Business Law Today

Volume 12, Number 4 - March/April 2003

Trap For The Venture Capitalist
Beware the Hart-Scott-Rodino Act
By Robert S. Schlossberg and Jason A. Lomax

Some venture capitalists seem to think they can do almost anything. But it's not always that easy. A certain piece of legislation just may ensnare these investors in its web.

The Hart-Scott-Rodino Antitrust Improvements Act of 1976, 15 U.S.C. § 18a (the HSR Act or act) was enacted to provide federal antitrust enforcement agencies the opportunity to review and investigate before closing certain mergers and acquisitions that may have an anticompetitive effect. The act establishes a series of reporting thresholds based on the size of the parties and the size of the transaction supplemented by a series of exemptions.

Because the act's reporting requirements, as further developed in detailed regulations, are not keyed directly to the competitive substance of the transaction — such as, there is no market-share test in the legislation — the act can be both over- and under-inclusive. Most of the transactions reported do not raise substantive antitrust issues, and a number of transactions too small to be reported are nevertheless ultimately challenged by federal antitrust agencies because they do raise serious antitrust issues.

Whether or not the transaction raises competition concerns, compliance with the act is mandatory and failure to comply can expose the parties to a transaction to civil penalties of up to $11,000 a day for each day of violation.

The HSR Act requires the ultimate parent entity of each party to a reportable transaction to file a Notification and Report Form with the Federal Trade Commission and the Antitrust Division of the Department of Justice (together the federal antitrust agencies).

A reportable transaction cannot be consummated until the expiration or early termination of the statutory waiting period, which is 30 days (15 days in the case of all cash tender offers and bankruptcies). In addition, before the expiration of the initial waiting period, the federal antitrust agencies may issue a request for additional information, which tolls the waiting period, prohibiting consummation of the transaction until 30 days (10 days in cash tender offers and bankruptcies) after satisfaction of the request. Filing fees range from $45,000 to $280,000.

Not every transaction requires a filing. Transactions must satisfy two main jurisdictional tests to be reportable under the HSR Act: the "size-of-person" test, 15 U.S.C. § 18a(a)(2), and the "size-of-transaction" test, 15 U.S.C. § 18a(a)(3), 16 C.F.R. § 802.20.

The size-of-person test requires inquiry into the size of the "ultimate parent entity" of both parties to the transaction, together with all entities "controlled" by that ultimate parent (which may be a natural person). The ultimate parent is the entity that is not controlled by any other entity as defined in the regulations. Generally, the size-of-person test is satisfied if one ultimate parent entity has $100 million in annual net sales or total assets and the other has $10 million in annual net sales or total assets.

The size-of-person test is not applicable to transactions valued at more than $200 million.

The "size-of-transaction" test is met if the acquiring person acquires assets or voting securities of the acquired person that exceed $50 million. 15 U.S.C. § 18a(a)(3).

It will come as a surprise to many that the HSR Act, designed to challenge anticompetitive acquisitions, may apply to the activities of venture capital companies that are focused on developing new business and thereby furthering competition in the market. The broad scope of the legislation and the rules governing the act, however, capture many transactions that may not seem reportable. Consider the following transactions by a venture capitalist that may require an HSR filing:

invests $25 million in a second round of financing for a start-up company;
invests $40 million in a first round of financing for a start-up company and invests another $15 million in a second round of financing, after the issuer burned through the initial investment; and
in a stock-for-stock transaction, acquires additional stock in an issuer because of the issuer's acquisition of a start-up the venture capitalist also funded;
purchases on the open market $62,500 of voting securities of an issuer in which it invested pre-IPO.

A venture capital company (VC) typically will participate in numerous rounds of a portfolio company's funding. If, after an initial investment, the VC does not increase its percentage share of the outstanding voting securities of the issuer, its acquisition of additional shares — irrespective of the value of the VC's holdings and the size of the transaction — will be exempt from the HSR reporting requirements.

Example 1 — Assume a VC invests $25 million in an issuer's first round of financing, acquiring 25 million shares of common stock that is 10 percent of the issuer's outstanding voting securities. Even assuming the VC and issuer have sufficient net sales or total assets to satisfy the size-of-person test, this transaction would not be reportable because the size-of-transaction test is not satisfied.

In a second round of financing, the VC acquires 500,000 shares of the issuer's common stock at $2 a share. As a result of this acquisition, the value of the VC's holdings in the issuer would be $51 million (25,500,000 shares x the acquisition price of $2 per share). This would satisfy the size-of-transaction test, and the VC would have to make an HSR filing before acquiring the additional shares.

If, however, the other shareholders participate in the second round of funding to the extent that the VC's second acquisition does not increase its 10 percent share of the outstanding voting securities of the issuer, the acquisition is exempt from the HSR reporting requirements. 15 U.S.C. § 18a(c)(10). The applicability of this exemption, therefore, depends on the other shareholders' participation in the new issuance.

How a start-up company spends cash between rounds of financing may be important in determining the reportability of a VC's investment. Even if a VC's investments satisfy the size-of-transaction test, the investments may not be reportable under the HSR Act if the issuer does not have sufficient assets or sales to satisfy the size-of-person test.

Example 2 — Assume a VC with more than $100 million in annual net sales or total assets invests $40 million in a biotech start-up company that has minimal assets and sales. The acquisition is not reportable because the size-of-transaction test is not satisfied, and the size-of-person test is not satisfied because the issuer is not a $10 million person.

The issuer then spends $35 million of the $40 million investment on staff and rent and approximately $5 million in laboratory equipment and other "hard" assets. In a second round of financing, the VC invests another $15 million in the issuer at the same price per share as the initial investment. As a result of this acquisition, the value of the VC's holdings in the issuer would be $55 million, enough to satisfy the size-of-transaction test.

However, because the issuer's last regularly prepared balance sheet will only show approximately $5 million in total assets, the issuer is not a $10 million person, and the size-of-transaction test is not satisfied. Until the issuer has $10 million in total assets, any additional investment by a $100 million VC will not be reportable under the HSR Act (assuming the issuer is not "engaged in manufacturing"), unless a transaction is valued at more than $200 million, in which case the size-of-person test does not apply.

A VC might not intuitively consider the requirements of the HSR Act when acquiring less than $50 million worth of stock. The size-of-transaction test is not, however, limited to the value of the voting securities being acquired; HSR rules require the VC to revalue voting securities previously held (as defined in the regulations) and add that to the value of those being acquired. If the stock being acquired is publicly traded, the value of voting securities of an issuer held prior to an acquisition shall be the market price (the lowest closing price in the last 45 days); if the stock being acquired is privately held, the value of the voting securities held prior to the acquisition is the fair market value.

Example 3 — Assume, in the first round of financing, the VC acquires 25 million shares of the issuer's common stock at $1 per share, which is 10 percent of the outstanding voting securities of the issuer. This acquisition is not reportable because the size-of-transaction test is not satisfied. Assume further that the VC also holds voting securities in a competitor.

The issuer acquires the competitor in a stock-for-stock transaction. In exchange for its shares of the competitor, the VC acquires 1 million newly issued common shares of the issuer valued at $2 per share. As a result of the acquisition of the new shares, the value of the VC's holdings in the issuer would be $52 million (the acquisition price of $2 x 1 million shares plus the fair market value of another 25 million shares which, logically, would also be $2 per share). This satisfies the size-of-transaction test, and, if the size-of-person test is satisfied, the HSR jurisdictional tests are met.

However, if, because of the issuance of a significant number of new common shares, the VC's percentage share of the issuer's total outstanding voting securities does not increase as a result of the acquisition, the acquisition is not reportable under the HSR Act. 15 U.S.C. § 18A(c)(10). Indeed, it would not be unusual for the issuance of a significant number of new common shares to dilute a shareholder's percentage share of the issuer's total outstanding voting securities.

Example 4 — Assume, in an initial investment, a VC acquires 2,500,000 shares of a start-up's stock for $25 million; the acquisition is not reportable because the size of the transaction does not satisfy the $50 million jurisdictional requirement. Assume that after the start-up's IPO, the stock goes to $40 a share, falls to a 45-day low of $20 a share, and the VC wants to acquire an additional 2,500 shares when the stock price is at $25. The relevant value for the HSR Act of the to-be-acquired shares is the acquisition price of $62,500 (2,500 shares x $25).

Applying the HSR aggregation rules, however, as a result of the open-market acquisition, the value of the VC's holdings in the issuer would be $50,062,500 (2,500,000 shares x $20 plus 2,500 x $25). The size-of-transaction test is satisfied, and, assuming the VC and the issuer are large enough to satisfy the size-of-person test, the $62,500 open market acquisition is HSR reportable.

The HSR aggregation rules are especially important with post-IPO stock appreciation. Indeed, if, after the appreciation of the issuer's stock, the current value of the VC's holdings is more than $50 million, the VC would not be able to acquire a single share without reporting.

When a VC's open-market purchase is HSR reportable, the VC will have to delay its open-market acquisition until the HSR waiting period has expired or has been terminated. A VC, however, typically cannot predict when the stock of a portfolio company will need support, and delaying the stock purchase may defeat the very purpose of the acquisition. The HSR rules provide no mechanism for avoiding the HSR waiting period.

The FTC's Premerger Notification Office has consistently been hostile to the concept of an escrow agent acquiring the stock on behalf of the VC. Unless the agent has beneficial ownership of the stock — which means the agent must bare the risk of loss and the advantage of gain — an escrow agent is not an option. Therefore, if it is likely that a VC will want to acquire the issuer's stock after an IPO, making an HSR filing sufficiently before the open market acquisition will give a VC the flexibility over the next year to acquire a certain amount of the issuer's stock without delay.

The HSR Act is a potential trap for the unwary, and venture capitalists and the issuers in which they invest must be aware of the subtleties of the act, both before and after an issuer's IPO.

Schlossberg is a partner and Lomax is an associate at Morgan, Lewis & Bockius LLP, in Washington. Schlossberg's e-mail is rschlossberg@morganlewis.com and Lomax's is jlomax@morganlewis.co.

ABA Section of Business Law