Copyright 2001 The Deal L.L.C.
The Daily Deal

October 23, 2001 Tuesday

SECTION: INDUSTRY INSIGHT

LENGTH: 897 words

HEADLINE: Panning for gold

BYLINE: by JonathanBick

HIGHLIGHT:
The search for an advantage that stands to benefit both company and investor becomes more painstaking as the high-tech funding process grows more selective.

BODY:
Technology businesses continue to be selectively funded through multiple sources, but with increased emphasis on legally protected advantages shared by the recipient and the provider of funding.

Both debt and equity funding are still available from friends and family angels, venture capital and private equity firms and other sources. Successful funding is usually based on legal and operating characteristics that are simultaneously unique to the technology business and the potential investor.

There are several ways to identify and exploit these competitive advantages. Three tactics that have emerged are segmenting rights by development stage, using existing strategic and international contracts and working with governmentally instituted legal advantages. Each of these approaches shares a common characteristic: It relies on a unique legal advantage that is simultaneously available to the technology business and the provider of funds.

John Huston of Millburn Capital notes that each stage in a company's development normally has different legal and operating characteristics. Startups usually possess such assets as patents, niche-oriented proprietary technology, vendor contracts and/or beta agreements with known e-companies.

Early-stage technology companies typically have used their legal and operating assets to build a revenue-producing model that takes advantage of trade secrets, customer lists and good will, and long-term customer contracts.

Mature technology companies usually have transformed their legal and operating assets into a sustainable revenue model.

Each of the legal and operating assets possessed by firms at these stages can be used as a foundation for funding technology businesses.

For example, a technology company that has an identifiable long-term contract may be able to raise money by pledging those cash flows to an investor who can legally participate in factoring.

Or, as another example, technology companies that own plant and equipment may be able to secure equipment financing with long payment terms from local banks or other financial institutions.

Daniel Von Kohorn of Technology Partners (Holdings) llc says his firm uses the legal advantages found in strategic partnerships and international contractual relationships. Strategic partnerships and contractual relationships often involve capital investment themselves.

Technology companies can use the contracts as a legally binding competitive advantage or revenue source. And companies also can also use them to set the stage for investments from the same sources in later rounds. Alternatively, the contracts represent valuable legal assets that new investors will consider.

Down rounds, offering new equity stakes at a discount to previous rounds, essentially allow investors to get more for their money. Some technology businesses agree to investor demands for options to acquire additional stock - often at no cost - if the company's value diminishes in subsequent financing rounds. This protects investment returns in the event of financial underperformance.

Another legal tool used to manage investment companies' risk is the claw-back provision, which causes individuals within investment firms to repay components of their personal compensation in the event of certain levels of down rounds.

In some cases, claw-back provisions create artificial incentives for re-investment. For this reason, they can represent a legal agreement that creates a competitive advantage with regard to valuation and capital investment.

Contracts that exploit international comparative advantages often include joint ventures or resource/distribution contracts. These legal assets can provide greater access to international investment firms. For example, contracts to do business in China can open up debt or equity investments from Chinese companies.

International contracts can become complicated, often depending on jurisdiction. But technology companies often operate on a more global scale than non-technical companies; this gives them good reason to enter such contracts, which then also serve as assets that can help them raise capital.

Ron Peterson of Three Arrow Capital has suggested another way of funding technology organizations: by capitalizing on unique legal advantages available through the participation of third parties. Among the most common third parties that help to precipitate capital for technology companies is the government.

Technology companies commonly take advantage of unique laws that allow the government to assist their funding - for example, government equity investments from state funds that have been earmarked to assist companies that bring growth and employment to the state.

Similarly, Small Business Administration loans, in which the federal government will guarantee the lender against loss, can be used to initiate funding of technology companies. And state bond guarantees are available for refinancing plant and equipment with low interest charges and long payment terms.

Mergers, of course, also can result in funding. They can allow a technology company access to capital reserved for larger entities.

Jonathan Bick is an adjunct professor of Internet law at Pace Law School and Rutgers Law School. He is the author of "101 Things You Need To Know About Internet Law" (Random House, 2000).

LOAD-DATE: October 24, 2001