Horizon 2020

Compliance and regulatory risk

While an investor may not always be exposed to direct liability risk for the acts of a non-controlled subsidiary (aside from directly authorizing or aiding and abetting illegal activity), the reputational risk from regulatory or compliance breaches by a portfolio company is not insignificant. These investments are usually paired with co-marketing, co-branding and similar arrangements, often with the portfolio company touting the corporate’s investment on its website or through other public means, exposing the corporate’s brand to leakage. And in some cases regulatory requirements directly apply. The Foreign Corrupt Practices Act (FCPA), for example, imposes on a non-controlling shareholder a duty to use its influence in good faith to cause an investee to maintain a system of FCPA-consistent controls. Despite this, investors are frequently inclined to conduct limited diligence in connection with investments that are immaterial in dollar terms, when they should be focused on identifying specific risks and conducting thorough but targeted diligence. Boards need to ensure that management has processes in place to do so; several well-known corporates have recently been the subject of corruption investigations associated with investments and joint ventures outside the US.

Accounting for minority investments

Accounting for a corporate minority investment will differ depending on the investment vehicle, percentage ownership and non-economic indicia of control, among other factors. Boards should ensure management has procedures in place to monitor these accounting issues, and management should be aware of the differing accounting that results from, for example:

1. qualitative indicia of control that would require a company to account for a minority investment on the equity method or by consolidation notwithstanding economic ownership below 20 percent; and
2. accounting reforms that became effective in 2018 requiring companies to run certain measurable changes in the value of an investment, even when below 20 percent and accounted for on a cost basis, through net income – meaning that each subsequent investment round in a portfolio company could trigger the requirement to record a loss in the investor’s P&L.

Portfolio company boards

Companies seeking investments from, and partnerships with, strategic investors will often request that the investor take a board seat – recognizing that the representation of a well-established strategic investor can provide significant credibility and experience to an early-stage company. However, corporate investors must be careful to avoid overboarding their employees. They should also ensure their directors are aware of the inherent conflicts associated with sitting on multiple portfolio company boards; the risks (including in relation to personal litigation) an employee assumes in becoming a director of another company; and the time required to be an effective board member.

To manage the tension between an employee director’s duties to the company versus the investee, corporate investors should at a minimum have policies in place to ensure corporate opportunity waivers are obtained for director appointees, and that those appointees can share information with their broader corporate team (in each case where appropriate). Companies should also ensure there is sufficient indemnification provided to directors to limit personal liability. With respect to overboarding across portfolio companies, a board should ensure management has policies in place to manage risks including:

1. board appointments detracting from the ability of an employee to focus on the core enterprise;
2. the tensions that may arise if a director appointee’s duty of candor to the portfolio company conflicts with his or her duty of disclosure to the corporation (or vice versa); and
3. the risk of an overlap between competitor boards being deemed an illegal interlocking directorate under the Clayton Act.

Companies can generally avoid the issues above by taking an observer seat instead of appointing a director, and should consider making an observer (with robust information rights) the preferred approach except where otherwise necessary or appropriate.

Competitor investors

Corporate investors may not want to risk being a co-investor in a target alongside a competitor. A portfolio company may be willing to give a strategic corporate investor a contractual right to veto an investment from a competitor or accept an investor blacklist. This is particularly the case if limited to a certain period or only for as long as the strategic investor keeps investing in subsequent rounds, but generally only if negotiated concurrently with the initial investment. If a contractual veto or blacklist is not an option, a corporate investor should consider up front the risks of competitor co-investments and whether the (often limited) ability to exit via a transfer is sufficient.

A well-counseled board of a company with significant minority investments should keep itself informed and ensure these risks are appropriately addressed by requiring periodic updates from management covering, at a minimum:

• investment strategy;
• size of the portfolio;
• criteria used by management to determine performance;
• potential reputational risk;
• an overview of board and other fiduciary roles across the portfolio;
• a summary of any past failures and related remedial actions taken; and
• management’s approach to exits.

The importance of this kind of oversight is likely to increase in 2020 as companies continue to expand their investment portfolios in an effort to keep pace with technological change.