During the last few years, the Finnish corporate finance market has experienced a significant growth in private equity financing, in particular as regards seed and venture capital (VC) financing of high tech operations, usually in the fields of biomedicine and information technology. However, the increased uncertainty in the US economy has also reflected upon such operations, which again has resulted in certain additional features that the lawyer practising in the Finnish VC market should pay attention to. Of these features, this article will discuss how to deal with VC financed operations that have encountered difficulties and, in respect of further or new financing, the increased sophistication of investors in relation to their investment targets.
All efforts aiming at dealing with financial difficulties, may be summarised with the term “rescue operations.” Rescue operations include corporate governance issues as to how management should act diligently, contractual reorganisation of the capital structure, statutory financial restructuring (resembling so called “Chapter 11” proceedings in the US) and, or even placing the business into liquidation or bankruptcy with the aim of saving what can be saved.
Rescue operations may, of course, become relevant for all types of businesses, not only VC financed, and in any event the common denominator is to control and plan the necessary actions. Therefore, the starting point in all rescue operations is corporate governance, which should serve as a tool for an increased awareness as to what options are available and support the formation of a systematic strategy on how to move forward. Although not being solely a VC feature, in most cases where there is a financial crisis, the question of how management should act is of such importance for the VC investor, that it deserves further discussion herein. The other interesting feature for the VC investor is, how certain standard US-origin VC clauses actually function under Finnish law in rescue situations.
How management should act diligently
VC investments are usually made in limited liability companies, which are governed by the Companies Act, and according to which the main rule is that the company is solely liable for its debts. Accordingly, the management, i.e. the managing director and the members of the board of directors, are not personally liable for the company’s debts and liabilities. The management may, however, under certain circumstances become liable for damage caused to third parties, normally the creditors of the company, for example, if the board of directors has omitted to restore the company’s equity should more than half of the share capital have been lost. The management may also incur criminal liability, for example, for failure to see to it that the company has duly withheld and paid preliminary income tax on salaries. Undue prolongation of insolvency without filing for liquidation, reorganisation or bankruptcy proceedings may also trigger criminal liability and liability for damages.
For the VC investor, these issues are important not only where the investor itself has appointed members of the board of directors. The investor also needs comfort that matters are dealt with properly so as to maintain the credibility of the investment target and, particularly, should it be possible to save the investment target, the key individuals should not become “contaminated” by personal liabilities for damages or criminal liabilities.
In order to minimise the risk of personal liability, the board of directors should at least do the following:
l Ensure that the bookkeeping is properly arranged.
l If more than half of the share capital has been lost, take immediate measures to prepare a balance sheet and convene a shareholders’ meeting as required by the Companies Act.
l Act openly towards all creditors, however, and if possible without endangering the day-to-day business of the company. Omission to keep creditors informed may give the impression that the company is acting to their detriment, which may trigger demands to investigate the actions of the board of directors.
l Pay special attention to debts owed to the tax authorities.
l Record all measures properly, so that they may be proved at a later stage if necessary.
Anti-dilution protection and liquidation preferences
Anti-dilution protection means that a current investor is compensated in issuances where shares are offered to a new investor for a lower subscription price than that paid by the current investor, so called dilutive issuances. The previous investor would look to be compensated for the decrease in the valuation of its investment by receiving more shares without paying anything for them (if possible), i.e. the investor’s base cost per share would be reduced to bring it more in line with the new valuation of the target. A dilutive issuance would typically occur where the target is in financial difficulties.
Usually anti-dilution protection is provided either on a weighted average basis or, to an increasing extent, a full ratchet basis. Full ratchet means that the current investor receives full compensation in a dilutive issuance. For example, if the current investor has paid six per share for 100 shares (i.e. 600 in the aggregate) and the new investor pays three per share, the current investor shall be put in a position as if it had paid three per share. The previous investor would therefore receive 100 new shares (600/200 = 3).
Weighted average means that the current investor’s compensation in a dilutive issuance is based on a new subscription price calculated on a weighted average-basis, usually in accordance with a formula which in an example where the current investor again has paid six per share for 100 shares and the new investor pays three per share for 100 shares, results in a new subscription price for the current investor of 4.5. The current investor would in such case receive 33 new shares (600/4.5= 133).
While the aforesaid appears rather straightforward, there are both legal and practical aspects, that make things more complicated. In order to achieve a mechanism, which actually works in all potential situations, at least the following should be considered:
l Under Finnish law, the current investor always has to pay the nominal or counter-book value in order to get more shares in an issuance;
l There may have been previous dilutive issuances where a current investor has not subscribed for new shares;
l Several current investors may have invested different amounts per share in different rounds;
l There may be “normal” issuances between dilutive issuances; and
l A current investor may also want to participate in the dilutive issuance at hand.
It is not uncommon that the formula used in the US have been adopted as such in executed Finnish investment documents. Such formulae have rarely taken into account all the above criteria, however, there appears to be an increased understanding of the need for a more sophisticated approach in this respect. In any event, there will be problems with the practical implementation of existing anti-dilution protection mechanisms, with the consequence that shareholders need to negotiate on further specification of those before implementing a dilutive issuance.
Liquidation preference means that investors have a priority over other shareholders to the target’s funds in certain situations defined as “liquidation”. These include typical insolvency situations, but also so called “deemed” liquidations, for example a sale of all the target’s assets. Such a sale may, in fact, sometimes be a recommendable rescue operation.
Normally, a liquidation preference should not be problematic from a legal point of view, as it is usually simply an agreement among shareholders to distribute what is left in the target. The most important thing is to ensure that the rights of creditors are not violated..
The lawyer’s role in assisting investors in deciding whether or not to invest, is to make a legal analysis of the investment target, usually with particular emphasis on intellectual property rights (IPR) and the background of the founders of the target. Traditionally, added value has been created for investors where they have obtained a clear picture of the target’s legal rights to IPRs reportedly being used in its business, and appropriate measures to rectify possible problems have been identified.
In the current financial environment, this approach is not sufficient. Investors need more sophisticated analyses to make their investment decisions and lawyers need to adapt to such demands by focusing even further on what aspects really bring added value for the investor.
A good example is an R&D intensive operation with a long- range business development plan, which assumes commercialisation of its own R&D results in combination with IPRs of others, perhaps in milestones over a development curve comprising even decades. In such case, the traditional legal due diligence focus on IPRs should be extended to reviewing how the IPR framework actually matches with commercialisation plans. In other words, the lawyer should consider what might happen when R&D results are exploited in the future; will they be sufficiently protected, does the target sufficiently control the IPR framework and what is the likelihood of enfringement?
The described enhanced approach actually fills up a gap between the traditional IPR legal due diligence focus and the ultimate form of review, which is to benchmark the target’s IPR portfolio and commercialisation plans to probable competitors. Such a review is clearly beyond the traditional scope of legal expertise, and there are only a few actors in the world, which actually can provide reliable services in this respect. However, also such review may be rendered useless, if the fundaments are not in order. Hence, there is a real challenge for VC lawyers, yet those who adapt and succeed can readily say that they have moved up the value added chain.