A common feature of U.S. venture capital deals is the provision of an opinion of counsel regarding certain key matters before investors will close a financing round. These opinions are part of an investor’s due diligence process and provide added assurance as to elements of the transaction.

What are legal opinions?

Legal opinions are addressed to the investors in a venture or growth financing round and summarize the legal conclusions of counsel (usually the company’s counsel) concerning the elements of a particular transaction.

Legal opinions confirm various legal matters, typically including topics such as that a transaction complies with applicable laws and that the rights and obligations of the parties involved are enforceable. Oftentimes, these opinions mirror warranties provided by the company to investors already.

If the company is giving many of these as warranties already, why do investors ask for opinions? 

As a starting point, a company may often not be legally sophisticated enough to understand the warranties. As such, they will seek advice from their counsel if they can give the warranties. The opinion serves as a means of confirming that the company has actually considered the warranties and disclosures it is giving since it requires a third-party law firm to validate the statements. 

The opinion also serves to leverage one of the most knowledgeable parties other than the company itself to help validate the key elements of the transaction. For example, while investor counsel can conduct a capitalization tie out as part of due diligence, it is often a new investor counsel each round. However, if company counsel remains consistent for each transaction, it can lever its existing knowledge and prior opinion work to bringdown the prior work performed rather than starting from scratch. This can bring significant cost savings to the parties and also lead to faster transactions.

Investors also view opinion practice as a valuable tool to reduce risk in evaluating the quality of the assets in which they invest.. As discussed in our preceding article regarding warranties, many investors care less about the legal recourse that warranties and disclosure provide since the target of a claim is often their own invested capital. Rather, many investors seek to perform sufficient diligence prior to investment to reduce the risk of value leakage on the front end. The legal opinion is a means of creating additional confidence in the warranties. 

Wait, does the lawyer provide Warranty & Indemnity (W&I) insurance?

Not quite, but the added rigor of the opinion is valuable protection for investors. Unlike the company or the founder, the law firm typically is a much greater repeat player in an ecosystem. If a law firm has a reputation for shoddy advice and opinions that are proven wrong, investors will not accept those law firms’ opinions.

That reputational risk motivates law firms to carefully review the content of their opinions and the underlying facts in ways that founders and companies do not. A founder’s focus is building a business, and they may be sufficiently risk tolerant to gamble on shoddy disclosure to investors. However, a law firm’s business is in part driven by providing that level of assurance, and they expect their business will be materially harmed with a reputation for failed opinions.

Additionally, beyond the concern for reputational harm, law firms and the lawyers that comprise them are bound by various rules of professional responsibility. As a result, they could be liable for malpractice or sanctions by their governing authority/bar. In many jurisdictions such as most U.S. states, law firms and lawyers are not permitted to limit their liability for malpractice contractually with a client.

OK, so the lawyer is paying more attention now. What is the opinion?

The opinion typically includes a description of the transaction, a list of reviewed documents and matters, assumptions and qualifications, limitations as to the laws of the relevant jurisdiction of interpretation and who may rely on the letter, and, of course, the actual opinions themselves. The legal opinions typically include the following in most U.S. venture deals:

• Due Incorporation and Good Standing: Is the company legally incorporated and in good standing?
• Corporate Power: Does the company possess the necessary corporate powers to enter into the transaction?
• Capitalization: What is the company’s capital structure, including what is authorized, issued, and outstanding?
• Valid Issuance: Are the shares issued in the transaction duly authorized and validly issued?
• All Necessary Corporate Action: Have all required corporate actions been taken to authorize the transaction?
• Enforceability: Are the transaction documents legally enforceable?
• No Conflicts with Laws or Material Agreements: Does the transaction violate applicable laws or significant agreements?
• No Government Consents: Are governmental or regulatory consents required to consummate the transaction?
• Securities Law Exemption: Do the securities issued in a transaction qualify for an exemption from U.S. securities registration requirements?
• No Litigation: Is there any pending litigation that could adversely affect the transaction?

How does the lawyer check all that stuff?

To be able to deliver an opinion, counsel must conduct a rigorous due diligence process and may require supporting documentation from the company. Counsel will also typically ask for a certificate from one of the company’s officers.

For example, one of the most complicated issues that often arise when drafting a legal opinion is a company’s capitalization. Many clients often believe that they will encounter no issues with their share capital. However, it is frequently uncovered in due diligence that significant problems do indeed exist.

At a practical level, identifying the need for a legal opinion should occur as early as possible in the transaction process, ideally at the term sheet stage, to ensure adequate preparation time.

That sounds like you are just trying to charge me more money for diligence the investor is doing anyhow?

The issuing company will end up spending more on diligence than they would if there was no opinion, but the opinion often brings costs down overall. First, it allows the company to negotiate for a lower investor fee reimbursement on the front end if they can promise an opinion. The investor knows they have less work to do and will rely on it. Second, the company counsel is a repeat player in each round typically, so they will largely roll forward from the prior opinion so the additional work is often less onerous than for an investor counsel that has no prior involvement with the company. Third, it reduces the risk of embarrassing disclosures and overblowing an issue. If an investor finds an issue without the company finding it, they tend to start flyspecking more and more, which results in more costs in the diligence process. The opinion process helps preempt the ugly disclosure but allowing company counsel to stay ahead of the issues.

So what is normal?

It depends on the jurisdiction in which the deal is taking place, and who are the parties. In UK-governed deals, legal opinions are generally not standard in venture capital financings. It is considered off-market to request or provide a legal opinion in such transactions. Instead, investors typically rely on their own due diligence efforts to assess the risks associated with a given transaction. This tends to be a function of the historical relationship with company counsel that is more stage specific. Early-stage counsels advise early-stage companies, late-stage counsels advise late-stage private companies and then Magic Circle firms historically advise public companies. 

The incremental benefit of obtaining a UK legal opinion in matters such as capitalization may be perceived as minimal (certainly when compared with the additional upfront cost) since there is little continuity of law firms resulting in a more transactional approach. However, the result of this is that it is quite rare for there to be no issues with UK venture-backed share capitalization upon exit. Those issues often drag out deal timelines, increase the risk profile on exits for the sellers and can, on occasion, go to value or even kill the deal.

By contrast, legal opinions are a common feature in U.S.-governed deals, especially in the context of venture financing transactions. In the U.S., the largest venture-stage law firms remain with their clients through their entire lifecycle, many times even taking them public. The opinion at a venture stage often serves as a means of better preparing the company for an exit event later. Thus, the value of the relationship is much greater and more efficient. Furthermore, U.S. investors largely expect opinions much more regularly as a matter of course. 

While there is no right or wrong answer on this, we would expect as the UK venture market moves closer in nature to the U.S. style of multiple venture rounds followed by a trade sale or IPO, opinion practice will become increasingly interesting to UK companies as a means of attracting better capital and preparing for exit.

For more information on transatlantic legal opinion practice in venture capital, please contact Wilson Sonsini attorneys Michael Labriola or Richard Goold.