Venture Capital Investing and JOBS Act

Investing in a new business startup, often called "venture capital investing," is a form of private placement investment. See (PSW article on Private Placements). Pearson, Simon & Warshaw's (PSW) lawyers have years of experience representing investors in high-tech startups, and our offices are conveniently located in San Francisco and Los Angeles. While venture capital investing involves exempt or private placement offerings subject to the same restrictions as other private placements (see PSW article on " Private Placements"), venture capital investing also raises unique legal issues. This is especially true following the recent enactment of the Jumpstart Our Business Startups (JOBS) Act.

Venture capital investing is a general term for providing financial capital, usually through private equity investments, in early-stage, high-potential, high-risk, startup companies. Most venture capital investments are in high technology industries such as social media, software, hardware, information technology and biotechnology.

Investing Through a VC Firm

The majority of venture capital is raised through private investment firms organized similarly to hedge funds (see article on " Hedge Funds"). A typical venture capital firm will establish an investment pool or fund which will be structured as a limited partnership or limited liability company with the firm's managers serving as general partners (or managing members in the case of an LLC). Just as with private placements, the venture capital firm will prepare a private placement memorandum (PPM) and require an investor to execute a subscription agreement attesting that the investor is "accredited" under SEC rules. However, one significant difference from other private placements is that the PPM will not identify what companies the firm will invest in since those decisions are made in the several years after investor monies are solicited. The PPM will identify the firm's managing partners, their track records and the firm's proposed investment strategy. Venture capital firms employ a wide variety of strategies. Those include the stage of a startup at which they typically invest, concentration in certain industries, whether they invest in local, national or international companies and their anticipated exit strategy from an investment. Another unique aspect of investing in venture capital firms is that an investor makes an initial capital commitment that is funded over time as specific venture investments are made. Such capital "calls" are mandatory and failure to meet a capital call can result in substantial penalties.

Even more than hedge fund investments, venture capital investments are highly illiquid. The typical life cycle of a fund is three to seven years with an option by the general partners to extend the fund's life by several years if necessary. Thus, venture capital investors should expect their investment to be tied up for at least five years, if not longer. Fees paid by investors can also be substantial. The typical venture capital fund pays 1.5% to 2% annually of the committed capital and pays to the general partner a share of the profits realized. This performance incentive, called a "carried interest," is at least 20%, and in recent years some highly successful venture firms have demanded carried interests as high as 30%.

In making a venture capital investment through a VC fund, the investor is chiefly picking the managers who will select the companies. It is those managers' ability to identify early stage companies with high growth potential that determines the success or failure of a particular fund. In many cases the venture capitalist must combine the skills of a scientist, businessperson, accountant and visionary. Because of the high risk involved in venture investing, most funds spread out their investments over a number of early stage companies in the hope that the large returns generated by a few big gainers will more than offset the many startups that fail. Although it is possible to invest directly in a startup without going through a venture fund, such a course is not recommended for all but the most sophisticated and experienced venture capital investor.

Venture capital investments typically occur in stages, or financing "rounds." The first stage is called seed or angel financing. (Not all startups go through each of these stages.) The newest concept in seed financing is the use of "crowd-funding," whereby money is raised through Internet solicitation of small investors. (See discussion of "crowd-funding" as allowed under the recently enacted federal law called the JOBS Act).

The second, or "startup," stage is sometimes referred to as a Series A round. This is the round in which many venture capital funds enter the picture with investments to allow product and market growth. The next round is often referred to as Series B round. Although in the past, Series B was for more mature companies selling a new product, depending on the capital needs, burn rate and the complexity of the new product or service, companies may require Series B financing at a relatively early development stage. Most rounds will contain rights of first refusal to the early round investors. These rights allow the earlier round investors to participate in subsequent rounds in order to avoid one of the key downsides of venture investing—dilution of early round investors' interest in the startup. Series B and later rounds may also include warrants or preferred stock to increase investor interest.

Series C and even D, E and F rounds may also be necessary. Also referred to as Mezzanine financing, these rounds typically, but not always, occur just prior (one year or less) to an initial public offering or liquidation event. For example, Instagram closed a Series B funding of $50 million just prior to being acquired by Facebook.

Cashing Out

The goal of any startup (aside from creating a fantastic company) is to reach a point where investors can cash out. This is referred to as a liquidation event. The most commonly known, but one of the least commonly employed, liquidation events is an Initial Public Offering, or IPO. In an IPO, a private startup transitions to a publicly traded company, giving its investors freedom to buy and sell their stock on the open market. Since the heyday of the early 2000's, IPOs have declined in popularity, and are now reserved for the most successful, and generally profitable, startups. The more common liquidation event these days is a buyout. In a buyout, a larger company will purchase a startup for cash and/or stock. A recent newsworthy example of this was Facebook's purchase of Instagram for $1 billion less than two years after Instagram's formation. In some cases, such as that of the startup Color, acquisition offers can pre-date a product launch (Google offered $35 million to the now-defunct company's founders before they released their product). In other cases, a buyout can occur after a company has mostly folded, but still has assets worth acquiring.

The JOBS Act and Crowd-funding

One of the more significant events to affect venture capital investing occurred on April 5, 2012, when President Obama signed into law the Jumpstart Our Business Startups ("JOBS") Act. The JOBS Act is a congressional attempt to force the SEC to adopt less restrictive rules on the raising of money through private placements or exempt offerings. On September 23, 2013, new SEC Rule 506(c) became effective. That rule allows general advertising of private placements for the first time since the Securities Act of 1933 was enacted. You will likely see such private placements advertised on the Internet, social media, seminars, print, radio and television. The impact of this new law and rules being promulgated by the SEC is uncertain.. Investors should expect to see an explosion of offers made over the Internet and other media outlets to invest in startup companies, hedge funds and other private investment vehicles. No doubt the persons soliciting these investment will emphasize the 500 to 1000 times returns made on now iconic companies such as Apple and Google. What they will not tell you is that only 1 out of 10 startups result in positive returns for venture investors. For every Apple, there are numerous other companies that have disappeared with no return on investment.

While the JOBS Act has the laudable goal of easing the burden of raising money for startups, investing in such companies involves substantial risks. With lowering of accreditation standards and allowing advertising of private placements, investors should expect to see a sharp increase in solicitations to invest in startups. As with any investment, investors must be diligent in evaluating such investments and be wary of offers that appear too good to be true. As a convicted securities fraudster recently stated about the JOBS Act: "I wish legislators would consult with people like me before they write something like this. I could tell them, I know what your intent was with this wording, but we can get around it so easily, it cracks me up."

One major concern is that, even if an individual invests in a "home run" company at an early stage through crowd-funding, subsequent financing rounds by more sophisticated investors could greatly dilute the early-stage investment. Without adequate dilution protection, which would not be a surprising facet of crowd-funding, given the relative inability to negotiate terms, smaller investors could be robbed of the returns they deserve. It is imperative that would-be investors scrutinize any offering documents and question whether they have any form of dilution protection to avoid this problem.

Your Legal Rights

Legal claims arising from a failed venture capital investment can take many forms. Fraud in the PPM (the making of a material misrepresentation or omission) as well as wrongdoing in the day-to-day operations of the company or the venture fund can give rise to federal and state securities law claims as well as claims under state law for breach of fiduciary duty, negligent or intentional misrepresentation and breach of contract. As a result of the JOBS Act, investors can expect to see more direct solicitations from startups including so called crowd-funding solicitations. For example, Kickstarter, a website designed to help fundraising for creative projects, such as independent films, now allows users to raise money for startups, but may have woefully inadequate disclosures. If you have suffered a loss from a venture capital investment, you may have a right to sue to recover your losses.

If you have questions about your investment in a venture capital offering, or if you believe you have been the victim of wrongdoing, please contact Pearson, Simon & Warshaw, LLP by e-mail at info@pswlaw.com or by telephone at (818) 788-8300.