Private Equity, Venture Capital, and Hedge Funds May Get Boost from SEC

Guest post by Alexandra M. Fenno , Lauren C. Jackson , John I. Sanders , Jeffrey T. Skinner from Kilpatrick Townsend & Stockton LLP

On June 18th, the SEC issued a concept release (the “Concept Release”) seeking public comment on ways to simplify, harmonize, and improve the rules related to private securities offerings.[i]  The Concept Release contains several elements, three of which suggest that the SEC may take action that would benefit private investment funds:

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The Evolution of Alternative Family Capital

Guest post by Ryan D. Harris, P.C., Jeffrey B. Kaplan, P.C., Cole Parker, David H. Stults of Kirkland & Ellis LLP

Family offices and other types of family investment vehicles are more frequently seeking new ways to invest and manage family capital, including ways to leverage outside capital. While there is no single solution that is appropriate for every family office, traditional models are increasingly evolving into new and unique structures.

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Materiality and Efforts Qualifiers – Some Distinctions, Some Without Differences

Guest post by Daniel E. Wolf and Eric L. Schiele, Kirkland & Ellis LLP

Much deserved attention has been paid to the first finding of a “material adverse change” (MAC) by a Delaware court in the recent Akorn decision. Of perhaps equal practical importance to dealmakers is the court’s guidance on a question that has long occupied draftspersons — whether or not there is, and the extent of, any legal difference between the many shades of qualifiers used in deal agreements on two key terms: materiality modifiers and efforts covenants. Building on earlier Delaware decisions, the court reached a clear split decision on this question.

In the case of efforts covenants, the court noted that qualifiers like “best efforts”, “reasonable best efforts”, “commercially reasonable efforts” and shades in between are used to define “how hard the parties have to try” to satisfy a commitment in the agreement such as obtaining regulatory approvals. VC Laster cited an ABA publication that purports to set a hierarchy among these clauses, with each prescribing a slightly different level of required efforts. However, he pointed to a string of recent cases, including the decision in Williams v. ETE, which view these standards — even when they appear in the same agreement — as largely interchangeable despite clearly seeming to suggest the parties intended a difference. In the Williams case, the court found that the “commercially reason- able efforts” and “reasonable best efforts” standards both “impose[d] obligations to take all reasonable steps to solve problems and consummate the transaction”. In another case (Alliance Data), the Delaware court said that even a flat “best efforts”, typically considered the most demanding standard, “is implicitly qualified by a reasonableness test”. A recent New York decision (Holland Loader) suggests that New York law will similarly imply a reasonableness standard regardless of which modifier is used.

By contrast, the Akorn decision confirms a sharp, and perhaps larger than expected, distinction between the two most common materiality qualifiers used to modify representations, covenants and closing conditions — “material adverse change/effect” and “in all material respects”. In the case of a MAC, VC Laster closely followed Delaware precedent (including Hexion and IBP) in holding that a buyer asserting a MAC “faces a heavy burden” and the relevant effect must “substantially threaten the overall earnings potential of the target in a durationally significant manner”. But in interpreting the similar-sounding “in all material respects” standard, the court articulated a much lower burden, stating that this qualifier merely “seeks to exclude small, de minimis, and nitpicky issues” and to limit the operation of the representation, covenant or condition to “issues that are significant in the context of the parties’ contract”.

The Akorn decision is a useful reminder that there sometimes is a gap between practitioners’ expectations about theoretical formulations and real-world outcomes when those expectations are judicially tested. While we do not necessarily expect the deal community suddenly to abandon negotiations around efforts formulations or to depart significantly from market practice for materiality qualifiers, parties can use an informed understanding of the case law to more effectively deploy negotiating leverage and goodwill where it matters most.


Daniel E. Wolf, Partner

www.kirkland.com/dwolf

Daniel Wolf’s practice focuses on mergers and acquisitions where he represents public and private companies, as well as private equity firms, in a variety of domestic and international transactions. His transactional experience spans the range of M&A activity including many significant cross-border and contested transactions. He also counsels public company clients on governance, finance, securities and other general corporate matters.

Eric L. Schiele, Partner

www.kirkland.com/eschiele

Eric Schiele is a corporate partner in the New York office of Kirkland & Ellis LLP. His practice primarily encompasses public and private mergers and acquisitions and board advisory work, including hedge fund activism defense.

Kirkland & Ellis LLP

www.kirkland.com

For more than 100 years, Kirkland has provided exceptional service to clients around the world in complex litigation, corporate and tax, intellectual property, restructuring and counseling matters. The groundwork has been established for another century of superior legal work and client service.

This communication is distributed with the understanding that the author, publisher and distributor of this communication are not rendering legal, accounting, or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. Pursuant to applicable rules of professional conduct, this communication may constitute Attorney Advertising. © 2018 KIRKLAND & ELLIS LLP. All rights reserved.

Sellers Alleged Breach of Stock Purchase Agreement Did Not Excuse Buyer in M&A Transaction from Its Own Performance

Guest post by Philip D. Amoa, Associate – McCarter & English, LLP

Original Title: Delaware Law Updates: Sellers Alleged Breach of Stock Purchase Agreement Did Not Excuse Buyer in M&A Transaction from Its Own Performance; Right of Set-Off Did Not Apply to Unliquidated Claims

According to the Merriam-Webster Dictionary, the word “unliquidated” is defined as “not calculated or established as a specific amount.” The Post Holdings case (Post Holdings, Inc., and Michael Foods of Delaware, Inc., v. NPE Seller Rep LLC, C.A. No. 2017-0772 AGB [Del. Ch. Oct. 29, 2018]) shed light on how a party’s right of set-off was construed to have limited applicability. The case also showed how a party may be excused from its obligations under a contract.

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Silicon Valley Venture Capital Survey – Fourth Quarter 2017

 

By Cynthia Clarfield Hess, Mark A. Leahy and Khang Tran

View the full report.

Background
This report analyzes the terms of 190 venture financings closed in the fourth quarter of 2017 by companies headquartered in Silicon Valley.

Overview of Results
Valuation Results Remain Strong
Valuation results continued to be strong in Q4 2017, but the percentage price increases declined moderately compared to the prior quarter, following three consecutive quarters of increases.

Internet/Digital Media Scores Highest Valuation Results
The internet/digital media industry recorded the strongest valuation results in Q4 2017 compared to the other industries, with an average price increase of 179% and a median price increase of 51%, both up from the prior quarter.

Valuation Results Down for Series D Financings
Series D financings recorded the weakest valuation results in Q4 2017 compared to the other financing rounds, with the highest percentage of down rounds and the lowest average and median price increases of all the financing rounds.

 

FULL REPORT

 

View the original post by Fenwick & West LLP

Venture Capital Fundamentals: Three Basic Rules-Dilution, Dilution, Dilution

Written by: Joseph W. Bartlett, VC Experts Founder

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stageinvestments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securitiesoptions and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.