Security Forward Agreements: Understanding and Application in Venture Capital

Macro Tech Titan on July 10, 2024

In the realm of finance, Security Forward Agreements stand as pivotal instruments for managing risk, hedging against price fluctuations, and facilitating strategic investments. This comprehensive exploration delves into the intricacies of Security Forward Agreements, particularly in the context of venture capital. We will elucidate their fundamental concepts, mechanics, benefits, risks, and specific applications within the venture capital landscape.

Understanding Security Forward Agreements

Definition and Components

A Security Forward Agreement, often simply referred to as a forward contract, is a financial derivative contract between two parties where they agree to exchange a specific asset (the underlying security) at a predetermined price (the forward price) on a future date (the maturity date). Unlike options, which provide the buyer with the right but not the obligation to buy or sell the underlying asset, forwards bind both parties to fulfill the contract.

The agreement typically includes:

  • Underlying Asset: This can be any financial instrument, commodity, or security whose price can be determined and agreed upon.
  • Forward Price: The price at which the asset will be exchanged in the future.
  • Maturity Date: The date when the exchange of the asset occurs.

Forward contracts are customized agreements traded over-the-counter (OTC), which means they are not standardized and can be tailored to meet the specific needs of the parties involved. This flexibility allows for a wide range of applications across different sectors of finance.

Mechanics of a Security Forward Agreement

To grasp the mechanics of a Security Forward Agreement, consider the following example involving a venture capital scenario:

Imagine a venture capitalist (VC) firm is interested in investing in a promising startup that plans to go public in the next two years. The VC firm anticipates significant growth in the startup’s valuation upon its IPO but is concerned about potential fluctuations in the stock price post-IPO. To mitigate this risk, the VC firm enters into a Security Forward Agreement with a counterparty, agreeing to purchase a certain number of shares of the startup at a predetermined price per share on the IPO date.

Let’s break down the steps involved:

  1. Agreement Initiation: The VC firm and the counterparty negotiate and agree on the terms of the forward contract. This includes specifying the number of shares, the forward price per share, and the maturity date (the IPO date).
  2. Execution: On the IPO date, regardless of the actual market price of the shares, the VC firm is obligated to purchase the agreed-upon number of shares from the counterparty at the predetermined forward price.
  3. Settlement: Settlement of the contract occurs either through physical delivery of the shares and payment of the agreed-upon price or through a cash settlement, where the difference between the forward price and the actual market price on the IPO date is settled financially.
  4. Purpose: The primary purpose of this forward contract is for the VC firm to hedge against potential price volatility post-IPO. By locking in a purchase price now, the firm can protect itself from adverse price movements and potentially capitalize on expected gains in the startup’s valuation.

Benefits of Security Forward Agreements

Security Forward Agreements offer several advantages to participants in venture capital and other financial markets:

  1. Risk Management: They provide a tool for hedging against price fluctuations, thereby reducing exposure to market volatility.
  2. Price Discovery: Forward contracts facilitate price discovery by allowing parties to agree upon a future price today, based on their expectations of market movements and fundamentals.
  3. Customization: Contracts can be customized to fit specific needs and circumstances, making them versatile instruments in portfolio management and strategic investment planning.
  4. Liquidity Management: For venture capital firms and other institutional investors, forward contracts help manage liquidity by allowing them to plan and allocate funds effectively over time.
  5. Speculation: They can also be used for speculative purposes, allowing investors to take positions on future price movements of assets without needing to own them outright.

Application in Venture Capital

Risk Mitigation in Pre-IPO Investments

Venture capital firms often face substantial risks when investing in startups, particularly those that are not yet publicly traded. These risks include uncertainty about the startup’s future valuation, market conditions post-IPO, and liquidity concerns. Security Forward Agreements can be instrumental in mitigating some of these risks:

  • Valuation Stability: By entering into forward contracts prior to an IPO, venture capitalists can secure a purchase price for shares of the startup, thereby stabilizing their investment valuation against potential market fluctuations.
  • Liquidity Planning: Forward contracts allow VC firms to plan their cash flows and liquidity needs more effectively, as they know in advance the amount and timing of their financial obligations related to the investment.
  • Exit Strategy Enhancement: For venture capital funds nearing the end of their investment horizon, forward contracts can facilitate smoother exits from portfolio companies by locking in exit prices and mitigating the impact of market volatility.

Strategic Investment Planning

Beyond risk management, Security Forward Agreements play a strategic role in the investment planning of venture capital firms:

  • Portfolio Diversification: They enable VCs to diversify their portfolios and manage exposure to specific sectors or types of startups without being overly dependent on the timing and conditions of public market exits.
  • Enhanced Return Potential: By leveraging forward contracts, venture capitalists can potentially enhance their returns by capitalizing on anticipated growth in startup valuations while protecting against downside risks.
  • Long-Term Investment Planning: Forward contracts support long-term investment planning by providing VCs with a structured approach to managing their investments across different stages of a startup’s lifecycle—from early-stage financing to eventual exit strategies.

Practical Considerations and Risks

While Security Forward Agreements offer numerous benefits, they also come with inherent risks and considerations:

  • Counterparty Risk: There is always a risk that the counterparty may default on its obligations under the forward contract, leading to financial losses or legal disputes.
  • Market Risk: If market conditions deviate significantly from expectations, the benefits of hedging through forward contracts may be diminished, and parties could incur opportunity costs.
  • Regulatory Considerations: Forward contracts are subject to regulatory oversight, and changes in regulatory requirements or interpretations could impact their use and effectiveness.
  • Cost Considerations: Depending on market conditions and the specific terms of the contract, entering into forward agreements may involve costs such as margin requirements or transaction fees.

Conclusion

Security Forward Agreements represent a powerful tool in the arsenal of financial instruments available to venture capital firms and institutional investors. By allowing parties to hedge against price fluctuations, manage risk, and strategically plan their investments, these contracts facilitate smoother and more efficient operations in both stable and volatile market conditions.

In the dynamic and competitive world of venture capital, where uncertainty and opportunity coexist, forward contracts provide a structured approach to navigating risks while pursuing investment opportunities with confidence. As the financial landscape evolves, understanding and effectively utilizing Security Forward Agreements will continue to be essential for achieving optimal portfolio performance and sustaining growth in the venture capital sector.

References

  1. Hull, John C. Options, Futures, and Other Derivatives. 10th ed., Pearson, 2017.
  2. Chance, Don M., and Roberts Brooks. Introduction to Derivatives and Risk Management. 10th ed., Cengage Learning, 2015.
  3. Lerner, Joshua. “Venture Capital’s Role in Financing Innovation: What We Know and How Much We Still Need to Learn.” Journal of Economic Perspectives, vol. 23, no. 3, 2009, pp. 3-23. JSTOR, www.jstor.org/stable/27735786.
  4. Gompers, Paul, and Josh Lerner. The Venture Capital Cycle. MIT Press, 2004.
  5. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options.” U.S. Securities and Exchange Commission, www.sec.gov/reportspubs/investor-publications/investorpubsoptionshtm.html.
  6. Financial Industry Regulatory Authority. “Understanding Options Trading.” FINRA, www.finra.org/investors/learn-to-invest/types-investments/options/understanding-options-trading.

These references provide foundational knowledge and scholarly insights into derivative contracts, venture capital finance, and the broader financial markets, enriching our understanding of Security Forward Agreements and their applications.

What founders and reps can do to limit liability when raising capital

Macro Tech Titan on March 25, 2024

Founders need capital to grow, and registered reps often help them get there – but it’s not only about the capital.  If you search “Issuer Liability” most of the results will talk about the regulations.  When you raise money from someone else (not friends and family) you are selling a security, which is a regulated activity.  When you take an investors money there is liability, they are expecting something in return.  Many founders ask what they can do to protect themselves from investor lawsuits, so we wanted to provide a short guide.  We are not lawyers and this is not legal advice, this is information about the market in general for education purposes.  Founders should always seek guidance from a lawyer and if you are planning on raising capital with or without a broker-dealer you should probably have an attorney who you feel comfortable with on retainer.

  1. Follow the rules

This is pretty straightforward, and if you are working with a registered rep of a broker-dealer they will ensure your offering ticks all the right boxes.  Broker dealers are regulated by FINRA and their job is to understand and implement the rules.

  1. Get a lawyer

Lawyers are like Doctors, you don’t need them when you’re healthy, you need them when you’re sick or if you just got run over by a bus (in that example you’ll need both).  If you’re raising capital as your business grows you’ll need a lawyer to create documents and to provide legal advice for a range of issues well beyond your offering.

  1. Disclose, disclose, disclose

One of the biggest drivers of investor lawsuits is the failure to disclose material facts.  If you disclose everything, it will greatly reduce the risk of getting sued.  Investors understand that there are risks with private investing, they are taking the risk and will be rewarded if it pays off and the project works.  For example, if the company has a loan that needs to be paid off and you fail to disclose that, investors would be very unhappy about that (and so would the regulators).  Most of the regulations center around disclosure, they don’t evaluate the quality of an individual offering or sector – when you file an SEC registration statement, the SEC will verify the format, and that you have addressed all the required points, they will never evaluate the quality of the offering or tell you if it’s a good idea or not.  What they do require is that all material facts are disclosed, including the backgrounds of the principals, financials of the company (if any), audits, reports, articles, business plans, patents or other intellectual property, etc.  The reason for this is simple, investors can only make informed decisions when they have all the facts.

  1. Target sophisticated investors

This is more about strategy; if you target investors who have experience in early stage companies, they are going to be in a better position to make a decision, and may even provide valuable feedback based on their experiences in other deals.  If you are dealing with someone who has never invested in a private offering before, that’s probably not your best investor.

  1. Explain to investors the Use of Proceeds well

This is actually the most important requirement when doing a raise with a FINRA BD; the reason is simple.  Investors want to know where their money is going.  Things don’t always work out, and investors may be receptive to that – where they get angry is if you do something outside the scope of your plan, or something they believe to be reckless.  If you explain that with $500,000 you’re going to do A,B,C, – and then you do it, and it doesn’t work out as anticipated, there’s a much lower chance of having a problem with investors vs. a situation where you went far off the business plan and invested in something not on the Use of Proceeds list.  Founders have multiple roles with investors, they are fiduciaries of the shareholders, and managers of the business.  They have an obligation to the shareholders to maximize their value.  As an executive of the business, their job is to ensure that they execute the business plan to the best of their ability.

  1. Get an Umbrella insurance policy

If you have a house, a ranch, or other family assets, you should probably get an Umbrella insurance policy which covers those assets if you get sued.  The umbrella insurance is not specifically for people raising funds, it’s for general situations like if a stranger trespasses on your property and breaks their leg and sues.  The insurance agent can explain the benefits of it, but the idea is to provide some protection to your core assets in the case of lawsuits.

  1. The LLC or Corp provides basic protection

Incorporation when starting a company is key, it means that any lawsuit would be against the entity, not the individuals.  Having said that, a founder is in a unique position because they typically are the main shareholder, the executive, and the person responsible for the entity.  However, this is the most basic protection and the reason that entities are formed, the group of shareholders are stakeholders who share in the profits or the losses of the business together.

  1. Setup a Trust

If you have children, having a Trust is a great idea to pass assets however modest without dealing with Probate.  A Trust can provide other advantages of asset protection, but it does cost money to set it up.  This varies from state to state, but you should talk to a local attorney near where your primary residence is located.  A Trust should be local, it shouldn’t be in Delaware where most Corporations are registered.

  1. Keep in touch with investors

There’s a reason why publicly traded companies have quarterly investor calls.  Imagine the following scenario-  you have an investor who gave you a decent amount of money to start your company and you don’t hear from him for years.  Time goes by and your business grows, and then you face a huge problem from a competitor, and there is a loss.  You call to tell him that, he’s not going to be happy to listen to this.  But it’s always about the lack of info and attention, if you were calling them or if you write an investor letter at least quarterly, you probably wouldn’t be in such an awkward position.  Regular updates are a great way to keep investors informed, and if they are displeased with anything they’ll tell you that then.

  1. Under promise and over deliver

Getting caught in litigation is usually because an investor feels they were abused, lied to, tricked, or that they got an unfair deal.  If you under promise, and then over deliver – this vastly reduces the chance of someone feeling bad about the investment.  Investors don’t expect miracles and founders are not magicians, things happen, everyone knows that.  But if you provide great results, defined as better than what you originally told them, how could anyone have a problem with that?

This goes to the core of writing great terms, be conservative, be reasonable, explain the risks.  Many will say, that it will be ‘harder’ to raise money if your projections are conservative – exactly!  It’s a filtering process, you don’t want someone to EXPECT a huge return because then if you don’t do it, it will be a problem.  There was a FINRA case where a REIT promised 8%, delivered 5%, and got sued (we’re paraphrasing the terms for the sake of the example).  Or in other words, the 5% return was actually very good, but they hard sold and promised 8%, so it left some to feel that it was misleading.

11. When Speaking, Speak Honestly

According to one lawyer, what can prevent lawsuits is simple honesty.  Don’t exaggerate claims or speculate about the future, and certainly don’t speak about future potential as if it’s fact.  Avoid superlatives such as “Will” and instead use language like “May” because you really don’t know what will happen in the future.

Conclusion

This is not an exhaustive list, but it should provide the idea of how to risk mitigate the potential for getting sued, which is a real liability for founders, issuers, and reps.  There isn’t any language you can add to an investment contract that prevents an investor from suing (which is logical, if you think about it, because real scammers could use that language to shield themselves).

So consider taking the high ground, the ethical approach, disclose more than necessary, be above regulatory standards, don’t just meet the minimum requirements.