New Venture Capital Landscape Will Change GC Practice

As the economic recession fades and the initial public offering market rebounds, the improving economy is reviving the venture capital market. This revival, however, will be on different terms than the resurgence in the late 1990s.

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As the economic recession fades and the initial public offering market rebounds, the improving economy is reviving the venture capital market. This revival, however, will be on different terms than the resurgence in the late 1990s. A new world order exists in the venture capital market, and the business of venture capital will impact the law surrounding it. Because the sources and uses of venture capital have evolved, the law and the customs and practice of lawyers dealing with the world of venture capital are changing as well. In-house counsel need to understand the new landscape, because lawyers at existing companies may be called upon to handle venture capital-related transactions.

In the venture capital community, it is spring after a long, cold winter. Slender green shoots of activity are sprouting; venture capital is alive and growing. The business has undergone organic changes, however. A revenue focus has replaced the technology-driven focus of the 1990s as venture capitalists try to figure out how to wrest revenues from existing technology rather than funding cutting-edge technology.

The players in the funds are evolving, too. Established companies interested in strategic future technologies for the next generation of their core businesses are turning to the venture capitalists to manage that process, in addition to, or perhaps in lieu of, internal research and development. Rather than simply dealing with legal issues raised by an in-house R&D department, corporate counsel must be prepared to handle the challenges that accompany outsourcing research to venture capitalists.

Finally, corporate governance is changing. This results not only partly from financial scandals, but also from down-round funding, a situation in which the price of a new round of financing is lower than the price of the previous round of financing. The structures for doing business in this market are beginning to respond to the new scrutiny of corporate governance, by paying attention to conflicts of interest and instituting new board structures to ward off problems.

But why should corporate counsel care about the venture capital market if they’re working for an existing corporation? Well-established companies are participating as investors in venture funds for the purpose of accessing new technologies. As a result, executives may present in-house counsel with potential venture fund transactions and, if the established company is monitoring the fund investment for technology, with actual venture transactions.

In evaluating these venture transactions, in-house counsel should focus on three primary legal areas: intellectual property; international patent rights and related marketing issues; and evolving transactional law, all of which will differ from the shape they took in the past.

Since companies’ primary purpose in investing is to obtain access to technology, in-house counsel must address the legal needs in this area. This means more than handling patent applications. The world of intellectual property protection is highly strategic and carries the threat — or opportunity, depending on your point of view — of treble damages and/or statutory fines if a company becomes embroiled in litigation. Trade-secret and confidentiality issues also rise in importance, since most of the value in any initial-stage venture capital lies in the talent of the technical team.

International issues also are changing rapidly. If executives’ goals are to fund and to acquire the new technology for the established business, in-house counsel must protect any future technology beyond U.S. borders. While Texas lawyers have tended to focus on Mexico and Europe, legal issues relevant to China and the Pacific basin will prove critical in the future, as companies seek to find new markets for their technology products and services.

But international protection of technology is only the beginning of the venture capital transaction. Issues of manufacturing, marketing and distribution loom much larger now than in the past because of the emphasis on faster positive economic returns. Venture capitalists focus on investments that can be brought to market and liquidated in the near term, and the markets overseas bear significant potential for that quick turn. In Texas, medical deals account for a greater percentage of venture capital transactions than they do in, say, Palo Alto, Calif., and international regulation of drug and medical devices also provides opportunity that the Food & Drug Administration may impede.

A Larger Role

Transactional work also has evolved. The down-round transactions of the past few years have caused transactional attorneys to refocus on fiduciary duty and conflict of interest issues affecting the investors. When the market was strong and the deals good, no liability attached and no damages were recovered because no companies lost money. Also, the issues of fiduciary duty owed by directors to shareholders are minimized in the venture capital world, because the players are largely the same people: The venture capitalist is the director and the shareholder. But when the valuations of down-rounds began to create conflict-of-interest transactions for those investors providing capital at lower values — the venture capitalist who bought at $1 per share versus venture capitalists who’d bought earlier at $5 per share — the fiduciary duty issues punched through to the attention of the players. Plaintiffs filed and litigated cases where shareholders were diluted on a down-round, then came back to claim a stake in a resuscitated company.

The Sarbanes-Oxley Corporate Fraud and Accountability Act of 2002 is on the radar screen of venture capital investing, but the tremendous stress on independent board committees is not filtering down to venture investments — and I do not think it will in the near future. Here’s why: The venture capital world has always struggled to attract and retain its personnel. Independence is difficult to find at the venture capital level because of the small number of players and a shortage of talented people. Outsiders generally do not understand the technical and marketing plays, and there is little money available for salaries to attract outsiders to become members of a board. As a result, attorneys generally will not see independent committees in the venture capital world. They will, however, see a focus on conflict-of-interest policies and a heightened review of conflict-of-interest transactions. The origins of these conflict-of-interest policies lies as much in the down-round experience as it does in the passage of Sarbanes-Oxley. So, unlike in the rest of corporate America, Sarbanes-Oxley has not been, by itself, a significant catalyst for change in the venture capital world.

The bottom line for in-house counsel is that venture capital is returning and established companies will play a larger role as investors, primarily to access future technology. In-house lawyers will be more likely to review potential venture fund investments and venture deals than they were in the past. This will require more intellectual property expertise, particularly in the strategic process of trying to protect a company’s IP assets and in the acquisition of an increased alertness to international issues. Sarbanes-Oxley still looks like an issue only for large companies, but there is definitely a trend for conflict-of-interest policies and related heightened review of transactions. In-house counsel will have to wait to see how these trends continue to unfold.

Bio: Adrienne Randle Bond, a Houston solo, focuses on complex corporate, partnership and securities law; oil and gas transactions; and mergers and acquisitions. A magna cum laude graduate of Rice University and a Harlan Fiske Stone Scholar at Columbia University Law School, she has served as an adjunct professor of corporate law at the University of Houston Law Center, past president of the Women’s Finance Exchange, and a member of the State Bar of Texas’ Corporation Law, Continuing Education and Venture Capital Committees. Her e-mail address is [email protected].

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