IF YOU EVER HAVE SECOND THOUGHTS about engaging good and separate counsel when raising capital, consider the following real world case involving a biotech entrepreneur who found an experienced venture fund to finance his fledgling business.
The investor committed to provide $4.0 million for which the investor would receive 51% of the company’s stock and the right to elect two of the company’s three directors. The entrepreneur would fill the other spot on the board.
Troubles started at the closing when the investor announced that he wanted to stage his investment. Instead of puttingin the $4.0 million as provided in his term sheet, the investor instead would provide $2.0 million at closing and a second $2.0 million in one year. The only requirement to receive the second $2.0 million was the passage of time.
Without viable alternatives (or independent legal counsel to advise him about risks or ways to mitigate those risks), the entrepreneur acquiesced. Twelve months later when the second $2.0 million came due, the investor had cooled to the company and refused to provide the second $2.0 million.
Notwithstanding the investor’s legally binding and unconditional funding obligation, the entrepreneur's options were limited. Cash was tight and there were no alternative investors. With the investor unwilling to fund, the company had little prospect of attracting a new investor.
Suing the investor to force funding was problematic. A lawsuit would be expensive and time consuming. Even a favorable result would come too late to save the company from financial ruin.
Not only that, the investor threatened to use its majority position on the board and as the 51% shareholder to liquidate the company if the entrepreneur tried forced it to put in the second $2.0 million. The investor had purchased a preferred security with his original investment that entitled it to take the first $2.0 million of new investment back in a liquidation before the inventor saw a penny.
Did the investor violate its contractual obligations? Absolutely.
But the investor had more on his mind than his duty to the company. He also had duties to his investors and was convinced that putting in the $2.0 million would result in losses to his investors.
The entrepreneur contributed to his own woes as well. Having no lawyer of his own at the initial fundraising and then using the investor's lawyer to advise him later, the entrepreneur missed fundamental issues that exacerbated his situation. For example, when the investor reduced his initial investment by half, the entrepreneur should have insisted that the investor take half of the stock originally promised and reduce his board representation until the deferred portion of the investment was received. He could have also negotiated for a penalties that would have made it more costly for the investor to renege on his promise to fund in one year.
Using the investor’s counsel for his company lawyer after the closing was also a mistake. Owing duties to both parties likely prevented counsel from proactively advising the entrepreneur about the risks inherent in his deal structure. When the issue did surface, counsel resigned the company account but continued to represent the investor, further complicating matters for the company and the investor.
How did it end? The entrepreneur eventually engaged qualified counsel to advise him. But the damage was done.
After much back and forth with the entrepreneur's new and independent counsel, the investor agreed to sell the entrepreneur all of the investor’s stock in the company for $1 plus a waiver of the entrepreneur’s rights as a shareholder to sue the investor for failing to provide the funding. Not having the time or money to sue the investor in any event, the entrepreneur took this settlement in hopes of raising money from new sources.
It was small comfort though. The company's prospects were badly damaged and likely funding sources, if they could be found at all, were sure to value the company below its valuation in the first round. The entrepreneur and his company were free to move forward but the cost of that freedom was high.
For more on this topic, check out the entry on Real World Conflicts in Fundraising in Richardson's Growth Company Guide 5.0 - Investors, Deal Structures, Legal Strategies at www.growco.com. Image by imagerymajestic courtesy of freedigitalphotos.net.
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Clinton Richardson, has been writing for decades. His critically acclaimed venture strategy books first appeared in 1987 and are now in their 5th edition. His Ancient Selfies is an International Book Awards Finalist and an eLit Award Gold Medal Winner. Ancient history and capturing photographic moments are among his passions. See his photo galleries at TrekPic.com.