2 Latin

Venture Capital: A Lawyers Role Presented By: Poupa Marashi Legal Counsel at IBG

Lawyers Role in VC I.

Developer

IV. Facilitator

III. Intermediary

Lawyers Role: Developer

Why is VC a Great Vehicle for Development?  VC promotes self reliance and entrepreneurship  Empowers small producers through access to capital  Leverages the impact of initial monies far beyond traditional grants and foreign investments  Involves the private sector, and private individuals in economic and social development

Job Opportunities  Iranian companies are privatizing, as prescribed in the Third Five Year Plan, job cuts are being made. There must be new job creation  Iran’s 70% population under 30 years old

VC’s Successful Development In Iran  Direct government investment in “seed” companies should be avoided  Fiscal measures should be developed to make VC investment more attractive  Legal accommodation of establishment of private equity funds  Temperate laws in areas such as bankruptcy stimulate demand  Favorable tax laws  Great respect for the rule of law in private contracts, as opposed to general corporate law  Favorable employment laws  Appropriate contractual technology  Legal Education should be more practical

Government Backed Programs  Meaning: either directly operated or controlled, or indirectly subsidized through tax incentives

Government Direct Investment  Negative impact in countries studied  Crowds out, up to 100%, private equity investment  Government funds act to compete with and overpay for investments  Should only be used where there is very strict financial discipline  Can learn more about successful and unsuccessful schemes by reading Gompers and Lerner

Advocating for Laws That Develop  Laws make an enormous difference on investment supply and demand  Two laws “capital gains tax cut: and “prudent man rule” increased VC funding from 68 million USD in 1977 to 978 million USD in 1998, in only one year  Studies have shown that the amount of VC investment in the US is responsive to : – Legal and fiscal variables, including pension fund regulation, taxes, and subsidies – Summaries of these policies are available from websites such as: www.evca.com and www.cvca.com and www.ventureeconomics.com , for Europe, Canada, and the US respectively

Policies Affecting Supply and Demand of VC Finance  Supply: affected by relevant taxes, subsidies, and regulations (e.g. regarding pension funds)  Demand: taxes, subsidies, bankruptcy law

Supply Factors: Investment Friendly EVCA in 2003 and 2004, has published a “benchmark index” for tax and legal environments that will increase supply (and more recently demand):

http://www.evca.com/images/attachments/tmpl_9_ar

(EVCA tables)

Demand: Bankruptcy Law  Provides an orderly mandate for insolvency of insolvent’s assets  Make bankruptcy laws less penal  Much “start up” is from entrepreneurs own pockets, but if he must borrow, then exposed— including exemptions, or reducing discharge time  Social stigma of bankruptcy

In Sum: What Kinds of Laws Should Policymakers Foster  Policymakers should indirectly implement legal measures that are foundational for the development of liquid stock markets, such as disclosure laws, minority shareholder protection, etc., and  Modify legal environment in accordance with EVCA index and other studies

Lawyer’s Role: Facilitator

Legal Drafting  Ensure transaction complies with Iran’s existing laws and regulations  Develop appropriate legal documentation

VC Clients: Entrepreneur  Entrepreneurs concern: • Loss of management controls • Dilution of personal stock • Repurchase of personal stock in the event of employment termination, retirement or resignation • Adequate financing • Security interests being taken in key assets of the company • Future capital requirements and dilution of the founder's ownership • Intangible and indirect benefits of venture capitalist participation, such as access to key industry contacts and future rounds of capital

VC Clients: Investor  Investor’s concerns: • • • • • • • • •

The company’s current and projected valuation; Level of risk associated with the investment; The fund’s investment objectives and criteria; Projected levels of return on investment; Liquidity of investment, security interests and exit strategies in the event of business distress or failure ("Downside Protection"); Protection of the firm's ability to participate in future rounds if company meets or exceeds projections ("Upside Protection"); Influence and control over management strategy and decision making; Registration rights in the event of a public offering; and Rights of first refusal to provide future financing

VC Contracts: Composition  Term Sheet  Principal transaction documents

– Securities purchase agreement: sets type of security to be purchased, purchase terms, representations, warranties and covenants

 Ancillary Documents – – – – –

Preferred stock designations Warrants Subordinated promissory notes Shareholders agreements Registration rights agreements

Model Forms From www.nvca.org A “template” set of model legal documents put together by a group of leading venture capital attorneys, consisting of: -Term Sheet -Stock Purchase Agreement -Certificate of Incorporation -Investor Rights Agreement -Voting Agreement -Right of First Refusal and Co-Sale Agreement -Management Rights Letter -Model Opinion Letter -Model Indemnification Agreement The model documents aim to: -reflect industry norms -be fair, biased toward neither the VC nor the entrepreneur, -consistent with industry norms -present a range of “typically seen” options (again, consistent with industry norms) -include explanatory commentary where necessary or helpful

VC Contracts: Specificity  The way a lawyer creates a contract, the degree of specificity, will absolutely help to define and encourage VC investments in the short term and increase its success, in the long term  Kaplan and Stromberg provide a complete analysis of financial contracting theory and an empirical analysis.

VC Contracts: Financial Contracting Theories  Big problem in developing countries because of a goal conflict between the VCs and the entrepreneur, where it is difficult for the VCs to verify the agent’s performance  Principal-agent: compensation must be dependent on outcome of signals. Provide cash flow rights to entrepreneur, ownership only important as far as it affects pure cash flow rights

VC Contracts: Allocation  VC contracts allow VC’s to separately allocate – – – – –

Cash flow rights Voting rights Board rights Liquidation rights Other control rights

VC Contracts: Staged Financing  Key method for minimizing investment risk is by using staged financing  Staged financing looking at Gomper’s analysis of Apple and Federal Express

VC Contracts: Performance  Cash flow rights, voting rights, control rights, and future financings are frequently contingent on observable measures of financial and nonfinancial performance

VC Contracts: Flexibility  The actual distribution of rights and responsibilities is dependent on: – The experience and reputation of the entrepreneur – The attractiveness of the portfolio company as an investment opportunity – The stage of the company’s development – The negotiating skills of the contracting parties – The overall state of the VC market

VC Contracts: Equity  VCs implement an allocation of rights using combinations of multiple classes of common stock and straight preferred stock  Convertible securities are used most often because: – Complex and sophisticated legal arrangements can be worked out – Claim becomes senior – Debt security is exposed to less potential legal liability

Main VC security percent 100 90 80 70 60 50 40 30 20 10 0 Convertible preferred

Ordinary common stock

Senior common Convertible debt stock

US sample (K&S 2003)

Common

other securities

Civil

Residual cash flow rights and incentive mechanisms percent 100 90 80 70 60 50 40 30 20 10 0 Founder stock vests over time Equity or funding milestones

US sample (K&S 2003)

VC anti-dilution protection

Common

Civil

VC Contracts: Performance  Rights commensurate to performance: – Poorly: VCs obtain full control – Improvement: entrepreneur obtains/retains more control rights – Very Well: VCs retain their cash flow rights, but relinquish most of their control and liquidation rights. Entrepreneurs cash flow rights increase

Board Control percent 80

70 60 50 40 30 20 10 0

VC board seats

Founder controls board

US sample (K&S 2003)

Neither/statecontingent

Common

VC controls board

Civil

VC Contracts:  VCs often include non-compete and vesting provisions aimed at mitigating the potential hold up problem between the investor and entrepreneur.

Activities Activity

DEVELOPING Country VC Firm

DEVELOPED Country VC Firm

Fund Structure

Corporation & Limited Partnership

Limited Partnership

Capital Sources

Pension Funds, Corporations, Insurance Companies, High Net orth Individuals, Government & Non Governmental Organizations (USAID, IFC)

Pension Funds, Corporations, Insurance Companies, High Net Worth Individuals

Types of Investments: Traditionally

Privatizations, Corporate Restructuring, Strategic Alliances, Infrastructure funds

High-technology, Early-stage, High growth firms

Types of Investments: Recently

Services expanding from Developed to Developing Labor-intensive industries Indigenous technology in Developing countries

Trend towards Late-stage

Deal Origination

Low number of attractive investments, Focus on quality of management, Problems of country risk, Corruption, Exchange rate risk

Focus on quality of management

Deal Structuring

Common stock and debt

Common stock, several classes of preferred stock, debt and convertible preferred stock

Pricing the Deal

Difficulty in assessing the value of an investee company – lack of transparency

Higher level of transparency

Exit Strategy

Sale to third parties, co-investors, investee firm’s management

Initial public offering (IPO)

Source: Aylward (1998) and Pacanins (2001), Scheela 2002

Lawyer’s Role: Intermediary

Networking  Policymakers  Local investors

– Lack of opportunities – Inefficient financial intermediation system – Absence of well functioning capital market and investment instruments – Will serve as powerful signal to foreign investors

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Information  Dealing with over 30 years of information, many thorough cross country studies, much literature available, assist in approximate ideas  As Iranian VC develops can conduct new surveys, studies, etc on problems and their alleviation  Middle east uses lowest percentage of internet, of any region in the world

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Foster Understanding of VC  Take time to understand the VC technical contracts  Make rules of the VC game, and normally standard contract provisions understandable to entrepreneurs, and investors  Educate clients/assist in obtaining info – Offer links – Educational materials, pamphlets, articles

VC’s Success Dependent on Transparency  Try to get transparency well bred into the system!!!!!!!!!!

Suggestions to Organize Efforts  Web site for VC in Iran  An active VC association

Sources •

Aylware, A. (1998). Trends in venture capital finance in developing countries. (36). Washington DC: International Finance Corporation.

•

Black, B.S., 2001 The Legal and Institutional Preconditions for Strong Securities Markets. UCLA law review 48, 781-849.

•

Gilson, R.J., 2003. Engineering a Venture Capital Market: Lessons from the American Experience. Stanford Law Review 55, 1067-1103.

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Gompers, P.A., and J Lerner, 1996. The use of covenants: an empirical analysis of venture capital partnership agreements. Journal of Law & Economics 39, 463-498.

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Gompers, P.A., and J. Lerner, 1998. What drives venture fundraising? Brookings Proceedings on Economic Activity – Microeconomics, 149-192. opt cit. National Bureau of Research Working Paper 6909 (January 1999).

•

Gompers, P.A., and J. Lerner, 2000. Money chasing deals?: The impact of fund inflows on the valuation of private equity investments. Journal of Financial Economics, 55, 281-325.

Sources •

Kaplan, S. and P. Stromberg, plan 2000. Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts. NBER Working Paper w7660.

•

Kaplan, S. and Martel F. and P. Stromberg, November 2003. How Do Legal Differences and Learning Affect Financial Contracts?

•

La Porta, R., F. Lopes-de-Silanes, A. Shleifer, and R.W. Vishny, 1997. Legal Determinants of External Finance. Journal of Finance 52, 1131-1150.

•

Megginson William L., Toward A Global Model of Venture capital, University of Oklahoma

•

Rajan, R.G., and Zingales, L., 2003. Banks and Markets: The Changing Character of European Corporate Finance. NBER Working Paper w9595. www.nber.org.

Contact Poupa Marashi, Esq. Legal Counsel Sayeh Tower, 3rd floor, Suite#6, 1409 Vali-e-Asr Ave., Tehran, Iran 19677 Tel:+98 21 204 3901-2 Fax:+98 21 204 3992 Mobile: +98 912 314 7038 [email protected] www.ibg-me.com