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Companies seeking venture capital must be more realistic Back  
Edward Millar highlights the legal implications for an Irish company looking for equity finance in today's climate.
The Irish venture capital industry has grown significantly over the last 4 years. According to the Irish Venture Capital Association report on venture capital activity presented by Matheson Ormsby Prentice, since 1 January, 1997 the amount invested annually by members of the IVCA has increased 429p.c. to a total of E208 million in the year to 31 December, 2000. Over that period, a total of E477 million was invested in 400 companies, of which 69p.c. were technology companies. The growth in the availability of venture capital has been a significant contributor to economic growth in Ireland, especially in the technology sector. But how will the recent turnaround in the capital markets effect companies seeking venture capital?

The volatility of the capital markets and its impact on the technology sector in particular has received wide spread media attention, not all of which has been objective. Venture capital investors, on the other hand, who are equity investors in the long term, appear to be taking a balanced and realistic approach to a market, which has undoubtedly become more competitive.

Company’s seeking venture capital need themselves to be more realistic about value creation and the valuations they are likely to achieve by focussing less on comparables and more on business fundamentals.

The time taken to complete an investment in the current market is undoubtedly longer than last year. Companies are less likely now to have competing offers from investors which previously gave them an opportunity to control the timetable to close a financing.

The detailed terms which an investor will require and which will be contained within the legal documents prepared by the investor’s lawyers, can depend on a number of factors including the investment criteria applied by the investors, the anticipated risk involved in the investment, the size of the investment and prevailing market practice.

Set out below are some of the areas which investors might now look to cover:-

Investors will often require preference shares convertible at the option of the holder into ordinary shares. The rate of conversion will depend upon the valuation agreed with the company. The terms of the preference shares often provide for the return of the amount invested by the preference shareholder in the event of a winding up or an exit (sale or IPO) (see below) before any return to other shareholders. In some cases, the preference shares carry a fixed dividend (as a percentage of the amount invested) which accumulates over the period of the investment and is payable either on an exit or on a winding up. In some cases the preference share is redeemable at the option of the holder after a fixed period (often 5 years) which would entitle the holder to the amount invested plus the accumulated dividend. This is only likely to be exercised if other forms of exits appear unattractive.

As mentioned above, preference share terms can include a preferential right in the event of an exit. What this means is that the preference shareholder is entitled to receive out of the proceeds of the exit the amount (or a multiple of the amount) invested (plus any accumulated dividend) prior to other shareholders and then, possibly, to participate in the balance of the proceeds of the exit as if they had converted into ordinary shares.

Companies can expect the usual ‘drag’ along provisions to be included as a term of the investment. The effect of these is that if an offer for the company is made which the investors (and possibly a specified majority of the other shareholders) wish to accept, then they have the right to require all other shareholders to accept the offer. Additionally, if within a specified period an exit has not been achieved, then investors often require the right to put the company up for sale.

Market volatility and the downward pressure on valuations means that a company’s valuation achieved in a funding round can be less than the valuation achieved on an earlier round. The effect of this is that an early round investor can suffer not only a dilution of the percentage of the issued share capital held by it but also an economic dilution (at the lower valuation, its share of the company is worth less than when it originally invested). An investor can seek protection from this by entitling it to such share of the company which the amount invested by it would have bought at the lowest valuation achieved prior to an exit. A variation on this is to take a weighted average of funding valuations prior to exit. The ultimate effect of provisions of this type are felt most by the company’s founders in the dilution that they will suffer in the event that they are unable to grow the company’s valuation through successive funding rounds.

The increased time in which to conclude an investment increases the time investors have for carrying out due diligence. Due diligence is the exercise by which an investor carries out, in conjunction with its legal and accounting advisers, an investigation into all aspects of a company’s business, assets, liabilities and prospects. The primary areas upon which an investor will focus will depend in part on what stage a company’s development is at. In the case of a technology company, all investors will investigate the extent to which the company controls the intellectual property in its products, as this is a technology company’s core asset.

Areas which often give rise to concern (and which can affect the time table for concluding an investment and a company’s valuation) include the assignment of intellectual property created by the founders (often before the company has been incorporated and possibly while they were still students), assignments of the work created by any contractor engaged to develop part of the products and confusion over whether a person engaged by the company was an employee or contractor (all contractors or consultants should enter into intellectual property assignments).

It is important for technology companies to realise that intellectual property is their core asset. By taking a detailed and prudent approach in conjunction with expert advice at an early stage to ensure control of their intellectual property is retained, will greatly assist a company during a due diligence process.

It is important for all companies, especially in competitive market conditions where the time taken to conclude financings has increased, to plan for subsequent funding rounds. Investors are often supportive of companies in which they have invested and companies may be able to negotiate bridging finance (although at a cost - usually conversion of any loan made at a discount to the next funding round) to take them through until a fundraising is concluded. Managing the negotiations will be important, especially if the valuation applied at the time of the subsequent funding round is less than that achieved in previous rounds.

A competitive market seems likely to remain, certainly in the short term. Equity finance will continue to be available from the venture capital community in Ireland and abroad for good management with realistic proposals but management teams will need to work hard to demonstrate that they are able to create value - and then they will need to deliver it.

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