The rapid return to "normal" investment levels has left angry creditors with underfunded portfolio companies, disgruntled shareholders facing lower valuations and the prospect of repeated "down rounds," and limited partners clamoring for a return of their invested capital 2. This, in turn, exposes general partners of venture capital funds to significant new legal and financial risks. In some cases, these risks could threaten the general partners' own economic survival and significantly limit their ability to raise additional capital for their funds. (Although partners rarely contribute significant capital to venture capital funds beyond their mandatory minimal commitment, they typically receive fees based on the profits of the funds.)
A portfolio company is a company in which a venture fund makes an investment. A down round (relative to the post-money valuation of the company in previous financings) is a subsequent financing that does not take into account the company's valuation in the immediately prior, or all prior, financings. Down round financing often severely dilutes the investment value of existing investors.
Role of General Partners
General partners of venture capital funds perform several roles simultaneously. General partners pursue investment opportunities and manage the investments of the funds. Limited partners invest capital based on their expectations of the general partners' abilities to identify investment opportunities that will generate an attractive return for the limited partners.
General partners can offer the significant business experience and management expertise of their principals or employees to portfolio companies, and often have their principals or employees serve as directors or officers of the companies. Also, general partners may serve as financial intermediaries for the purpose of:
Each of these roles creates significant legal risks. Although these legal risks are generally ignored in a growing economy, they become real business liabilities when portfolio companies fail and the expected returns on invested capital evaporate.
This article reviews the principal legal risks to general partners of venture capital funds and advises how to minimize them.
Characteristics of Venture Capital Funds
Venture capital funds are typically organized as limited partnerships. The limited partners provide the capital available for investment, and the general partners provide investment expertise and asset management services in exchange for a management fee and significant profit participation. The general partners of the limited partnership may be individuals, but are usually corporations or limited liability companies.
Limited partners generally consist of a diverse group of investors, including pension funds, investment banks, insurance companies, wealthy individuals, and charitable foundations. Limited partners are often sophisticated, wealthy investors who wish to engage the general partner of a venture capital fund to identify investment opportunities and to make investment decisions for them.
The limited partners often lack expertise in a certain industry or do not have the information or capacity to make direct investments in privately held companies. Accordingly, they rely on the general partners to select and monitor appropriate investment opportunities through the venture capital fund.
Duties and Responsibilities of General Partners to Limited Partners
As managers of venture capital funds, general partners have specific legal obligations to the limited partners who invest in the funds. These obligations are contractual (such as those set forth in a limited partnership agreement) or are based on statutes.
The contractual and statutory obligations of general partners to the limited partners in a limited partnership determine the relationship of the parties and any ensuing liabilities. Many of the obligations owed to the limited partners are specified by statute and cannot be amended by contractual provisions. For example, Corp C õ16103(b)(3) sets the limits under which the duty of loyalty may be changed by a partnership agreement.
Generally, the obligations of general partners to the venture capital fund, if the fund is formed as a California limited partnership, are governed by the California Revised Limited Partnership Act (CRLPA) (Corp C õõ15611-15723). These obligations include the duties of loyalty, care, and good faith and fair dealing.
The duty of loyalty particularly applies to general partners of venture capital funds, and it includes the duty to refrain from adverse dealing and from competing with the venture capital fund.
Compliance with these duties may be called into question by limited partners if the general partners are managing more than one fund simultaneously. Technically, the general partners act as agents for the limited partners, with the limited partners paying the general partners management fees and a carried interest for the general partners' expertise.
A general partner usually receives a carried interest as payment for its services, which is a specified percentage (typically 15-35 percent) of the venture capital fund's equity share of any portfolio investments.
Duties Should Be Specified in Agreement
The duties of general partners should be specified upon formation of the venture capital fund. All partners in a venture capital fund must carefully ascertain that the limited partnership agreement or other formation document provides not only for capital distributions and gains, but also for any negative events that may occur during the life of the fund (for example, defaults by limited partners and restrictions on the powers of general partners).
The authority of the general partners regarding investment decisions is a key provision. The limited partners may choose to trust the general partner and be willing to accept the investment decisions of the general partner for the limited partnership. Or, the limited partners may want to impose limitations on the general partner's investment authority. Provisions regarding the scope of authority of the general partners, as well as any restrictions on those powers, should be specified in the partnership agreement. Such provisions may serve as a defense in the event that the limited partners become impatient with the lack of returns of the fund.
Limiting the Liability of the General Partner
Another key provision that should be included in the partnership agreement is a limitation of the liability of the general partner against the following events: (1) disappointing returns from investments selected by the general partner; (2) failure by the general partner to invest committed funds within an agreed timetable; and (3) mismanagement by the general partner. These issues often are not adequately considered when the fund is formed, but become increasingly important when the fund's investments fail to meet expectations.
Limited partners have become more demanding regarding the management of venture capital funds. This can be due to a lack of returns over several quarters, a failure to achieve complete subscription for funds, and the slow pace of new investments. To limit their economic exposure, limited partners are now asking general partners to downsize funds, lay off employees, cut back management fees, and accept defaults on capital calls. (A capital call is a contractual obligation on the part of a limited partner to invest additional capital, at a time, or on the occurrence of an event, defined in the limited partnership agreement, and is typically related to a need for funds for investment or payment of management fees).
These demands by the limited partners affect general partners both economically and legally. As an example, in a recent court case, a group of minority investors filed a $1 billion claim against Idealab, Inc. and accused its chairman and chief executive of mismanagement following the decline of their portfolio value. See Kline Hawkes & Co. v Idealab, Inc. (Los Angeles Super Ct, filed Feb. 28, 2002, No. BC 266647). This case illustrates the need for selectivity when general partners choose their limited partners, as well as the importance of drafting provisions in the partnership agreement that protect general partners. The agreement must give general partners appropriate discretion regarding investment decisions.
Issues Related to Downsizing an Investment Fund
Due to current economic conditions, including lack of funding, lack of good investment opportunities, impatient limited partners, and nonperforming portfolio companies, general partners and limited partners of venture capital funds may consider downsizing the fund. Downsizing can be a voluntary decision made by the general partner and the limited partners, or may be an involuntary consequence of a limited partner's failure to complete its capital commitment or the general partner's lack of additional capital calls due to unacceptable investment opportunities.
Capital commitments are designed to permit the fund to grow at a pace consistent with its growth objectives. If the limited partners do not fund their capital commitments (because of, for example, a lack of available cash or even a loss of interest in the fund's investments), the absence of expected contributions may jeopardize the fund's ability to grow as planned, which in turn may limit the general partners' ability to take advantage of investment opportunities or make follow-on investments to which the fund may be contractually obligated.
One of the results from a voluntary downsizing of a venture capital fund may be a request by limited partners that general partners release them from their capital commitments. General partners may be reluctant to release the limited partners, however, because a downsizing gives the perception in the market place that the general partners have a reputation for failed business plans or for providing inaccurate growth objectives.
Also, downsizing may impact both the expected compensation of general partners and the expected return of the limited partners. Because limited partners invest with the expectation of a certain size and growth of the venture capital fund, a failed capital call is a significant change in circumstance.
Response to Failed Capital Call
In response to a failed capital call, general partners must act quickly to resolve the lack of contributions. Such an action must be consistent with general partners' fiduciary duties to optimize the return for the fund and its limited partners, and must also avoid conflicts of interest or questions of loyalty that could be raised by the limited partners.
The general partners must carefully follow the procedures and penalties for limited partners who default in their capital contribution commitments, as set forth in the limited partnership agreement. General partners must take special care to document the failure of the limited partners to make capital commitments, treat all nondefaulting and defaulting limited partners as such, in accordance with the partnership agreement, and avoid obtaining a personal advantage for the gener al partner in light of the limited partners' defaults. General partners must also consider pursuing the defaulting limited partners for breach of contract or making a claim for expected income due to a loss of management fees or fees from a carried interest.
Limited partners now more review carefully the fees that general partners are paid for the management of venture capital funds and for the successes obtained from the funds' investments. Typically, management fees charged by general partners are based on the volume of capital commitments. With limited partners defaulting on their capital commitments, general partners' fees and profits are decreasing. Limited partners are also frustrated because they often have to keep paying fees over the period that a fund is invested, which could continue for several years, or in some instances pay fees on capital commitments that are not yet invested. Some limited partners complain that general partners' fees should be reduced when less capital is being invested in portfolio companies.
Uncertain of their ability to raise adequate funds as projected or to invest all of the projected and committed funds, some general partners are considering downsizing the funds even before any complaints or concerns are received from the limited partners. However, for general partners to downsize, the fiduciary duties the general partners owe to the limited partners must be carefully considered, and general partners may be required to renegotiate or redefine the objectives of the partnership that the limited partners relied on to make their investments.
Duties and Responsibilities of General Partners of Venture Capital Funds to Portfolio Companies, Other Shareholders, and Creditors
General partners of a venture capital fund may be exposed to liability to their portfolio company and third parties because they are providing management resources to the portfolio company and are acting as a financial intermediary on behalf of the portfolio company and other venture fund investors. In particular, liability may arise if the general partners, directly or through their employees, exercise significant control over a portfolio company's business activities, such as through controlling shareholder interests, controlling positions on the board of directors, having contractual veto powers conferred on them, and playing an instrumental role in structuring rounds of financing.
In addition, the ultimate downsizing of a portfolio company raises its own concerns about the general par tners' role in the process. A bankruptcy, and the corresponding lack of adequate assets to satisfy creditors and shareholders, may create an incentive for these creditors and shareholders to seek additional recovery from the venture fund investors and their general partners.
Participation in the Management of Investments
General partners of venture capital funds are often deeply involved in the management of their portfolio company investments. This involvement can take three forms:
Frequently, a venture fund will negotiate for the right to have at least one representative on the portfolio company's board of directors who can then actively partic ipate in the management, operations, and financing of the company. The number of members of the board to be nominated by a venture fund varies widely. In transactions in which the venture fund has significant leverage, the venture fund may seek control of a majority of the seats on the board from the date of the initial investment. In other transactions, the venture fund may have a minority of the seats on the board as an initial matter, but retain the right to take control of the board at some point in the future if the portfolio company defaults on its obligations to the venture fund or fails to meet specified financial or strategic covenants.
General partners may wish to make certain that their principals, or employees whom they make available to the portfolio company, serve as part of the management team. The experience, skills, and connections that general partners of a venture capital fund can bring to a portfolio company, particularly a company in formation, can be very attractive to the company and can provide valuable depth to a sometimes inexperienced management team.
Participation in the portfolio company may also include contractual restrictions on certain types of business activities through the use of an investor rights agreement, shareholders' agreement, or similar documents. The restrictions may require the portfolio company to absolutely comply with both affirmative and negative covenants, unless the company's board of directors specifically authorizes a waiver of the covenant. Affirmative covenants typically include pre-arranged composition of the board of directors, prompt financial reporting, payment of taxes, maintenance of insurance, and compliance with laws. Negative covenants may include prohibitions on dividends, sale of new securities, sale of assets, mergers, or consolidations, liquidations, acquisition activity above a certain dollar threshold, additional or new indebtedness (other than in the ordinary course), investments in other lines of business, research and development expenditures above a certain dollar threshold, and capital expenditures above a certain dollar threshold.
Finally, a venture capital fund with a majority or controlling shareholder interest in the portfolio company, through its general partner, will have opportunities to influence the management of the company, particularly if given specific shareholder approval rights in an investor rights agreement or charter documents.
Fiduciary Duties of General Partners
Providing management resources undoubtedly benefits the portfolio company and its shareholders. However, general partners providing management resources must be mindful of the fiduciary duties created by the fund's status as majority shareholder, the fund's contract-based control mechanisms, or its representation on the company's board of directors. These fiduciary duties extend to the portfolio company and its shareholders.
General partners should also note that exercising control over the affairs of a portfolio company may result in the general partner or the venture capital fund being deemed the alter ego of the portfolio company and thus liable for the debts and obligations of the portfolio company.
California has long recognized that the dominant or controlling shareholder of a corporation has a fiduciary responsibility, not only to the corporation, but also to the minority shareholders, to use its ability to control the corporation in a fair, just, and equitable manner. See Jones v H.F. Ahmanson & Co. (1969) 1 C3d 93, 81 CR 592.
A venture capital fund may find itself in the position of controlling shareholder, not merely from a majority ownership of the portfolio company's equity, but also based on the contractual rights the fund may possess in controlling corporate activities (particularly if the fund, through its general partner, by virtue of its position, possesses information that is not available to outside shareholders). 1 C3d at 109. In accordance with this fiduciary duty, majority shareholders may not use their power to control corporate activities for their own benefit or in a manner detrimental to the minority. Any use to which they put the corporation or their power to control the corporation must benefit all shareholders proportionately and must not conflict with the proper conduct of the corporation's business. 1 C3d at 108. Indeed, even if the majority shareholders have the statutory power to take certain actions, the exercise of such power is subject to equitable limitations in favor of the minority. See In re Security Fin. Co. (1957) 49 C2d 370, 317 P2d 1. Conversely, the general partners owe no fiduciary duty to the shar eholders if the venture capital fund is not a controlling shareholder and does not sit on the board of directors through its general partner. See, e.g., Kimberlin v Ciena Corp. (SD NY, Sept. 9, 1998, 96 Civ 8704 (SS)) 1998 US Dist Lexis 14366.
General partners and their employees should be made aware that members of the board of directors are subject to similarly high standards. A corporate director owes statutory fiduciary duties of care and loyalty to the corporation and its beneficiaries. Corp C õ309. The duty of care obligates directors to act in an informed and diligent manner when making decisions and overseeing the corporation's operations, and to exercise their responsibilities without negligence. The duty of loyalty prohibits directors from making an unfair profit from their positions. All transactions by employees and directors designated by general partners must be carefully scrutinized for evidence of unfair dealing to the detriment of the portfolio company and its shareholders, with potential for liability for breach of fiduciary duty if such evidence is uncovered. See Remillard Brick Co. v Remillard-Dandini Co. (1952) 109 CA2d 405, 241 P2d 66.
Although business decisions by corporate directors are entitled to deference under the business judgment rule, directors may not engage in a self-enriching transaction to the detriment of the company or its minority shareholders. See Nixon v Blackwell (Del 1993) 626 A2d 1366. The rule that has developed in California, as well as in other states, is a comprehensive rule of inherent fairness and good faith.
These duties of general partners and their employees are highlighted in claims that may be brought by a portfolio company's other shareholders following a down round financing. For example, in 1994, the founders of Alantec Corp., a computer networkin g company, filed a lawsuit against the company's venture capital investors and the fund representatives who were members of the company's board. Kalashian v Advent VI L.P. (Santa Clara Sup Ct, filed March 23, 1994, No. CV739278). The founders claimed that the board representatives of the venture capital fund breached their duty of loyalty during a down round financing in which preferred stock was issued to the venture funds at allegedly less than fair market value, which in turn diluted the founders' interest in the company. Defendants argued that the company could not attract any other investors due to its distressed financial situation, and that the preferred stock at issue was sold at fair market value. The case was eventually settled for a reported $15 million.
Methods of Meeting the Good Faith and Inherent Fairness Requirements
If a transaction negatively affects other shareholders of the portfolio company, directors designated by general partners have several ways to meet the good faith and inherent fairness requirements and avail themselves of the business judgment rule. First, there should be a proper corporate purpose in structuring the down round. See, e.g., Bauer v Bauer (1996) 46 CA4th 1106, 54 CR2d 377 (dealing with a claim based on improper "squeeze-out;" a situation analogous to a down round in which the majority controlling shareholders engage in a course of conduct designed to exclude minority shareholders from participating and benefiting from the corporation's business); Orban v Field (Del Ch, Apr. 1, 1997, Civ Action No. 12820) 1997 Del Ch Lexis 48 (a board may deploy corporate power against its own shareholders in some circumstances if it can demonstrate that it acted both in good faith and reasonably.)
Second, general partner directors considering a down round financing can take a number of steps to protect any decisions from later attacks. Directors should be satisfied that the following issues are discussed at a board meeting and that the board minutes reflect such discussion:
General partner directors should also scrupulously follow state corporate law on conflict-of-interest transactions if the fund is the only participant in the down round or will benefit most dramatically from the round. See Corp C õ310. Accordingly, general partner directors should consider:
Third, general partners can negotiate for contractual rights that afford all shareholders an opportunity to participate in subsequent rounds through preemptive rights, often referred to as a "pay-to-play" provision.
A pay-to-play provision typically requires a shareholder to participate in the company's next round of financing in order for the shareholder's antidilution preference or other preemptive rights to apply to the new financing.
Courts may be inclined to defer to existing contractual arrangements between the parties, made at the time the shareholders purchased their stock. Leaving parties free to construct their own contractual protections is viewed as preferable to post hoc imposition of judicially created remedies. The Delaware Supreme Court has noted that the tools of good corporate practice are designed to give purchasing shareholders, whether majority or minority, the opportunity to bargain for protection before parting with consideration. Nixon v Blackwell (Del 1993) 626 A2d 1366.
Another solution that may be available to address fiduciary duty concerns is a "next round pricing" strategy. If valuation is disputed or uncertain because of the immaturity of the portfolio company, financing may take the form of a bridge note or convertible security that would convert, if at all, at a price calculated based on the pre-money valuation established in a subsequent round. See Bartlett, The Next Round Pricing Strategy, posted on Mar. 26, 2002, on The VC Buzz, www.vcbuzz.com. Because the general partner is not setting the price at a time when the valuation is uncertain (or at a significant disparity from the previous round), next round pricing may create a defense for venture funds engaged in a round that would otherwise dilute the existing shareholders of the company to insignificance.
Fourth, even without preexisting contractual rights, general partner directors may also consider recommending that the portfolio company offer all the shareholders, or at least the accredited shareholders, the right to partic ipate in the down round financing. If the financing must be consummated quickly, the portfolio company may offer the participation after an initial closing with the lead investor.
Finally, general partner directors can recommend that the portfolio company obtain a fairness opinion or independent appraisal to validate the valuation of the down round. Unfortunately, although fairness opinions may be useful in a down round context as a means of establishing the fairness of the transaction from the perspective of the company's shareholders, they are rarely used as a practical matter because of the high cost and the time required to complete the opinion. Portfolio companies facing down rounds are usually short on both cash and time.
Duties When Portfolio Company Is Downsizing or Becomes Insolvent
When a portfolio company's financial condition dictates that it must downsize, liquidate, and/or file for bankruptcy, general partner directors must continue to exercise fiduciary duties to the company and its shareholders. General partners, in their capacity as majority or controlling shareholders, must similarly continue to exercise their fiduciary duties to the company and its shareholders.
When the company actually becomes insolvent, the fiduciary duties of the board of directors to the shareholders may expand to include the company's creditors. The fiduciary duties of the majority or controlling shareholder of the company will also extend to the company's creditors. Thus, the general partner's interests will be in direct conflict with the interests of the company's creditors, because the creditors have a superior claim to the company's assets. This conflict is even greater if the general partners made bridge loans to the portfolio company through the venture fund. This is because the venture fund is also a creditor of the company.
Fiduciary Duties to Creditors
The scope or even existence of a director's fiduciary duty to creditors of a portfolio company is unclear. When a corporation is financially healthy, directors owe fiduciary duties of care and loyalty to the corporation and its shareholders. Although directors are obligated to maximize the long-term interests of the corporation's shareholders, they are not required to take creditors' interests into account in their decision-making process. As a result, creditors' rights are generally limited by the terms of their contracts with the corporation.
Nevertheless, case law indicates that a director's fiduciary duties may extend to creditors when the corporation becomes insolvent. This case law, however, closely resembles the law of fraudulent conveyances or voidable preferences under bankruptcy law, and seems to extend a director's fiduciary duties only to creditors in instances when the director is also a creditor of the insolvent corporation and acts in a way that scarce corporate assets were diverted to the repayment of the director's own loan at the expense of other creditors. See Title Ins. & Trust Co. v California Dev. Co. (1915) 171 C 173, 152 P 542 (noting the firmly established rule that directors of an insolvent corporation who have claims against the company as creditors cannot secure to themselves any preference or advantage over other creditors through the use of their powers as directors).
It has been suggested that the fiduciary duty to creditors in a period of insolvency, in theory, could be so broadly construed as to require directors to take affirmative action to maximize the interest of the creditors. However, existing case law indicates that courts (including courts in California) have adopted a narrower version of the directors' obligations by interpreting the duty to require that directors treat all creditors equally and to prohibit directors from withdrawing corporate assets for the benefit of themselves, shareholders, or some preferred creditors. See Lin, Shift of Fiduciary Duty Upon Corporate Insolvency: Proper Scope of Directors' Duty to Creditors, 46 Vanderbilt L Rev 1485 (1993). This extension of a director's fiduciary duties to creditors when the director is also a creditor is consistent with California law, which views all the assets of a corporation as part of a trust fund for the benefit of all the creditors once the corporation becomes insolvent. See Nahman v Jacks (In re Jacks) (BAP 9th Cir 2001) 266 BR 728.
Designated directors of general partners are often faced with a dilemma when, in an effort to keep the portfolio company solvent, the fund has made bridge loans to the company shortly before the company declares bankruptcy. These bridge loans suddenly place the general partner director in the position of acting at the direction of a creditor of the company, and may create fiduciary duties to creditors that would not otherwise exist. Thus, the very decision to downsize a company or file for bankruptcy protection will implicate the conflict-of-interest concerns that arise from down round financings. Several of the techniques discussed for down round financings will also be helpful in managing the fiduciary duties of the directors (and controlling or majority shareholders) to creditors.
General Partners as Alter Ego of Portfolio Company
An additional troubling aspect for general partners who participate in the management of a portfolio company is the potential claim that the general partner is the alter ego of the portfolio company and should be held liable for the debts of the portfolio company. General partners can stray into dangerous legal territory quickly when they assume so many roles simultaneously. Although a general partner acting on behalf of the venture capital fund, as a shareholder, would typically enjoy the limited liability benefits of the "corporate veil," a corporate identity may be disregarded if an abuse of the corporate privilege justifies holding the equitable owner of a corporation liable for the actions of the corporation. Sonora Diamond Corp. v Superior Court (2000) 83 CA4th 523, 99 CR2d 824.
California courts identify and weigh a number of factors to determine whether a person is really a corporation's alter ego, including the following (83 CA4th at 538):
At least one creditor has attempted to hold a venture capital fund liable for the debts of a portfolio company by alleging that the portfolio company was the alter ego of the venture capital fund because the fund purportedly exercised substantial control over the finances, activities, management, and business affairs of the company. See G&L Realty Partnership LP v McNeil (San Luis Obispo Super Ct, filed Aug. 1, 2001, No. CV 010645) (the case was eventually dismissed with prejudice).
Alter ego liability can be avoided by limiting the general partner's involvement in the portfolio company's management and operations. General partners should be cautious about having their employees and principals serve as officers of the portfolio company.
A venture fund may take a proactive approach to ameliorating the risk of alter ego allegations by its portfolio companies by (1) prohibiting fund employees from serving as officers of the company; and (2) reques ting written confirmation from the company's general counsel (or outside counsel) that the company has a full complement of directors, has regular board meetings (with proper notice and advance briefing m aterials), and authorizes all material corporate action in compliance with board and shareholder approval requirements under the company's charter.
The venture capital fund's contract with a portfolio company usually bases power to approve the day-to-day operations of the portfolio company on the approval of the fund's general partner. Accordingly, the contract should be drafted in detail to limit the need for such approval to corporate activities or events that would have a material effect on the fund's investment. Finally, it may be more prudent to have only minority representation on the board, absent some material misconduct by the portfolio company.
Participation in Subsequent Rounds of Financing
Given that general partners typically provide the portfolio company with experience, skill, and connections to capital markets, it is not surprising that general partners may actively participate in the brokering of subsequent rounds of equity and/or debt financing. Even if the portfolio company identified investors for subsequent rounds without the assistance of the venture fund, the venture fund would most certainly participate in the approval of that transaction, either through board representation or the exercise of contractual rights.
With the significant tightening of the current venture capital market and increased scrutiny of portfolio companies by funds, a company seeking financing is probably facing significantly lower valuations and terms that are much less favorable to the company and its existing shareholders than in previous years. A company's existing investors may be its only resort for raising capital, and the terms of a down round financing may have the effect of dramatically diluting the interests of the founders, employees, and other shareholders. In brokering such a transaction, the general partner must be mindful of the fact that it is again playing a number of liability-laden roles simultaneously. The general partner may be acting as a director, controlling shareholder, and possibly broker/ dealer to the company.
General partners structuring an investment round do not usually consider themselves broker/dealers or investment bankers. The general perception is that a general partner negotiates deal terms for the fund's account and not for the benefit of other participants, if any. However, it is not uncommon for a particular fund, through its general partner, to assume the role of "lead investor" for purposes of facilitating negotiations with the portfolio company, particularly when a group of venture funds is interested in the transaction.
The lead investor may even engage legal counsel for the benefit of the investor group and receive a closing or success fee when the financing round is completed. In this context, the lead investor appears to be acting very much like an investment banker or broker/dealer because it is facilitating the combination of venture capital resources with the portfolio company for a fee.
California law exempts from the definition of brokerdealer a person who trades in securities solely for his or her own account and does not engage in the business of effecting transac tions in securities. See Corp C õõ25004, 25009. A person is generally not considered a dealer if the person does not hold himself or herself out as one engaged in buying and selling securities at a regular place of business with a regular turnover in volume and time, does not handle other people's money or securities, does not make a market, and does not furnish the services ordinarily provided by dealers. However, applying this definition, a general partner acting as lead investor in a partic ular transaction should at least consider whether the licensing or registration provisions of applicable state law will apply to the general partner's conduct in the transaction.
The general partner acting as lead investor should also consider the fiduciary obligations owed by inves tment bankers to their clients. Because the interests of the lead investor are adverse to the portfolio company and aligned with the interests of the other participating venture capital firms, it is arguable that those other venture firms are clients of the "lead investor," and therefore the lead investor owes the other venture firms a duty of reasonable care and diligence to effect the transaction to the best advantage of the other venture firms.
An unanswered question is whether the fiduciary duties of an investment banker continue to obligate a lead investor to structure the down round so as to not disadvantage the other venture firms in a situation in which the subsequent down round dilutes the other venture firms, when the lead investor does not individually meet the criteria as a majority or controlling shareholder and does not serve on the board of the portfolio company or of other venture firms.
No case has yet addressed these issues. However, an analogy might be drawn to loan participation transactions in which a lead bank initiates a loan transaction and then syndicates the loan to other participating banks. The Comptroller of the Currency has suggested that individual participating banks in a multibank lending transaction must obtain full and timely credit information to conduct an informed and independent analysis of the credit in a manner consistent with its formal lending policies and procedures. Banking Circular BC-181 (rev), Comptroller of the Currency, Administrator of National Banks (Aug. 2, 1984). In other words, it is not prudent for the participating banks to simply rely on the due diligence and negotiating efforts of the lead bank. Similarly, participating venture firms may have to conduct their own due diligence and negotiate the terms of the investment transaction for their own benefit. An offer by a lead investor to coordinate the transaction must not supplant or diminish the informed and independent analysis of the transaction by the participating venture firms.
"Lead investors" can seek to minimize the risk of being viewed as investment bankers, with attendant fiduciary obligations and legal risks, by requiring participating venture firms to perform their own due diligence on a portfolio company, obtain separate legal representation, and participate actively in the negotiation of the transaction documents.
Effect on Employees
The decision to downsize a portfolio company will certainly have an adverse effect on the company's employees. Although it is relatively rare, general partners have been sued by employees of portfolio companies. The employees of the portfolio company may claim that the venture capital fund, through its general partner, exercised control over the employment decisions of the portfolio company.
In a lawsuit filed in 2000, which has not been finally adjudicated, the employees of a bankrupt portfolio company claimed that the company's venture capital investor committed fraud against the employees in an effort to get the employees to stay with the bankrupt company. See Deger, Hunting VCs, The Recorder, Apr. 18, 2002, p 1, citing Smith v Genstar Capital (San Francisco Super Ct, filed July 2000, No. 313964). The employees claim that the venture fund and the company's chief executive officer knew that the company's financial situation was poor at the time the chief executive officer sent e-mails to the employees stating that the company was financially sound.
The outcome of the lawsuit may shed more light on the duties of a general partner to the employees of a portfolio company. In the case of a financially troubled company, however, the general partner director of a portfolio company would be well-advised to consult with the company's management to determine that communications being made to the employees are not false.
Until recently, general partners of venture capital funds have been virtually immune to legal actions by their limited partners, portfolio companies, and third parties. Previous significant liquidity events-through initial public offerings or acquisitions based on exceptionally high multiples of earnings-and associated returns made the liabilities theoretical only. Increasingly, traditional legal theories are being used to force general partners to perform their legal duties and to penalize them if they fail to do so.
1 The authors would like to thank A. Anna Capelle, Eunice Paik, and Lars Johansson, associates of Coudert Brothers LLP, and Julian Lim, summer associate of Folger, Levin & Kahn, for their assistance with this article.
2 Venture capital funds invested a total of $102.3 billion in 2000, compared to $54.5 billion in 1999. In 2001, investments by venture capital funds suddenly dropped to $37.6 billion. See the statistics published by the National Venture Capital Association, which showed that $47.7 billion was invested in the second half of 2000, compared to $49.3 billion invested during the seven-year period between 1990-1997 (the online version of these statistics can be found at the association's website, www.nvca.org). See also Beacon Management, Venture Capital Statistics at www.beaconmgmt.com/Corporate Finance/Venture Capital Statistics/venture capital statistics.htm.
This material is reproduced from California Business Law Reporter (v. 24, 1 (July 2002)) copyright 2002, by the Regents of the University of California. Reproduced with permission of Continuing Education of the Bar - California. (For information about CEB publications, telephone toll free 1-800-CEB-3444 or visit our Web site, CEB.com).