The venture capital industry is likely to face many tough decisions in the coming months, including about which start-ups in need of capital should get it, and how portfolio companies should try to adapt to newly hostile conditions. Current portfolio companies seem likely to be the primary focus for many funds, in preference to new investments, and this environment brings with it foreseeable potential for conflict with co-investors in a number of areas, analysed below.
Companies having to raise money at lower valuations than previous rounds is a notable risk at present, particularly given the high valuations at which many companies have recently raised money notwithstanding weak revenues in a long boom that has come to an abrupt halt, and many start-ups’ pressing need for runway. However, co-investors who face unfavourable dilution may resist down rounds (e.g. by exercising veto rights individually or in conjunction with other shareholders) and seek to meet financing needs via other means, such as venture debt or cost-cutting.
Strategic conflicts with co-investors about funding may be particularly problematic where the co-investors resisting dilution are founders or directors (who may conceivably be among the least able to inject additional finance), as such co-investor disputes have potential to also become company management issues. These types of problem may in some circumstances have been pre-dealt with via “pay to play” or equivalent provisions, albeit that these terms may themselves give rise to contractual interpretation disputes if they are insufficiently well-drafted.
Where equity finance is required, it is likely that investors with capital to inject will push for preferential terms such as liquidation preferences, price protection provisions and enhanced company control. While in the short term the scope for disputes may be limited by a lack of options for reluctant co-investors, disputes may nonetheless arise over the longer term. For example, if a company goes on to be successful, diluted shareholders may look to recoup some lost value (and perhaps seek revenge) via legal actions, which may be timed to interfere with liquidity events to improve the claimant’s settlement prospects.
For funds with dry-powder and a willingness to jettison the friendly image that venture capital has sought to project in recent years, the current market may also represent an opportunity to obtain valuable preferred equity at prices that may later seem like a bargain when the fog of Covid-19 lifts from the global economy. In addition to the opportunities provided by funding rounds within existing portfolio companies, well-capitalised investors of many stripes may look to advance finance to start-ups in need of liquidity by way of convertible loan notes as a means of obtaining cheap equity and/or attractive rates of interest.
One recent model for this would be the UK government’s Future Fund, which allows eligible start-ups to draw between £125K – £5m for 36 months on thoroughly commercial terms (e.g. a minimum of 8% p/a, with a redemption premium of at least 100% of principal and conversion to equity at no less than a 20% discount to the company’s valuation on the next funding round). A further condition for this support scheme, which many start-ups may be looking to as a lifeline, is that government funding is at least matched by other investors, with both the government and the ‘matched funders’ then benefitting from preferential terms. It is conceivable that the question of whether to apply to the Future Fund may itself become a source of intra-investor disputes, as well-capitalised investors seek to put up the requisite funding to access government support and thereby benefit from enhanced terms as ‘matched investors’, to the detriment of shareholders who are not in a position to do so.
For some portfolio companies, merger with competitors or sale to larger organisations may be the preferred ‘get out of jail free’ card, which might also be useful to venture capital firms seeking to generate returns in a hostile environment. A not inconsiderable number of companies are sitting on lots of cash and will be conscious that good businesses may now be bought cheaply in circumstances where market demand may plausibly bounce back, once the public health crisis and its immediate financial shockwaves have passed.
Despite this happy thought, shareholders falling out over entitlements can often come to a head in the context of an anticipated liquidity event, given the immediate financial significance attaching to questions of precisely who owns what. The legal architecture of some start-ups, particularly at the earliest stages of development, is poor, which can mean that owners’ rights are unclear. In addition to the potential for shareholder disputes, such matters may also cause serious problems for the company itself, as a portfolio company’s attractiveness as a target for third parties is predicated on its shares carrying clear legal entitlements. In addition, service contracts for those working in start-ups often involves complex and frequently contingent equity components, which are sometimes poorly documented, with obvious potential for disputes.
IP ownership is another potential banana skin. Cavalier legal practices can mean that software and other IP is not effectively assigned to the company and/or that there is insufficient clarity as to the capacity in which the creator of the IP was acting, making its ownership (often the main repository of company value) unclear. These issues are perhaps most obviously likely to cause problems on sale, but may also be relevant in the currently relevant and unhappy context of insolvency, as portfolio companies that fail may nonetheless have valuable IP that can generate returns. Determining IP ownership in these circumstances may be contentious, in particular given the illiquid, hard to value and often very personally significant nature of the assets.
The prospect of things going off course may motivate existing or incoming investors to seek to grab the wheel themselves, perhaps to pivot the company towards what are perceived to be new opportunities. That also has potential to cause conflict with stakeholders with differing ideas about the best strategic course. Some large investors with dormant entitlements to board representation who were content to leave management to others during the good times may decide that desperate times call for asserting unused rights. However, directors owe fiduciary duties to their companies, breaches of which are fertile ground for company litigation, with co-stakeholders whose noses have been put out of joint being a prototypical claimant for this type of dispute. If a pivot is forced on a company by new management, and that later transpires to have been a mistake, litigation may ensue. Related issues concerning shadow director liability for shareholders who seek to influence company affairs via proxies may also plausibly arise in this context.
For companies at risk of insolvency where investors have board representation, different contentious issues may come into play (not least as directors are liable to have to consider the interests of the company’s creditors as a whole when carrying out their fiduciary duties). For example, an investor with board representation seeking to use a down round as an opportunity to negotiate a ‘best in class’ liquidation preference in a company at risk of insolvency might wish to consider the rules against preferences under the Insolvency Act (i.e. where the company puts an investor in a better position than it otherwise would have been on an insolvent liquidation).
While this is of course just one example, and this article just an overview, of the co-investor disputes issues that venture capital firms may face in the current climate, if further information on any of the above matters would be useful, please do get in contact.