Many foreign VCs and startup founders are concerned about the new CFIUS rules. In this blog post we explain what is CFIUS and how foreign VCs and founders can structure and mitigate CFIUS risks. CFIUS is also new to our law firm and we are not experts in this field but we have been educating ourselves and wanted to share with you what we know. Keep in mind the rules are very confusing and it took us some time to crack the maze, including how mitigate the legal risk. Although CFIUS introduces uncertainty to the venture capital business the rules are manageable for investors and founders. This introductory post is general in nature and there are items that we skip (real estate and detailed rules). If you feel you want more answers you can always write us.
What is CFIUS?
Good news CFIUS is not a new mutation of COVID-19. CFIUS stands for the Committee on Foreign Investment in the United States. It is an interagency committee that assists the President and has the authority to review, approve or block certain foreign investments including venture capital investments in US businesses to evaluate whether such investments could threaten to impair US national security. CFIUS could apply to EU startup with a US holdco structure, operations in Europe and limited sales office in the US. It could also apply to a YC company with EU structure that in its decks states that it will aim have 1 million users.
Under the CFIUS rules a startup and its investors have to do mandatory filings when certain triggers and may need to only notify CFIUS via short form filing (five-page declaration). Post notification, CFIUS may approve, suspend or prohibit any covered transaction when, in the President’s judgment, there is credible evidence to believe that the foreign person exercising control over a US business might take action that threatens to impair the national security. We hear from other professionals that most cases are approved by CFIUS. In most cases short form declarations are reviewed by CFIUS in 30 days (there is a general misconception that the process takes months, which is incorrect). Moreover, if a covered transaction was not previously submitted voluntarily to CFIUS by the parties and cleared through the CFIUS process, CFIUS can require a review of such transaction even after a deal closes and, if determined necessary to protect national security, order divesture, unwinding, or other mitigation measures with respect to the deal. We discuss filings at the end of our post.
Scope of Review
CFIUS is empowered to conduct national security reviews of “covered transactions”. A “covered transaction” is defined as a proposed or pending “transaction” with any “foreign person” which could result in “control” of a “US Business” by a foreign person.
· “Transaction” is broadly defined to include mergers, acquisitions, joint ventures, leases, and other investments.
· “Foreign person” can be a foreign national, foreign government, or foreign entity, including a partnership, corporation, trust, or other entity organized abroad. For example, a foreign person could be a US VC with 5 GPs including one foreigner as GP or a US VC with a foreign LP or foreign VC with a governmental entity as LP (CFIUS refers to this last case as “significant government interest”).
· “US business” is any entity engaged in interstate commerce in the United States. The definition here is wide. However, absent US business there is no CFIUS review.
· “Control” is defined broadly as the power — whether or not exercised — to directly or indirectly determine, direct, or decide important matters affecting the US business. Control means 10% or more voting stake, significant veto right and/or board/observer seat. Absent “control” there is no CFIUS jurisdiction.
· “TID Business” means critical technology, critical infrastructure or sensitive personal data. The scope of TID Business is complicated and the full list contained in several lists. If you need information on this we can point you in the right direction. For TID business, CFIUS may exercise jurisdiction eve if the investment does yield control. In the event that the technology is in the “TID business” batch you must show no other trigger rights such as:
· Board/observer seat
· Information access
· Involvement in decision making
The TID rules get more complicated if there is a government entity involved in the transaction.
Seed funding — Greenfield Exception?
In general, CFIUS should not be applicable to new business formation. However, it is not clear whether seed rounds fall under the green field exception. It would seem that an investment in a greenfield startup would require CFIUS approval. You should know that Patient Like Me venture financing was blocked by CFIUS because an affiliate of Tencent invested. Another venture deal that got blocked was the venture financing in Grinder and Pamplona because the respective shares were being acquired by a Russian and Chinese investor.
Two Stage Investment Approach
When CFIUS filing is required it is possible to structure two stage investment to facilitate a venture financing. Please note that CFIUS has 30 days for the short form notice approval, which can be built into the two-stage investment approach. Most venture capital investor are familiar with two stage investments. The Stock Purchase Agreement (SPA) in the venture financing should contain a provision that the investor is paying its investment in two tranches. The first tranche can be for a percentage of ownership that is below 10% of the fully diluted capitalization. The rational for this would be to mitigate the control issue pursuant to CFIUS. The investor in the first tranche could either prepay an equity threshold below 10% (control) or pay the full investment amount, but would have a risk that the deal might not be approved by CFIUS. The second tranche would be payable by the investor when CFIUS approval is granted, which would work as a secondary closing. The second closing is also important because to further mitigate risk the startup and the investor can agree that control provisions like board seat/observer rights, information rights and veto rights can become fully operational (triggered) only if the deal is approved by CFIUS. Indemnity
VC Financing Contractual Terms
In addition to two stage investment structure it is advisable to add specific language into the Investor Rights Agreement (IRA) dealing with CFIUS issues. For example, to make a deal more CFIUS compliant you can add an information carveout for investors, which would exclude non-material technical information access for technologies that would fall under TID to investors. Moreover, the IRA should contain a company and investor covenant in which the both parties promise to cooperate in good faith connection to a prospective CFIUS review. Finally, in order to prevent trigger rights, it might be possible to remove observer rights and board level veto rights for preferred directors from the IRA to prevent CFIUS scrutiny.
SAFEs or Convertible Notes
Generally, CFIUS does not have jurisdiction over lending transactions between foreign investors and US businesses. However, CFIUS jurisdiction might be triggered by a lending transaction where a foreign investor acquires a “contingent equity interest” in a US business. A “contingent equity interest” is defined as a ‘financial instrument that currently does not constitute an equity interest but is convertible into, or provides the right to acquire, an equity interest upon the occurrence of a contingency or defined event.’ Thus, contingent equity interest would consist of convertible debt instruments, such as a SAFEs or convertible notes, that confer equity to investors upon conversion.
A convertible debt instrument held by a foreign investor will fall under CFIUS jurisdiction if it is imminent that upon conversion of such debt instrument: (i) the foreign investor would acquire control of the US business as contemplated by the “covered transaction”; or (ii) acquire qualifying non-controlling interest in a TID business, which is critical business as stated above.
A convertible debt instrument can trigger such CFIUS jurisdiction either (i) at the time of acquisition of the instrument, or (ii) upon conversion, depending on the terms of such instrument.
The CFIUS will consider the following factors in determining when a particular debt instrument would trigger CFIUS jurisdiction:
· The imminence of conversion;
· Whether conversion depends on factors within the control of the foreign investor; and
· Whether the amount of interest and the rights that would be acquired upon conversion can be reasonably determined at the time of acquisition.
If the terms of the instrument are such that it is sufficiently imminent or within the control of the lending foreign investor that the debt instrument will convert into equity interest then the determination of CFIUS jurisdiction will be triggered upon acquisition of the debt instrument, as opposed to upon conversion.
Exceptions for Qualifying Investors
CFIUS’s application of its expanded jurisdiction over non-controlling investments do not apply to certain categories of foreign persons termed as “excepted foreign investors”. These “excepted foreign investors” eligible for exclusion from the coverage of CFIUS’s expanded jurisdiction include foreign investors who are: (i) foreign national of one or more “excepted foreign states”; (ii) a foreign government of an excepted foreign state; or (iii) a foreign entity that meets certain conditions regarding its ties to non-excepted foreign states.
Currently, “excepted foreign states” only include Australia, Canada, and the United Kingdom of Great Britain and Northern Ireland.
A foreign entity with the following kinds of ties to non-excepted foreign states would still qualify as an “excepted foreign investor”:
(i) even if up to 25 percent of its board members are not nationals of an excepted foreign state;
(ii) even if one or more foreign persons holding 10 percent or less of its ownership interest is not from an excepted foreign state; or
(iii) even if its minimum excepted ownership is 80 percent, meaning the majority of its ownership interests are held by excepted foreign persons or non-foreign persons and rest is held by persons belonging to non-excepted foreign states.
Most filings with CFIUS are voluntary, but certain foreign investment transactions involving critical technology or foreign government ownership require mandatory filings describing the transaction, the parties involved, and any additional background about each parties’ respective business activities. The mandatory filings are required for the following transactions:
(i) Transactions covered by Foreign Investment Risk Review Modernization Act of 2018 (“FIRRMA”) pilot program. These transactions include foreign investments in US businesses engaged in the following critical technologies:
· Defense articles and defense services subject to the International Traffic in Arms Regulations.
· Certain civilian/military dual-use technologies subject to Export Administration Regulations.
· Nuclear technologies covered by rules relating to foreign atomic energy activities and export and
· import of nuclear equipment and materials
· Select agents and toxins
· Emerging and foundational technologies controlled pursuant the Export Control Reform Act of 2018
(ii) Transactions involving investments where a foreign government has a “substantial interest,” which is determined based on a certain voting interest threshold (foreign government’s voting interest in the foreign investor is 49 percent or more, and the voting interest that the foreign person is acquiring in a Critical Business is 25 percent or more).
Failure to make a mandatory filing can result in a civil penalty ranging from $250,000 up to the value of the transaction.
Although all other CFIUS notice filings remain voluntary, CFIUS maintains the right to review any covered transactions on its own accord, even if the parties elect not to make a voluntary filing.
It is imperative for foreign investors to determine if their investment in US business would fall under the jurisdiction of CFIUS. Making a voluntary filing of any investment that is covered by CFIUS jurisdiction will protect the foreign investors from facing a potential suspension or reversal of the deal in the later stages of the transaction and prevent any penalties in case of mandatory filings.