Monday, January 19, 2009

Can VCs Get Early Liquidity by Selling?

In a recent post by Dan Primack on peHUB, Dan proposes a new "third leg" exit strategy for venture capital funds. In addition to 1) IPOs and 2) M&A, Dan proposes that VC funds directly sell their equity position in a company to another later stage venture fund. For example, an early stage VC fund could make an initial investment in a company and grow the company for 2 or 3 years, then sell its position to a growth stage VC fund for a multiple of the first fund's initial investment. This type of exit strategy will not generate the spectacular returns that VC funds hope for from IPOs, but it could potentially generate consistent smaller successes. Swinging for singles rather than the fences, so to speak. Also, with the IPO market effectively shut and with middle market M&A a basket-case, any sort of liquidity could be good liquidity for some VCs.

While Dan -- and the commentators to his post -- examine the business factors that may influence a VC fund's decision to take this sort of exit, what they do not touch on are the potential legal obstacles to this sort of exit. More on this after the break.

In addition to the business obstacles noted in the original post, there may also be legal obstacles to a VC fund selling a minority position to another fund. Not only would the transferee have to comply with federal and state securities laws, but also there are typically contractual rights in the VC setting that could hamper any transfers.

The federal and state securities laws dealing with this sort of transfer are complex and cannot be summarized here. However, the basic issue is whether the first VC fund that wants to make the sale will be treated as an "underwriter" under securities laws. Any transferring VC will want to be very careful that they have held the securities for a long enough period of time and that when they made the original purchase they did not make that purchase with a view to further distribution. The VC and its lawyers will have to carefully consider whether the VC always intended to transfer the shares to another VC -- which could make the original VC seem like they are acting as an underwriter.

In addition to these securities law issues, there are also potentially contractual limitations on a VC fund exiting its investment. Unlike a PE portfolio company where the PE fund is the owner of the whole company and basically can do what it wants, in the VC context the fund usually holds a minority position. These shares are typically subject to various contractual restrictions on transfer such as First Refusal Rights and Tag Along Rights. Also, there are potentially Drag Along and other forced sale rights involved. A quick glance at the VC industry's sample forms at the NVCA website shows that these sort of provisions are common.

The company's other institutional shareholders and founders may not take kindly to one VC exiting without providing pro rata liquidity. By refusing to waive their contractual rights and allowing the VC to exit without a Tag Along or Right of First Refusal, the founders and other investors could scuttle the VC's potential deal. That is, the prospective purchaser of the minority position may not want to honor these contractual rights and buy different types of equity or a smaller share in the company. Also, depending on how the board seats are apportioned, the transferred shares could be entitled to a board seat which could create an uncomfortable situation on the company board if the transfer is not friendly.

A VC with foresight and pre-planning could easily negotiate for the flexibility to do an early exit. However, the vast majority of VC investments as they are currently structured would not work for an easy exit unless the other investors and founders approved of it.

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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.