Venture Capital Lending: Usury and Fiduciary Duty Concerns

• Publication year: 2004
• Pages: 49
• Citation: Vol. 33 No. 4 Pg. 49

33 Colo.Law. 49 Colorado Lawyer 2004.

2004, April, Pg. 49. Venture Capital Lending: Usury and Fiduciary Duty Concerns

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49

Vol. 33, No. 4, Pg. 49

The Colorado Lawyer
April 2004
Vol. 33, No. 4 [Page 49]

Specialty Law Columns
Business Law Newsletter
Venture Capital Lending: Usury and Fiduciary Duty Concerns
by David J. Kendall

This column is sponsored by the CBA Business Law Section to apprise members of current information concerning substantive law. It focuses on business law topics for the Colorado practitioner, including, but not limited to, issues surrounding anti-trust, bankruptcy, business entities commercial law, corporate counsel, financial institutions franchising, nonprofit entities, securities law, and small business entities

Column Editors:

David P. Steigerwald of Sparks Willson Borges Brandt & Johnson, P.C., Colorado Springs - (719) 475-0097, dpsteig@sparkswillson.com; Troy Keller, senior attorney at Qwest, (303) 992-6167, troy.keller@qwest.com.

About The Author:

This month's article was written by David J. Kendall, Denver, a partner with Kendall, Dickinson & Koenig PC - (303) 672-0102, dkendall@kdkfirm.com. The author thanks his law partner, Jeff Quick, for contributing to the research and editing of this article.

Venture capital investors, venture-backed companies, and their respective counsel need to be wary of unique usury and fiduciary duty issues that arise in venture capital lending transactions. This article addresses these issues and provides guidance for parties involved in bridge loan financings.

Many venture-backed companies have struggled to survive during the recent economic downturn. Unable to turn to the public markets for financing, some companies have approached venture capitalists already holding equity interests. In response, those venture capitalist investors increasingly have made bridge loans to their portfolio companies. Bridge loans are short-term loans that ordinarily are intended to meet a company's capital needs until it is able to obtain long-term financing.

Such equity financing has served to buy more time for companies, without committing the investors to make additional equity investments. As a result of the funding arrangements, venture capitalists, in addition to being equity investors, are becoming lenders to their portfolio companies.

Although bridge loan financings can be relatively uncomplicated transactions, they require some degree of cross-disciplinary expertise in both equity and debt financing. Thus, practitioners should be sure to include attorneys with adequate credit finance and venture capital expertise in the working group for a venture capital lending transaction.

This article highlights certain legal issues that are especially relevant to venture capital bridge financings. Such issues relate to usury and fiduciary duties arising at or near insolvency, which are aspects of debt transactions that venture capitalists, venture-backed companies, and their respective legal counsel usually do not face in connection with equity investments. This article also provides a brief overview of the standard structure of bridge loan financings and the purpose of these specialized debt instruments.

Reasons for Bridge
Financings

Equity investments are the norm in venture investing. Start-ups usually do not have the cash flows necessary to obtain traditional debt financing. In addition, venture investors look for high returns that only equity investments can provide. Under certain circumstances, however, venture investors will provide bridge financing for timing reasons, to protect a prior investment, or to obtain priority over equity investments.

Timing Considerations

Venture capital firms may want to provide the funding necessary for a start-up company to continue to move forward with its business plan and operations, instead of stalling due to lack of funds. Generally, bridge financing transactions can be negotiated and documented in less time than a full venture capital equity financing.

The short life of bridge indebtedness also allows the parties to put off negotiating certain terms or provisions that are important in the long term but inconsequential in the short term. However, there is some danger in entering into a bridge debt transaction without agreeing on the terms of the equity investment that will replace the bridge debt. It is unwise for parties to consummate the bridge debt transaction without having agreed to critical terms, such as: (1) the price at which the equity investment will be made; (2) liquidation preferences; (3) governance rights; and (4) anti-dilution protection. (See "Structure of Venture Capital Bridge Loans,"
below.)

Protecting Prior Investment

The venture capital firm often is an investor in the company when the parties enter into a bridge financing transaction. The venture firm may plan on following up with another equity infusion, but that is not necessarily the case. The venture firm may simply hope to sustain the business until the next equity financing.

An existing investment may prompt a venture capital firm to provide bridge financing in a situation in which the firm otherwise would not invest. The magnitude of the initial investment and the bridge financing may play an important part in an investor's decision to make a bridge loan. A venture investor with a large initial investment may be more willing to put additional money at risk to avoid taking a total loss on its existing investment. However, an investor with a small initial investment may be more apt to write off the initial investment and not put additional money at risk.

In some situations, a venture capital firm may agree to provide bridge financing to a company in which the firm had not previously invested, such as where there is a basic understanding between the investor and a company on the terms and conditions pursuant to which an investor will provide equity financing. The financing may be documented by a term sheet, but more time is needed to finish negotiations or to bring in other investors. The venture firm may feel that because it has invested resources into finding, investigating, and analyzing the investment opportunity, it will bridge the company, even though all terms of the ultimate equity investment have not been finalized.

Priority Over Equity

Bridge loans are almost always intended to be converted into equity in connection with an equity financing. However, such bridge debt financing also provides various economic and legal benefits and advantages of debt, which allows the investor to hedge its bets in case the equity financing does not materialize. In this event, a debt investment generally will provide greater downside protection to the investor. For example, if the company is liquidated, creditors will have priority over all equity holders, including preferred equity holders. In the event of a liquidation, a bridge loan allows a venture capital investor to be higher in the capital structure than if it had provided...