Switzerland

Author: | Published: 4 Jan 2001
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While the development of the market for venture capital financing outside Switzerland, in particular in the US, has been dramatic in the past decade, the evolution in the Swiss domestic market has been slower. Venture capital financing has just started to take off in Switzerland. There are several reasons for the increasing interest of investors in start-up companies. One major reason is the changed environment for venture capitalists, providing them the opportunity to obtain a return on investment in a relatively short time. More transparent listing rules and reporting requirements for investment companies were implemented in March 1998 and the SWX New Market was introduced in June 1999, and proves to be an attractive exit prospect for venture capitalists.

The increased transparency rules for investment companies, reduced entry barriers for an initial public offering (IPO) on the SWX New Market and, last but not least, the success of certain listed stock of young high-technology firms have led to an increased interest in direct venture capital financing and indirect investment through investment companies. Additional regulatory changes and developments in the capital markets and corporate law are likely to increase further the venture capital activities in Switzerland.

Elements of venture capital transactions

In this article, the term venture capital is used as a subset of private equity, i.e. for equity investments made into new companies for the launch, early development, or the expansion of a business, which entails some investment risk but offers the potential for profits substantially above average.

Preparatory steps

Start-up companies typically produce an information memorandum setting out certain key information for the preliminary evaluation of the venture. Among others, it briefly describes the background of the venture, the key personnel, the main business activities and its core competencies. It also includes selected financial data, and may contain forecasts on the future product and business developments. Because of the confidentiality of this information, investors are generally required to enter into a secrecy and non-disclosure agreement.

If an investor is still interested after having studied the information memorandum, the parties normally enter into a letter of intent, or term sheet setting out the basic terms of the investment, the rules between the investor and the existing shareholders, and for the continuing operation and management of the company. A further important element of the letter of intent is to define the conditions precedent to be satisfied, such as the performance of satisfactory due diligence, approvals by third parties such as other shareholders, the setting up of a business plan satisfactory to the investor, or the termination of any agreements which may be in contradiction with the contemplated agreement.

Once the parties have agreed on the basic terms of the investment, the investor will carry out a technical, business, financial and legal due diligence audit to assess the benefits and the risks of the investment. Since these transactions often relate to high-technology businesses, particular attention should be paid to an adequate protection of intellectual property rights.

Agreement on the venture capital investment

The subject matter of the agreement between the venture capitalist and the existing shareholders is the acquisition of an equity participation in the start-up company, the setting of certain rules between the investor and the existing shareholders, and the continuing operation and management of the company. The key elements of a typical agreement are as follows:

Investment and investment mechanics, liquidation preference, dilution protection

The investment and the mechanics of the transfer need to be defined. The structure of the transaction and, in particular, the timing and valuation of further tranches of investments must be identified. Quite often, the investor will agree to make further venture capital contributions subject to the achievement of the goals set out in an agreed business plan. In case the investor is considering further investments through capital increases, it must be determined whether or not the existing shareholders will participate and, if necessary, waive their preferential subscription rights in favour of the investors. Typically, adequate protection will be included to protect the investors against dilution, in case of future issues at a lower price. It may also be agreed that in the event of liquidation, dissolution or winding up of the company, the investors receive an amount at least equal to the amount paid in connection with the acquisition of the equity participation.

Representations and warranties of the existing shareholders and the investor

Detailed statements about the legal and financial condition of the venture are made by the existing shareholders.

Covenants of the existing shareholders and the investor

The main purpose of the covenants is to define the obligations of the parties after signing the agreement. Typically, investors want the existing shareholders to operate the business in accordance with the business plan, to assure prompt and accurate information to the investor if certain targets of the business plan are not met, and to prevent leakage of money and property out of the venture.

Representation on the board of directors

The venture capitalist has a significant interest in being represented on the board of directors of the venture. The interest is normally twofold. First, the investor expects to be informed on the business development and, second, it may be wise to have an experienced representative of the investor assisting and guiding the management in taking the business forward. Finally, it is clear that an investor will want a certain control over material resolutions, which have to be taken by the board, and to veto rights with respect to certain major decisions.

Conditions precedent to closing

The conditions precedent specify the ability of each party to withdraw from the investment if one of the conditions precedent is not satisfied. Typically, a venture capitalist will, among other things, insist on the following conditions precedent: a) the preparation of a business plan satisfactory to the investor; b) conclusion of employment agreements with key personnel, including adequate notice periods and non-compete obligations; c) the adoption of an employee stock-option plan, which is usually a very efficient tool to bind financially certain key personnel; and d) amendments to the company's articles of incorporations and organizational regulations, which are necessary and/or appropriate to implement the terms of the agreement on a corporate level.

Indemnification

In this section, the parties set out the circumstances under which either can claim damages or take other remedial action if the other has breached a representation or warranty, or failed to comply with its covenants.

Termination procedures

Ultimately, the agreement should define the termination procedures and the different exit possibilities.

Exit strategies

From the outset, it is the venture capitalist's goal to realize a substantial profit through the sale of its investment when the company's value has been maximized, generally two to seven years after the initial investment in the company.

When structuring the original investment, the investor will already be planning ultimate exit strategies. Contracts signed at the time of the initial investment will generally give the investor certain rights to control the future exit strategy. This is especially important where the investor will not (or may not) control the company at the back-end when the exit strategy is executed. Even where the investor controls the company at the time of exit, the actual exit strategy employed may require cooperation from some shareholders who will not, or may not, be in agreement with the timing, price or other terms as proposed by the investor. For these reasons, it is of utmost importance that under the investment contract, the investor can control the exit strategy.

The investor's exit options may include an IPO, the sale to a strategic investor, the sale to a new (financial) investor, the trade sale to a third party (competitor), the reduction of the share capital, the repurchase of the shares held by the investor through the company, or finally the liquidation of the company.

The preferred exit option is the IPO. An IPO ordinarily procures the highest price (i.e., the highest profit for the investor and the original shareholders), the continuity of an independent management, and a prominent position in the market. However, this exit strategy is inconvenient in that it is very much dependent on a favourable stock exchange environment, and requires that the company complies with increased regulations and the permanent obligation to disclose price-sensitive facts. In addition, the company and its management are subject to quarterly or semi-annual pressure, when publishing the interim reports.

The trade sale, or the sale to a strategic investor, often has the disadvantage of a lower price as compared with the prices obtained through an IPO, and the loss of independence. On the other hand, such a transaction may achieve valuable synergies between the companies, and could also lead to enhanced management and financial resources. In fact, for smaller and medium-sized companies, the financing needs following an IPO are often difficult to satisfy, as the access to additional equity or debt financing is frequently not easy to obtain. The integration of the company into the buyer's organization may avoid such problems.

Common to all exit strategies, is that the contracts executed at the time of the investor's initial investment provide for exit-strategy rights for the investor or other shareholders. In the initial investment agreement, all shareholders ordinarily agree that it is their common ambition to sell part or all of their investment, and thereby realize a capital gain. In order to achieve that, the investor, together with the other shareholders, may decide to join forces in any exit strategy.

It is also sometimes agreed that the investor (or the management in its capacity as shareholders) has the right to make the company complete an IPO if it has not occurred by a certain date. Although that kind of provision is quite common in many investment agreements, it is doubtful whether a Swiss court would allow specific performance of such a contractual obligation in the event of its breach.

The investment agreement also provides for other rights protecting the exit strategy, or at least easing the exit at the given time by providing, for example, for emption and pre-emption rights, drag-along and tag-along rights, call or put options, priority rights of the investor as regards voting rights, dividends and liquidation proceeds, as well as investor protection with respect to the dilution of its capital or voting rights. Such rights can be found in many ordinary shareholders' agreements and have proved to be valid and enforceable in numerous circumstances.

Regulatory changes

Listing rules for investment companies

The purpose of the listing rules of the SWX Swiss Exchange is to give issuers as free and equal access as possible to the Exchange, and to guarantee transparency for investors with regard to issuers and securities. The provisions for admission and trading of investment companies, which came into force on March 1 1998, are laid down separately to the listing rules governing the main market. Investment companies are capital-investment bodies, organized according to company law, whose purpose is to generate yields and/or capital gains, and that do not pursue active entrepreneurial activities in the original sense of the term.

In addition to the general listing conditions set out in the listing rules, an investment company must disclose, among other things, the following information in its listing particulars:

  • a detailed explanation of the guidelines of its investment policy, including details on a) investment objectives, b) investment targets, c) instruments and investment techniques, d) any restrictions on the investment policy, and e) principles and provisions concerning risk diversification;
  • accounting methods in the case of investments, which have only limited marketability or whose value is difficult to assess for other reasons;
  • the guidelines issued concerning risks; and
  • disclosure of any potential conflict of interests and/or links between members of the board of directors, the management and the auditors on the one hand, and promoters, significant shareholders, administrators and depository banks of the investment company on the other hand.

To maintain the listing, the investment company which holds a substantial number of investments with only limited marketability, or whose value is difficult to assess for other reasons, must also disclose whether a third-party valuation has taken place, and disclose the valuation method applied for each investment. The auditors' report must also contain an opinion on the plausibility of the valuation method applied. Investments must finally be subjected periodically, at least semi-annually, to an assessment regarding their value sustainability.

These rules efficiently improved the disclosure standards previously in effect, and have lead to an increased interest in investment companies and a more liquid market for that type of investment on the SWX Swiss Exchange.

Listing rules on the SWX New Market

SWX Swiss Exchange created the SWX New Market in the summer of 1999 to make it easier for fast-growing companies to raise capital on the Swiss equity market, and to give investors the opportunity to benefit from their above-average growth potential. The SWX New Market also offers venture capitalists a means by which to sell their holdings to free-up capital for further investments. Typical candidates are found in the areas of life science, information technology and micro-technology. Up to now, 16 companies have been listed on the SWX New Market.

The additional rules and regulations governing the SWX New Market have been drawn up in accordance with internationally recognized standards (e.g., Neuer Markt, Nouveau Marché). While market access has been made easier by introducing lower capital requirements and a shorter operating track record, requirements on transparency have been toughened.

The main provisions of the separate rules for the listing on the SWX New Market are as follows:

  • the minimum equity capital requirement is Sfr2.5 million ($1.4 million) and Sfr25 million on the main segment;
  • the free float of the shares should represent at least 20% of the company's outstanding shares (25% on the main segment);
  • the total market value of the public offering must amount to at least Sfr8 million ($4.5 million); and
  • the listing prospectus (which may be in English) must contain at least one year's financial accounting (three years on the main segment).

These relaxed listing requirements are counterbalanced by stricter requirements for transparency as follows:

  • the published accounts must comply with IAS or US GAAP;
  • the companies must publish quarterly financial results; and
  • the issuer needs a member of the SWX Swiss Exchange as a sponsor, who undertakes to maintain a market for a certain period of time in the newly listed securities, and to make every effort to provide regular, at least semi-annual investment research studies of the issuer during the first two years of its listing.

The SWX New Market serves as a platform for financing growth, and is not only intended to be an exit opportunity. A public listing in this segment requires that a capital increase takes place at the time of the initial listing. The shares offered to the public, must be at least 50% of the capital increase (primary shares).

The Fantastic Corporation – A case study

The Fantastic Corporation is one of the more successful start-up companies which has emerged in recent years in Switzerland. Fantastic, which provides end-to-end software solutions for data broadcasting, was incorporated in November 1996. The company was at that time financially backed by its founders, managers and ETF Group, a venture capital investment company specializing in high-tech start-up companies.

About six months after its formation, Fantastic managed to raise additional share capital from a number of strategic investors and private venture capitalists. The new investors, together with the original shareholders, entered into a shareholders' agreement, which effectively allowed them to control the company until its initial public offering (IPO) in September 1999 at the Neuer Markt of the Frankfurt Stock Exchange. The shareholders' agreement provided for the minority rights typically found in such arrangements.

At the same time, Fantastic set up an employee share purchase programme, and an employee share option plan in order to incentivize not just management and key employees, but all employees. Ten percent of the company's issued share capital was set aside for the stock option programme.

Approximately 10 months after its first capital increase, Fantastic did a follow-on capital increase at roughly five times the valuation of its first capital round. Again, primarily private venture capitalists and strategic investors took up the investment offer. The money raised in this capital round allowed Fantastic to grow and expand its business aggressively, and to prepare the IPO. In July 1999, just three months before the scheduled IPO, Fantastic did a final capital round, raising an additional $30 million in order to protect itself against any unfavorable securities market conditions, which might lead to a delay of the IPO.

In structuring the IPO, Fantastic faced a problem common for Swiss start-ups: under Swiss corporate law, the nominal value of shares may not be lower than Sfr10 ($5.50). Given the valuation increase of Fantastic since its incorporation, the issue price of one share would have been equal to euro450 ($380), an offering price way above the price range at which shares on the Neuer Markt are customarily traded. To resolve the problem, Fantastic decided to implement a German depositary receipt programme by issuing bearer securities, each of which represented one-tenth of an ordinary registered share. Through this programme, Fantastic managed to offer its securities at euro45, an issue price in line with market practice. There is a bill before Swiss Parliament which would, if approved, lower the minimum nominal value of shares from Sfr10 to Sfr0.01.

By Matthias Oertle, partner of Lenz & Staehelin, Zurich




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