ABA Section of Business Law

Business Law Today
September/October 2001 (Volume 11, Number 1)

Doing documents vs. doing deals
A lawyer confronts a venture capitalist

By Sarah Reed

The venture capitalists who actually fund new companies and the lawyers who draw up the documentation for those investments on their behalf often seem to inhabit parallel universes. The points so meticulously negotiated and drafted in the documents drawn up by the lawyer are often never revisited as the company actually evolves over time.

Picture the following not uncommon scene: Two lawyers sit sweatily across the table from each other, arguing about the terms of the term sheet that will govern the venture capitalist's investment in a hot new start-up. The venture capitalist's lawyer makes vague rumblings about what would happen if the portfolio company went into a "sideways situation," and asks for "participating preferred, with a 3X hurdle." The entrepreneur's lawyer retorts that his clients are "subsisting on nuts and berries - this is not a lifestyle company." (One unstated rule of legal venture capital negotiations is: Whoever throws around the most buzzwords, wins. Thus, the proliferation of sub-literate expressions in this article is intentional.)

What the venture capitalist's lawyer is asking for, in plain English, is that, if the company is liquidated, the venture capitalist first gets the opportunity to recoup three times his original investment with interest (in the form of dividends) and then, assuming anything is left, also gets to participate in the division of any remaining assets with the common stockholders - so-called "participating preferred."

Meanwhile, walk into the office of the venture capitalist who will actually be funding the company and ask how many times he has ever taken out many multiples of his original investment when the company is in a "sideways situation." For that matter, ask him how many times he has ever exercised his redemption rights (the right to force the company to buy back the venture capitalist's stock) or demand registration rights (the right to force the company to file for an IPO) - other terms of the deal that are often the subject of protracted negotiation. Probable answer: Never.

Similarly, all of the deal terms relating to the company's hoped-for eventual IPO - the cutback, the lock-up, and on and on - will actually be dictated by the underwriters, and not by what the investment documents say.

Houston, we have a disconnect.

So what would the venture capitalist identify as the things that are important to a successful deal? His likely answers are all "off-term sheet" items: Entrepreneurs with a proven track-record; finding a great CEO to manage the company to success; technologies that are difficult to replicate and that solve an identifiable customer pain point; an addressable market of sufficient size (roughly $1 billion, assuming that the company will only capture part of that market) to create and sustain a large company; and some type of lead over competitors, be it time-to-market, customer traction or established partnerships.

As to the term sheet items that the venture capitalist is most concerned with, they are the ones that the lawyers will not negotiate at all, because they have been established by the venture capitalist and the entrepreneur at the outset: The company's valuation, the amount of the investment, the number of shares that will be reserved for the company's option pool and the significant terms of those options - for example, what percentage, if any will accelerate on a change of control? Will the acceleration be "double trigger" - that is, not only must there be a change of control, but the employee must also be terminated (usually within some specified period of time - say a year or two) within that change-of-control event in order to have his options accelerated.
Why this often-substantial gap between business reality and the legal terms of the venture capital investment documents? Part of the explanation certainly lies in the fact that the lawyer and the venture capitalist, by professional predilection, could not be more unlike.

The lawyer inhabits a world where hidden dangers and ill intentions lurk around every corner. Her job is to anticipate and attempt to eliminate risks through pages and pages of legal obligations and restrictions, with a dollop of Latin thrown in for good measure. (First time I heard someone ask for Perry Passoo, I thought he was a junior associate on the deal - turns out, "pari passu" just means you get the same deal as the prior investor.)

The venture capitalist is - yes, even in this economy - by definition an irrational exuberantist, investing breathtakingly large sums of money in high-risk propositions. His mission is to "swing for the fences" - his time and energy is better spent ensuring that he returns many multiples of his original investment in the promising deals, rather than ensuring that he receives back 15 cents, as opposed to 10 cents, on the dollar in the failed deals.

In short, the lawyer's job is to minimize the downside, the venture capitalist's job is to maximize the upside.

Although the company founders have far more patience than the venture capitalist investor for the legal details of the deal - after all, whereas the investor will do many deals over the course of his career, this may be the entrepreneur's first and last one - they, too, almost invariably come to view "the lawyers" as a cross they have to bear.
In defense of the lawyer, however, some of the standard venture capital terms that to the businessperson seem like just more of the lawyer's typical "belts and suspenders," "full bells and whistles" approach to the world are in fact underpinned by important business considerations - considerations which, moreover, are not always unilaterally favorable to the venture capitalist.

For example, if the preferred stock (the typical form of security underlying the venture capital investment) does not have "rights, preferences, privileges and restrictions" (such as, dividends, liquidation preference, redemption rights, special voting rights) that distinguish it in meaningful ways from the common stock, then the company will likely lose its ability to grant low-priced common stock options to its employees.
That is, if the preferred stockholder were really not much better off than the common stockholder, then there would be no justification for the difference in price between the two types of stock.

Or, to take another example, the terms that grant the venture capitalist investor certain management rights (typically, a board seat, although sometimes the venture capitalist might simply have board observer rights) serve to ensure that the venture capitalist can add value to the company by contributing his management expertise and monitor his investment.

However, equally important, but much more obscure, these "management rights" provisions also ensure that the funds invested in the company will not be subject to all of the onerous legal requirements regarding the investment of pension plan assets - and hence make it possible for pension funds to participate in venture capital funds. To obtain the "Venture Capital Operating Company" exemption under the Employee Retirement Income Security Act (ERISA), the venture capitalist must ensure that the investment is an active, as opposed to a passive one, by obtaining management rights.

However, some of the other draconian legal terms that one often finds in a venture capital deal, such as the redemption and demand registration rights noted above, let the legal trade secret be revealed - have very little basis in the real world. Their primary function is to protect against downside risk - but, as noted above, the venture capitalist is investing for a home run, not to collect pennies on the dollar when the company is going under.

The far-sighted venture capitalist (and his lawyer) realizes that the long-term gains in reputation and credibility to be gained from not, for example, plundering a portfolio company in crisis far outweigh any benefit of having documents that secure such rights to the investor, rights which, in practice, are largely chimerical.

So, how do the lawyer and the venture capitalist learn to live with, if not love, one another in an era when deals still need to be completed in Internet time, despite the recent slowdown occurring in the economy?

Indeed, for those rare and fortunate entrepreneurs lucky enough to receive a commitment from a venture investor today, the pressure to close and get that money in the bank, before some new disaster is announced in the Wall Street Journal, is enormous.
"Closing Date" is at least one term sheet provision where the investor and entrepreneur are happy to gang up on their lawyers with a united front. It is impossible for them to comprehend why the whole transaction should take more than a week - "Isn't this just cookie cutter?" they ask the lawyers in exasperation. The lawyers, well aware of the hundreds if not thousands of pages of documentation and due diligence that need to be prepared, reviewed and redlined - and redlined, and redlined and redlined - swallow hard and mumble that two weeks would really be more realistic.
The solution must begin with a better understanding of each other's role and goals. The lawyer must appreciate that the venture capitalist is a "big picture" guy, focusing on the long-term and the big return, while the venture capitalist must accept that the lawyer is a professional worry-wart whose job is to attack the forest one tree at a time.
The working relationship is sure to succeed once each learns to perceive the other not just as a necessary evil, but instead as indispensable to a successful deal.

Reed is general counsel at Charles River Ventures, a venture capital firm in Waltham, Mass. Her e-mail is sreed@crv.com. Although all of her deal documents contain a construction provision stating that "the masculine gender shall include the feminine and neuter genders," she expressly repudiates that provision here. All of her bosses are men, and hence the masculine gender in this article includes only the masculine gender.