United States: Advice Of Counsel : Q&A On Tech Transfer

Question: As increasing numbers of venture capital-backed biotech and device companies are offered for sale to larger firms, what negotiating issues, other than price, are most critical to getting the VCs to go along?

Answer: After the deal's price, timing, and form of payment, VCs care most about the representations and warranties given by the company to the buyer and the VCs' liability if a representation turns out to be untrue.

It is nearly always the case that the VCs in the target company are held responsible for the representations and warranties that the company makes to the buyer in the acquisition agreement. Venture funds are concerned about such representations and their accompanying indemnification obligations, since most funds are required by the terms of their partnership agreement to distribute acquisition proceeds to limited partners soon after they are received. So the fund must retain any liabilities associated with the sale proceeds or otherwise establish some mechanism to protect itself against exposure after the closing.

As venture funds invest their money more quickly and fund lifetimes shorten, they are increasingly sensitive to the possibility of being held responsible for liabilities that may extend out years in the future. In the typical acquisition scenario, the seller is responsible not only for liabilities that have arisen prior to the closing, but also for unknown and unknowable liabilities associated with the assets being sold. This liability can be a particular problem for companies sold at very early stages in their technological lives, when it is more difficult to uncover hidden risks. For example, most of their patents will not yet have issued, so there is considerable uncertainty about the strength of their intellectual property positions.

The most critical questions concerning a venture fund's exposure to liability for breaches of representations and warranties are as follows:

1. Are the shareholders of the seller jointly or severally responsible for a breach, and do all shareholders shoulder this responsibility—or just the VCs who are on the board and sign the purchase and sale agreement?

A buyer will seek to hold the selling shareholders jointly and severally liable, meaning that the buyer can sue any single shareholder and recover the entire loss. VCs will want their liability limited to their pro rata share of the sale proceeds. In addition, although the VCs may control the company and could approve a sale on their own, they will want as many other shareholders as possible to sign the acquisition agreement, so that the risk of loss is spread over more parties.

2. Are venture capital fund stockholders responsible for all representations and warranties, or only those of which they have actual knowledge?

Since management runs the company, VCs may insist that they will make representations and warranties only about matters within their direct knowledge and control, such as their ownership and ability to deliver clear title to their shares, while requiring management to make the remainder of the representations and warranties and bear the responsibility if they turn out to be untrue. This is rarely a tenable position, since the pockets of management will not be deep enough to give the buyer assurance that he can recover damages in the event of an unforeseen loss after the closing. If the VCs don't share in the representations made by the company, then the buyer will require a large escrow to be established, so that it can easily access funds in order to make it whole in the event of a loss.

3. What is the scope of typical representations and warranties?

If the seller is a private company, its representations and warranties will be extensive, covering every aspect of its business, including representations about intellectual property, environmental, financial, contractual, and tax matters. If the seller is a public company, normally the representations and warranties are quite limited, and relate only to statements made in public filings with the SEC and similar agencies.

4. How long after the closing will the representations and warranties be in effect?

This is a matter of significant negotiation. The normal time period of survival for most representations is between six and eighteen months after the closing. However, the buyer may insist that representations concerning environmental matters, intellectual property, and tax liability (and possibly employee benefits) extend for the applicable statute of limitations. For tax liabilities, this is six years; the typical statute of limitations for contractual liability for breaches of intellectual property representations is also six years. This period may extend beyond the lifetime of the venture fund that has made the investment. The situation is even worse for representations about environmental matters; there is, effectively, no statute of limitations that can bar a suit on an environmental matter, so the parties typically negotiate an arbitrary cut-off date for this liability. The only solution under these circumstances is for the venture fund's general partner to assume these liabilities upon expiration of the fund and distribution of proceeds to limited partners, which is not an attractive prospect. Instead, it is more common for a company's VCs to try to estimate the dollar value of the exposure and to deduct from the sale proceeds a pool of funds to protect against future losses, or to purchase representation and warranty insurance.

5. Is representation and warranty insurance a sensible idea?

It can be, but it's expensive (normally 2-5% per $10 million of coverage). There are a small number of insurers who provide this coverage and, since it is relatively new, insurance practices in this area tend to be quite conservative. While the coverage extends to breaches of all representations and warranties, it only pays for funds spent in the event of an actual breach of a representation or warranty. In other words, if a patent infringement suit is brought against the buyer relating to use of the seller's intellectual property, and the seller is forced to spend significant legal fees to defend the buyer and it wins (demonstrating that the seller's patents are valid and that there is no infringement), the insurance policy pays nothing to cover these legal fees, since the seller's intellectual property representation or warranty was not, in fact, breached. This perverse set of incentives could lead the seller to try to lose a case quickly and leave the damages bill with the insurer—but the insurer's attorneys are looking over the shoulders of the seller's attorneys just to prevent such an action.

6. Are there ways to limit the amount of indemnification?

Yes, typically through a "basket" at the lower end and a "cap" at the upper end. A basket is like a deductible on an insurance policy; the seller is not responsible for the first X dollars of liability. If the basket is exceeded, the liability exposure could begin with "dollar one" or at the first dollar above the basket: such details are matters for negotiation. A cap sets a limit on the seller's liability.

Another sensible way to limit exposure is to give the seller the right to handle all litigation that may be brought against the buyer relating to the acquired assets. In this way, the seller's attorneys can control costs. Normally, the buyer will agree to this, but it will insist that the seller not have the ability to settle a case without the buyer's consent.

7. Are there ways to limit representations and warranties so that indemnification exposure is similarly limited?

Yes, the best approach is to qualify representations by the actual knowledge of key members of management. In response, the seller may want management to be held to a constructive knowledge standard, i.e., the seller's stockholders should also be responsible for what its management should have known. This can be tricky in the case of intellectual property or environmental problems, since it may be hard to determine an appropriate standard of diligence to require of management. It is also important to establish whose knowledge is pertinent; is it the CEO and the chief scientific officer, or does the knowledge criteria apply to a broader group of employees?

Another way in which a seller can limit its exposure under representations and warranties is to preserve its ability to update the representations during the time period between signing the acquisition agreement and closing the transaction. Often, the various legal requirements can drag out a closing. In stock-for-stock deals, for example, the stock of the acquiring company will need to be registered with the SEC, and sometimes the parties may have to get antitrust clearance from the Federal Trade Commission and/or the Department of Justice. The seller's corporate partners may also need to consent to the deal, delaying matters further. During this period, it is not uncommon for a competitor of the buyer or seller to bring a lawsuit against the seller in hopes of discouraging the buyer from consummating the transaction. In such an event, the seller will want the ability to update its representations at closing to take account of the lawsuit, with the buyer being granted the ability to walk away from the transaction if the exposure to the lawsuit is judged to be "materially adverse." However, the buyer will want to have the choice of either walking away from the deal or simply adjusting the purchase price to account for the potential liability.

8. Given the limited lifetime of venture funds and their need to distribute proceeds to limited partners, how can funds handle disputes that may arise after the closing of a transaction?