Venture capital funds financed partly or entirely with government money have been all the rage in the equity markets these past few years. Initially the Jeremie funds pumped capital into the market in four successive rounds, but as the placement period for this scheme ended, the first solely state-owned venture capital investor also entered the market. And from this year on, new venture capital funds with EU money at their disposal are coming on stream, as well as a state-financed equity fund is set up to assist ventures with potential for future stock exchange listing.
With this abundance of venture capital in the market, it’s important for businesses that want to make use of the funding to consider what the venture capital fund will ask for in exchange for the assistance – especially if it disposes over government money.
Primary objective: the exit
Venture capitalists make no secret of the fact that their primary objective is to sell their stake in the company for the highest possible return. And they use a whole arsenal of legal safeguards to secure the achievement of this goal.
To ensure that the original founders don’t leave the party before the venture capitalists themselves withdraw, it is usual for the latter to stipulate a “right of first exit”. This means that the venture capital fund is entitled to sell its share before the other owners, and the founders cannot leave the company until it has done so. Another important right usually enjoyed by the equity investor is that, if it finds a buyer for the company, it can compel the other owners to participate in the sale process at the same terms as those it has negotiated (“drag-along” right). In return for this, however, the founders are usually assured of the right to join the planned sale process at the same terms even if the prospective buyer would not have negotiated with them originally (“tag-along” right).
The owners of certain types of company have a statutory right of first refusal (pre-emption right) if another owner wants to sell their shareholding. Venture capital firms usually demand that the parties forego this pre-emption right, as it would limit their ability later on, to sell their stake in the company as effectively and for as high a price as possible.
The venture capitalist is also first in line when it comes to sharing out the proceeds from the sale: a standard clause gives priority of claim for the sale price, stipulating the minimum return that the venture capital fund intends to realise – the founders are only entitled to receive profit after this minimum return has been paid out.
How much of a say does the investor have?
Ventures capital firms don’t want to take part in the day-to-day running of the company, as they often lack the expertise and/or time and resources to do this. Instead, they usually entrust management tasks to the founders. They do, however, reserve the right to initiate a change of management if the company’s performance falls significantly short of the set business objectives (“control flip-over” right).
But this does not mean that the investor stays completely out of the company’s decision-making processes. The capital investor still participates in the company’s executive bodies, and even where it only holds a minority share of the company it has a right of veto in virtually every important matter. It’s rare for a representative of the venture capital fund to participate in an operative management board of the company (such as the board of directors), because the members of these can incur personal liability. A more common solution is to set up a supervisory board with executive authority, or a member’s committee with members delegated by the capital fund. These have the authority necessary to oversee the company’s day-to-day operation and decision making.
Administration and restrictions
Businesses that plan to bring in venture capital have to comply with stringent administrative requirements, both at the time of disbursement of the capital and during their subsequent operation, especially if the investor is disposing over government funds. Besides having to allow themselves to be inspected by government agencies to ensure that they are using the funds properly, they are also faced with the prospect of regular reporting and disclosure obligations.
The capital investor also sets out in stone what the founders can and cannot do in the future. An important restriction is the obligation to maintain their employment, which means that for as long as the venture capital fund is an owner of the company, the founders must work to promote the company’s development. Meanwhile, the founders are also subject to formidable non-compete clauses, prohibiting them from engaging in activity that competes directly or indirectly with the company’s business interests either during the investment period or for a few years thereafter. Fulfilment of these obligations is often ensured by severe penalties for non-compliance, such as a prohibitively high amount of liquidated damages, the right of the fund to sell its share for a high price, or perhaps an obligation for the founders to sell their share to the fund at a low price.
Is it worth it?
Whether it makes sense for the founders to take on these strict requirements in exchange for the capital is purely a business question. But based on experience to date, the answer is a resounding yes in light of the many success stories that we have already seen in the Hungarian venture capital market. Nevertheless, it does no harm for the founders to go into the negotiations knowing what the expectations of the investor will be, if they want to achieve realistic compromises.