Venture capital investment in Australia: market and regulatory overview

A Q&A guide to venture capital law in Australia.

The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.

To compare answers across multiple jurisdictions, visit the Venture Capital Country Q&A tool.

This Q&A is part of the PLC multi-jurisdictional guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-mjg.

Mark McFarlane, Matthew Coull and Scott Heezen, King & Wood Mallesons, Australia
Contents

Market overview

1. What are the main characteristics of the venture capital market in your jurisdiction?

Venture capital and private equity

Australian venture capital transactions typically involve the provision of investment capital to early-stage companies that are considered to be high risk, high growth businesses.

Venture capital is distinguished from private equity (PE) in that the PE investor typically acquires a controlling interest in more established companies through leveraged investments. These PE transactions typically involve a larger equity contribution given the later stage of the investee business. As such, the PE investor seeks greater control rights over the management of the investee business than that found in venture capital transactions.

Sources of funding

An early-stage company's initial funding source is primarily the company's founders. It is also common for founders to seek investments from family and friends, and in fortunate cases, from high net-worth individuals (angel investors).

Once funding requirements increase, early-stage companies seek additional investment from institutional investors. The institutional investors comprise both domestic and offshore venture capital funds and, less frequently, institutions. It is rare for an early-stage company to be able to access external debt from banks of a level sufficient to reach scalable operations.

The Australian government has also established investment programmes to assist early-stage companies requiring capital. Two high profile examples are the Innovation Investment Fund (IIF) and Commercialisation Australia.

The IIF programme is a co-investment scheme where capital raised by selected fund managers from the private sector is matched (at an agreed ratio) with capital from the Australian government. Government funds committed through the IIF programme are typically invested in new technology sectors. This programme started in 1998 and has implemented three rounds of funding, amounting to over A$350 million of committed government capital. Round 3 is the last round of announced funding and applications for this round have now closed. Whether further rounds will be announced remains to be seen.

Commercialisation Australia is a government initiative that commenced in early 2010. It is a merit based, competitive assistance programme that offers skills and knowledge support to help build capability and connections to commercialise new ideas. From 2010 to 2013, the Australian government will provide A$196 million to the programme, and ongoing funding of A$82 million for each year thereafter.

Types of company

Venture capital investments typically target early-stage businesses with high risk/high growth business models. Usually the founders have a particular expertise or have developed a new idea. Venture capital investments are made in a wide range of sectors, including biotechnology, information technology, media and communications. Businesses requiring high capital costs are generally less suited to venture capital investments. However, sectors such as energy, industrial products, chemicals and construction have attracted venture capital investment in Australia in recent years.

The most active sectors in the Australian venture capital industry in recent years have been healthcare and life sciences, followed by computer and consumer electronics, and the media and communications sectors. According to the Australian Private Equity and Venture Capital Association's (AVCAL) survey of PE and venture capital deal activity in the financial year ended 30 June 2011 (FY11), the healthcare/life sciences and computer/consumer electronic sectors accounted for 55% and 29% of the total value of venture capital investments in FY11, respectively. This is consistent with the long-term trends of these sectors from FY06 to FY11 of 49% and 23% respectively.

Market trends

Although government initiatives such as the IIF programme and Commercialisation Australia have been welcomed as a stimulus for the industry, the venture capital environment remains challenging in Australia. This is reflected in an overall decline in both investment value and volume in FY11, as captured by AVCAL's FY11 deal activity survey. The value of venture capital investment fell from A$182 million in FY10 to A$119 million in FY11, which was recorded as the lowest value over the last five years. The number of venture capital investments (both new investments and subsequent round investments) fell from 161 in FY10 to 97 in FY11.

Although, according to AVCAL's figures, the number of new investments fell from 93 transactions in FY10 to 34 transactions in FY11, the average size of these new investments remained steady at an average of about A$1 million. The average size of subsequent rounds of venture capital funding increased from an average of A$1.2 million to A$1.3 million.

Anecdotally, recent years have seen an increase in US-style influenced venture capital investment and transaction terms as more Australia-based investment professionals have experience in and personal contacts from Silicon Valley. The industry has also seen an increasing numbers of US-based investors, including both high net-worth individuals and institutional investors, investing in Australian early-stage companies.

 
2. Are there any recent or proposed regulatory changes affecting the venture capital industry?

The introduction of a framework for establishing tax-effective investment vehicles has been the main regulatory development affecting venture capital in recent years. These vehicles comprise Venture Capital Limited Partnerships (VCLPs) and Early Stage Venture Capital Limited Partnerships (ESVCLPs).

VCLPs are funds structured as limited partnerships that make equity investments in start-up and expanding Australian companies. According to AusIndustry (the Australian government body that administers the VCLP programme), since the programme was established in 2002, registered VCLPs have to date invested about A$1.9 billion in 175 businesses. As at 15 June 2012 there were about 40 registered VCLPs.

The ESVCLP structure was established in 2007. These have the same structure as VCLPs but are targeted at investments in start-up companies. As with VCLPs, ESVCLP investments must meet prescribed criteria (see Question 3). Favourable tax treatment is available for certain investors and managers under both structures (see Question 3).

The Board of Taxation (a non-statutory body charged with contributing a business perspective to improving the design and operation of Australia's taxation laws) is currently undertaking a review of collective investment vehicles, including VCLPs and ESVCLPs. While no recommendations have yet been provided, the Board is expected to release its recommendations in the near future. These recommendations may be used as a basis for amending the current venture capital regime.

Another recent development in the area of collective investment has been the introduction of the Managed Investment Trust (MIT) provisions that provide certain concessions for qualifying unit trusts (including the ability to elect to treat certain gains as capital gains). While MITs are being used as part of PE investment arrangements, they have not been designed to facilitate PE or venture capital investment. In particular, there are some disadvantages for funds looking to utilise MIT, including that any "carried interest" paid as a distribution from an MIT would be assessed as ordinary income and not on capital account as is the case if paid from a VCLP or ESVCLP (see Question 3).

 

Tax incentive schemes

3. What tax incentive schemes exist to encourage investment in venture capital companies? At whom are the schemes directed? What conditions must be met?

There are a number of tax incentive schemes aimed at encouraging investment in venture capital entities. The tax incentives relating to VCLPs and ESVCLPs are outlined below.

Overview

In 2002, the Australian government passed the Venture Capital Act 2002 (Cth) (Venture Capital Act) to facilitate foreign investment in the Australian venture capital industry by providing tax incentives to foreign investors who invest in high-risk start-up and expanding businesses that may have otherwise been unable to attract funding through normal commercial means (VCLP scheme).

The eligibility requirements for the VCLP scheme were relaxed in 2007, which provided greater access to foreign investors. At the same time, a new scheme (ESVCLP scheme) was put in place to provide tax concessions for Australian resident and foreign investors who invest in early-stage venture capital activities.

Broadly, the key tax benefits associated with each incentive scheme include:

  • "Flow-through" treatment for VCLPs and ESVCLPs (even though these entities would generally be taxed as companies under Australian tax laws).

  • Disregarding revenue or capital gains and losses arising on a disposal of eligible investments by a VCLP or ESVCLP for certain partners.

  • Assessing the general partner of a VCLP or ESVCLP on capital account with respect to their "carried interest" in the partnership.

Entities must be registered with Innovation Australia, which is an independent statutory body, to be classified as a VCLP or ESVCLP (and access these tax concessions).

VCLP scheme

An entity can register as a VCLP if it satisfies the following requirements:

  • It is organised as a limited partnership under a law in force in Australia or other country that has entered into a comprehensive double tax agreement with Australia (Treaty Country).

  • All of the partners who are general partners are residents of Australia or a Treaty Country.

  • The partnership agreement provides that the partnership is to remain in existence for a period of not less than five years and not more than 15 years.

  • The partnership's committed capital is at least A$10 million.

  • Each investment that the partnership holds is an "eligible venture capital investment" and other restrictions in relation to investments are observed at all times.

Eligible venture capital investments

An investment constitutes an "eligible venture capital investment" if:

  • It is shares, units, options (including warrants) or convertible notes that are "equity interests" (for the purposes of the Income Tax Assessment Act 1997 (ITAA 1997)) and are held "at risk". An investment is held "at risk" if there are no arrangements as to the maintenance of the value of the investments or the maintenance of any earnings or returns that may arise in connection with the investment.

  • The investee company or unit trust:

    • is located within Australia (that is, operated and controlled in Australia), subject to certain exceptions;

    • does not have more than 25% of its total assets used primarily in activities which are "ineligible activities";

    • has total assets of less than A$250 million just before the time the investment is made;

    • has a registered auditor;

    • is not listed (or ceases to be listed within a specified time frame); and

    • does not use the funds to invest in other entities unless permitted by the relevant provisions; and

    • the sum of all debt interests and equity interests the partnership owns in the investee company or unit trust (and any of their connected entities) does not exceed 30% of the partnership's committed capital.

Flow-through tax treatment

On registration, a VCLP is eligible for flow-through tax treatment and is not taxed as a company. This means that the partners in the VCLP are taxed on the basis that they hold a direct interest in the underlying VCLP assets.

Disregarded profits and gains

Eligible venture capital partners in a VCLP are exempt from Australian tax on their share of the profit or gain made on the disposal by the VCLP of an eligible venture capital investment, provided that the investment was owned by the VCLP for at least 12 months, was held at risk and the VCLP was unconditionally registered. Conversely, any loss on that investment is not deductible.

An eligible venture capital partner includes:

  • A tax-exempt foreign resident who is not a general partner of the VCLP.

  • A foreign venture capital fund of fund who is not a general partner of the VCLP and who holds no more than 30% of the VCLP's committed capital.

  • A foreign entity who is not a general partner of the VCLP who holds less than 10% of the VCLP's committed capital.

Unless the income of the partner falls under the income tax concession above, it will be assessable as ordinary income or under the capital gains tax (CGT) regime. For example, any management fees paid to a general partner will be ordinary income. Interest and dividends received from investments will also be ordinary income.

The above concession does not extend to a partner in a VCLP who is an Australian resident for tax purposes.

Taxation of carried interest

"Carried interest" is a partner's entitlement to a distribution from the VCLP that is contingent on profits being attained for the partners of the VCLP. A carried interest may be held by the general partner of a VCLP.

Carried interest is taxed under the CGT provisions and qualifies for the general CGT discount, which, for an individual, results in only 50% of the gain being subject to tax, where the partnership agreement was entered into at least 12 months before the carried interest is paid (that is, the carried interest is not taxed as ordinary income but is taxed under the CGT regime).

The general partner's carried interest does not include any entitlement the partner may have to a management or similar fee that is paid for the management of the VCLP. Similarly, it does not include any amount paid to the partner in respect of an equity interest it holds in the VCLP.

ESVCLP scheme

An entity is eligible to be registered as an ESVCLP if it satisfies the requirements for a VCLP (see above, VCLP scheme) with the following modifications:

  • The partnership's committed capital is at least A$10 million and does not exceed A$100 million (there is no cap on committed capital for a VCLP).

  • None of the partners have committed capital in the partnership that exceeds 30% of the partnership's committed capital.

  • Each investment is in accordance with the partnership's approved investment plan (see below).

  • At the end of the partnership's income year, it does not hold an investment in an entity whose total assets exceed A$250 million (for VCLPs, the A$250 million restriction is tested at the time of investment only).

Eligible venture capital investments

This is broadly the same for ESVCLPs as for VCLPs (see above VCLP scheme), with some minor differences. For example, at the time an investment is made in an investee entity, the entity cannot have total assets exceeding A$50 million.

Tax concessions

Tax concessions are similar to those provided under the VCLP regime (see above, VCLP scheme). One key difference with the ESVCLP regime is that Australian resident partners also qualify for the exemption on profits and gains realised in connection with the realisation of eligible venture capital investments by an ESVCLP. The tax concessions relating to "carried interests" (see above, Taxation of carried interest) also apply to ESVCLPs.

 

Funding sources

4. From what sources do venture capital funds typically receive funding?

Venture capital funds typically receive funding from private high net-worth investors, large institutional investors (such as superannuation funds) and offshore investors (see Question 1). There has also been Federal Government and some State Government support from time to time, for example, the IIF (see Question 1).

 

Fund structuring

5. Can the structure of the venture capital fund affect how investments are made?

ESVCLPs and VCLPs have certain constraints imposed on them as to the investments they can make. Unit trusts have fewer restrictions on the investments that can be made. Proper structuring of the fund is important to ensure the anticipated tax treatment is obtained.

 
6. Do venture capital funds typically invest with other funds?

The venture capital industry in Australia is not as mature or well-developed in comparison to, for example, the US. Therefore, it is more difficult to consider typical practice in Australia. Typically, it has not been unusual for venture capital investments to be made by a number of funds or venture capital investors at each round of expansion.

 
7. What legal structure(s) are most commonly used as vehicles for venture capital funds in your jurisdiction?

See Question 2. Funds may be structured as an ESVCLP, VCLP or as a unit trust.

 

Investment objectives

8. What are the most common investment objectives of venture capital funds?

The venture capital industry in Australia is not as mature or well-developed in comparison to, for example, the US. Therefore, it is more difficult to consider typical practice in Australia. Typically, funds have a term of ten to 12 years with a three- to five-year investment period.

Early stage funds typically target investments that can provide very large multiples of return given the risk/reward nature of these investments. Funds targeting later-stage investments typically target lower multiples.

 

Fund regulation and licensing

9. Do a venture capital fund's promoter, manager and principals require licences?

Australia has a highly regulated financial services sector. Generally, a venture capital fund promoter and manager must hold an Australian financial services licence or rely on an exemption from doing so.

Australian financial services licenses are issued by the Australian Securities & Investments Commission (ASIC). In order to obtain a licence the applicant must apply to ASIC, pay an application fee and complete various documentation to demonstrate competency to hold the licence and comply with the conditions of and other legal requirements relating to holding a licence.

The principals of the manager do not usually require their own Australian financial services licence provided that they act as representatives of the manager, who itself holds an Australian financial services licence or is exempt from licensing.

 
10. Are venture capital funds regulated as investment companies or otherwise and, if so, what are the consequences? Are there any exemptions?

Depending on the structure of a venture capital fund, the fund or trustee (if structured as a unit trust) may require an Australian financial services licence or rely on an exemption from holding an Australian financial services licence.

The offering of interests in a venture capital fund typically takes place under certain exemptions from regulated disclosure (whether a prospectus or product disclosure statement). There are exemptions for offers to sophisticated and professional investors and to wholesale clients, each as defined in the Corporations Act 2001.

 
11. How is the relationship between investor and fund governed? What protections do investors in the fund typically seek?

The relationship between the investors and the fund is typically governed by the limited partnership agreement in the case of a ESVCLP or VCLP, and by the trust deed in the case of unit trust, together with any subscription agreement and information memorandum or other offering document.

Investors typically seek protections relating to the following:

  • Investment strategy.

  • Investment period.

  • Term.

  • Termination.

  • Key person.

  • Fund size.

  • Clawbacks.

  • Limited liability.

These protections are not dissimilar from those sought in offshore venture capital and are largely derived from US experience.

 

Interests in investee companies

12. What form of interest do venture capital funds take in an investee company?

Venture capital funds generally invest using a class of preferred equity in the investee company, typically convertible into ordinary equity. The terms of issue will have preferential rights designed to protect the venture capital fund's downside risk.

Convertible loan notes are less common but are becoming more favoured for investing in seed stage companies in the US, and Australia is likely to follow this trend. The terms of such loan notes usually have a shorter time horizon and therefore may be onerous on the investee company.

Except in specific circumstances, it is unusual to see a venture capital fund invest by way of ordinary shares or straight debt.

 

Valuing and investigating investee companies

13. How do venture capital funds value an investee company?

There is no single industry standard valuation method for early-stage companies. More conventional valuation methods (for example, using a multiple of revenue) may provide initial guidance but are only useful if the investee entity's historic financial data provides a realistic proxy for the underlying value of the business. As this is rare, a venture capital fund will more commonly utilise more arbitrary valuation techniques including assessing the expertise, experience and track record of the founders and management team, any "rule of thumb" benchmarks for the relevant industry and a consideration of what alternative investment opportunities exist at the relevant time. Ultimately, the valuation will be determined by the relative bargaining positions of the founders and the venture capital fund.

 
14. What investigations do venture capital funds carry out on potential investee companies?

Venture capital funds conduct a range of commercial, financial and legal investigations. Given the start-up nature of potential investee companies, there is limited relevant due diligence material in comparison to more mature businesses and a targeted approach is therefore taken to due diligence. Legal due diligence focuses around key risk areas such as ownership and protection of intellectual property rights, and ownership of IT systems and software.

Often in the early stages of a business' development, its intellectual property is held in the names of the individual founders and not the investee company. To protect both the venture capital fund and the investee company, it is important to ensure that these assets are effectively transferred to the investee company before entering into the investment.

In addition, due diligence inquiries seek to ensure that any investment is eligible to be made for a VCLP or ESVCLP.

 

Legal documentation

15. What are the principal legal documents used in a venture capital transaction?

Venture capital transactions typically involve the following documentation:

  • Subscription agreement.

  • Shareholders' agreement.

  • New constitution (incorporating the terms of any new class of shares issued to the new investors).

  • New employment agreements for the key management team.

  • Documentation relating to employee incentive schemes.

 

Protection of the fund as investor

Contractual protections

16. What form of contractual protection does an investor receive on its investment in a company?

Market practice is less established in Australia than in the US, although Australia tends to use US practice as a guide. Subject to the parties' relative bargaining power and the ownership level sought by the venture capital investor, the following protections are typical:

  • Board representation. A venture capital investor will hold at least one board seat and at lower ownership levels, observer rights.

  • Information rights. A venture capital investor will receive access to financial information (for example, financial reports, quarterly or monthly management accounts), and at higher ownership levels, copies of information provided for board meetings.

  • Governance controls. At higher ownership levels a venture capital investor will receive negative control rights over key corporate or operational decision making (see Question 19).

  • Restrictions on dealings in shares. The shareholders' agreement and constitution generally contain anti-dilution protections in respect of new share issues and impose restrictions on the transferability of shares.

  • Restrictive covenants. Founders will typically agree to non-compete obligations in the event they cease to be employed by the business.

  • Employment agreements. Key employees will enter into new agreements on arm's length terms as part of the investment documentation.

  • Warranty protection. The investee company and/or the founders will provide warranties relating to the state of the business.

Forms of equity interest

17. What form of equity interest does a fund commonly take (for example, preferred or ordinary shares)?

A venture capital fund typically receives a form of preferred shares in the investee company (see Question 12).

Preferred shares

18. What rights does a fund have in its capacity as a holder of preferred shares?

An investor holding preferred shares typically has certain rights over and above those rights of an ordinary shareholder, including:

  • Dividends (cumulative or non-cumulative) paid in priority over holders of ordinary shares.

  • Preferential rights to a return of capital on winding up or liquidation.

  • Conversion rights into ordinary shares.

  • Redemption rights (following a prescribed investment period).

The preferred shares will typically carry voting rights, which may be determined on an "as if converted" basis, depending on agreed conversion terms.

Management control

19. What rights are commonly used to give a fund a level of management control over the activities of an investee company?

The degree of management control sought by venture capital funds is typically a function of the level of ownership sought, either by a venture capital fund investing individually or on an aggregated basis of all venture capital investors participating in a financing round (often such interests are aggregated for decision-making purposes). The shareholders' agreement usually includes rights to board representation (or at a minimum, observer rights) and access to financial information.

The shareholders' agreement typically grants the venture capital fund negative control rights over certain material actions such as:

  • Declaration of dividends.

  • Borrowings.

  • Acquisitions.

  • Disposals.

  • Activities outside the business plan or budget.

In contrast to private equity transactions, venture capital investors typically impose less onerous restrictions on management in recognition of the company's early stage of development.

Share transfer restrictions

20. What restrictions on the transfer of shares by shareholders are commonly contained in the investment documentation?

The shareholders' agreement will typically restrict the transfer of shares. Such restriction applies to all shareholders, including venture capital investors. Typical exceptions include:

  • Transfers to affiliates or associated parties.

  • Transfers having followed a prescribed right of first offer or right of first refusal regime.

  • Tag-along rights or co-sale rights to allow all shareholders to sell a corresponding proportion of their shares in the event of a sale of the investee company to a third party.

 
21. What protections do the investors, as minority shareholders, have in relation to an exit by way of sale of the company?

Depending on the percentage of the investee entity held by the venture capital investors (either individually or collectively) the strategy and level of protection for an exit will vary. Typically, venture capital funds have less control over the exit process than a private equity investor.

The founders, as majority shareholders and having operational management of the investee entity typically control the exit process, although in many cases the venture capital investor's consent is required to implement a formal exit process. Drag-along rights may apply if a prescribed proportion of shareholders accept a bona fide third party offer to acquire the company. These drag-along rights will oblige all other shareholders to sell their shares. The prescribed proportion is a negotiated outcome, and can range from 50.1% to 75%.

Where a venture capital fund agrees to be subject to a drag-along right, this is typically subject to the sale proceeds meeting minimum return thresholds to the venture capital fund.

Pre-emption rights

22. Do investors typically require pre-emption rights in relation to any further issues of shares by an investee company?

Pre-emption rights in relation to the issue of new shares in favour of all shareholders are standard. This anti-dilution protection is a right, but not an obligation, and a venture capital fund is under no obligation to subscribe for additional shares.

In some cases, the issue of new shares may be prohibited without investor consent, providing additional minority shareholder protection. Certain exceptions will exist for pre-agreed share issues such as employee share ownership schemes.

It is typical for the shareholders' agreement to be explicit that an investor need not provide any additional funding through new share issues or other financial accommodation.

Consents

23. What consents are required to approve the investment documentation?

The investee company customarily obtains board approval to enter into the relevant transaction documentation. Shareholders of the investee company will typically adopt a new constitution containing the issue terms of the shares to be issued to the venture capital fund (requiring approval from 75% of shareholders) and waive any pre-emption rights under existing shareholder arrangements.

It is uncommon for third party approvals to be required given the early stage nature of the investee entity. The third party approvals may involve external financiers or key contractual counterparties.

There are not typically any fund-specific approvals required unless the proposed investment is going outside terms of investment restrictions in the fund documents.

 

Costs

24. Who covers the costs of the venture capital funds?

A venture capital fund will often seek to have some or all of its costs paid by the investee company, including costs of due diligence. However, depending on the parties' relative bargaining power, it is common to see an investor meet the majority of its costs after the investee company has contributed an agreed sum.

Directors of the investee company should ensure that any costs borne by the investee company do not breach the restriction on an Australian company providing financial assistance in connection with the acquisition of its own shares. This will involve the directors needing to form a view that providing such financial assistance does not materially prejudice the interests of the investee company or its shareholders or the investee company's ability to pay its creditors.

 

Founder and employee incentivisation

25. In what ways are founders and employees incentivised? What are the resulting tax considerations?

Founders and employees may be incentivised in a number of ways. Generally speaking, management in Australia are incentivised by way of bonuses (or other similar payments) or the granting shares or options to acquire shares. As venture capital instruments are generally structured as limited partnerships, which for Australian tax purposes would be taxed as a fiscally transparent entity if structured as a VCLP or ESVCLP, it is not possible to grant shares or rights to an employee or founder apart from interests in the partnership. Where the eligibility criteria is satisfied distributions on carried interest should be taxed as a capital gain and not income (and may therefore be eligible for discount CGT concessions) (see Question 3).

 
26. What protections do the investors typically seek to ensure the long-term commitment of the founders to the venture?

A range of protections can be used to ensure the long-term commitment of the founders, including primarily:

  • Restrictive covenants. The most common protection against loss of value from one or more founders leaving the business is to restrict them from competing with the business. While they remain employed by the investee company, this typically involves a requirement in their employment agreement to devote all of their time to the business and not to undertake any potentially competing activities. Once they have ceased to be employed, a restrictive covenant (in either the employment agreement, shareholders' agreement or both) will apply to prevent the founder from competing with the business of the investee company and from soliciting any clients, suppliers or staff from the business, in each case for an agreed period after they exit the business (typically one to three years) and within an agreed geographical area.

  • Leaver provisions. Founders who leave the business are typically designated as either a good leaver or a bad leaver. The terms of each definition are heavily negotiated, especially in relation to the satisfaction of performance criteria. The distinction is relevant to valuations of the relevant founder's shares. Where a founder ceases to be employed by the business, the investee entity will have a right to acquire the shares held by that founder (which for a good leaver will be valued at fair market value and for a bad leaver will be valued at the lower of cost and fair market value). If the company does not acquire the relevant shares, those shares may lose particular rights, such as voting rights.

  • Vesting arrangements. The shareholders' agreement may provide that some or all ordinary shares held by founders may vest in tranches. If the founder ceases to be employed before a particular vesting date then the company may have the right to buy back unvested shares. The terms of the buyback (including the valuation mechanics) will depend on whether the founder was a good leaver or bad leaver.

 

Exit strategies

27. What forms of exit are typically used to realise a venture capital fund's investment in an unsuccessful company? What are the relative advantages and disadvantages of each?

In order of preference, the following routes are potential exit avenues for an unsuccessful investment:

  • Sale as a going concern. Shareholders will seek a third party buyer for the investee company as a going concern. Competitors can often be interested in acquiring key intellectual property at a discount price. If such a buyer is not forthcoming, potential buyers of the company (or its assets) include investors or funds specialising in acquisitions of distressed assets. This avenue is likely to generate greater proceeds than either avenue below.

  • Solvent liquidation. If a buyer for the business cannot be found but the company remains solvent, shareholders may resolve to liquidate the business. Assets will be sold in an orderly manner to repay creditors. To the extent cash proceeds exist after the distribution of asset sale proceeds to creditors, venture capital investors will usually receive the balance of any proceeds (usually up to the value of their initial capital investment) in priority to the remaining ordinary shareholders.

  • Voluntary administration/insolvent liquidation. Where the company is unable to pay its debts as they fall due, directors of an investee company may appoint an external insolvency practitioner to take control of management of the company. Board appointees of venture capital funds are sensitive to this issue given their potential personal liability for insolvent trading. If the investee company's directors do not do so, secured lenders may appoint an external insolvency practitioner (a receiver). If the insolvency practitioner cannot find a buyer for the business as a going concern, it will sell the assets and apply the asset sale proceeds to repay creditors. To the extent there are any cash proceeds remaining after the distribution of such proceeds to creditors and other parties with priority rights, upon liquidation venture capital funds usually receive the balance of any proceeds (usually up to the value of their initial capital investment) in priority to the remaining ordinary shareholders. This process is least likely to generate significant proceeds and can result in the greatest degree of reputational damage to those concerned.

 
28. What forms of exit are typically used to realise a venture capital fund's investment in a successful company? What are the relative advantages and disadvantages of each?

The following are typical exit avenues, in order of frequency:

  • Private treaty sale to third party. These sale processes are typically described as sales to trade buyers or financial sponsors. The former typically features the buyer being an industry participant whereas the latter contemplates a PE buyer. Such sale processes provide the venture capital fund with an opportunity to realise its entire stake in a single transaction. A sale to a trade buyer may require anti-trust approval or other regulatory approvals, depending on the sector. Financial sponsors face challenges of securing finance to fund the acquisition, which in recent years has led to subdued levels of activity.

  • Management buy-out. This avenue features existing management (including the founders) acquiring the interests of exiting shareholders. The terms are typically more seller-friendly than a third party private treaty sale given existing management's familiarity with the business. The challenge in these sale processes is for existing management to acquire sufficient commitments (whether through debt or their own resources) to fund the purchase price.

  • Initial Public Offering (IPO). While an IPO is a "glamorous" exit strategy, only a low percentage of venture capital funded investee companies float on publicly listed exchanges. In part this is due to recent volatile IPO market conditions, but in practice successful start-ups are often acquired at a stage before they are ready for a public offering. In a formal exit strategy, an IPO is typically run as a dual track process, that is, together with a private treaty auction process to maximise competitive tension. An IPO will require substantial support from key institutional investors, and robust financial statements to support any capital raising. It is also the exit mechanism that requires the greatest commitment of management time. An IPO exit typically involves selling shareholders (including the venture capital fund) being subject to a lock-in period for a portion of their shares in order to provide stability post-listing.

 
29. How can this exit strategy be built into the investment?

The shareholders' agreement sets out agreed forms of exit mechanisms. There is a wide variance in practice regarding the level of detail of such provisions. The shareholders agreement may build in certain rights for the founders and venture capital fund to take steps to initiate the exit process. This may involve the appointment of an investment bank, in conjunction with a consultation regime with key stakeholders. Such provisions will usually not create absolute rights and in practice the relevant parties recognise that a value-enhancing exit process requires collaboration of all parties.

Although significant planning goes into developing a range of pre-agreed exit strategies, in practice, the form of the exit usually varies in some way from that set out in the shareholders' agreement. Financial investors typically act as a group and follow the value maximising sale process. Sources of tension as to the preferred exit path may arise if the founders' future in the company post-acquisition is less certain.

 

Contributor details

Mark McFarlane

King & Wood Mallesons

T +61 2 9296 2478
F +61 2 9296 3700
E mark.mcfarlane@au.kwm.com
W www.kwm.com

Qualified. High Court of Australia, 1994; Supreme Court of Victoria, 1994

Areas of practice. Financial services; private equity and other structured funds; hedge funds and structured transactions.

Recent transactions

  • Advising MLC Investments on various transactions including its investment in Shoes of Prey's series A funding round and its investment in Engine Yard Inc's series C funding round.
  • Legal due diligence on investment by institutional investor into local and foreign private equity partnerships and venture capital partnership in the US, Europe, Asia and South America including Archer Capital, Blackstone, CVC, Kleiner Perkins and Sequoia.

Matthew Coull

King & Wood Mallesons

T +61 2 9296 2366
F +61 2 9296 3700
E matthew.coull@au.kwm.com
W www.kwm.com

Qualified. High Court of Australia, 2011; Supreme Court of New South Wales, Australia, 2007; England and Wales, 2003; New Zealand, 1999

Areas of practice. Venture capital; private equity; M&A; corporate advisory; joint ventures.

Recent transactions

  • Advising MLC Investments on various transactions including its investment in Shoes of Prey's series A funding round and its investment in Engine Yard Inc's series C funding round.
  • Advising CHAMP Private Equity on various transactions including its acquisition of Australian Temporary Fencing, its sale of United Malt Holdings and its sale of International Energy Services.
  • Advising Catalyst Investment Managers on its disposal of Valley Longwall.

Scott Heezen

King & Wood Mallesons

T +61 2 9296 2078
F +61 2 9296 3700
E scott.heezen@au.kwm.com
W www.kwm.com

Qualified. Supreme Court of New South Wales, Australia, 2007; High Court of Australia, 2001

Areas of practice. Taxation aspects of Australian domestic, inbound and outbound investment including venture capital, private equity, and listed and unlisted funds.

Recent transactions

  • Advising China Investment Corporation on its participation in the consortium acquisition of Connect East by way of an Australian MIT.
  • Advising CHAMP Private Equity on various transactions including the sale of United Malt Holdings and the sale of International Energy Services.
  • Advising various US private equity funds on structuring investments in, and acquisitions of, Australian groups.
  • Advising Catalyst Investment Managers on its disposal of Valley Longwall.

{ "siteName" : "PLC", "objType" : "PLC_Doc_C", "objID" : "1247309266767", "objName" : "Venture Capital Australia", "userID" : "2", "objUrl" : "http://us.practicallaw.com/cs/Satellite/us/resource/8-500-9478?null", "pageType" : "Resource", "academicUserID" : "", "contentAccessed" : "true", "analyticsPermCookie" : "2-62dceab2:15b13e442a1:-180f", "analyticsSessionCookie" : "2-62dceab2:15b13e442a1:-180e", "statisticSensorPath" : "http://analytics.practicallaw.com/sensor/statistic" }