CFIUS Reform: How Private Equity Funds Are Affected

Guest post by Rod Hunter, Sylwia A. Lis, and Karl Paulson Egbert, Partners at Baker McKenzie LLP

With the signature of President Trump on August 13, 2018, the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) became law. FIRRMA represents the most significant changes to the law governing the Committee on Foreign Investment in the United States (CFIUS or Committee) since the creation of the U.S. foreign investment regime in 1988. Although prompted primarily by national security concerns with Chinese investments, the legislation will affect investments by all non-U.S. investors, including investors in private equity and other funds. The changes reflect a trend across advanced markets for greater scrutiny of investments made via fund vehicles.

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Digital Tokens: Rethinking the term “Cryptocurrency”

Guest post by Daniel DeWolf, Rachel Gholston, and Marine Bouaziz of Mintz Edge

What are the similarities between a one dollar bill, a share of a company, and a pre-paid gift card? The answer is……..not so much! The same is true of the similarities between virtual currencies, security tokens, and utility tokens; in truth, not so much. Yet, if you follow the world of digital tokens in the media and popular press, you would think that virtual currencies, security tokens, and utility tokens are all very similar because they are often concurrently and interchangeably discussed under the topic of “cryptocurrency.”  On the news, in numerous blog articles, and even in investment prospectuses, “cryptocurrency” is used to describe virtual currencies, security tokens, and utility tokens even though they are very different concepts, each of which is subject to different legal frameworks and regulations. While each of these items are created on distributed ledgers using blockchain software, from both a legal and a functional perspective, the similarity ends there. We should re-think the use of the word “cryptocurrency,” and instead use the terms that are specific to the categories that have developed: virtual currencies, security tokens, and utility tokens.  In our descriptions below we provide further information on the meanings of each of these categories.

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Tail-End Funds: Should End Of Life Be A New Beginning?

Guest post by Julia D. Corelli, Partner, Pepper Hamilton LLP

This article sponsored by Pepper Hamilton originally appeared in The Legal Special 2018 by PEI in April 2018.

The top challenges of the private equity business model have always been threefold: replenishing the coffers every four to five years, deploying capital successfully in the investment period and harvesting investments at the peak of their valuations. Underlying these concerns is one salient fact: the fund usually has a finite term. Since nothing goes perfectly in life or investment management, this article considers the challenges faced by fund managers as the fund approaches the end of its term.

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The Entrepreneur’s Shares: A Balanced Approach To Founder’s Equity

Guest post by Daniel I. DeWolf, Evan M. Bienstock, Samuel Effron, and Ilan Goldbard – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

When accepting money from outside investors, entrepreneurs are generally asked to give up some degree of control over their start-up, exchanging equity in their company for cash. In an effort to minimize the control they relinquish, upon formation of their company entrepreneurs can grant themselves equity that comes with special rights. These rights, such as special voting privileges or guaranteed board seats, allow founders to maintain control of their company in spite of a dwindling ownership percentage. They may also include special rights that make it possible for a founder to cash out some of his equity prior to an IPO or other exit event.

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A Goldilocks Market For Unicorns?

Guest Post by Sven Weber-SharesPost

There’s been much hand-wringing about whether the venture capital community is producing an unusually high number of unicorns and is creating a bubble, but is the worry justified?

The answer is “no” if you compare the number of successful start-ups being minted by the venture capital community today to the historical average. That’s one of a handful of key findings from SharesPost’s newest white paper about the innovation economy and unicorns.

Unicorns and Home Runs
To validate that assertion, it’s important to first define the terrain. Prior to the “unicorn” moniker of the past few years, the venture capital industry defined success in terms of “VC batting averages” and “home runs.”

Historically, venture capitalists deployed their capital with an investment strategy betting on a batting average of 1%-2% of “home runs.” That is, for every 100 venture capital backed start-ups, 1 to 2 companies becomes a “home run,” which is defined by its outsized returns.

Because there are many unicorns and they are a relatively new phenomenon, they also tend to get outsized visibility and feed the perception that we may be in a bubble. But the numbers on the batting average of recent years tell a different story.

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With the exception of the dot-com bubble, the batting average on unicorns is consistent with the historic VC batting average of 1% to 2% for homeruns. In other words, venture capitalists are doing what they’ve done for decades – produce 1 to 2 homeruns for every 100 companies they fund. The big difference is that these homeruns are staying private today instead of going public.

Timing of Unicorns Coincides with past IPO timing
Interestingly, one of the findings of the research shows that the median time to “produce” a unicorn in the US today is 76 months. This means for 50% of today’s unicorns, it took about 6 to 7 years for a company to reach a $1B valuation.

It’s no coincidence that this length of time is about how long it took in the past for a company to go IPO. Historically, the time to an IPO was 6 to 8 years whereas today it is 9 to 11 years.

Both the batting average and the timing of unicorn production show that venture capitalists are producing home runs at a normal rate. There seems to be no over-production of successful VC backed companies.

A Higher Multiple
A key question is why VC home runs today seem to be much more substantial than they have been in the past. In other words, why are the valuations so high?

This answer is exceptional growth, combined with the private market.

The private market allows firms to grow significantly larger than before an IPO. When Apple had its IPO it was 5½-years-old, it had $114 million in revenue and grew 145% per year. Today, a company with this profile stays private.

To that point about growth, SharesPost’s research found that the aggregate market cap of unicorns grew more than 500% since 2014. That’s enormous. Companies didn’t enjoy that kind of growth rate before the private market because they were pushed to get an IPO to both finance their growth and to provide liquidity to its employees and investors.

It’s no wonder private market companies are staying private today: Private growth companies can secure all the capital and liquidity they need, while achieving phenomenal revenue growth and enterprise value without enduring the challenges of being a young, publicly traded company. One misstep in quarterly earnings can be disastrous. In February, LinkedIn lost 40% of its value – $11 billion in one day when it missed earnings.

VC, Founders In Synch
Interestingly, the desire to remain private has created a new alignment between VCs and entrepreneur founders.

For the first time, their interests are in synch. VC-funded tech firms can get liquidity for themselves, employees and angel investors through the rapidly expanding secondary markets. In addition, a later exit drives to higher valuation and higher valuations drive the return multiples for venture capitalists.

Today VCs can harvest a higher multiple on their home runs than ever before in the history of venture capital. During the first decade of the 21st century, VC returns have been less than attractive and many people predicted the end of venture capital. The new private growth market generates today a win-win: Founders can achieve liquidity and VCs can make the math work for their returns.

When emotions run high, one of the first casualties is rational analysis. We’ve always liked numbers, and these numbers tell an entirely different story than what many are others are saying.

Sven Weber is a Managing Director of SharesPost’s SEC-registered investment advisor, SharesPost Investments Management, LLC. He is responsible for the management of the SharesPost investment vehicles. Sven is also the President and a Trustee of the SharesPost 100 Fund.

Confronting a Down Round

Guest post by Dror Futter, Rimon PC

The last few years have witnessed Unicorns become common and down rounds become scarce. Now the venture market is returning to a more normal state, which means more down rounds and fewer Unicorns.

If your venture is confronting a down round, you should not wear it as a badge of shame. In normal times, few ventures make an uninterrupted march up and to the right on the valuation curve. More importantly, if you are doing a down round, it still means you were able to raise capital. Although a down round will dilute your economics, no venture has ever died from excess dilution, the same cannot be said for lack of funds.

What is a “Down Round”

Simply stated, a “down round” is a round in which the pre-money valuation of a company is below the post-money valuation of its last round. As result, shares in the company purchased in a down round will be less expensive than those bought in the last round. Down rounds are never fun. To existing shareholders, it means the value of their investment has dropped and they will absorb additional dilution to raise the same amount of money. To venture investors, who report their illiquid holdings to their limited partners based on “mark-to-market” principles, it almost inevitably means a write-down of the carrying value of the investment. As a result, reported fund returns drop.

Down rounds are most common when a new investor enters the scene or most existing investors are not funding their pro rata. In addition to a lower valuation, funding terms of a down round are usually more investor friendly. Often shares sold in a down round will have a senior liquidation preference (i.e. they will sit above prior classes of shares in terms of priority for getting a return at exit), a participating preferred return (i.e. investor gets its investment back and sometimes a multiple of its investment back and then participates with common), dividends that are accruing and at a higher rate, and class-specific veto rights on multiple corporate decisions.

Why Do Down Rounds Occur?

There are several reasons why your company may be subject to a down round, including:

  • Your company failed to reach the financial and operational goals it set for itself the last time it raised money;
  • You did a particularly good job of selling your company at the last round and received financing at a favorable valuation. The down round may just be reversion to a more conservative valuation; or
  • Overall valuations have dropped in your sector or market-wide.

A down round, therefore, is not always a sign of a struggling company. However, even if your down round result from broad market forces, you will subject to the valuation drop, and likely many of the same unfavorable deal terms, as a struggling company.

What Can You Do to Prepare?

There are a few things a company can do that will help its down round proceed more smoothly.

1. Review the Corporate Charter and financing documents from prior rounds. Make sure you understand the rights of existing shareholders in a down round and have identified any relevant supermajority voting requirements and pay-to-play obligations. Also, identify all pre-emptive rights that existing shareholders have and the timetables they have to exercise. Down rounds are often Eleventh Hour fire drills and you do not want to be stymied by a multi-day notice period for pre-emptive rights.

2. If your shareholders have anti-dilution rights, make sure you have assembled a spreadsheet that will allow you to determine the impact of financings at various price points on the existing cap table. This will be essential information for the new investors as they determine the new pre-money valuation of the company. In some cases, new investors may require existing investors to waive their anti-dilution right as a condition of funding.

3. Down rounds are risky events for a company’s Board of Directors. This is especially true for a Board that does not have independent directors to provide an unbiased view on the fairness of the reduced share price in a down round. Shareholders who do not participate in the new financing and are significantly diluted may bring an action against the Board. To reduce this risk, the Board should shop financings to multiple investors and should document these efforts in writing. Also, the Board should conduct market research to fully understand market terms. If possible, the Board should seek to obtain the approval of non-participating shareholders and at a minimum, such shareholder should routinely be updated on attempts to find financing and findings on current market terms. The Board should also consider doing a “Rights Offering” where each existing shareholder is offered the opportunity to purchase its pro-rata piece the financing at the down round price, even those shareholders who do not have the benefit of a contractual pre-emptive right. Finally, a down round is a good time to make sure that D&O insurance is in place and includes adequate coverage.

4. Develop a communications plan for employees. Despite your best efforts, this is the type of information that often can get out there. Decide how you will position the down round to your employees. Since the dilution of a down round will also impact their options, consider whether some star performers should get option refreshes (i.e. a supplemental option grant to reduce the economic impact of the dilution).

One Final Word

Success lifts many boats. As a result, when a company is doing well and experiencing a string of “up rounds,” it is easy to gloss over different interests among shareholders and directors. A down round can create two or more classes of investors with very different economics. In the wake of a down round, it is important to be sensitive to this change, factor it into decision making, and develop a communications plan that addresses the potentially divergent interests of these shareholders.


Dror Futter focuses his practice on startup companies and their investors, and has worked with a wide range of technology companies. His fifteen years’ experience as in-house counsel includes positions with Vidyo, Inc., a venture-backed videoconferencing company, and New Venture Partners, a venture fund focused on corporate spinouts. Prior to that, Mr. Futter was Counsel to the CIO of Lucent Technologies, as well as supporting parts of its sourcing organization.

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