USA Law and Practice Contributed by: D. Scott Bennett, Nicholas A. Dorsey, Virginia M. Anderson and Ellen H. Park, Cravath, Swaine & Moore LLP
3. Investments in Venture Capital Portfolio Companies 3.1 Due Diligence The level of due diligence conducted by ven - ture capital investors in the USA can vary greatly depending on, among other things, the relevant investment round, company valuation and the size of investment as well as the overall interest by potential investors. Scope Diligence is typically led by the lead investor in a given investment round, while other investors generally focus on key issues or issues that are specifically relevant to their fund. In early rounds, the main focus is on: • capitalisation matters, such as the company’s capitalisation table, convertible securities, investors’ rights agreements, pre-emptive rights, voting agreements and the like, as well as any outstanding indebtedness; • alignment of the incentives of founders and key employees with those of external stock - holders through appropriate employment and equity compensation arrangements; and • ownership of IP needed to run the business, including patents, licence agreements and IP assignment agreements with founders and employees. In later rounds, more robust legal and business diligence is conducted, including detailed review of financials, material contracts, employment agreements, litigation and regulatory matters. When conducting diligence on AI compa - nies, investors may also evaluate whether the technology is truly “generative AI” or simply machine learning. Generative AI creates new content (making such technology more valu -
as well as developing relationships with and tak - ing stakes in founders at the earliest possible stage. This increasing diversity and sophistica - tion should lead to more specialised venture capital fund vehicles, the proliferation of custom - ised accounts and overlapping strategies, ever - green funds and increased interest in asset and portfolio sales across different funds managed by the same sponsor – all of which increase the attendant potential conflicts of interest that need to be managed. The industry, more broadly, has been exploring new models of holding onto companies for the long term throughout their entire life cycle – from inception through to post-IPO – while providing current opportunities for carry crystallisation and investor liquidity. While these liquidity strategies are not nearly as popular as they have been in the more traditional private equity space – likely due to the comparatively greater flexibility for longer hold periods in venture capital funds as compared to traditional private equity funds and the depressed valuations in recent years – there is a renewed optimism around exploring liquidity solutions in the venture capital space, as evi - denced by increasing secondaries transaction volume (including, in particular, large multi-asset continuation vehicle fundraisings) and optimis - tic fundraisings for dedicated secondaries funds targeting venture capital strategies. These struc - tures include secondaries transactions (such as continuation funds), GP stakes and net asset value (NAV) financing, which recognise the cur - rent reality of increased pressure to provide liquidity for LPs who have been struggling to make new allocations (even to successor fund vintages for the same sponsor) because low exit transaction volume has limited their return of capital in recent years.
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