Venture Capital:

A Lawyers Role
Presented By: Poupa Marashi
Legal Counsel at IBG
 Lawyers Role in VC

I. Developer

IV. Facilitator

III. Intermediary
Lawyers Role:
Developer
 Why is VC a Great Vehicle for
Development?
 VC promotes self reliance and entrepreneurship
 Empowers small producers through access to
capital
 Leverages the impact of initial monies far
beyond traditional grants and foreign
investments
 Involves the private sector, and private
individuals in economic and social development
 Job Opportunities

 Iranian companies are privatizing, as prescribed

in the Third Five Year Plan, job cuts are being
made. There must be new job creation

 Iran’s 70% population under 30 years old

 VC’s Successful Development
In Iran
 Direct government investment in “seed” companies
should be avoided
 Fiscal measures should be developed to make VC
investment more attractive
 Legal accommodation of establishment of private equity
funds
 Temperate laws in areas such as bankruptcy stimulate
demand
 Favorable tax laws
 Great respect for the rule of law in private contracts, as
opposed to general corporate law
 Favorable employment laws
 Appropriate contractual technology
 Legal Education should be more practical
 Government Backed Programs

 Meaning: either directly operated or controlled,

or indirectly subsidized through tax incentives
 Government Direct Investment

 Negative impact in countries studied

 Crowds out, up to 100%, private equity
investment
 Government funds act to compete with and
overpay for investments
 Should only be used where there is very strict
financial discipline
 Can learn more about successful and
unsuccessful schemes by reading Gompers and
Lerner
 Advocating for Laws That
Develop
 Laws make an enormous difference on investment
supply and demand
 Two laws “capital gains tax cut: and “prudent man rule”
increased VC funding from 68 million USD in 1977 to
978 million USD in 1998, in only one year
 Studies have shown that the amount of VC investment in
the US is responsive to :
– Legal and fiscal variables, including pension fund regulation,
taxes, and subsidies
– Summaries of these policies are available from websites such as:
www.evca.com and www.cvca.com and
www.ventureeconomics.com , for Europe, Canada, and the US
respectively
 Policies Affecting Supply and
Demand of VC Finance

 Supply: affected by relevant taxes, subsidies,

and regulations (e.g. regarding pension funds)

 Demand: taxes, subsidies, bankruptcy law

 Supply Factors: Investment
Friendly

EVCA in 2003 and 2004, has published a

“benchmark index” for tax and legal
environments that will increase supply (and
more recently demand):

http://www.evca.com/images/attachments/tmpl_9_ar
(EVCA tables)
 Demand: Bankruptcy Law

 Provides an orderly mandate for insolvency of

insolvent’s assets
 Make bankruptcy laws less penal
 Much “start up” is from entrepreneurs own
pockets, but if he must borrow, then exposed—
including exemptions, or reducing discharge
time
 Social stigma of bankruptcy
 In Sum: What Kinds of Laws
Should Policymakers Foster

 Policymakers should indirectly implement legal

measures that are foundational for the
development of liquid stock markets, such as
disclosure laws, minority shareholder
protection, etc., and

 Modify legal environment in accordance with

EVCA index and other studies
Lawyer’s Role:
Facilitator
 Legal Drafting

 Ensure transaction complies with Iran’s existing

laws and regulations

 Develop appropriate legal documentation

 VC Clients: Entrepreneur

 Entrepreneurs concern:

• Loss of management controls

• Dilution of personal stock
• Repurchase of personal stock in the event of employment
termination, retirement or resignation
• Adequate financing
• Security interests being taken in key assets of the company
• Future capital requirements and dilution of the founder's ownership
• Intangible and indirect benefits of venture capitalist participation,
such as access to key industry contacts and future rounds of capital
 VC Clients: Investor
 Investor’s concerns:

• The company’s current and projected valuation;

• Level of risk associated with the investment;
• The fund’s investment objectives and criteria;
• Projected levels of return on investment;
• Liquidity of investment, security interests and exit strategies in the
event of business distress or failure ("Downside Protection");
• Protection of the firm's ability to participate in future rounds if
company meets or exceeds projections ("Upside Protection");
• Influence and control over management strategy and decision
making;
• Registration rights in the event of a public offering; and
• Rights of first refusal to provide future financing
 VC Contracts: Composition

 Term Sheet
 Principal transaction documents
– Securities purchase agreement: sets type of security to
be purchased, purchase terms, representations,
warranties and covenants
 Ancillary Documents
– Preferred stock designations
– Warrants
– Subordinated promissory notes
– Shareholders agreements
– Registration rights agreements
 Model Forms From
www.nvca.org
A “template” set of model legal documents put together by a group
of leading venture capital attorneys, consisting of:
-Term Sheet
-Stock Purchase Agreement
-Certificate of Incorporation
-Investor Rights Agreement
-Voting Agreement
-Right of First Refusal and Co-Sale Agreement
-Management Rights Letter
-Model Opinion Letter
-Model Indemnification Agreement
The model documents aim to:
-reflect industry norms
-be fair, biased toward neither the VC nor the entrepreneur, -consistent with
industry norms
-present a range of “typically seen” options (again, consistent with industry norms)
-include explanatory commentary where necessary or helpful
 VC Contracts: Specificity

 The way a lawyer creates a contract, the degree

of specificity, will absolutely help to define and
encourage VC investments in the short term and
increase its success, in the long term

 Kaplan and Stromberg provide a complete

analysis of financial contracting theory and an
empirical analysis.
 VC Contracts: Financial
Contracting Theories
 Big problem in developing countries because of
a goal conflict between the VCs and the
entrepreneur, where it is difficult for the VCs to
verify the agent’s performance

 Principal-agent: compensation must be

dependent on outcome of signals. Provide cash
flow rights to entrepreneur, ownership only
important as far as it affects pure cash flow
rights
 VC Contracts: Allocation

 VC contracts allow VC’s to separately allocate

– Cash flow rights

– Voting rights
– Board rights
– Liquidation rights
– Other control rights
 VC Contracts: Staged Financing

 Key method for minimizing investment risk is

by using staged financing

 Staged financing looking at Gomper’s analysis of

Apple and Federal Express
 VC Contracts: Performance

 Cash flow rights, voting rights, control rights,

and future financings are frequently contingent
on observable measures of financial and non-
financial performance
 VC Contracts: Flexibility

 The actual distribution of rights and

responsibilities is dependent on:

– The experience and reputation of the entrepreneur

– The attractiveness of the portfolio company as an
investment opportunity
– The stage of the company’s development
– The negotiating skills of the contracting parties
– The overall state of the VC market
 VC Contracts: Equity

 VCs implement an allocation of rights using

combinations of multiple classes of common
stock and straight preferred stock
 Convertible securities are used most often
because:
– Complex and sophisticated legal arrangements can be
worked out
– Claim becomes senior
– Debt security is exposed to less potential legal liability
 Main VC security
percent 100
90

80

70

60

50

40

30

20

10

0
Convertible Ordinary Senior common Convertible debt other securities
preferred common stock stock

US sample (K&S 2003) Common Civil

 Residual cash flow rights and
incentive mechanisms
percent
100

90

80

70

60

50

40

30

20

10

0
Founder stock vests over time Equity or funding milestones VC anti-dilution protection

US sample (K&S 2003) Common Civil

 VC Contracts: Performance

 Rights commensurate to performance:

– Poorly: VCs obtain full control
– Improvement: entrepreneur obtains/retains
more control rights
– Very Well: VCs retain their cash flow rights,
but relinquish most of their control and
liquidation rights. Entrepreneurs cash flow
rights increase
 Board Control

percent 80

70
60
50
40
30
20
10
0
VC board seats Founder controls Neither/state- VC controls board
board contingent

US sample (K&S 2003) Common Civil

 VC Contracts:

 VCs often include non-compete and vesting

provisions aimed at mitigating the potential
hold up problem between the investor and
entrepreneur.
 Activities
Activity DEVELOPING DEVELOPED
Country VC Firm Country VC Firm
Fund Structure Corporation & Limited Partnership Limited Partnership
Capital Sources Pension Funds, Corporations, Insurance Companies, High Net Pension Funds, Corporations,
orth Individuals, Government & Non Governmental Insurance Companies, High Net
Organizations (USAID, IFC) Worth Individuals
Types of Investments: Privatizations, Corporate High-technology, Early-stage,
Traditionally Restructuring, Strategic Alliances, Infrastructure funds High growth firms
Types of Investments: Services expanding from Developed Trend towards Late-stage
Recently to Developing Labor-intensive industries
Indigenous technology in Developing countries
Deal Low number of attractive investments, Focus on quality of Focus on quality of
Origination management, Problems of country risk, Corruption, Exchange management
rate risk
Deal Structuring Common stock and debt Common stock, several classes of
preferred stock, debt and
convertible preferred stock
Pricing the Deal Difficulty in assessing the value of an investee company – lack Higher level of transparency
of transparency

Exit Strategy Sale to third parties, co-investors, investee firm’s management Initial public offering (IPO)
Source: Aylward (1998) and Pacanins (2001), Scheela 2002
Lawyer’s Role:
Intermediary
 Networking

 Policymakers
 Local investors
– Lack of opportunities
– Inefficient financial intermediation system
– Absence of well functioning capital market
and investment instruments
– Will serve as powerful signal to foreign
investors
 Expatriates
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 Information

 Dealing with over 30 years of information, many

thorough cross country studies, much literature
available, assist in approximate ideas

 As Iranian VC develops can conduct new

surveys, studies, etc on problems and their
alleviation

 Middle east uses lowest percentage of internet,

of any region in the world
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To
 Foster Understanding of VC

 Take time to understand the VC technical

contracts
 Make rules of the VC game, and normally
standard contract provisions understandable to
entrepreneurs, and investors
 Educate clients/assist in obtaining info
– Offer links
– Educational materials, pamphlets, articles
 VC’s Success Dependent on
Transparency

 Try to get transparency well bred into the

system!!!!!!!!!!
 Suggestions to Organize Efforts

 Web site for VC in Iran

 An active VC association
 Sources

• Aylware, A. (1998). Trends in venture capital finance in developing countries. (36).

Washington DC: International Finance Corporation.

• Black, B.S., 2001 The Legal and Institutional Preconditions for Strong Securities
Markets. UCLA law review 48, 781-849.

• Gilson, R.J., 2003. Engineering a Venture Capital Market: Lessons from the American
Experience. Stanford Law Review 55, 1067-1103.

• Gompers, P.A., and J Lerner, 1996. The use of covenants: an empirical analysis of
venture capital partnership agreements. Journal of Law & Economics 39, 463-498.

• Gompers, P.A., and J. Lerner, 1998. What drives venture fundraising? Brookings
Proceedings on Economic Activity – Microeconomics, 149-192. opt cit. National
Bureau of Research Working Paper 6909 (January 1999).

• Gompers, P.A., and J. Lerner, 2000. Money chasing deals?: The impact of fund
inflows on the valuation of private equity investments. Journal of Financial
Economics, 55, 281-325.
 Sources

• Kaplan, S. and P. Stromberg, plan 2000. Financial Contracting Theory Meets the Real
World: An Empirical Analysis of Venture Capital Contracts. NBER Working Paper
w7660.

• Kaplan, S. and Martel F. and P. Stromberg, November 2003. How Do Legal

Differences and Learning Affect Financial Contracts?

• La Porta, R., F. Lopes-de-Silanes, A. Shleifer, and R.W. Vishny, 1997. Legal

Determinants of External Finance. Journal of Finance 52, 1131-1150.

• Megginson William L., Toward A Global Model of Venture capital, University of

Oklahoma

• Rajan, R.G., and Zingales, L., 2003. Banks and Markets: The Changing Character of
European Corporate Finance. NBER Working Paper w9595. www.nber.org.
 Contact

Poupa Marashi, Esq.

Legal Counsel
Sayeh Tower, 3rd floor, Suite#6, 1409 Vali-e-Asr Ave.,
Tehran, Iran 19677
Tel:+98 21 204 3901-2
Fax:+98 21 204 3992
Mobile: +98 912 314 7038
poupa@ibg-me.com
www.ibg-me.com