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  • 1. Venture Capital Law Fordham University Law School Spring 2010 Lawrence G. Graev, Esq. Chairman The GlenRock Group, LLC 126 East 56th Street New York, N.Y. 10022 Email: Tel: 212 994 0660 Course Description and Syllabus I. Introduction and Background Private equity plays an essential role in the global economy and in the United States economy in particular. It has fueled this country’s growth by bringing new companies to the national and global marketplaces and by bringing greater operational efficiencies to mature companies that are straining under weak business models or the burdens of being public, reporting companies. In short, private equity touches all aspects of the business world as we know it today—and it is a highly structured industry governed by complex legal documentation that determines the way a private equity sponsored company conducts its business. 1
  • 2. In general, private equity represents an alternative asset class of investments in businesses that lack the liquidity normally found in investments in publicly traded securities. Within private equity, there is a broad range of investment groups that focus on different stages of a corporation’s development and on different segments of a corporation’s balance sheet. Investment groups that acquire mature businesses as a whole (and that “control” the business after the transaction) are often described as being in the “buyout business”, while those investment groups that invest in earlier stage businesses based on new technologies, new business processes or new growth strategies (and that usually do not have mathematical “control” over the business after the transaction) are often described as being in the “venture capital business”. And there are all sorts of transactions in- between these two extremes. Private equity has transformed the face of corporate America and most of the industrialized world. Today, the amount of capital available for investing in private equity on a worldwide basis has reached staggering proportions— probably in excess of $1.5 trillion. As more capital has become available for investing, transactions have grown in size to the point where most publicly traded companies can consider a leveraged buyout as a viable alternative for creating and extracting shareholder value and achieving liquidity. But private equity is not immune from financial and economic events that have impacted United States and global capital markets. The bursting of the “Internet bubble” in 2001 practically destroyed the venture capital business--those venture capital funds investing in “the next new thing” for the Internet during this period suffered severe losses of capital from which there was very little recovery. The three to five year period following 2001 was one of the worst periods in the history of venture capital. 2
  • 3. The almost catastrophic events in the subprime mortgage markets during the summer of 2007, followed by a loss of liquidity in the credit markets generally during 2008 and 2009, has had a significant negative impact on the ability of buyout funds to conduct business. Given the need for leverage to drive the returns of buyout transactions, the lack of a robust credit market has had a very negative impact on the ability of private equity funds to complete such transactions. In fact, at the time of this writing, the litigation landscape is littered with the remains of “broken deals” that were abandoned by private equity funds that could not obtain acceptable debt financing for their transactions, leaving the courts to determine whether or not an M&A agreement had been breached and, if so, the liability for such breach. Venture capital funds, on the other hand, do not usually utilize leverage in their transactions—instead, they invest in the equity of companies and they take the balance sheets of those companies “as is”. And as a result venture capital activity still seems to be rather robust. The venture capital industry seems to have come out of the malaise that gripped it after the bubble burst and investment activity has generally been fairly robust. However, the ability of a venture capital fund to experience an “exit” from an investment has been severely limited by the worst IPO market in the last 30 years. As a result, an acquisition by a strategic buyer has become a more likely “exit”, but not without some negative consequences—simply stated, the absence of an IPO market relating to venture capital backed companies has resulted in lower prices for most strategic acquisitions because these companies cannot point to heated IPO prices as a competitive alternative to a strategic buyer. 3
  • 4. Although the credit markets are currently under extreme pressure, buyout funds will find ways to get deals completed and they will find ways to make money for their investors. The buyouts actually executed in the next couple of years may utilize less leverage, may have more stringent equity and debt terms and conditions and may produce lower returns, but the buyout business will continue to play an important role in our economy. By way of example, prior to the financial crisis of 2008-2009, leveraged buyout transactions were being completed with equity representing, on average, 25-35% of the capitalization of a company, with several layers of debt making up the difference. Today, it is more likely that the equity component of a transaction will be in the range of 50% of total capitalization. In addition, prior to the financial crisis, lenders were providing debt financing into these transactions at 8-9 times EBITDA. Today, a private equity firm will be lucky to get 3-4 times EBITDA. This course examines the private equity marketplace from both a theoretical and a practical perspective and focuses on the interplay of the legal, business, economic and financial issues that need to be dealt with in the legal documentation that supports private equity transactions. This course has been designed to provide students having a fundamental knowledge of corporate law with a practical understanding of the private equity marketplace— the dynamics of (a) organizing and managing a private equity fund, (b) organizing, structuring, financing, managing and exiting private equity-backed companies and (c) executing a buyout transaction. This course will cover a variety of issues that arise in the private equity life cycle and it will address the competing economic and financial issues that are played out among the cast of characters in what can best be described as an evolving legal and financial drama. 4
  • 5. This course will include negotiating sessions organized to provide students with the opportunity to “represent” the various players in the private equity world—(a) fund sponsors vs. prospective limited partners, (b) companies vs. entrepreneurs and executives, (c) private equity funds vs. entrepreneurs and executives and (d) buyers vs. sellers of a business. In such a way, students will be exposed to the negotiating issues that are important to each group and they will “develop” the methodology for resolving competing views. The final exam, which will be a take-home exam, will provide the students with another opportunity to demonstrate that he or she understands the dynamics of the competing interests among the various players. II. Structure of Course Active student participation will be strongly encouraged and will form a significant portion of a student’s final grade. Students will be required to engage in the negotiation of key transaction documents, including term sheets and definitive agreements for the organization of a private equity fund, for the investment of capital by a private equity fund in a portfolio company and for the acquisition of a business. An attorney involved in the private equity life cycle is very often in a negotiating mode or otherwise counseling one group or another on how to deal with problems that arise in private equity relationships and it is critical to understand the various drivers and incentives that form the behavior of each group. This course will be organized into five focus areas: 1. Private Equity Overview and the Formation and Structure of a Private Equity Fund. It is critically important in understanding the private equity lifecycle that the practitioner has a deep sense of the dynamics and metrics of the industry 5
  • 6. and the world in which the private equity investor operates. While the legal documentation that supports the formation and organization of a private equity fund is very often quite complex (and the detail is beyond the scope of this course), it is important to understand how this documentation drives the behavior of private equity investors and how they deal with prospective investee companies. 2. The Organization and Structure of an Earlier Stage Company and How to Attract and Retain Employees. Any business organized on the premise that it needs to raise outside capital, and private equity in particular, needs to organize itself in a way that will be “user friendly” to the private equity investor. In short, the legal documentation that supports a private equity investment in a prospective portfolio company is relatively predictable and an entrepreneur and his counsel should structure the company in a way that will not create investment “show stoppers” for the private equity investor. The key to the success or failure of a business is ultimately dependent upon the quality of the people managing and working for the company, and it is critical that the business have in place a legal and business structure that increases the likelihood of attracting and retaining the best people. 3. The Deal. Once an initial decision is made by a private equity investor to invest in a particular business, the real fun begins—the parties have to negotiate the terms and conditions of the investment and the future relationship between the investor(s) and the investee company. These terms and conditions will drive the legal, business, economic and financial aspects of the relationship between the management of the prospective portfolio company and the private equity investor and they will set the stage for how the two groups interact during the life of the company. 6
  • 7. 4. The Exit. While there are exceptions, the entrepreneurs, management teams and private equity investors have at least one thing in common—they all want to experience a liquidity event at some point and be financially rewarded for their hard work and/or investment of capital. There may be a difference as to timing or methodology, but a liquidity event is the real “pay day” in the private equity world. 5. The Buyout. A buyout transaction requires a working knowledge of all the issues we will be addressing in the first four focus areas. In its simplest form, a buyout transaction is really three transactions in one—first, it is the acquisition of an existing business, second, it is an equity financing for the acquiring entity and, third, it is a debt financing for the acquiring entity. III. Prerequisites Corporations Required; Securities Regulations and Corporate Finance Recommended IV. Grading The final grade for the course will be based on a take- home exam and class participation. V. Reading Materials Since there is no single text that encompasses the full scope of this course, we will focus on selected readings from the following texts: A. Guy Fraser-Sampson, Private Equity as an Asset Class (John Wiley & Sons, Inc., 2007); and 7
  • 8. B. Constance E. Bagley and Craig E. Dauchy, The Entrepreneurs Guide to Business Law (Thomson- West, Third edition, 2008) In addition, students may want to consider relevant readings from the following texts: C. Josh Lerner, Felda Hardymon and Ann Leamon, Venture Capital & Private Equity—A Casebook (John Wiley & Sons, Inc., Third Edition, 2005); D. Janet Kilholm Smith and Richard L. Smith, Entrepreneurial Finance (John Wiley & Sons, Inc., Second Edition, 2004); E. Joseph W. Bartlett, Equity Finance—Venture Capital, Buyouts, Restructurings and Reorganizations (Aspen Publishers, Second Edition, Volumes 1-3 and 2005 Cumulative Supplement). Handouts of model term sheets and operative agreements, as well as clarifying materials and case studies, prepared by Mr. Graev will be distributed at various times during the course. Students will also be required to familiarize themselves with the following sections and regulations under the Securities Act of 1933, as amended—Sections 4(1), 4(2) and 5 and Regulations D and Rules 144 and 144A. 8
  • 9. VI. Course Syllabus Week 1 The Private Equity/Venture Capital Industry From 30,000 Feet—We will focus on: (a) the history of the private equity/venture capital industry and follow its evolution from its early days where wealthy families reigned to the present time where the industry is run by professional managers with access to enormous amounts of capital and where no “deal” is too large; and (b) the “players” in the industry—the entrepreneurs, managers, employees, angel investors, venture capital investors, lawyers, accountants, investment bankers, business brokers, institutional investors, investment advisers and other constituents that play an active role in the process. Reading: Fraser-Sampson, Introduction and pp 1-23 Weeks 2-3 Organizing a Venture Capital Fund—We will explore the legal, financial and business issues that need to be addressed and negotiated in the organization of a venture capital fund and we will attempt to develop “market” terms and conditions that will be “user friendly” to institutional investors and that align the interests of the parties; and we will look at 9
  • 10. certain of the securities, tax and labor law issues that must be addressed to have a viable fund-raising effort. Reading: Fraser-Sampson, pp 23-43 and 115-136 Summary of Principal Terms – Formation of the General Partner of a Venture Capital Fund Limited Liability Operating Agreement – Formation of the General Partner of a Venture Capital Fund Summary of Principal Terms—Formation of a Venture Capital Fund Limited Partnership Agreement—Formation of a Venture Capital Fund Code of Federal Regulations Pertaining to U.S. Department of Labor (“CFR”), Title 29, Chapter XXV, Part 2510.3-101(d) -as referenced in ‘Limited Partnership Agreement’ Weeks 4-5 Organization of the Business and Attracting and Retaining Employees—We will explore the alternative structures available for organizing a business and focus on the legal, financial, business and tax issues that drive the decision-making process. It is critical for the newly formed company to attract and retain executive, managerial and other 10
  • 11. employees and we will examine the philosophy behind various compensation arrangements and plans, including (a) use of employment agreements; (b) cash compensation; (c) equity compensation; (d) restrictive covenants; and (e) vesting mechanics. Reading: Bagley and Dauchy, pp. 51-131. Employment Agreement Background for Employment Agreement Issues under Employment Agreement Chart – Summary of Consideration in Choice of Entity Week 6 Private Placements and Related Issues Under the Securities Laws—A venture capital investment in a business must satisfy the requirements of both Federal and State securities laws and we will examine the statutory and regulatory framework that must guide every transaction, with particular focus on 11
  • 12. (a) Sections 4(1), 4(2) and 4(1 ½) of the Securities Act of 1933 (the “1933 Act”); (b) Regulation D under the 1933 Act; (c) Rule 144 and Rule 144A under the 1933 Act; (d) Integration challenges; and (e) State securities law issues generally. Reading: Bagley and Dauchy, pp. 132-179 Statutory and Regulatory Material Noted Above Weeks 7-10 The Art of the Deal—We now have the necessary players in the same room and the task at hand is to develop the terms and conditions for an investment by the venture capital fund in the business. We will review a case study and analyze a typical term sheet and explore the issues that must be addressed and resolved, including (a) Valuation (b) Capitalization (c) Common Stock vs Convertible Preferred Stock 12
  • 13. i. Dividends ii. Liquidation preference iii. Participating vs. nonparticipating iv. Conversion v. Antidilution protection vi. Redemption vii. Protective provisions (d) Stock Purchase Agreement i. Representations and warranties ii. Indemnities iii. Conditions to closing iv. Securities law compliance (e) Stockholders Agreement; i. Organization of Board of directors ii. Restrictions on transferability iii. Information rights (f) Registration Rights Agreement i. Demand rights ii. Piggyback rights iii. Underwriters cutbacks Required Reading: Fraser-Sampson, pp 137-202 Bagley and Dauchy, pp. 434-491 Summary of Principal Terms—Proposed 13
  • 14. Investment Series B Preferred Stock Purchase Agreement Certificate of Incorporation Shareholders Agreement Registration Rights Agreement Dilution Model Operating Entities (Blackstone) Week 11 The Payday—Getting to a Liquidity Event— The venture capital investor has now been an investor in the portfolio company for several years, the company has been a moderate success and the venture capital investor is looking to raise a new fund and needs a liquidity event to help improve its track record. We will explore the process and methodologies for turning the investors illiquid investment in a private company into cash or liquid securities, and we will focus on: (a) the sale of the entire company; (b) the sale of a portion of the investment to a third party or the company itself; (c) an initial public offering; (d) the sales process—auction vs direct approach and dealing with the issues of confidentiality, exclusivity, disclosure, 14
  • 15. and ongoing shareholder liability; (e) the tax and securities law implication of a liquidity event; (f) the relationship between the legal documentation that was executed at the time of the investment and the execution of the particular liquidity event; and (g) the personal, personnel and strategic issues that arise in connection with a liquidity event. Reading: Bagley and Dauchy, pp. 660-728 Weeks 12-13 Buyouts We will review and analyze a case study of a buyout transaction and focus on the business, financial and legal “drivers” of such a transaction, including: a)Understanding earnings, earnings growth, transaction multiples, leverage and returns; and b)Resolving the allocation of risk between a buyer and a seller that needs to be addressed in the legal documentation. Reading: 15
  • 16. Fraser-Sampson, pp 67-114 Bagley and Dauchy, pp. 595-659 16