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A Primer on Venture Capital Operations

The Basic Role of an Attorney Specializing in Venture Capital

Venture capital operations typically involve a number of different players. When one refers to a "venture capitalist," they are usually talking not only about the actual human being who is active in venture capital but also about the legal entity that was formed and under which the venture capital operations take place. This vehicle - whether a corporation, limited liability company, or partnership - usually creates additional subsidiaries. These subsidianes act as general partners or managing partners of the investment funds created to capture investments for the venture capital operations. The investment fund is usually organized as a limited partnership. A venture capital organization may have multiple funds. The number of investment funds and subsidianes depends on the complexity of the operations (see also about Asset Management Firm).

An attorney representing a venture capital firm is normally involved in advising the client in most of the major areas of their business, from cradle to grave: organizing the business entity or entities that are to manage the process of raising money and that will be making the actual decisions to invest in the various businesses; organizing and promoting the venture capital fund (which is usually the vehicle for captunng the monies raised and which is the entity that actually makes the venture capital investments); advising on the day-to-day operations of the overall venture capital operations, generally including negotiating and drafting the necessary documents to facilitate investments by the fund; and subsequently advising as to the liquidation of the fund's investments and the distribution of fund assets to investors. Each of these areas has specific legal issues and concerns that require a case-by-case approach and are best addressed by an attorney who fully understands the venture capital fund's operations. An attorney specializing in venture capital is generally able to be more centrally involved in the business aspects and decision-making processes of the fund's operations than with any other type of client. For example, the attorney typically is involved in advising on the effects a fund investment may have, whether buying an existing business (in part or completely), making seed capital investments in a new venture, or selling previously acquired assets.

Adding the Most Value for a Client

The goal of any attorney should be to add as much value as possible for his or her client. In the field of venture capital, the areas in which an attorney can most help clients vary based upon the stage of the fund's life. During the formation stage of a new investment fund, an attorney can add value by counseling the fund promoters on where the market is relative to fund terms and economics. In addition, at this stage, attorneys can assist in drafting an offering document that accurately and effectively markets the fund to potential investors. When the fund ism the operations and investment stage of its kfe, an attorney assists the fund on investments, counsels on alternative investment structures, and negotiates with the principals of the target investment.

The venture capital attorney assists in the structure and formation of any entities, offering documents and other necessary filings to comply with applicable law. Among other things, clients rely upon counsel for help in preparing the fund's offering document; assisting the fund promoters with the development of fund strategy, objectives, and economic terms; and counseling the fund regarding investment transactions. Counsel also assists the fund during the end stage when the fund is selkng or kquidating its investments and, ultimately, kquidating the fund.

Counsel provides financial value for clients in a number of ways, including averting potential future legal situations by helping them proactively enact pokcies designed to safeguard against actions that would violate applicable laws or result in the operation taking greater risks than desired by the firm's principals. Among the many other services typically provided, counsel will also deal with corporate governance issues and help keep track of required regulatory filings. Another benefit of having attorneys that are experienced in advising in venture capital is to direct ckents to potential investors for the investment fund and find potential ventures in which the fund may invest.

The estabkshment of a good relationship with venture capital ckents involves being good at the ''blocking and tackling" needed to effectively maintain operations from day to day. An attorney provides value by being there to make sure the ckent develops and maintains the appropnate pokcies, procedures, and controls to assure continued compkance with appkcable laws.

Laws Impacting Venture Capital Operations

With respect to the appkcable laws governing venture capital activity, it is important to remember that "venture capital law" is not one clearly defined set of laws; rather, it is a conglomerate of multiple laws, both federal and state. These include laws regarding the offenng and issuance of secunties, such as laws that may apply to the persons offenng the secunties (broker-dealer laws) and laws affecting the entity advising the venture fund as to the investments to make (such as the Investment Advisers Act of 1940 and any similar state laws). There are also vanous laws that impact the formation of the investment vehicles, such as federal tax laws, federal and state bankruptcy laws, and state laws governing corporations, limited liability companies, and general and limited partnerships. Also, once the investment fund is operational, attorneys specializing in venture capital assist in investments being made or liquidated by the fund, which includes counseling in the navigation of considerable federal and state laws and regulations.

Most Common Mistakes Made by Venture Capitalists

From a business point of view, the biggest mistake clients often make in their venture capital dealings is failing to think through an investment and not doing the necessary due diligence before committing the capital.

From a legal point of view, the biggest legal nsk is usually related to how the offering is conducted and the danger that a pnvate offenng will turn into an unregistered public offenng and violate federal and state secunties laws.

Establishing venture capital operations can be a costly business. Typically, the most expensive venture capital legal issues for clients are, particularly for new players, the costs involved in the preparation of the offenng documents (i.e., pnvate placement memorandum). The cost of prepanng the offenng documents increases unnecessarily due to lack of up-front planning. Careful planning includes, among other things, knowing the exact parameters and types of investments to be made, and how to actually manage those investments. Also, even at the early stage, the venture capitalist should be able to explain the anticipated exit strategies. Often, it takes the drafting of the offenng document for a client to focus on those "details," which can lead to frequent re-drafting and thus significant costs.This is particularly true as to "first funds" and the "on-the-job" training of the principals of the venture capital firm.

Sitting with a New Client: The Overview on Exposure to Legal Issues

A solid initial strategy when sitting with a new client is to first discuss the vanous laws that apply to a typical venture capital operation. It is also important to provide an overview of the typical documents that will be required so as to avoid future surprises. Counsel should assure clients that he or she will be there working with and for them throughout the process. Lastly, it is important to emphasize that clear and honest communication between kwyer and ckent is essential to making sure the process goes smoothly.

Helping Companies Succeed with Respect to Legal Issues

There is no single strategy for success in the venture capital industry given the almost endless permutations of venture capital operations, the variety of investments that can be made, and the broad variety of legal issues a particular ckent could face. For the attorney to be able to effectively support the ckent's business, it is important that the attorney and client develop a strong working relationship. For this to occur, it is necessary for the attorney to first be knowledgeable on the applicable laws and then take the time to develop a clear understanding of what the particular client is trying to accompksh. A successful attorney works hard to find a way for the client's goal to be met in a lawful manner and in a way that most effectively enhances the ckent's business. There is no magic to this process - it simply takes good communication and hard work.

International Issues

Many international issues are similar to those in the United States. Most countnes have laws that apply to the offering process (private placements versus pubkc offerings, often referred to as exempt offerings versus registered offerings), broker-dealer laws, and other relevant issues. If you are dealing with international issues, special consideration needs to be given to a number of factors, including: local/foreign taxes, as well as any tax treaty between that country and the United States; the ability to withdraw capital from the country; and any filings as to investments being made in that country, which are often required. The existence of any free trade or other agreements and treaties, including the North America Free Trade Agreement between Canada, Mexico, and the United States; the Central American Free Trade Agreement between the United States and the Central American countnes of Costa Rica, Honduras, El Salvador, Guatemala, and Nicaragua, and to which the Dominican Republic has been added; and the World Trade Organization, must be considered. Moreover, partnership structures are not as common outside of the United States, and unique corporate governance issues need to be considered. The best advice with respect to international venture capital dealings is to retain a local lawyer with experience in similar transactions.

Major Issues Companies are Dealing with Today

Perhaps the largest issue for venture capital clients is potential legislative and regulatory changes that could impose greater regulation on venture capital fund activities. Specifically, during 2005, the Secunties and Exchange Commission adopted rules to limit the venture capital fund managers' exemptions from registering as investment advisers under the Investment Advisers Act of 1940. Additionally, the venture capital fund now must comply with recent regulations about providing its investors with pnvacy notices and developing written procedures to address disclosure controls. Finally, as of the end of 2005, the venture capital industry appears to be on the front end of regulations limiting a private equity fund's exemptions from registration under the Investment Company Act of 1940. The legal landscape is continually changing.

Achieving Success: Advice to Lawyers and Clients

When dealing with clients, the first and most important guideline to lawyers is to demonstrate responsiveness. Being there when a client needs you is the most important thing you can do. Because other lawyers and law firms may have competency to provide the same services, it is important for a lawyer to demonstrate a high level of responsiveness.

When dealing with their lawyers, it is vitally important for the client to have good and clear communication. Clients need to be proactive in seeking their lawyer's advise and input. It is better to be safe than sorry.The most important golden rule of venture capital operations is to communicate, communicate, and communicate. Attorneys cannot advise clients about the "dos and don'ts" if they do not know what they are doing or planning to do. Venture capital operations involve a cross current of many different laws and regulations, most of which seem to be changing all the time. Advice that was good last year may no longer be valid. Constant communication with counsel is the only surefire way to address the volatile nature of the industry in a proactive and effective way.

Staying on Top of Changes: Keeping an Edge in the Industry

First, it is critical for an attorney who specializes in venture capital (or any area of law for that matter) to create a routine process by which he or she will review commentary and regulation changes that affect his or her area of practice. Most frequently, this can be achieved by diligent review of the trade publications.

However, the best way to stay sharp is to actively practice in the area. Beyond regular review of publications, being exposed to numerous deals of varying size and industry enables the attorney to know what the market is demanding from venture capital and correspondingly allows the attorney to counsel his or her clients on the best terms.

Keeping clients up to date on any new changes in the environment is usually done in the form of a telephone call or letter for issues that may impact a limited number of venture capital operations and via memorandum or newsletter for issues that have broader impact on the venture capital industry.

The Legal Documents a Firm Needs when Starting a New Fund

Typically, the central documents are the private placement memorandum and the fund entity documents, which represent the operating agreement for a limited liability company and the partnership agreement for a limited partnership. In addition, most fund structures require a management agreement pursuant to which a fund manager will obtain the nghts and obligations from the general partner/managing member to manage the fund's affairs.The private placement memorandum is important for three major functions: disclosure, explanation, and marketing. Although the first two functions are related, they should be considered separately in order to underscore the regulatory component of each new fund. A pnvate placement memorandum must explain to potential investors the fund's operations, features, and strategies. Part and parcel of this explanation is the disclosure of risks associated with investment and features an investor would reasonably consider in determining whether to invest in the fund. Finally, the pnvate placement memorandum should sell the fund, so a significant portion should be dedicated to the fund management and other items the promoters consider to represent benefits of the fund, all in accordance with the disclosure requirements.

The partnership agreement/operating agreement is the document that actually supports the operational functions and disclosures made in the pnvate placement memorandum. This document is the seminal document of the fund operations, dictating how the fund will be managed, and should be controlling in the event of an inconsistency or discrepancy between it and the pnvate placement memorandum.

Strategies for Giving the Most Favorable Terms to the Fund

Because the fund must "sell" itself to the market, terms are often dictated by the market itself. Strategically, it is important for fund promoters to be cognizant of the fact that most fund terms interrelate and the impact of changes to one term may have negative effects on other terms. Perhaps the best way for fund promoters to gain the most favorable terms is by demonstrating to the market the fund's benefits and how it is differentiated from other funds. After all, gaining favorable terms for the fund is a function of nsk versus reward. The fund and its promoters can keep more favorable terms if they can decrease the nsk component to the potential investors. Typically, major fund economic terms should be fleshed out in principle during the initial evaluation stage of fund organization (i.e., taking the executive summary to the market). At this time, the market will "enlighten" the promoters on what will be acceptable terms, and thereafter the fund should be built around these terms, with only minor modifications made later. When giving the fund the most favorable terms, there are specific clauses/strategies an attorney must include in the documents. Particularly, fund promoters should be most interested in two facets of fund organization: economics and flexibility. First, promoters want the largest promote, or carried interest, for themselves (the general partner/managing member) with the smallest preferred interest for the investors and the smallest clawback, if any, for the investors. These items play off one another, so a certain level of give and take usually occurs. Second, promoters should seek to reserve as much flexibility in the fund operations as possible. For example, some investors may push for a specific investment process and criteria to be adhered to by the fund. Promoters may want to avoid these types of very specific terms, for they may unnecessarily bind the hands of fund management.

Overall, the types of documents that are utilized in fund organization remain constant across fund size and industry, although some industries may require ancillary agreements, such as a property management agreement for a real estate fund. However, terms of these documents can vary greatly depending on the investor pool and whether it is compnsed of individuals or institutions. Vanations in terms also will occur across specific types or industries of the fund. For example, real estate funds generally have different economics and concerns than a fund concentrating on leveraged buyouts.

Logistical Changes and Trends: How Today's Legal Documents Differ from Those Used Several Years Ago

There have not been wholesale changes over the past several years with respect to venture capital-related legal documentation. The basic documents have been around for many years and include private placement memoranda, partnership agreements, and other cntical documentation. However, there are new legal vehicles that did not exist years ago, such as limited liability companies and their related operating agreements.

Within these "traditional" documents, there is a considerable amount of development and fluctuation that is ongoing relative to the terms of the fund. For example, ten years ago a clawback was not necessary for certain fund types. Today, it is unheard of not to have a clawback of some sort in every fund. Nothing demonstrates this concept more than the private placement memorandum. This document is constantly in development, for it is the document that "sells" the fund to the market and thus must capture the market's demands at any given time. As discussed above, the pnvate placement memorandum is the result of a balance struck between the marketing component and the regulatory component. Thus, with the ongoing development of terms to address the market, there are typically corresponding changes to reflect the development of regulatory components.

With respect to these "traditional" documents and the developing documents and terms, counsel adds value for clients by helping them to draft such documents in a clear and concise manner. Attorneys also help clients to understand the current market for their fund and what terms and conditions would find greater acceptance in the investor market.

Overall, attorneys who specialize in venture capital must be armed with current knowledge of the industry as well as the nuances of setting terms for funds and other market-sensitive procedures. The most essential skill in this role is the ability to communicate well with a broad spectrum of people - especially clients. Good communication between lawyer and client is the foundation for success in this business, and it will help the attorney add the most value for his or her client in almost any scenario.

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