Tag: investors

Practical and Legal Considerations for Extending Cash Runway in a Changing Economy

The funding environment for emerging companies has fundamentally shifted in 2022 for both venture capital and IPOs, particularly after a banner year in 2021. Whether these headwinds suggest significant economic changes or a return to previous valuation levels, companies need to be realistic about adapting their business processes to ensure they have sufficient cash runway to succeed through the next 2-3 years.

This article provides a comprehensive set of tactics that can be used to extend cash runway, both on the revenue/funding and cost side. It also addresses areas of liability for companies and their directors that can emerge as companies change business behaviors during periods of reduced liquidity.

Ways to Improve and Extend Cash Runway

Understanding Your Cash Runway

Cash runway refers to the number of months a company can continue operations before it runs out of money. The runway can be extended by increasing revenue or raising capital, but in a down economy, people have less disposable income and corporations are more conservative with their funds. Therefore companies should instead focus on cutting operating costs to ensure their cash can sustain over longer periods.

As a starting point, companies can evaluate their business models to determine expected cash runway based on factors such as how valuations are currently being determined, total cash available, burn rate, and revenue projections. This will help guide the actions to pursue by answering questions such as:

  1. Is the company currently profitable?
  2. Will the company be profitable with expected revenue growth even if no more outside funding is brought in?
  3. Is there enough cash runway to demonstrate results sufficient to raise the next round at an appropriate valuation?

Even if companies expect to have sufficient cash runway to make it through a potential economic downturn, tactics such as reducing or minimizing growth in headcount, advertising spend, etc. can be implemented as part of a holistic strategy to stay lean while focusing on the fundamentals of business model/product-market fit.

Examining Alternative Sources of Financing

Even though traditional venture capital and IPO financing options have become more difficult to achieve with desired valuations, companies still have various other options to increase funding and extend runway. Our colleagues provided an excellent analysis of many of these options, which are highlighted in the discussion below.

Expanding Your Investor Base to Fund Cash Flow Needs

The goal is to survive now, excel later; and companies should be open to lower valuations in the short term. This can create flexibility to circle back with investors who may have been open to an earlier round but not at the specific terms at that time. Of course, to have a more productive discussion, it will be helpful to explain to these investors how the business model has been adapted for the current environment in order to demonstrate that the new valuation is tied to clear milestones and future success.

Strategic investors and other corporate investors can also be helpful, acting as untapped resources or collaborators to help drive forward milestone achievements. Companies should understand how their business model fits with the investor’s customer base, and use the relationship to improve their overall position with investors and customers to increase both funding and revenue to extend runway.1

If the next step for a company is to IPO, consider crossover or other hybrid investors, understanding that much of the cash deployment in 2022 is slowing down.

Exploring Venture Debt

If a company has previously received venture funding, venture debt can be a useful tool to bridge forward to future funding or milestones. Venture debt is essentially a loan designed for early stage, high growth startups who have already secured venture financing. It is effective for targeting growth over profitability, and should be used in a deliberate manner to achieve specific goals. The typical 3-5 year timeline for venture debt can fit well with the goal of extending cash runway beyond a currently expected downturn.

Receivables/Revenue-Based Financing and Cash Up Front on Multi-Year Contracts

Where companies have revenue streams from customers — especially consistent, recurring revenue — this can be used in various ways to increase short-term funds, such as through receivables financing or cash up front on long-term contracts. However, companies should take such actions with the understanding that future investors may perceive the business model differently when the recurring revenue is being used for these purposes rather than typical investment in growth.

Receivable/revenue-based financing allows for borrowing against the asset value represented by revenue streams and takes multiple forms, including invoice discounting and factoring. When evaluating these options, companies should make sure that the terms of the deal make sense with runway extension goals and consider how consistent current revenue streams are expected to be over the deal term. In addition, companies should be aware of how customers may perceive the idea of their invoices being used for financing and be prepared for any negative consequences from such perceptions.

Revenue-based financing is a relatively new financing model, so companies should be more proactive in structuring deals. These financings can be particularly useful for Software-as-a-Service (SaaS) and other recurring revenue companies because they can “securitize the revenue being generated by a company and then lend capital against that theoretical security.”2

Cash up front on multi-year contracts improves the company’s cash position, and can help expand the base where customers have sufficient capital to deliver up front with more favorable pricing. As a practical matter, these arrangements may result in more resources devoted to servicing customers and reduce the stability represented by recurring revenue, and so should be implemented in a manner that remains aligned with overall goal of improving product-market fit over the course of the extended runway.

Shared Earning Agreements

A shared earning agreement is an agreement between investors and founders that entitles investors to future earnings of the company, and often allow investors to capture a share of founders’ earnings. These may be well suited for relatively early stage companies that plan to focus on profitability rather than growth, due to the nature of prioritizing growth in the latter.

Government Loans, Grants, and Tax Credits

U.S. Small Business Administration (SBA) loans and grants can be helpful, particularly in the short term. SBA loans generally have favorable financing terms, and together with grants can help companies direct resources to specific business goals including capital expenditures that may be needed to reach the next milestone. Similarly, tax credits, including R&D tax credits, should be considered whenever applicable as an easy way to offset the costs.

Customer Payments

Customers can be a lifeline for companies during an economic downturn, with the prioritization of current customers one way companies can maintain control over their cash flow. Regular checks of Accounts Receivable will ensure that customers are making their payments promptly according to their contracts. While this can be time-consuming and repetitive, automating Accounts Receivable can streamline tasks such as approving invoices and receiving payments from customers to create a quicker process. Maintenance of Accounts Receivable provides a consistent flow of cash, which in turn extends runway.

To increase immediate cash flow companies should consider requiring longer contracts to be paid in full upon delivery, allowing the company to collect cash up front and add certainty to revenue over time. This may be hard to come by as customers are also affected by the economic downturn, but incentivizing payments by offering discounts can offset reluctance. Customers are often concerned with locking in a company’s services or product and saving on cost, with discounts serving as an easy solution. While they can create a steady cash flow, it may not be sustainable for longer cash runways. Despite their attractive value, companies should use care when offering discounts for early payments. Discounts result in lower payments than initially agreed upon, so companies should consider how long of a runway they require and whether the discounted price can sustain a runway of such length.

Vendor Payments

One area where companies can strategize and cut costs is vendor payments. By delaying payments to vendors, companies can temporarily preserve cash balance and extend cash runway. Companies must review their vendor agreements to evaluate the potential practical and legal ramifications of this strategy. If the vendor agreements contain incentives for early payments or penalties for late payments, then such strategy should not be employed. Rather, companies can try to negotiate with vendors for an updated, extended repayment schedule that permits the company to hold on to their cash for longer. Alternatively, companies can negotiate with vendors for delayed payments without penalty. Often vendors would prefer to compromise rather than lose out on customers, especially in a down economy.

Lastly, companies can seek out vendors who are willing to accept products and services as the form of payment as opposed to cash. Because the calculation for cash runway only takes into account actual cash that companies have on hand, products and services they provide do not factor into the calculation. As such, companies can exchange products and services for the products and services that their vendors provide, thereby reserving their cash and extending their cash runway.

Bank Covenants

In exercising the various strategies above, it is important to be mindful of your existing bank covenants if your company has a lending facility in place. There are often covenants restricting the amount of debt a borrower can carry, requiring the maintenance of a certain level of cash flow, and cross default provisions automatically defaulting a borrower if it defaults under separate agreements with third parties. Understanding your bank covenants and default provisions will help you to stay out of default with your lender and avoid an early call on your loan and resulting drain on you cash position.

Employee Considerations

As discussed extensively in our first article Employment Dos and Don’ts When Implementing Workforce Reductions, the possibility of an economic downturn not only will have an impact on your customer base, but your workforce as well. Employees desire stability, and the below options can help keep your employees engaged.

Providing Equity as a Substitute for Additional Compensation.

Employees might come to expect cash bonuses and pay raises throughout their tenure with an employer; in a more difficult economic period this may further strain a business’s cash flow. One alternative to such cash-based payments is the granting of equity, such as options or restricted stock. This type of compensation affords employees the prospect of long-term appreciation in value and promotes talent retention, while preserving capital in the immediate term. Further, to the employee holding equity is to have “skin in the game” – the employee now has an ownership stake in the company and their work takes on increasing importance to the success of the company.

To be sure, the company’s management and principal owners should consider how much control they are ceding to these new minority equity holders. The company must also ensure such equity issuances comply with securities laws – including by structuring the offering to fit within an exemption from registration of the offering. Additionally, if a downturn in the company’s business results in a drop in the value of the equity being offered, the company should consider conducting a new 409A valuation. Doing so may set a lower exercise price for existing options, thus reducing the eventual cost to employees to exercise their options and furnishing additional, material compensation to employees without further burdening cash flow.

Transitioning Select Employees to Part-Time.

Paying the salaries of employees can be a major burden on a business’s cash flow, and yet one should be wary of resorting to laying off employees to conserve cash flow in a downturn. On the other hand, if a business were to miss a payroll its officers and directors could face personal liability for unpaid wages. One means of reducing a business’s wage commitments while retaining (and paying) existing employees is to transition certain employees to part-time status. In addition to producing immediate cash flow benefits, this strategy enables a business to retain key talent and avoid the cost of replacing the employees in the future. However, this transition to part-time employees comes with important considerations.

Part-time employees are often eligible for overtime pay and must receive the higher of the federal or state minimum hourly wage. And if transitioned employees are subject to restrictive covenants, such as a non-competition agreement, they might argue their change in status should release them from such restrictions. Particularly since the COVID-19 pandemic, courts have shown reluctance to enforce non-competes in the context of similar changes in work status when the provision is unreasonable or enforcement is against the public interest.

Director Liability in Insolvency

Insolvency and Duties to Creditors

There may be circumstances where insolvency is the only plausible result. A corporation has fiduciary duties to stockholders when solvent, but when a corporation becomes insolvent it additionally owes such duties to creditors. When insolvent, a corporation’s fiduciary duties do not shift from stockholders to creditors, but expand to encompass all of the corporation’s residual claimants, which include creditors. Courts define “insolvency” as the point at which a corporation is unable to pay its debts as they become due in the ordinary course of business, but the “zone of insolvency” occurs some time before then. There is no clear line delineating when a solvent company enters the zone of insolvency, but fiduciaries should assume they are in this zone if (1) the corporation’s liabilities exceed its assets, (2) the corporation is unable to pay its debts as they become due, or (3) the corporation faces an unreasonable risk of insolvency.

Multiple courts have held that upon reaching the “zone of insolvency,” a corporation has fiduciary duties to creditors. However, in 2007 the Delaware Supreme Court held that there is no change in fiduciary duties for a corporation upon transitioning from “solvent” to the “zone of insolvency.” Under this precedent, creditors do not have standing to pursue derivative breach of fiduciary duty claims against the corporation until it is actually insolvent. Once the corporation is insolvent, however, creditors can bring claims such as for fraudulent transfers of assets and for failure to pursue valid claims, including those against a corporation’s own directors and officers. To be sure, the Delaware Court of Chancery clarified that a corporation’s directors cannot be held liable for “continuing to operate [an] insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors,” along with other caveats to the general fiduciary duty rule. Still, in light of the ambiguity in case law on the subject, a corporation ought to proceed carefully and understand its potential duties when approaching and reaching insolvency.

1 Diamond, Brandee and Lehot, Louis, Is it Time to Consider Alternative Financing Strategies?, Foley & Lardner LLP (July 18, 2022)

2 Rush, Thomas, Revenue-based financing: The next step for private equity and early-stage investment, TechCrunch (January 6, 2021)

Article By Natasha Allen, David W. Kantaros, Nikhil T. Pradhan, and Graham P. MacEwan of Foley & Lardner LLP

For more financial institutions and banking legal news, click here to visit the National Law Review.

© 2022 Foley & Lardner LLP

SEC Adopts Expansion of “Accredited Investor” Definition

On August 26, 2020, the U.S. Securities & Exchange Commission (SEC) adopted amendments to Rule 501, Rule 144A and other related rules (the Amendments) to expand the definition of “accredited investor” under the Securities Act of 1933 (the Securities Act). The amendments were adopted largely as proposed and broaden the scope of natural persons and entities that may qualify to participate in private offerings of securities that are exempt from registration under the Securities Act.

In particular, the “accredited investor” designation will now include the following:

  • Natural persons holding certain professional certification and designations. The SEC will periodically issue orders designating those professional certificates, designations or credentials that, when held by a natural person, would qualify such person as an accredited investor. Contemporaneously with the Amendments, the SEC designated holders in good standing of the Series 7, Series 65 and Series 82 licenses as qualifying for accredited investor status. In evaluating additional professional designations for qualifying status, the SEC will consider a non-exhaustive list of attributes established by the Amendments.
  • “Knowledgeable Employees” of private funds as defined under the Investment Company Act, but only with respect to investment in such private fund. A Knowledgeable Employee’s spouse will also be considered an accredited investor with respect to joint investments in the private fund.
  • Certain enumerated entities, including:
    • federal- or state-registered investment advisers and exempt reporting advisers, regardless of the level of assets under management;
    • rural business investment companies (RBICs), as defined in Section 384A of the Consolidated Farm and Rural Development Act;
    • limited liability companies that have total assets in excess of $5 million and were not formed for the purpose of acquiring the securities offered1 ; and
    • any entity with at least $5 million in investments (as defined under the Investment Company Act of 1940) that has not been formed for the purpose of investing in the securities offered, in order to encompass entities such as Indian tribes, foreign entities and local government bodies that were not previously covered by Rule 501.
  • “Family offices” and their “family clients,” each as defined under the Advisers Act, provided the family office has at least $5 million in assets under management, was not formed for the purpose of acquiring the securities offered and was directed to make the investment by a person who has such knowledge and experience in financial and business matters such that the family office is capable of evaluating the merits and risks of the investments.

The Amendments would also clarify that spousal equivalents can pool finances when determining qualification as an accredited investor and update the definition of “qualified institutional buyer” under the Securities Act to conform with the new accredited investor definition.

The expansion of the accredited investor definition has many implications for asset managers, including updates to offering and subscription documents and questionnaires, consideration of expanded options for funding GP commitments via the expanded pool of knowledgeable employees and affiliated professionals and evaluation of fund-raising opportunities. Commissioners adopted the amendments on a 3-2 vote, with commenters disagreeing with the SEC’s decision not to index the wealth thresholds, which were initially adopted in 1982, for inflation.

The Amendments will go effective 60 days after publication in the Federal Register.

_________________________________________________

1 While Rule 501 did not explicitly include LLCs meeting these requirements prior to the Amendments, the SEC historically has taken the position that such LLCs qualify as accredited investors.

© 2020 Vedder Price
ARTICLE BY Robert M. Crea, Joseph M. Mannon, and Adam S. Goldman of Vedder Price.
For more SEC news, visit the National Law Review Securities, SEC, & Financial Institution Law News section.

Using “Finders” to Find Capital: Avoiding Problems for Your Company

Raising money for your startup can be hard. Not every entrepreneur can walk into Silicon Valley with a business idea and walk out with multiple VC term sheets in hand. Sometimes the only path to financing your startup is through the hard work of pitching and cobbling together a group of angels and other individual investors. But that path takes time and can be frustrating. Potential investors may hesitate to commit or, even worse, give you the dreaded “you’re-too-early-for-us” response. The offer from a “finder” to introduce you to investors with cash sounds attractive. Why not, right? What’s the downside?

You can use a finder if their role is limited and their compensation is structured properly. But you can cause major problems for yourself and the finder if they’re too involved and paid commissions on the money raised. These are activities that only registered broker-dealers (persons or firms engaged in the business of buying and selling securities for themselves or others) can engage in. If your company uses a finder acting as a broker-dealer, you might find your fundraising round unraveling, and your finder might find themselves in trouble with the Securities and Exchange Commission (SEC).

A “true” finder

A “true” finder can be OK if they limit their role to making introductions, receive a flat or hourly consulting fee that is not contingent on the success of the offering, and avoid any active role in negotiating and completing the investment. Finders acting in this very limited capacity are not considered broker-dealers. As a result, true finders are largely unregulated under the securities laws and need not be registered with the state or federal government as broker-dealers. This area is murky, however, because there are not clear regulations and the rules of the road have been developed in court cases and case-by-case “no-action” letters from the SEC.

The real problem is that many finders do not limit their activities to mere introductions. These finders end up assisting in structuring and negotiating the offering, providing advice regarding the offering and investment, and even encouraging and inducing investors to invest. These activities make them a “broker” under the securities laws, and federal and state governments require that brokers be registered. Often the finder is not registered as a broker.

Finders also prefer success-based compensation, calculated as a percentage of the funds raised by the company, and companies prefer to pay finders only if and when they’re successful in helping to raise capital. Both courts and the SEC, however, take the position that such success-based compensation (also referred to as transaction-based compensation) is the telltale factor indicating whether a finder is acting as an unregistered broker-dealer.

So, what’s the risk?

For the company, using an unregistered broker-dealer to assist with an offering could create a rescission right in favor of the investors. If investors succeed in rescinding their investments, the company must return their money. For the finder acting as an unregistered broker-dealer, they could be subject to severe SEC sanctions and the company could void the finder’s engagement agreement, requiring return of the finder’s compensation. Moreover, even if a finder’s activities and compensation are perfectly legal, the relationship alone can still give rise to problems for the company. Any financial relationship with a finder must be disclosed to investors and listed on the company’s Form D filed with the SEC and state securities departments. Disclosure of such a relationship, again, even if perfectly legal, may nevertheless prompt some states to initiate an investigation.

The situation in Michigan, however, is even murkier. In the recent case Pransky v. Falcon Group, the Michigan Court of Appeals held that a “finder” as defined in the Michigan Uniform Securities Act, was not required to be registered with and regulated by the State of Michigan, even where the company agreed to pay success-based compensation. Michigan companies and finders, however, should not take the opinion as a green light to engage in a finder relationship, structured with success-based compensation, without fear of regulatory oversight. The trial court initially dismissed the case on summary judgment, and as a result there was no evidence in the record of whether or not the finder’s activities went beyond mere introductions. In addition, some commentators have criticized the court’s decision. Perhaps sensing such impending criticism, the Court of Appeals, in a footnote, cautioned that the “better course of action would be for finders acting pursuant to similar contracts to protect themselves by registering, at the very least, as broker-dealers; the line between a finder’s activities and that of a broker-dealer…is a thin one and persons acting under such contracts without being registered are inviting litigation.”

The bottom line

Using finders for raising capital is not the easy solution it appears to be at first glance. Worse yet, it can lead to significant problems. As the saying goes, nothing worth having is easy. If you don’t have a VC-backable business, you may have an even harder time raising capital than most. Regardless, when it comes to raising money for your startup, be your own “finder”. Network, hustle, and tell your story. No one is more effective than you at explaining your business and the investment opportunity.

For more legal analysis check out the National Law Review.

This post was written by Matthew W. Bower of  Varnum LLP.

What Cuba Wants From Investors

American investors have made their way into Cuba. What Cuba Wants From Investors Just this week, the U.S. Treasury Department has approved the first significant U.S. business investment in Cuba since 1959: the Oggun tractor factory. This plant represents a $5 million to $10 million investment by an American company in Cuba.

​Both countries seem serious about moving their recently-resurrected commercial relationship forward. The U.S. and Cuba have entered into an agreement to resume commercial flights between the two countries the same week Cuba’s Minister of Foreign Trade and Investments, along with other officials from the Ministry of Foreign Affairs, Cuba’s Central Bank, and the Cuban Chamber of Commerce, have come to meet with the U.S. Secretary of Commerce to discuss how the two countries could further bilateral commercial relations.

While the focus of politicians’ rhetoric and scholars’ analysis has been on either what Americans are allowed to do, or on what Americans should want to do in Cuba, attention should be paid to what Cuba wants from its investors.

Cuba Wants Investors

First, there can be no doubt that Cuba wants investors.

In September 2013, Cuba created a Special Development Zone at Mariel (Zona Especial de Desarrollo Mariel). This $900 million port was formed in November 2013, 30 miles west of Havana, with the express purpose of attracting foreign investment. Many Americans are already familiar with Mariel, but remember it for the 1980 mass boatlift that carried thousands of Cuban refugees to America’s shores.  Instead of being a point of departure, Mariel is now a destination for foreign capital.

A few months after the creation of the Special Development Zone, Cuba’s National Assembly unanimously passed the Foreign Investment Act (Law 118) on March 29, 2014.  Law 118 promises foreign investors tax breaks and legal protections for their investments.

These far-reaching overtures to potential foreign investors were not made, however, without certain conditions.

Cuba Wants Investments in Particular Sectors

The Foreign Investment Act delineates, among other things, which investment vehicles are permissible, how investment shares may be transferred, who may be hired to work on the investment projects, and how disputes may be resolved.

Cuba has also specified in what it wants foreigners to invest. Last year, Cuba published a Portfolio of Opportunities for Foreign Investment detailing 326 projects in twelve sectors ripe for foreign investment:

  1. Tourism – 94 Projects

  2. Oil – 86 Projects

  3. Agriculture and Food – 40 Projects

  4. Renewable Energy – 22 Projects

  5. Industrial – 21 Projects

  6. Mining – 15 Projects

  7. Transportation – 15 Projects

  8. Construction – 14 Projects

  9. Biotechnology and Medicine – 9 Projects

  10. Business – 4 Projects

  11. Health – 3 Projects

  12. Audiovisual – 3 Projects

The highest number of projects was, not surprisingly, in the tourism sector. Cuba’s official policy on tourism investment is to direct foreign capital towards building or reconstructing new hotels and corresponding infrastructures. The President of Cuba’s Chamber of Commerce has noted the need to increase hotel capacities and standards in Havana and other heritage cities. So far, 74 hotel marketing and administration contracts have been signed, and these include almost 20 contracts with foreign firms.

Interestingly, Cuba has expressed a desire to attract foreign chains to its coasts, and is reportedly working on establishing agreements with renowned international chains across 58 facilities. Cuba is also promoting real estate development, including golf courses, marinas, and theme parks. Cuba has predicted that it will be one of the Caribbean’s top golfing destinations, and has already created two joint ventures, with British and Chinese investors, responsible for hotel construction. These projects are said to be worth over $400 million.

Furthering its efforts to attract investment in its tourism sector, Cuba is hosting its 36th International Tourism Fair (FITCUBA 2016) this year, which will be dedicated to Cuba’s culture and will feature Canada as the guest of honor.  Canada represents one of the highest sources of visitors to Cuba each year.

Notably, the Beacon Council, Miami-Dade County’s official economic development partnership, has identified seven target industries Miami’s business leaders should focus on:

  • Aviation

  • Banking and Finance

  • Creative Design

  • Hospitality and Tourism

  • Information Technology

  • Life Sciences and Healthcare

  • Trade and Logistics

The overlap between Cuba’s and Miami’s lists of target industries, along with Miami’s geographical proximity to Cuba and supply of Spanish-speaking professionals make the city an obvious key player in the development of Cuba’s business sector.

There are certain sectors, however, in which Cuba will not allow private ownership.

Cuba Does Not Want Investments in Particular Sectors

Notably, last December, Cuba’s official newspaper, the Granma, published an article titled, “Open Also Your Mind to Foreign Investment,” encouraging the Cuban people to embrace foreign investment. Cuban officials have reiterated that these changes in economic policy will not threaten the country’s socialist regime. Cuba’s policies expressly prohibit investment in sectors that may threaten Cuba’s political landscape.

For example, the Foreign Investment Act makes it illegal for a foreigner to invest in education services for Cubans and in the armed forces. Cuba’s Constitution also states that Cuba’s press, radio, television, film industry, and other mass media can never be privately owned.

These carve-outs are consistent with the Cuban government’s assurances to its people: Cuba is importing only capitalists’ capital, not their ideologies.

While it has been said that profit is apolitical, investors should not ignore the political contours of Cuba’s budding foreign investment regulations, as these may impact their investment opportunities.

ARTICLE BY Jose M Ferrer & Yasmin Fernandez-Acuña of Bilzin Sumberg Baena Price & Axelrod LLP
© 2016 Bilzin Sumberg Baena Price & Axelrod LLP

Should Investors Buck the Status Quo with LLCs?

The National Law Review recently published an article by Jason B. Sims of Dinsmore & Shohl LLP regarding Investors and LLCs:

Sometimes change is good.

Too often investors and entrepreneurs just stick with the status quo, in terms of structuring a venture capital or private equity investment. One notable example is requiring that target portfolio companies formed as limited liability companies reincorporate into a “C” corporation because…well…that is just how it is always done.

Actually, the decision is a bit more thoughtful than that. One concern that investors have with LLCs is the typical pass-through tax election these entities make to provide economic benefits to the founders during the lean, loss years.That is a valid concern because funds investing in a pass-through vehicle will experience phantom losses and gains that flow to them as a result of the investment, which creates accounting nightmares. Many limited partnership or operating agreements for funds prohibit investments in pass-through vehicles for that reason.

Another reason that investors often prefer corporations, particularly in Delaware, is the generally corporation-friendly laws and the deep body of judicial opinions interpreting those laws create some level of predictability on how bad situations will play out. The laws governing LLCs and the related judicial opinions interpreting those laws are not nearly as robust in Delaware or any other state when compared to dealing with corporations.

Avoiding unnecessary tax issues and enjoying the protection of a wealth of well interpreted corporate laws are both relevant analytical points to consider, but they are not necessarily determinative of the choice of entity question.

Funds can eliminate the issue of phantom losses and gains in two ways. The most obvious is to have the LLC make an election to be taxed as a corporation. That sort of flexibility is one of many attractive features of an LLC. The other method to avoid phantom losses and gains is to set up a corporation, often referred to as a “blocker corp,” to serve as an intermediary between the fund and the LLC. This is something that private equity firms do more than traditional venture funds.

Delaware LLCs are not going to win the battle of legal precedent any time soon. But that doesn’t necessarily matter, because there is one step that the LLC can take that arguably trumps all the general predictability—at least, as far as the investors are concerned. That step, of course, is limiting, or even eliminating, fiduciary duties.

Venture capital or private equity investors often want to insert one (or more) of their own onto the boards of directors for their portfolio companies. That makes perfect sense because the investors have a vested interest in keeping abreast of the progress of their investment. The investors also typically have a wealth of experience that adds tremendous value to the development of the company, when they serve on the board. The rub is that serving on the board opens a Pandora’s Box for liability in the form of fiduciary duties.

In an earlier blog post, Mike DiSanto discussed the impact of fiduciary duties have on investor designees serving the board of directors of a portfolio when that portfolio company completes an inside round of bridge financing. But that isn’t the end of the analysis. Inside-led rounds of equity investment present the same issues, and investors wanting to truly double down on an investment shouldn’t be prevented from doing so from the fear that the valuation and other terms used to consummate the equity round will later be deemed to fall outside the inherent fairness test imposed by Delaware corporate law – remember, that standard is applied using 20/20 hindsight, making it ultra risky.

Of course, there is more. In the unfortunate event of a fire sale of a portfolio company, a board dominated by investor designees faces liability when the preferred holders consume all of the acquisition proceeds due to previously negotiated liquidation preference (full case here). Those same directors face potential liability when the board approves a reverse stock split that has ultimately forces a cash-out of minority stockholders (full case here).

There are lots of other examples, but you get the point. Fiduciary duties generally force investor designees serving on the board of a portfolio company to think about what is in the best interest of the stockholder base as a whole (or sometimes just the common holders), not what is best for the investment fund.

Delaware LLCs have a distinct advantage vis-à-vis corporations when it comes to mitigating potential damages for breaches of fiduciary duties. The Delaware Limited Liability Company Act allows for LLCs to expressly limit, or even eliminate, the fiduciary duties of managers or members by expressly stating that in the operating agreement.

Delaware takes this position because LLCs, unlike corporations, are a creature of contract. Not an organic form of entity that is regulated by well established corporate laws. Delaware has long encouraged the policy of freedom of contract, and that policy extends to the operating agreement of a LLC, even if that includes eliminating fiduciary duties.

It is also important to note that, as a creature of contract, Delaware LLCs have the freedom to establish all the various enhanced rights, preferences and privileges that typically go along with an investor acquiring preferred stock in a corporation. In fact, LLCs are often more flexible when it comes to the ability to tailor those rights into exactly what the parties want, rather than having to conform to existing corporate laws on liquidation or voting rights, for example.

All the pros combine to make Delaware LLCs a pretty attractive choice of entity from the perspective of a venture capital or private equity investor. I think it may be time for private equity funds and venture capital firms to reconsider investing directly into LLCs.

© 2012 Dinsmore & Shohl LLP.