start-up must really matter.
The corporate partner’s appetite for this type of relationship varies wildly according to market dynamics and the personalities involved, but in positive economic environments, it is fairly easy to rev up Goliath’s engines. Some large companies are very aggressive in their pursuit of strategic tie-ups at the balance-sheet level. In fact, it isn’t uncommon for them to actually institutionalize the process to a level where a formal and rigorous conversation around investment must take place before any strategic partnering deal is consummated. However, note that many of these companies aren’t investing solely to realize a return on their capital, but rather are looking to attach themselves to the perceived value they believe will be created by virtue of them doing business with you. If this is the case, your partnering deal is likely to include a purchase option for your company.
I now have the benefit of having raised money or otherwise partnered with seven strategic investors over the course of five start-ups during the past two decades. With significant hindsight as my guide, I now believe that there are primarily two scenarios where it is beneficial to take money from a corporate investor:
1. Access to new markets via partner distribution. In this instance, the investor agrees to distribute your product to markets that they dominate; ideally, these markets are both large and cleanly separated from your existing distribution channels. This kind of operating leverage makes it worth taking on a corporate investor along with the potential pitfalls that accompany this type of relationship. Early on in my career, my company sold IBM 10% of its stock in return for IBM distributing a version of our software to their customers through their massive sales force. They guaranteed a certain level of revenue and the product was tied to their operating system. It worked incredibly well for both parties, and we were able to go public largely on the back of our mutual success. At a different company, we took on a strategic investment from Cisco in return for a large internal software license plus a distribution agreement that brought our technology to their sizable customer base in Japan. It allowed us to safely and quickly enter a new market and rack up millions of dollars in revenue with little operating risk.
2. Access to proprietary technology. In this case, you take the investment because it is coupled with a license to critical (and potentially patented) technology that you would otherwise find challenging or impossible to develop on your own. If the technology is clearly game-changing and you can box out potential competitors from also gaining access to it, a strategic investment easily can make sense. I had a positive experience with Intel many years ago, where they spent tens of millions of dollars developing a technology but were challenged with bringing it to market. My company exclusively licensed the technology from them, packaged it for sale to our customers, and quickly built it into a multimillion-dollar revenue stream. They invested in our company and ultimately profited from both the license fees associated with the technology and the sale of our company two years later.
Taking an investment from a corporate partner simply because they are a very large customer (or plan to be) is typically not a good reason to do this kind of deal. You have all the potential issues mentioned below, without adding any significant leverage to your business. Similarly, raising money from a strategic partner as a means of “getting closer”—i.e., in hopes of some future operating agreement—is generally not a sufficient rationale.
The following are the more frequent common pitfalls associated with raising money from strategic partners:
Stamina. Corporate venture investors generally have a reputation for being interested in strategic investing when markets are good. But when economic times are tough, the corporate VC group is often among the first casualties. It is fairly routine to see corporate VC funds turned into caretakers, sold off at a steep discount, or entirely shuttered. Unfortunately, this usually occurs exactly when the entrepreneur needs an engaged and supportive investor team. If you are hitting the road for a challenging follow-on round, you can’t afford to also be scrambling to explain and fill in a new hole in your capitalization table.
Polarity. The presence of a well-known strategic investor on your capitalization table (and perhaps on your board) can present problems later in life when you’re trying to enter into a strategic relationship with one of that investor’s major competitors. Downstream deal-making can be very challenging when the prospective partner is concerned about information being shared upstream, or when deal champions worry about losing points internally for doing anything that can be perceived by their peers as aiding and abetting the balance sheet of the enemy. Why should they help their competitor when they can build a similar relationship with your competitor?
Absenteeism. This pitfall falls into the “frustrating but not fatal” category. Unlike traditional venture capital and private equity investors, the individuals behind a corporate investment often have a different day job. They are being paid to run their businesses, not yours. Despite their best intentions, I found that getting operating executives to burn road time on your behalf is nearly impossible.
Entanglement. Finally, the more your strategic partner puts into the operating agreement portion of the deal, the greater the chance that your investment will come with significant strings attached. If the strategic investor is helping to make you an important player in your shared industry, they will want to be sure your company isn’t easily snatched up by somebody else. This concern typically manifests itself in some form of Right of First Refusal (RoFR) or Right of First Offer (RoFO) as part of the investment agreement. Many early-stage companies will want to avoid this deal feature, but if you are pressed on the matter, try to negotiate a time constraint so that you’re freed up if they don’t move within the first year of the arrangement. In the one case where we were stuck with an unbounded RoFR, it nearly derailed an acquisition. The prospective acquirer refused to negotiate a deal price unless the strategic investor agreed to waive their RoFR. There was little incentive for our investor to waive the right to acquire us, but after numerous very intensive discussions, we ultimately convinced them that they should. Of course, this did little to then help us maximize price—our suitor had flushed our greatest leverage point completely out of the picture.
Dave Panos is the CEO and co-founder of Pluck Corporation, a social media software pioneer that successfully sold to Demand Media in early 2008. An executive in five early-stage software companies, Dave also spent two years as a venture partner with Austin Ventures. Dave can be reached at email@example.com.
By Kent Richardson and Erik Oliver, ThinkFire Services
Many companies in search of a cash infusion are not aware that they might be sitting on an asset that can be monetized to help meet their liquidity needs. Whether you are an early- or late-stage company in need of cash, if you have a patent portfolio, you might consider selling some of those patents, particularly those that you do not need today. Indeed, the cash generated from any such sale may reduce the impact of, or eliminate the need for, a dilutive down-round financing.
The Market for Patents
We estimate that approximately $1 billion a year changes hands buying and selling bare patents. These patent sales occur almost exclusively in the information technology sector, including such fields as wireless communications, Web 2.0, SaaS, and LCD TVs. Prices can range from a few thousand dollars to more than $10 million per patent.
In the last decade, the growth of this market has been remarkable. In 1998, only a few large companies, such as Intel, Broadcom, and IBM, were buying or selling patents. Today, there is a robust market of buyers and sellers, along with a developing community of patent brokers and finders. With the growth of this emerging market also come the challenges of volatile pricing, deal transparency, lack of standard terms and conditions, and lack of standard processes.
Who is buying? Specialized private equity funds, specialized start-ups, large and medium corporations, licensing organizations, and defensive patent pools. Depending upon the patents in a transaction, there may be more than 50 buyers to contact. The mix of buyers—and their interests—changes often, but it has been, and continues to be, an ever-growing pool.
Who is selling? The sellers’ pool is similarly large and growing—from Fortune 500 corporations to individuals and small corporations, and from bankrupt companies to universities. Investors, in particular, are finding that patents are one of the few underexploited distressed assets that are also uncorrelated with the broader markets.
The patent-transaction market today breaks down into two broad categories: (1) high-quality patents with high market impact and (2) everything else. Even during this recession, the first category has seen prices increase. The second category, however, has witnessed a steep decline.
How Do We Participate?
For context, here is an example of the kinds of transactions we have done at ThinkFire: A venture-backed company is running out of cash. An infusion of a few million dollars could bridge them to a crucial partnership or financing deal. The company has a few patents issued and a few more pending. By selling some of their patents, the company raises cash without impacting their product offering or operations, and without diluting their shareholders.
Whether you use a broker or not in this process, the first step is developing the sales package, which typically includes:
The sales package is then distributed to likely buyers. Over a period normally ranging from 45 to 90 days, buyers review the materials and ask questions about the market data, the patents, and the bidding process. Bids are then accepted and sales are typically closed in the following 45 days.
Many sellers use brokers and some buyers prefer to buy from qualified brokers, who usually provide the following services:
Often, brokers do this work on a contingency-fee basis, so there is no cost to the seller if the deal does not close. Depending on the complexity and expected price, the range of fees is typically 15 to 30% of the sales price.
Finding the Right Price
Pricing the patents may be the most difficult part of the sales process. Valuations can range from zero to millions of dollars for the same patents. One might assume that the price range varies due to the different information possessed by each of the potential buyers. For example, finding an as yet undiscovered problem with the patents can lead to a zero valuation. Similarly, a prospective purchaser may have better comparables data. Since there is no multiple listing service (MLS) for patent transactions, only a few large buyers and brokers have information on enough transactions to really help here. But even when all the parties have the same market, patent, and pricing data, the valuations can vary considerably.
The primary reason for this variation is that patent value is context specific, with the context of the owner dictating the value. For example, a patent held by a licensing company can generate multiple royalty streams, while that same patent held by a start-up is unlikely to generate any. That makes the net present value for each potential owner significantly different. Thinking about who the potential buyers are and how they would use the patents is a critical element in pricing and, ultimately, obtaining a higher valuation.
Importantly, keep in mind that, in any context, the sales price is also significantly lower than the cumulative future royalty stream. Where a business case exists for $100 million in future royalties, when risk adjusted, the same patents likely will sell for $1-10 million. A surprisingly large discount, but the patent licensing risks are numerous and large, and the investment is likely to be slow to yield any financial returns.
What Happens After You Sell?
After the sale has closed, you now can use the proceeds to move forward. Imagine a few years into the future—your company has annual revenues greater than $50 million, for instance, and big competitors have begun to enter the same market. These competitors might have patents that are a concern.
But you are prepared to meet these challenges because you planned ahead. Your company kept a license back in the patent sale, so you know that your former patents will not be used against you. Also, you never stopped innovating and you continued your patent program. You've also bought a few companies, along with their patent portfolios. Now, because of your increased revenue, you can participate in the patent market as a buyer to purchase patents to address the specific threat posed by your competitors. In other words, by selling your patents early, you gave yourself the cash to move the business forward, and the time and resources to rebuild your patent portfolio.
Other Structures for Monetizing Patents
There are other structures that you can use to make money from your patents. Licensing, hybrid licensing-brokering, or patent pools (depending on your specific market) all can yield attractive returns. Licensing your patents can involve planning and execution requirements as complex as product development and launch. As such, it is often too much of a distraction for the patent owners to pursue as a strategy. However, you can spinout the patents to a limited liability corporation (LLC) responsible for licensing and participate as a limited partner. As a limited partner in the LLC, you can receive revenue from the licensing activities without control of, or direct responsibility for managing, the licensing process. This structure allows tremendous flexibility. For example, once set up, the LLC can pursue hybrid models of licensing some companies and then selling the patents to another company or group. Transferring the patents or patent rights to a third party in exchange for a portion of future licensing fees is a relatively common practice (for example, MPEG LA acts as a clearinghouse for MPEG patents). All of these options can result in significant revenues; however, the time to money can be too long for a cash-squeezed start-up.
Kent Richardson is the general manager of the Silicon Valley office of ThinkFire Services, a leading patent brokerage, licensing, and strategy consulting firm that includes leadership from several of the world's most-renowned IP organizations, such as Lucent/Bell, IBM, Cisco, and Rambus. Kent advises clients on patent strategy, management, and licensing. He has licensing and marketing patent portfolio experiences resulting in more than $600 million of patent license bookings. Kent can be reached at firstname.lastname@example.org.
Erik Oliver is the managing director of the Silicon Valley office of ThinkFire Services. With licensing experience involving several hundred million dollars of patent and technology licenses, Erik advises clients on patent strategy, management, and licensing. He can be reached at email@example.com.
By Mark Baudler, Partner (Palo Alto Office)
The first quarter of 2009 saw a very sharp decline from previous quarters in both the number of equity financings that were completed as well as dollars invested. The acceleration of the decline from the fourth quarter of 2008 to the first quarter of 2009 was steep in comparison to the decline from the third to fourth quarter of 2008. This accelerated decline in the first-quarter private equity financing market trails by roughly a quarter the steep decline in the public equity markets beginning in September 2008.
The backdrop for venture financing in the first quarter continued to be challenging:
These and other factors have had a significant negative impact on venture capital investing in recent periods, which is borne out by the data from the financing transactions captured in our database. These trends continue to impact the rate of return for the venture capital asset class.
The number of financing transactions of all types decreased from 151 transactions in the fourth quarter of 2008 to 101 transactions in the first quarter of 2009, a decline of approximately 33%. This decline is even steeper when compared to the financing transaction activity in the third quarter of 2008, during which 183 transactions were completed. The number of transactions completed in the first quarter of 2009 was significantly lower than the number of transactions completed in any recent quarter.
There was also a steep decline in the aggregate dollars invested in the first quarter of 2009. The $606 million aggregate investment amount was nearly 60% less than the $1,485 million aggregate investment amount in the fourth quarter of 2008. The first quarter saw no megadeals, i.e., single financing transactions involving an amount in excess of $100 million. The absence of megadeals in the first quarter of 2009 had a significant impact on the aggregate investment amount (three such megadeals accounted for approximately $550 million in investment amount in the fourth quarter of 2008). However, even after eliminating the megadeals from the fourth quarter 2008 data, the decline in investment dollars from $920 million in the fourth quarter of 2008 to $606 million in the first quarter of 2009 was significant, representing a decline of approximately 34%. The decline in investment dollars in the first quarter of 2009 is significant in comparison not only to the fourth quarter of 2008 but also to other recent quarters.
The number of Series A financing rounds was down significantly in the first quarter of 2009 when compared to not only the fourth quarter of 2008, but also to each of the other three quarters of 2008. Given the macroeconomic climate, this is not surprising, but it does shed light on just how difficult it has been recently for new start-ups to attract venture financing. Not shown in the tables is the significant decrease of angel-led financing transactions. Our database only recorded two such angel financing transactions in the first quarter of 2009. There are likely a number of factors contributing to the paucity of angel financing rounds, including steep declines in many angels’ personal net worth and increased conservatism for new investments. As a result, entrepreneurs are experiencing significant difficulties in securing early-stage financing for their companies in the current environment.
Similarly, the number of Series B and the number of Series C and later rounds of financing have continued to decline from prior periods. These decreases are likely attributable to a number of factors, including heightened conservatism, increased diligence time prior to making investments, and venture capital firms deploying a greater amount of capital to their existing portfolio companies (and often only to certain of these portfolio companies).
The first quarter of 2009 also saw a marked decrease in the number of bridge transactions. Bridge transactions are often made for the purpose of providing capital between investment rounds or to provide capital to enable a company to complete an exit transaction or a wind-down. Bridge transactions also are used in some cases as a means of financing prior to a first equity round of financing. This type of seed-investment bridge financing also declined sharply in comparison to prior periods.
Not surprisingly given the economic climate, the percentage of down-round financing transactions—transactions where a company’s valuation declines from the prior round of financing, resulting in a price per share of the new security that is less than the price of the security issued in the previous round—has increased significantly. In the first quarter of 2009, slightly over 50% of all Series B and later financings were down rounds, as compared to just over 25% in the fourth quarter of 2008. The percentage of down-round financings in the first quarter of 2009 is over twice as high as the percentage of down-round financings in the years from 2005 through 2008.
Further on this point, in the first quarter of 2009, only 29% of Series B and later rounds of financing were up rounds, as compared to financings that were down rounds or where the per share valuation was flat. In comparison, at least 65% of such financings were up rounds in the years from 2005 through 2008. This data reflects the deterioration of the national and global economies combined with the severely challenged exit opportunities for venture-backed companies.
The charts below set forth the median amounts raised and median pre-money valuations broken down by series of equity financing. The first quarter of 2009, compared with the quarterly data from 2008, reflects decreases in both median amounts raised as well as median pre-money valuations. The same holds true for Series B financings (with the exception that median amounts raised in the first quarter of 2009 increased slightly in comparison to the data from the fourth quarter of 2008) and for Series C and later financings. The steepest decline in all of these charts is the median pre-money valuation for Series C and later financings in the first quarter of 2009 as compared to prior periods. This ties to the down-round financing data trends discussed above.
In sum, the data shows that the deterioration in the investment climate that began in 2008 accelerated in the first quarter of 2009.
The table below reflects certain terms regularly used in venture financing deals.*
Overall, the data does not show that deal terms in the first quarter of 2009 (other than valuations) changed dramatically as compared to prior periods. Nonetheless, given how difficult it is to raise venture money in the current environment, it is not surprising to see that the number of Series B or later financings where there is a pay-to-play provision for such round of financing increased. Pay-to-play provisions are structured so that existing investors have to participate in the next financing or else lose some or all of the benefits they currently hold as preferred stockholders—these provisions are “sticks” to encourage investment in new rounds of financing.
*To see how the terms tracked in this chart might be used in the context of a financing, you can construct a draft term sheet using the automated term sheet generator available on wsgr.com.
Private Company Financing Trends1
A Technology Company’s Guide to Making the Most of Government Funding Opportunities
By Sandra Pak Knox, Special Counsel (Palo Alto Office)
Last year’s financial market collapse has made for tough times for technology companies that traditionally have looked to venture capitalists, venture lenders, or the public markets for financing. Venture capital investment in the first quarter of this year was down 47% in terms of dollars and 37% in deals from the fourth quarter of 2008. After a banner year, capital investment in clean technology companies was down 63% in dollars and
Government funding long has been available to technology companies in the form of grants, loans, loan guarantees, tax incentives, tax credits, and cooperative research and development arrangements that are cost-shared with the government. With the new Administration’s and Congress’s focus on mainstreaming renewable energy, ensuring energy security and energy independence for the United States, creating American jobs, and reducing greenhouse gas emissions, the American Recovery and Reinvestment Act (ARRA) and 2009 federal budget appropriations process already have directed tens of billions of dollars into programs administered by federal, state, and local agencies to provide an immediate and substantial boost to the renewable energy industry.
We expect this trend to continue in 2010 and beyond. For example, the entire budget for the Department of Energy’s (DOE’s) Office of Energy Efficiency and Renewable Energy for the 2008 fiscal year was $1.7 billion, but the ARRA alone provided the same office with an additional $16.8 billion to commit by September 2010. Given the state of the financial markets and the large amounts of government funding now available, technology companies, particularly those in the energy and clean technology industry, should consider applying for some form of government funding.
For venture-backed companies, applying for government funding may be a foreign concept, approached only with great trepidation. However, in our firm’s experience with emerging technology companies and the government, we have found that the government and venture capitalists are not so dissimilar.
How do I decide which government funding opportunities to pursue?
In the same way that certain venture capitalists are known for their focus on certain industries or on companies at a particular stage of development, each government funding opportunity has a specific focus. For example, the DOE’s Advanced Research Projects Agency-Energy (ARPA-E) funding opportunity is targeted toward R&D-stage companies with “transformational” technology, while the Advanced Battery Manufacturing funding opportunity focuses on shovel-ready projects for companies to create a domestic battery manufacturing industry for electric vehicles, and specifically excludes R&D-stage companies.
Therefore, determining which solicitations might be useful should start with an assessment of your business and needs. Are you an early-stage R&D company in need of funds to get to proof-of-concept? A later-stage company in need of funds to put up a manufacturing or production plant? Isolate what you want to accomplish, the anticipated timing of your project, and your funding needs, and then assess which funding programs
Given the number of applicants for each funding opportunity and the amount of management time (and in some cases, non-trivial sums of money) that can be expended on a funding application, companies would be well advised to make a very clear-eyed, upfront assessment of which opportunities to pursue.
How do government agencies decide which companies to support?
Government agencies make decisions about which companies to back in much the same way that venture capitalists do. Just as venture capitalists do not give handouts to companies based on financial need, neither does the government. Each agency will make funding awards to companies that it believes can best use its available funds (i.e., our tax dollars) to advance the agency’s strategic goals in particular target industries. Across the board, we have found that government agencies ask the same basic set of questions of applicants:
Is your project technically sound?
When funding applications are reviewed, the bulk of the applicant’s “score” in most cases will be based on the results of the agency’s technical review, which is to be conducted by reviewers schooled in the art of your technology. Do you have good research conducted by reputable scientists backing up your claims? Do you have positive results from small- or large-scale demonstrations of your technology? Does your manufacturing process work? Can you point to previous success in this field to bolster your case? Applicants who inspire the confidence of the government in their companies’ technology are those most likely to obtain funding.
Will funding your business help the government achieve its policy objectives and programmatic priorities?
The Obama Administration has high-level policy objectives to mainstream renewable energy technology, enhance energy security and energy independence, reduce greenhouse gas emissions, and create jobs; programs within the federal agencies have more specific objectives, such as developing the electric vehicle industry or encouraging partnerships between academia and industry to collaborate on wind-energy technology research. Companies that are able to make the case that their project will help the applicable agency achieve these goals quickly and with greater success are more likely to receive a government funding award.
Is your project plan financially feasible?
In most cases, a separate financial review of your application will be conducted by people who are sophisticated in such matters, including major consulting firms and accounting firms who are retained to assist the applicable agency in application review. Are your spending plans and revenue projections realistic? Is the timing you propose for the commencement and completion of your project supported by reasonable assumptions? Overly optimistic projections are likely to be viewed as just that, and may detract from the credibility of an otherwise strong application.
Do you have an experienced management team that inspires confidence that the project can be completed as planned?
Just like venture capitalists, the government wants to bet on horses that have won in the past and are likely to win again. An experienced management team with past successes in a similar industry gives the government confidence that it is backing a company that will put taxpayers’ money to good use. This is particularly important with respect to funding obtained through ARRA programs; the intense focus on weeding out waste, fraud, or abuse of taxpayer funds distributed through these programs puts additional pressure on the government to pick likely winners who will run their companies in a trustworthy and ethical manner that will achieve success.
Do you have good references?
When your funding application goes into the hopper at a particular agency, it is likely to be competing with many (possibly hundreds of) other applicants for the attention of the agency’s reviewers. How will you differentiate yourself?
One way is to try to get to know key people within the relevant departments or programs and introduce your technology to those individuals well before your application is submitted. If you are able to meet with these key individuals, you should treat that opportunity as you would an opportunity to present to a venture capitalist. Prepare well, use your time wisely, and have a succinct, high-impact presentation that will leave a positive and lasting impression of you and your company that will give you name recognition when applications are reviewed.
In addition, try to make yourself known at industry conferences and through positive media coverage. The program managers and application reviewers are going to the same conferences and reading the same press
Do your traditional investors have skin in the game?
Most funding opportunities have a cost-sharing requirement (or equity investment requirement in the case of loans and loan guarantees) typically mandating that 20 to 50% of the proposed project cost be borne by the applicant company. One of the goals of the ARRA is to bring skittish investors off the sidelines, and requiring cost-sharing or an equity investment alongside debt financing provided or guaranteed by the government is one way to accomplish that goal. The government also has found that the higher the proportion of project cost borne by the applicant, the higher the likelihood of success of the project, because the applicant is literally more invested in the project. Note that cost overruns will not be cost-shared by the government, but borne by the applicant. Yet more reason to make sure that your cost projections are as realistic as they can be.
How is the government different from a traditional venture capital investor?
There are a few key differences, including:
No equity investment. The government’s investment is not an equity investment (though there has been some discussion about whether this should continue to be the case). So long as government funding is in the form of grants, loans, or loan guarantees, your traditional equity investors will have far greater control from a stock ownership perspective relative to the percentage of capital they have invested. Particularly if an equity investment is contingent upon receipt of a government funding award, you must consider the effect of this dynamic on the company’s valuation when negotiating investment terms with those investors.
More process, a different kind of control. The Energy Secretary is not going to come to your board meetings if you receive funding from the DOE. However, starting with the application process itself, you will be subject to strict procedural requirements, and if you receive an award, you will be subject to government contracting regulations that sometimes can be quite onerous, especially compared to the information rights that are granted to board members and key investors in a venture-backed company. Government funds come with restrictions regarding the manner in which they may be spent, and may require that an awardee company institute new accounting procedures to ensure that the necessary tracking and reporting can be done accurately and on a timely basis. If you are selected to negotiate a funding award with a government agency, please consult with experienced government contracting accountants and attorneys so that you understand and are prepared to meet these requirements.
Intellectual property rights of the government should be understood and negotiated wherever possible. Each funding program will have intellectual property rights provisions in the relevant funding opportunity announcement that should be considered when formulating an application and in negotiating a funding award. The government may have certain rights in technology created using a funding award by statute, or there may be flexibility to negotiate those terms. Questions for an applicant company to ask include: Does the Bayh-Dole Act apply to me? If so, what does that mean? What position is the applicable agency likely to take when they are negotiating intellectual property rights under a Technology Investment Agreement? Will I be able to commercialize my technology as planned, domestically and overseas, if I use government funding? Companies should consult with experienced government contracting and intellectual property attorneys to structure the award to preserve maximum flexibility to commercialize technology developed using government funding.
By Paul Huggins, Eric Natinsky, and Jay Reddien, Associates (Austin Office)
When entering into commercial contracts during uncertain economic times, it is important for a company to contemplate the consequences of a counterparty becoming insolvent or otherwise failing to perform. While such considerations are prudent for all companies, they can be particularly critical for early-stage companies, which inherently tend to have fewer contracts and less diversification and, consequently, may be disproportionately harmed by the failure of one or more commercial relationships.
When a counterparty to a commercial contract fails, there are a variety of potential consequences for the other company. The specific consequences depend on the nature of the relationship, the type of failure, and whether or not the failing party files for, or is involuntarily forced into, bankruptcy protection. In most cases, a party can mitigate the risks of a worst-case outcome by negotiating protective provisions at the outset of the relationship, by paying attention to the counterparty’s performance, and by taking action before a bankruptcy petition is filed.
To understand the risks, one has to know some basics about the overlay of bankruptcy law. First, because bankruptcy law is a body of federal law, it takes precedence over (or preempts) commercial arrangements, which are governed by state law. In other words, if bankruptcy law requires one outcome and a contract provides for a different outcome, the outcome dictated by bankruptcy will prevail. One of the more important provisions of bankruptcy law (and an illustration of the consequences of preemption) is the imposition, effective immediately upon the filing of a bankruptcy petition, of an automatic stay, which is in essence a wall that divides the failing party’s world into pre-bankruptcy and post-bankruptcy periods (also called pre-petition and post-petition periods). The automatic stay severely limits the ability of aggrieved counterparties to take any action against the failing party without the approval of the bankruptcy court, even if there is an explicit contract provision to the contrary.
A primary purpose of bankruptcy law is to ensure that when debt claims are too much for the failing party to handle, those claims are processed in an orderly manner. Thus, claims for payment
A party can mitigate payment risk by getting and perfecting a security interest in collateral, or something that approximates this kind of protection, e.g., a performance guaranty from a credit-worthy third party, such as a parent company, or a letter of credit from a bank that can be drawn upon to make payment. Getting these protections is easier said than done, however, and in many cases these are not practical options. But even where these protections are not possible or practical, a party can mitigate payment risk by requiring pre-payment, or including a right in the contract to suspend performance of services or shipment of goods following nonpayment. If a contract does not have these protections at the outset, it might be possible, when a counterparty begins to fall behind on its payment obligations, to amend the contract to put such protections in place or to otherwise reduce the counterparty’s credit and payment period. But due to the limitations imposed by the automatic stay and other aspects of bankruptcy law, timing is important and can affect the validity of any such amendment; thus, it is important to closely monitor payments.
Many contracts contain express rights to terminate in the event the other party is subject to a bankruptcy filing. But because of the automatic stay, that right cannot be exercised without the approval of the court, which in the absence of extraordinary circumstances, is unlikely to be granted. In many cases, being held in a contractual arrangement while the bankruptcy process plays itself out may be perfectly acceptable, but often this can leave parties in limbo while waiting to find out whether the agreement ultimately will survive.
If it is important to be able to exit a relationship upon signs of instability, then the termination rights need to be carefully structured so that the right to terminate arises prior to the actual filing for bankruptcy. This means identifying events that are common precursors to a bankruptcy filing (such as making a public statement regarding financial difficulty or amending a credit facility) or providing a more general right to terminate upon a material change in financial condition. Additionally, a company procuring goods or services can mitigate risk due to the failure of a vendor by insisting upon termination rights in the event of an uncured material breach or a number of immaterial breaches, because such breaches may indicate that the counterparty does not have the resources needed to support its business. Further, deeming the non-payment of any amount to be a material breach and providing for a shorter cure period for non-payment than for other material breaches can further mitigate exposure. But these rights only help if used before the bankruptcy filing, and so it is important to promptly send notices of default, and to be diligent and precise in complying with notice provisions, in order to start the cure-period clock running and reduce or preclude arguments that rights of termination have not arisen.
Conversely, as part of the bankruptcy process, the bankrupt party can reject, and thereby terminate, certain types of contracts—generally, any contract that has unperformed material obligations of both parties. This right is provided by federal bankruptcy law and, thus, is available to the failing party even if the contract does not expressly provide such a right. If the failing party exercises its right to reject a contract, the other party will be left with an unsecured claim for damages.
Integrity of Inbound Licenses to Intellectual Property
As an exception to the bankrupt party’s general right to elect to terminate a contract, parties holding a license to the bankrupt party’s intellectual property, including patents, copyrights, mask works, and trade secrets (but not trademarks), are afforded special protections under Section 365(n) of the U.S. Bankruptcy Code. In short, a license within the meaning of Section 365(n) will be preserved irrespective of whether the contract granting that license is rejected by the bankrupt party. In other words, the right to use intellectual property within the scope of the license granted by a licensor that subsequently fails will be unaffected by a bankruptcy filing. That is good news for the licensee and underscores the importance of being explicit that a license is intended to fall under Section 365(n).
The bad news is that, while the license is preserved, the license agreement itself can be rejected. Accordingly, if a failed licensor has ongoing performance obligations (e.g., development work, maintenance, and support obligations), it can get out of those obligations by rejecting the license agreement. If the contract is rejected and the license grant is not broad enough to enable the aggrieved licensee to support the intellectual property, the licensee may not have very useful rights. And even with broad use rights, if the licensee does not have access to the source materials (e.g., source code, blueprints, and technical instructions) or personnel with know-how, the use rights may be significantly handicapped.
Consequently, if an inbound license to intellectual property is of vital importance and mere use rights are not in and of themselves sufficiently protective, it can be critically important to require that relevant supporting materials be placed into a third-party escrow account, to carefully define the release triggers (e.g., material breaches of performance obligations, insolvency, and termination of the contract by licensee for cause) and, if applicable, provide for expanded use rights upon release, so that the licensee can access the materials and use them to support its license. Here again, monitoring performance can help to mitigate risk. If a licensee who negotiated for source materials to be placed in an escrow account never bothered to verify delivery or periodic updates, it may be left without access to those source materials post-petition and left at the back of a line with an unsecured breach-of-contract claim.
By Robert Housley and Evan Kastner, Associates (Austin Office)
Fundraising in today’s tight capital markets may present entrepreneurs and board members with unique challenges. Entrepreneurs may find that it is difficult to identify new, outside investors that are willing to participate in a round at a valuation that reflects the company’s progress as viewed by management and insider stockholders. Companies may find themselves with fewer financing opportunities and may have an immediate need for cash to fund operations, begin critical projects, or make payroll. In situations where companies have limited alternatives or have to rely on inside investors, it is particularly critical that they implement a process whereby they can balance the need to bring in that vital cash infusion with the requirement that the board and management maintain an appropriate level of oversight to satisfy their fiduciary duties and lessen the risk of stockholder litigation.
Good Process Leads to Good Substance
Corporate law generally holds directors to a standard of conduct that ensures that they address the various interests involved, carefully weigh important decisions, consult with appropriate advisors, and disclose conflicts of interest. In theory, implementing procedures early in a transaction to ensure compliance with such fiduciary duties will lead to an optimal—or at least a more fair—result when looking at the transaction through the eyes of the stockholders as a group.
In recognition of these principles, courts have provided certain protections for the benefit of directors and the decisions they make where minimum standards of board conduct are met. For example, the business-judgment rule generally provides that if directors comply with their fiduciary duties of due care, loyalty, and good faith (further discussed below), most state courts will not second-guess the business judgment of the board. Further, even in many cases where a director has a financial or other interest in a transaction (such that it might be considered an “interested-director transaction”), the transaction may be protected from invalidation on that basis alone if the directors’ interests are fully disclosed and it is otherwise approved by a majority of the disinterested directors or the stockholders, or if it is ultimately determined to be fair to the stockholders as a group. Whether or not a transaction is fair to the stockholders will be determined by reviewing the transaction under the “entire-fairness” standard. The entire-fairness standard encompasses two major concepts: fair price and fair process (i.e., timing of the transaction; how it was initiated, structured, negotiated, and disclosed to stockholders; and how the approvals of the directors and stockholders were obtained).
The rationale underlying the business-judgment rule and upholding certain interested-director transactions is that risky business decisions are better left to those immersed in the operations of the business and the surrounding circumstances rather than judges and legislators. Directors should not be viewed as guarantors of success or guardians against mistakes. Directors do not have to be right in every decision so long as they satisfy their fiduciary duties in good faith.
Understanding the Fiduciary Duties
Directors are subject to the duty of care, the duty of loyalty, and the duty of good faith, as described below:
Duty of Care. Directors must inform themselves of all material information reasonably available (which includes seeking input from relevant members of management); engage in a deliberate decision-making process; seek advice from lawyers, accountants, and bankers when appropriate; consider the short- and long-term effects of a decision; and weigh the risks associated with making a decision, including a decision not to act.
Duty of Loyalty. Directors must not take advantage of corporate opportunities at the expense of the company and shall refrain from self-dealing.
Duty of Good Faith. This is generally considered a director’s duty to act with an honest purpose and without a disingenuous mindset.
It is important that a board implement procedures to ensure that it discharges its fiduciary duties, especially with respect to transactions that involve interested directors. Therefore, companies should implement procedures engineered to maximize compliance with fiduciary duties and minimize, or at least fully disclose, conflicts with respect to a given transaction and appropriately evidence such actions.
Accordingly, and in light of some of the protections for directors and their decisions described above, this article focuses on the decision-making process rather than the substance of the decisions themselves.
So What Do You Do?
Certain steps can be taken to minimize a board’s exposure to liability from stockholder claims in connection with the fundraising process, particularly where one or more directors or funds affiliated with them are participating as investors in the financing. A number of these are practical and easy to implement, and often make good business sense from the standpoint of maximizing stockholder value. Others are more formalistic process protections that have proven to be beneficial under scrutiny by trial courts.
It is important to be mindful of best practices from the very onset of the fundraising process. While there usually will be a sense of urgency to close a venture financing once a term sheet is signed, often six months or more will have passed from when a company identifies the need to raise money to when it finally signs a term sheet and advances to a closing. Therefore, it is critical to contemporaneously consider these best practices throughout this entire process to create a clear record evidencing the company’s deliberations and discussions.
Cast a Wide Net
Make your company’s fundraising pitch to as many potential investors as possible. Reach out to the investors who are known to make investments in your company’s space; take a fresh look at whether it makes sense to bring in strategic investors (see “Cozying Up to Goliath”); even consider making overtures to investors who have previously passed on making investments in your company. If a board is required to demonstrate the fairness of a financing transaction in the face of a stockholder challenge, showing that the company canvassed the community of potential investors can be strong evidence that the company tried to obtain the best terms for its stockholders that it could—particularly in the case of an inside-led round, where it may be helpful to show a lack of interest from outside investors on more favorable terms.
Compliance with a board’s fiduciary duties does not require it to turn down a term sheet just because the terms are tough. However, a board should be prepared to show that it made an informed decision in approving a financing. Having as many data points as possible demonstrates that the board was adequately informed.
Keep Detailed Records
When your company does receive a financing term sheet, whether from an outsider or for an inside-led round, the company is likely to have pressing short-term cash needs and may want to close quickly. A displeased stockholder may seize on this as evidence that the board did not carefully consider the terms, did not actively weigh the financing alternatives, or that the transaction was not fair to the stockholders. In order to dispel any such perception, the officers and directors principally involved in the fundraising process should carefully document each step of the process.
Make sure board discussions of fundraising alternatives and status are recorded in meeting minutes during the months leading up to the financing. Save copies of meeting requests, presentation materials, and other communications with potential investors (including “no, thank you” correspondence). Make it a habit to jot down notes after each investor meeting or telephone conference with a brief explanation of the results. Follow up on potential leads and inform the board of the current status of all discussions. Then, even if your company is required to move quickly to close a fundraising, the board still can demonstrate that the company engaged in a methodical, well-informed negotiation and approval process.
Throughout the course of fundraising, consider keeping stockholders who may not otherwise have day-to-day visibility into the process involved and apprised. If the board is called upon to defend the fairness of an interested-director financing transaction in the face of a stockholder challenge, it may be helpful to demonstrate consideration of minority stockholder interests and solicitation of their feedback during the transaction negotiation process.
From a practical perspective, stockholders who are kept informed or consulted during the fundraising process may be less likely to instigate a stockholder lawsuit; they also may be more cooperative during the closing process (e.g., submitting signatures required of them on a timely basis). For example, if initial investor feedback indicates that the company is likely to receive a low valuation or that a recapitalization may be necessary as a condition to their investment, you may not want to surprise your stockholder base with this information late in the fundraising process.
Maximize Stockholder Approval
Your company’s charter documents or applicable corporate law typically will necessitate obtaining approval from your stockholders as a whole before you can close a financing transaction. There also may be separate approval requirements associated with specific series or classes of your company’s stock. However, you also should consider whether seeking separate approval from other groups of your stockholders would be beneficial, even where such approvals are not legally mandated.
For example, if as part of a financing transaction current holders of preferred stock are treated more favorably than holders of common stock, you should consider obtaining separate approval from the holders of a majority of the outstanding shares of common stock. You also might consider obtaining approval from the holders of a majority of the shares held by stockholders who are not participating as investors in the financing. Obtaining these separate approvals may provide your board with an advantage in its defense of an interested-director financing transaction. Additionally, actively seeking these approvals may help you identify in advance of closing a financing which stockholders are likely to object to its terms.
Conduct a Rights Offering
Consider conducting a rights offering in connection with your financing. This involves setting aside a meaningful portion of the shares or debt being sold in the financing and making them available for purchase by existing stockholders. Generally, a substantial majority of the securities being offered in a financing are sold to one or a few lead investors who negotiate the terms of the financing with the company. However, we recommend that you offer your other stockholders (at least those who are accredited for the purposes of applicable securities laws) the opportunity to maintain at least their pro rata ownership in the company by investing alongside the lead investors on the same terms.
This can be strong evidence of the fairness of the financing in the face of a stockholder challenge. This also may foster goodwill with stockholders who may otherwise feel that they are being excluded from the process or disadvantaged by the terms of the financing.
Special Committee; Fairness Opinion
If your financing could be considered an interested-director transaction, your board should consider whether it would be beneficial to empower a special committee of independent directors to negotiate on behalf of the company and approve the terms of the financing. While the use of a special committee does not in itself insulate a board from liability for breach of fiduciary duty in connection with a financing, in some cases the use of a truly independent special committee can shift the burden of demonstrating that the transaction was not fair to the party challenging an interested-director transaction (as opposed to the board bearing the burden of demonstrating the fairness of the transaction).
While it is not cost effective, a board also may consider engaging an outside financial advisor to render an opinion to the board or special committee that the transaction is fair to the stockholders (generally referred to as a fairness opinion). This assists the board in carrying out its fiduciary duty of care, and helps it defend the fairness of an interested-director financing transaction.
Interested-director and fiduciary-duty issues can be complex and fact-specific and may vary by jurisdiction, but with the assistance of legal counsel, there are steps that companies may take to maintain a high level of oversight and transparency in a challenging financing market. Entrepreneurs can help focus the board on potential issues early and implement procedures that should lead to good decision-making, disclosure, and, ultimately, a better result for all stockholders as a group.
REMAINING SPRING 2009 SESSIONS
Clean Tech Session, July 1
Exits & Liquidity, July 15
Board Relations & Corporate Governance, July 18
Biotech Session, July 29
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Editorial Staff: Derek Willis, editor-in-chief (Austin Office); Mark Baudler (Palo Alto Office); Doug Collom (Palo Alto Office); Herb Fockler (Palo Alto Office); Craig Sherman (Seattle Office); Yokum Taku (Palo Alto Office)
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© 2009 Wilson Sonsini Goodrich & Rosati, Professional Corporation