Strictly Business http://www.strictlybusinesslawblog.com A Business Law Blog for Entrepreneurs, Startups, Venture Capital, and the Investment Management Industry. Tue, 18 Nov 2014 15:40:13 +0000 en-US hourly 1 http://wordpress.org/?v=4.0.1 Venture Capital Term Sheet Negotiation — Part 16: Closing Conditions and Expenses http://www.strictlybusinesslawblog.com/2014/11/17/venture-capital-term-sheet-negotiation-part-16-closing-conditions-expenses/ http://www.strictlybusinesslawblog.com/2014/11/17/venture-capital-term-sheet-negotiation-part-16-closing-conditions-expenses/#respond Mon, 17 Nov 2014 18:11:05 +0000 http://www.strictlybusinesslawblog.com/?p=1761 This post is the sixteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior fifteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per share, dividends on preferred stock, liquidation preferences, the conversion rights and features […]

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This post is the sixteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior fifteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per sharedividends on preferred stockliquidation preferencesthe conversion rights and features of preferred stockvoting rights and investor protection provisionsanti-dilution provisionsanti-dilution carve-outs and “pay to play” provisionsredemption rightsregistration rights,  management and information rightspreemptive rightsdrag-along rights, representations and warranties, and rights of first refusal and co-sale. In this post, we will discuss closing conditions and expenses.

Closing Conditions

Conditions to closing in an agreement are events that must take place or tasks that must be completed before the transaction the agreement provides for can be consummated. A stock purchase agreement sets forth an agreement for one party to purchase stock from the other, but the purchase may not actually happen on the date the parties sign the agreement. It might happen on a future “closing” date, after specified conditions are satisfied. This is appropriate, for example, when the transaction requires governmental approvals that take some time to obtain. The NVCA model term sheet (here) provides that the stock purchase agreement among the company, the founders, and the venture capital investor will contain “standard” closing conditions, including satisfactory completion of due diligence, qualification of the preferred stock under state “blue sky” securities laws, filing of an amended certificate of incorporation for the company establishing the new preferred stock to be issued, and an opinion of the company’s counsel. All of these conditions must be satisfied before the venture capital investor is actually obligated to purchase the company’s preferred stock (unless the parties waive any of them). Following is a brief discussion of each of these conditions.

Due Diligence

The venture capital investor will perform an investigation of the company’s financial and legal affairs and history, known as a “due diligence” investigation. Naturally, if the investor discovers anything during this investigation that causes it to rethink its decision to invest in the company, it will want an “out” to avoid having to complete its purchase. Thus, the stock purchase agreement conditions the investor’s obligation to close on the “satisfactory completion” of the due diligence investigation. Founders will want to respond quickly and thoroughly to the investor’s due diligence requests in order to avoid unpleasant surprises late into this expensive and painstaking process that could prevent a closing.

Blue Sky Qualification

State securities laws that govern the offer and sale of securities are known as “blue sky” laws. With some variation, each state requires that offers and sales of securities in that state must be registered or qualified, and the persons conducting the offering or sale of securities must be registered as brokers or dealers (or similar), unless an exemption is available. Counsel to the company will determine which states are involved in the transaction and, therefore, which states’ blue sky laws apply. Most states have exemptions from the lengthy and expensive registration and review process for limited offerings of securities to certain types of purchasers, which often cover venture capital transactions. In the event qualification is required, however, it must be complete and the relevant state agency’s approval obtained before the investor is obligated to close the stock purchase.

Amended Certificate of Incorporation

The characteristics of all classes of a corporation’s stock must be set forth in its certificate of incorporation (which in some states might be called a charter or articles of incorporation). Since the venture capital investment involves the creation of a new class of preferred stock, an amendment to the company’s certificate of incorporation establishing the rights and preferences of that class must be filed before the investor is obligated to purchase any shares of that stock.

Opinion

It is common in venture capital transactions for the company’s counsel to deliver an opinion letter to the investor covering such legal matters as the company’s valid formation, power to conduct business, and valid issuance of stock. The investor relies on the legal conclusions in the opinion in entering into the investment. The company’s lawyers will need to review the company’s corporate documents and minute books and get various certifications from the company’s officers and directors in order to prepare this opinion. Founders sometimes find out at this stage, to their chagrin, that they have not properly observed corporate formalities in past, and need to go back and ratify their past actions. Counsel to the investor and company’s counsel may go back and forth to some extent about the content of the opinion, but opinion letters have become fairly standardized. The inclusion of an opinion letter as a closing condition adds to the expense of the transaction for the company.

Other Conditions

Some other typical conditions to each party’s obligations to close include the following:

  • The other party’s representations and warranties (see this post for a discussion of representations and warranties in a venture capital transaction) are true and correct as of the closing and the other party has performed all of its pre-closing obligations.
  • As of the closing, the board of directions is a certain size and comprises certain members.
  • The other party has executed and delivered various related agreements and documents.
  • A minimum number of shares has been sold at the initial closing (when there is more than one closing).

The conditions to closing in a venture capital transaction are largely standard and in many cases amount to no more than a checklist to guide the lawyers in exchanging signed documents at the closing. Be on the lookout, however, for anything atypical, especially when the approval or consent of third parties is required, as that can be time-consuming or even prevent a closing from taking place.

Expenses

A venture capital term sheet typically sets forth who will draft the stock purchase agreement and other transaction documents — counsel to the venture capital investor or counsel to the company. The term sheet also states who will pay the expenses of the deal. It is usual for the company to pay the legal and administrative costs of the transaction, including the fees of the investor’s attorneys. (Given that, it is generally less expensive for the company to designate its own counsel to prepare the transaction documents, as it will have more control over the time spent by its own counsel.) Founders may wish to try to limit the investor’s legal fees to a specified cap. Expenses are often paid at the closing of the transaction from the proceeds of the investment. The expenses section is often listed as one of the binding sections of the term sheet, which in practicality means that if the deal doesn’t close, the company would still have to pay for the investor’s legal fees. If that is the case, founders should at least ask for a clause that provides that the company is not required to pay expenses if the deal doesn’t get done because the investor withdraws its commitment without cause.

In the next post, we’ll discuss board matters.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 15: Rights of First Refusal and Co-Sale http://www.strictlybusinesslawblog.com/2014/11/09/venture-capital-term-sheet-negotiation-part-14-rights-first-refusal-co-sale/ http://www.strictlybusinesslawblog.com/2014/11/09/venture-capital-term-sheet-negotiation-part-14-rights-first-refusal-co-sale/#comments Sun, 09 Nov 2014 23:05:56 +0000 http://www.strictlybusinesslawblog.com/?p=1759 This post is the fifteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior fourteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per share, dividends on preferred stock, liquidation preferences, the conversion rights […]

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This post is the fifteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior fourteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per sharedividends on preferred stockliquidation preferencesthe conversion rights and features of preferred stockvoting rights and investor protection provisionsanti-dilution provisionsanti-dilution carve-outs and “pay to play” provisionsredemption rightsregistration rights,  management and information rightspreemptive rights, drag-along rights, and representations and warranties. In this post, we will discuss rights of first refusal and co-sale.

Rights of First Refusal

The NVCA model term sheet contains a right of first refusal in favor of the company and the venture capital investor. If the founders ever want to sell any of their shares to a third-party, the right of first refusal requires them to give the company the first opportunity to purchase the shares on the terms offered by the third-party. If the company doesn’t exercise its right of first refusal, the venture capital investor then has the opportunity to purchase the shares on the same terms. If both the company and venture capital investor forego their rights of first refusal, then the founders may proceed to sell their shares to the third-party. A right of first refusal is designed to control which parties may own a significant number of shares in the company and give the venture capital investors the first opportunity to purchase shares if they desire to do so. While the right of first refusal appears not to limit the founders’ ability to transfer their shares, it can have that impact (third parties may not spend the time to negotiate a deal with founders if they believe the company or venture capital investor can step in and take their offer via the right of first refusal).

If there is more than one venture capital investor, if the investors exercise their right of first refusal, each investor may participate in the purchase pro rata based on the number of shares held by each. If any investor declines to participate in the purchase, the others have a “right of oversubscription” to purchase the shares that the non-purchasing investor was entitled to purchase, again pro rata based on the number of shares held by each purchasing investor.

A right of first refusal applies to all “transfers” of shares, which encompass a variety of dispositions in addition to outright sales. Definitions of “transfer” typically include offers to sell, assignments, pledges (for example, to secure a debt), mortgages, grants of options, and encumbrances, of the shares themselves or any interest in the shares. The definition can include involuntary transfers, such as those that happen upon death or divorce. The NVCA model term sheet points out that the parties will negotiate exceptions, for example for estate planning purposes or in the case of transfers of very small amounts. If the consideration to be paid by the third-party is property or services or other non-cash consideration, the board of directors of the company may have the right to determine the fair market value of the consideration and those exercising the rights of first refusal can pay the cash equivalent of such value.

Rights of Co-Sale

The NVCA model term sheet also contains a right of co-sale (also called a “take-me-along” provision or a “tag-along” provision) for the venture capital investor. If the founders wish to sell their shares and the shares are not purchased pursuant to the rights of first refusal (discussed above), they must give the venture capital investor the opportunity to participate in the sale pro rata based on the number of shares held by the selling founders and by the participating investors. This gives the investor the opportunity to a partial exit from the company along with the founders if the latter are presented with the right opportunity. If the transaction with the third-party constitutes a “Change of Control” (e.g. shares representing more than 50% of the voting power), the co-sale provisions may require that the aggregate proceeds be divided among the selling stockholders in accordance with the Certificate of Incorporation as if the transaction were a “deemed liquidation event”; this gives the investors their liquidation preference upon a sale to a third-party. See discussion of liquidation preferences here.

Negotiation Tips

While rights of first refusal and co-sale rights are common in venture capital deals, founders should pay attention to these provisions and make sure they are customary and not overreaching. For example, founders can (and should) negotiate a provision that provides those exercising the rights of first refusal must purchase all (and not less than all) of the stock subject to the rights or they forfeit their right to do so. This prevents investors from disturbing the deal with the third-party and not purchasing all of the subject stock. Also, founders should make sure the rights of first refusal do not apply to their preferred stock (if any) or any common stock issued upon conversion of preferred stock. The theory is that the founders have purchased this stock and so the rights of first refusal should not apply.

In the next post, we’ll discuss closing conditions and expenses.


© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 14: Representations and Warranties http://www.strictlybusinesslawblog.com/2014/10/30/venture-capital-term-sheet-negotiation-part-14-representations-warranties/ http://www.strictlybusinesslawblog.com/2014/10/30/venture-capital-term-sheet-negotiation-part-14-representations-warranties/#comments Thu, 30 Oct 2014 21:12:28 +0000 http://www.strictlybusinesslawblog.com/?p=1756 This post is the fourteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior thirteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per share, dividends on preferred stock, liquidation preferences, the conversion […]

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This post is the fourteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior thirteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per share, dividends on preferred stock, liquidation preferences, the conversion rights and features of preferred stock, voting rights and investor protection provisionsanti-dilution provisionsanti-dilution carve-outs and “pay to play” provisions, redemption rights, registration rights,  management and information rightspreemptive rights, and drag-along rights. In this post, we will discuss founder representations and warranties.

One of the items that the stock purchase agreement in a venture capital deal will include is the representations and warranties the company (and perhaps the founders) will make to the venture capital investor. Representations and warranties are the statements that a party to an agreement makes to the other party and upon which the other party is entitled to rely in entering into the transaction. They encompass both assertions about factual matters and promises that the facts truly are as stated, as of a certain date. The NVCA model term sheet (available here) provides that the company will make “standard” representations and warranties, and, as an option, that the founders will make representations and warranties regarding technology ownership, etc.

Since the details of the representations and warranties are usually negotiated after the term sheet has been signed, I won’t go into detail here. That said, the “standard” representations and warranties in a venture capital deal are lengthy and quite involved and you will need counsel to assist you in negotiating them. The founders should not disregard them as mere boilerplate or legalese, even though they are extremely complex and opaque. They also should not assume that their obligation to disclose all of these matters is fulfilled simply by making all of the company’s files available to the venture capital investor. The founders should carefully read and digest each of the statements and promises the company is making and prepare thorough lists or descriptions of any exceptions, keeping in mind that if any of the statements the company is making is untrue, or any of the promises the company is making is breached, then the venture capital investor may be entitled to damages. The founders may feel that the company cannot make certain blanket statements with a high degree of confidence – for example, the founders may not be 100% sure that the company’s intellectual property does not violate the intellectual property rights of any third-party anywhere in the world. From the venture capital investor’s point of view, however, the company should be the one to give assurance on that point in the agreement and bear the risk of liability in case it should prove untrue.

One issue that does arise during the term sheet stage is whether the founders will also be giving representations and warranties personally. Founders’ representations and warranties are not included in every venture capital purchase agreement. They are more likely to be included if the founders are to receive liquidity, if there are intellectual property concerns, or in international transactions. They are more likely to be included in an initial venture capital round, in which the founders bear greater risk, than in any later rounds.  Founders should avoid making significant representations and warranties, if possible. If the founders cannot avoid making representations and warranties, the founders should request that the representations and warranties be made severally and not jointly, which means that each founder is responsible only for his proportionate share of the liability. Founders can also negotiate to have their liability for breaches limited to the then-current fair market value of the shares of company common stock currently owned by that founder and have that liability terminates on the earlier of the first or second anniversary of the agreement or an IPO.

The following is a list of typical founders’ representations and warranties:

  • Conflicting agreements — statement that the founder is not in violation of any fiduciary or confidential relationship, any agreement, or any judgment, decree, or order, and none of these conflict with the founder’s obligations to promote the company’s interests or with the venture capital agreement.
  • Litigation — statement that there is no pending or threatened litigation or investigation against the founder or any basis for any litigation.
  • Stockholder agreements — statement that there are no agreements relating to the acquisition, disposition, registration, or voting of the company’s securities.
  • Prior legal matters — statement that the founder has not been subject to petition under bankruptcy laws or the appointment of a receiver or similar, convicted in or subject to a criminal proceeding, subject to any court order, judgment, or decree limiting the founder’s engagement in business or acting as an officer or director of a public company, or found by a civil court, the SEC, or the CFTC to have violated any securities, commodities, or unfair trade practices law.
  • Company representations and warranties — statement that the company’s representations and warranties are true and complete.

If the founders agree to make representations and warranties, they should be aware that they are assuming personal liability risk. The last representation in the list above is the most difficult one for founders to make, because they are essentially guaranteeing all of the company’s representations and warranties; if any are untrue or are breached, the founders’ personal assets are on the line. The venture capital investor, however, may insist that the founders stand behind the company’s representations and warranties to ensure that such representations and warranties are correct and so that it has recourse other than against the company it has invested in. The discomfort founders may feel about risking everything they own can be ameliorated by limiting their liability, as described above, to a certain amount and within a certain time frame. Given the high stakes that are involved in negotiating these issues, founders should not ignore them.

In the next post, we’ll discuss rights of first refusal and rights of co-sale.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

The post Venture Capital Term Sheet Negotiation — Part 14: Representations and Warranties appeared first on Strictly Business.

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Venture Capital Term Sheet Negotiation — Part 13: Drag-Along Rights http://www.strictlybusinesslawblog.com/2014/08/19/venture-capital-term-sheet-negotiation-part-13-drag-along-rights/ http://www.strictlybusinesslawblog.com/2014/08/19/venture-capital-term-sheet-negotiation-part-13-drag-along-rights/#comments Tue, 19 Aug 2014 22:55:27 +0000 http://www.strictlybusinesslawblog.com/?p=1746 This post is the thirteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior twelve posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, […]

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This post is the thirteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior twelve posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, described redemption rights, examined registration rights,  looked at management and information rights, and explained preemptive rights. In this post, we will discuss drag-along rights.

A “drag-along” provision requires the founders and certain other stockholders to enter into an agreement with the venture capital investor that will allow the investor (perhaps acting with certain other stockholders) to force a sale of the company if certain conditions are satisfied. This is a very key provision for consideration by founders and should be carefully reviewed.

There are several important concepts founders should understand with respect to the “drag-along” provision, including the following:

  • which stockholders can elect to trigger the drag-along provision;
  • must the board of directors also approve the transaction;
  • the types of transactions that will trigger the drag-along rights;
  • any limitations on the applicability of the drag-along provision;
  • the potential liability of stockholders in a drag-along sale; and
  • how the sale proceeds will be distributed.

A brief summary of each of these concepts follows:

Electing Holders

The NVCA model term sheet contemplates that the term “Electing Holders” (i.e., the stockholders who can trigger the drag-along right) is defined as holders of a certain percentage of the outstanding shares of preferred stock on an as-converted basis. Venture capital investors may commonly try to include 51% as the applicable percentage. For founders, this means that stockholders owning 51% or more of the preferred shares on an as-converted basis can force them to sell, even on terms that could be very unfavorable for the founders (as happened in the In Re Trados Incorporated Shareholder Litigation case discussed below).

Founders should carefully consider the definition of Electing Holders and may want to seek to require a higher percentage for approval (e.g., 66 2/3% of the preferred).  In addition, founders may want to attempt to require some percentage of the common stock to approve the transaction as well (e.g., 66 2/3% of the preferred and more than 50% of the common). (Preferred stockholders may be able to convert some of their stock to common in order to make sure the required common vote is achieved, although they will usually lose some or all of their liquidation preference in doing so, which benefits the common.)

Board Approval

Drag-along provisions could include the requirement of board approval of a sale. However, as illustrated in the 2013 Delaware Chancery Court decision, In Re Trados Incorporated Shareholder Litigation, board approval of a sale can expose the venture investor-appointed directors to liability.  In that case, a merger was approved for a price that was, in effect, below the preferred liquidation preference; i.e., the common stockholders received $0. The common stockholder plaintiffs claimed that the board breached its fiduciary duties to the company and the common stockholders by approving the merger. Eight years after the merger, the court ruled that the directors did not breach their duties because they were able to prove that the merger transaction was “entirely fair.” Although this case exonerated the directors, it highlights the issue that is raised when the board has to approve a transaction such as a “drag along” sale.

Founders should push for board approval in the drag-along provision. Venture capital investors may resist the board approval requirement due to potential liability concerns, but they can incorporate mechanisms to protect their directors from claims of breach of duty.

Types of Transactions Subject to the Drag-Along Provision

In the NVCA model term sheet, the drag-along provision comes into play when the Electing Holders (and the board, if applicable) have approved one of the following types of transactions:

  • a merger or consolidation (other than one in which the company’s stockholders own a majority of the survivor or acquiror);
  • a sale, lease, transfer, exclusive license, or other disposition of all or substantially all of the company’s assets; and
  • a transaction in which 50% or more of the company’s voting power is transferred.

This list of transactions is fairly standard and would not typically be heavily negotiated.

Price Limitation

A price limitation is one of the more important aspects for founders to consider.  As discussed above under “Board Approval,” a sale at a price below the preferred liquidation preference results in the common stockholders walking away with nothing. To avoid that result, founders might try to push for a minimum purchase price before the drag-along provision is triggered. For example, the minimum purchase price could be twice the total preferred liquidation preference. Venture capital investors might be reluctant to agree to this, however, since a transaction in which they exit the company at a price that doesn’t leave much or anything for the common is exactly the type of situation in which they would need drag-along rights.  Nevertheless, founders should carefully consider a minimum price requirement and seek to protect themselves from being “dragged” into a sale transaction that is very unfavorable.

Potential Stockholder Liability

When stock is sold, the sellers usually must give certain representations and warranties to the purchaser and the seller has liability for breaches of those representations and warranties. That liability can either be joint or several. Under joint liability, each of the stockholders would be liable for the entire amount of any liability to the purchaser. Under several liability, each stockholder is only liable for its pro rata share of any liability. Drag-along provisions are often structured so that the shareholders being “dragged-along” are only required to subject themselves to several, rather than joint, liability. This is obviously more favorable and founders should insist on including it. In addition, founders should push for capping their liability at the amount of consideration they received.

How Proceeds Are Distributed

The NVCA model term sheet conditions the drag-along rights on the allocation of sale consideration as if it were liquidation proceeds to be distributed under the company’s certificate of incorporation. The certificate of incorporation, which is amended in a venture capital transaction to reflect the rights and preferences of the new preferred stock, will describe how the proceeds from a liquidation of the company must be allocated to the common and preferred stockholders. For further discussion, see our previous post on liquidation preferences.  This provision is also fairly standard and not generally heavily negotiated.

Conclusion

Founders should be aware that drag-along rights are increasingly common and very important to consider.  Founders should pay very close attention to the drag along provision and should be prepared to negotiate the some of the key terms discussed above, particularly those concerning who can trigger the “drag along” provision and any minimum price requirement.

In the next post, we’ll discuss representations and warranties.


© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 12: Preemptive Rights http://www.strictlybusinesslawblog.com/2014/07/07/venture-capital-term-sheet-negotiation-part-12-preemptive-rights/ http://www.strictlybusinesslawblog.com/2014/07/07/venture-capital-term-sheet-negotiation-part-12-preemptive-rights/#comments Mon, 07 Jul 2014 20:50:49 +0000 http://www.strictlybusinesslawblog.com/?p=1742 This post is the twelfth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior eleven posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation […]

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This post is the twelfth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior eleven posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, described redemption rights, examined registration rights,  and looked at management and information rights. In this post, we will discuss preemptive rights.

The word “preemptive” in “preemptive rights” refers to the purchase of a company’s new shares before they are offered to anyone else. The National Venture Capital Association (NVCA) term sheet (here) includes a sample preemptive rights provision, titled “Right to Participate Pro Rata in Future Rounds.” This provision entitles investors to participate in later securities issuances on a pro rata basis (assuming conversion of all preferred stock). The right can be limited to investors who hold a certain large amount of preferred stock. The right does not apply in the case of issuances that are excluded from issuances that trigger the anti-dilution adjustment, such as stock issued upon the conversion of preferred stock or stock issued as part of an equity compensation plan (see post on anti-dilution provision carveouts). If an investor chooses not to purchase its entire pro rata share, the other investors can purchase the remaining shares pro rata. This provision enables investors to maintain their original percentage ownership and avoid dilution if they choose to do so. (Contrast this with anti-dilution provisions, discussed here, which enable investors to avoid dilution of the value of their investment, as opposed to their percentage ownership.) Maintaining percentage ownership can be key to an investor keeping certain voting rights, board appointment rights, or the information rights discussed here, if those rights are conditioned on a certain percentage ownership.

Preemptive rights provisions might incorporate a “pay to play” feature, like the ones anti-dilution provisions sometimes have (discussed here). If an investor does not participate in a subsequent financing round, exercising its preemptive rights, certain penalties may apply, such as the conversion of its preferred stock into common stock at the pre-issuance conversion price. As with anti-dilution provisions, a “pay to play” feature gives investors an incentive to participate in future rounds.

Founders should be aware that preemptive rights provisions are standard and venture capital investors will expect to see them in the term sheet. They are not worth spending a lot of time negotiating. Founders should simply be careful that the investors don’t attempt to make these provisions too onerous, for example by adding terms that are broader than the ones in the NVCA term sheet, such as terms giving an investor the right to purchase any and all shares the company issues in the future, rather than just its pro rata share, or terms that do not include the customary carveouts referenced above.

In the next post, we’ll discuss drag-along rights.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Is it time for the JOBS Act, Part Two? http://www.strictlybusinesslawblog.com/2014/06/30/time-jobs-act-part-two/ http://www.strictlybusinesslawblog.com/2014/06/30/time-jobs-act-part-two/#comments Mon, 30 Jun 2014 22:26:15 +0000 http://www.strictlybusinesslawblog.com/?p=1738 When the JOBS Act was passed, a lot of people hoped that it would de-regulate startup finance, resulting in a boom of new startups being funded.  Through repealing the ban on general solicitation, allowing online angel investment platforms, creating the new “Regulation A+,” and allowing equity crowdfunding, the JOBS Act was supposed to make funding […]

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When the JOBS Act was passed, a lot of people hoped that it would de-regulate startup finance, resulting in a boom of new startups being funded.  Through repealing the ban on general solicitation, allowing online angel investment platforms, creating the new “Regulation A+,” and allowing equity crowdfunding, the JOBS Act was supposed to make funding startups considerably easier.  But there have been some significant bumps in the road.  First, in my view, the equity crowdfunding exemption that was included in the bill was unworkable from the beginning. That continues to be true under the crowdfunding regulations proposed by the SEC and of course the SEC has yet to adopt final equity crowdfunding regulations (which means that equity crowdfunding is still largely prohibited for non-accredited investors). While the SEC finally did implement the lifting of the ban on general solicitation by creating the new Rule 506(c), it also has proposed new onerous rules governing its use (as well as the use of the existing Rule 506(b)). The SEC has proposed implementing regulations for Regulation A+, but has not adopted final regulations, which means that the exemption still cannot be used. In addition, the SEC is getting pushback from state securities regulators on the proposed Regulation A+ on the issue of preempting state registration requirements, which may result in the removal of preemption from the final regulations (which would make the exemption considerably less useful).  Furthermore, since Regulation A+ investors would be counted as shareholders for purposes of triggering reporting under the Securities Exchange Act of 1934 (the “Exchange Act”), as the proposed rules are currently written, any use of the exemption would also likely trigger expensive Exchange Act reporting requirements.

Because of all of these issues with the implementation of the JOBS Act, some members of Congress have decided to once again get involved.  Three pieces of proposed legislation, all intended to retool parts of the JOBS Act that have proved unworkable, have recently been introduced or are in the draft stage:

  • The Equity Crowdfunding Improvement Act of 2014;
  • The Startup Capital Modernization Act of 2014; and
  • A Bill to direct the Securities and Exchange Commission to revise its proposed amendments to Regulation D, Form D, and Rule 156.

Following is a summary of each of these bills.

The Equity Crowdfunding Improvement Act of 2014 (H.R. 4564)

The Equity Crowdfunding Improvement Act of 2014, introduced on May 6, 2014 (available here), was proposed in response to concerns that the JOBS Act makes crowdfunding difficult and costly for small businesses to implement. It would repeal Title III of the JOBS Act and replace it with new provisions amending the federal securities laws to allow crowdfunding. It would amend the Securities Act of 1933 (the “Securities Act”) by adding securities transactions with the following characteristics to the list of securities transactions exempted from federal securities registration requirements:

  • Issuer is a corporation
  • Total amount sold per year under exemption is up to $3 million, or $5 million if investors receive audited financial statements (caps to be adjusted for inflation annually)
  • Total amount sold to any non-accredited investor per year does not exceed the greater of—
    •  $5,000 (adjusted for inflation annually); or
    • 10% of the investor’s annual income or net worth
  • If funds are raised from non-accredited investors, an intermediary that complies with Section 4A(a) (discussed below) must be used
  • Issuer provides potential investors with financial statements that have been certified or reviewed in accordance with certain procedures

It would also amend the Securities Act by adding a new Section 4A that sets forth requirements for intermediaries in crowdfunding transactions, comprising the following:

  • Register with the SEC as a broker or an intermediary who does not (i) offer investment advice; (ii) explicitly solicit purchases, sales, or offers to buy particular securities on its website or portal; (iii) directly compensate anyone for direct sale of securities on its website or portal; or (iv) handle investor funds or securities
  • Warn investors of the speculative nature of investments in startups, emerging businesses, and small issuers
  • Warn investors that they are subject to restrictions on resale
  • Take reasonable measures to reduce the risk of fraud
  • Provide the SEC with its address, website, and names of the intermediary, its chief officer, and any employee responsible for compliance with securities laws
  • Provide the SEC with continuous investor-level access to its website
  • Require each potential investor to answer questions demonstrating an understanding of risks and other areas the SEC determines appropriate
  • Require the issuer to state a target offering amount and a deadline to reach it and ensure a third-party custodian withholds offering proceeds until 100% of the target is raised and the issuer has complied with all requirements
  • Perform a background check on the issuer’s officers, directors, and shareholders with 15% or more voting control to ensure they haven’t committed any of the “bad acts” that are excluded from Rule 506 offerings under the Dodd-Frank Act
  • Provide the SEC and potential investors with notice of the offering including certain information
  • Outsource cash functions to a qualified third-party custodian
  • Maintain certain books and records
  • Offer on its website a method for the issuer and investors to communicate
  • Provide the SEC with notice of completion of the offering
  • Do not offer investment advice

Other provisions that would apply to intermediaries include the following:

  • An intermediary may rely on a certification by an investor of its status as an accredited investor or its annual income, net worth, and the aggregate amount of securities sold to it within the previous year
  • Securities purchased in an exempt crowdfunding transaction may not be resold for one year unless to the issuer or an accredited investor
  • An issuer may only enter into an exempt crowdfunding transaction with an unaccredited investor through the use of an intermediary, and any resale of a security originally issued in reliance on the crowdfunding exemption may only be made with an unaccredited investor through the use of an intermediary
  • An intermediary in a transaction either made pursuant to the crowdfunding exemption or involving the resale of a security originally issued pursuant to a crowdfunding exemption is not required to register as a broker
  • An intermediary may select which transactions to be involved in, and this is not considered investment advice [1]
  • An intermediary may review a transaction and terminate it at any time if termination is appropriate in doing due diligence, it is able to return all funds, and the custodian has not transferred the offering proceeds to the issuer

The bill would require the SEC to issue rules for Section 4A within 120 days of enactment. The bill would also require the SEC to establish disqualification regulations prohibiting an issuer from using the crowdfunding exemption based on its history or that of its related persons, and disqualifying intermediaries, within 120 days of enactment.

The bill would provide for federal law to preempt state law by adding securities sold under a crowdfunding exemption to the statutory list of “covered securities.” However, it clarifies that this amendment relates only to registration, documentation, and offering requirements and does not limit state enforcement authority.

The crowdfunding exemption proposed in this bill is far simpler, and I believe, far superior to the one that was included in the original JOBS Act. By allowing portals to select which transactions they are involved in (i.e. curating) and also allowing for larger capital raises, the new proposed crowdfunding exemption addresses many of the issues that make the original JOBS Act crowdfunding exemption unworkable.

The Startup Capital Modernization Act of 2014 (H.R. 4565)

The Startup Capital Modernization Act, also introduced on May 6, 2014 (available here), is intended to reform and improve Regulation A securities offerings. It would increase the maximum amount of a single public offering under the original Regulation A exemption (now often referred to as a “Tier 1” offering) from $5 million to $10 million. The bill would provide for federal law to preempt state law by adding securities sold in a Tier 1 Regulation A exempt offering to the statutory list of “covered securities.” [2] However, it would clarify that this amendment relates only to registration, documentation, and offering requirements and preserves state enforcement authority.

The bill would direct the SEC to exempt securities acquired under Regulation A offerings from Section 12(g) of the Exchange Act, which requires registration of an issuer’s securities when a certain number of shareholders is reached, if the issuer has filed audited financial statements with the SEC and is in compliance with all required periodic disclosures. The bill would require the SEC to issue a rule to carry this out within 180 days of enactment.

The bill would also allow for a more streamlined process for the resale of restricted securities (e.g., securities sold in a Rule 506 offering) if the resale meets the following conditions:

  • Each purchaser is an accredited investor, as defined in Rule 501
  • If any securities are offered by means of any general solicitation or general advertising, the seller takes reasonable steps to verify that each purchaser is an accredited investor
  • The seller is not an issuer, its subsidiaries, or its parent; an underwriter acting on behalf of the issuer, its subsidiaries, or its parent that receives compensation from the issuer; or a dealer.

The bill would provide for federal law to preempt state law by adding securities sold under this exemption to the statutory list of “covered securities.”

As I’ve pointed out before, the fact that use of Regulation A or A+ would trigger Exchange Act reporting requirements is a major deterrent to the use of the exemption.  This bill addresses this problem. In addition, I have long thought that there should be a simpler way to resell restricted securities to accredited investors, as the existing Rule 144 requirements are quite cumbersome.

A Bill to direct the Securities and Exchange Commission to revise its proposed amendments to Regulation D, Form D, and Rule 156

Title II of the JOBS Act required the SEC to make rules allowing general solicitation and advertising for certain private securities offerings under Rule 506 of Regulation D. These rules were adopted in July 2013 (see discussion here). The SEC issued separate proposed amendments not required by the JOBS Act that would impose a number of new requirements in connection with Rule 506, including the submission of Form D to the SEC before and at the completion of an offering and the filing of written general solicitation materials. Under the proposed rules, an issuer could be disqualified from using Rule 506 for one year if it failed to comply with the additional Form D filing requirements. The SEC has received over 500 comment letters but has not adopted a final rule.

The bill, which is in the discussion draft phase and has not yet been introduced (the draft is available here), would require the SEC to revise its proposed amendments to Regulation D, Form D, and Rule 156 in the following ways:

  • The SEC may not adopt any requirement to file Form D before the sale of securities under Rule 506 of Regulation D or after the offering has ended
  • The SEC may not condition the availability of the Rule 506 exemption on the filing of Form D
  • The SEC may not condition the availability of the Rule 506 exemption on the steps taken to verify that purchasers are accredited investors, as required under section 201(a) of the JOBS Act and Rule 506(c)
  • The SEC may not extend Rule 156 requirements covering investment company sales literature to private funds
  • The SEC must revise Regulation D to permit issuers to sell securities to their employees (with this phrase in brackets in the draft: “[who are not otherwise accredited investors]”)
  • The SEC may not require issuers to submit written general solicitation materials any earlier than 60 days after the closing of the Rule 506 offering, and may not require more than one filing

I have opposed the SEC’s proposed rules on Form D filing requirements, which I believe have the potential to be very burdensome and destructive to emerging businesses. However, this bill also takes an additional step and changes Rule 506(c) so that a failure to take steps to verify that purchasers are accredited investors does not invalidate the exemption. I’m not sure that is necessary, as it seems to me to be an essential part of the bargain that if general solicitation is used, then the accredited investor verification provisions kick in.

In general, I think all three bills are a step in the right direction and address squarely some of the disappointments that have occurred in the implementation of the JOBS Act.

Footnotes

[1] This provision is badly needed. One of the worst features of the proposed SEC rules is that attempts to curate offerings on crowdfunding sites are considered prohibited “investment advice.”  This means that the SEC is literally mandating that crowdfunding portals not remove deals that they consider bad for their customers(!)

[2] Congress may also want to consider removing the language which limits Regulation A preemption solely to securities offered or sold on a national securities exchange or offered or sold to a qualified purchaser. While the SEC, in its proposed rule, has deemed all offers and purchasers of Regulation A+ securities to be qualified purchasers, the state regulators have objected to this.  By leaving this language in the JOBS Act, if Congress’ goal is to ensure that preemption of state registration requirements applies to Regulation A, it risks the SEC caving into state regulators’ pressure and thwarting that goal by creating a more narrow definition of “qualified purchaser.”


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 11: Management and Information Rights http://www.strictlybusinesslawblog.com/2014/06/29/venture-capital-term-sheet-negotiation-part-11-management-information-rights/ http://www.strictlybusinesslawblog.com/2014/06/29/venture-capital-term-sheet-negotiation-part-11-management-information-rights/#comments Sun, 29 Jun 2014 18:29:54 +0000 http://www.strictlybusinesslawblog.com/?p=1737 This post is the eleventh in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior ten posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, […]

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This post is the eleventh in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior ten posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, described redemption rights, and examined registration rights. In this post, we will discuss management rights and information rights.

Management Rights

For a sample management rights provision, see the National Venture Capital Association’s (NVCA) term sheet here. It provides that the Company will deliver a “Management Rights letter” to each investor who requests one. The NVCA also has a model management rights letter, which can be found here.

The reason venture capital funds request such a letter is to avoid becoming subject to the requirements of the Employee Retirement Income Security Act of 1974, or ERISA, and its regulations. Many institutional investors who invest in venture capital funds are pension plans, and pension plans that are subject to ERISA are required to follow certain ERISA plan asset rules. Under these rules, the plan’s assets must be held in trust and the plan’s managers have fiduciary duties and are prohibited by ERISA and the Internal Revenue Code from engaging in certain transactions. If the plan invests in a venture capital fund, then generally the fund’s assets are treated as the plan’s assets and the managing partner of the venture fund is treated as an ERISA fiduciary (and therefore subject to all of the applicable ERISA rules). A venture capital fund can avoid these rules only by qualifying for an exemption from the ERISA plan asset rules. One such exemption under Department of Labor regulations provides that if the fund is a “venture capital operating company,” it is deemed not to hold ERISA plan assets.

 Under the regulations, a venture capital fund is a “venture capital operating company” if at least 50% of its assets are invested in venture capital investments. These include investments in operating companies (other than venture capital operating companies) as to which the fund obtains “management rights.” In addition, to qualify for the exemption, the venture fund must actually exercise these management rights with respect to at least one operating company a year. “Management rights” are defined as “contractual rights directly between the investor and an operating company to substantially participate in, or substantially influence the conduct of, the management of the operating company.” A management rights letter, then, is intended to create these contractual rights so that the venture capital fund may legitimately avail itself of the exemption from plan asset rules described above.

In opinions, the DOL has stated that whether specific rights qualify as “management rights” is a question of fact that depends on the particular facts and circumstances. The DOL has implied that the right to appoint a director or have a representative serve as an officer would be sufficient, but not necessary, and other sets of rights may suffice. DOL guidance indicates that the following set of rights set forth in a written agreement constitutes “management rights,” as long as there is no limitation on the ability to exercise any of them, so they may be thought of as a safe harbor of sorts for the venture capital fund:

  • the right to receive quarterly financial statements;
  • the right to receive annual audited financial statements;
  • the right to receive any periodic reports required by securities laws;
  • the right to receive documents, reports, financial data, and other information as reasonably requested;
  • the right to visit and inspect the company’s properties, including books of account;
  • the right to discuss company’s affairs, finances, and accounts with the officers; and
  • the right to consult with and advise management on all matters relating to the company’s operation.

The management rights may not exist “only as a matter of form”; they must be exercised regularly and the venture capital operating company must devote effort to their exercise. However, the portfolio company management does not have to comply with the venture capital operating company’s advice or compensate it for its management activities.

The NVCA’s model management rights letter includes the following rights:

  • If the investor is not represented on the board, the right to advise management on significant issues and to have regular meetings with management;
  • The right to access the company’s books and records, inspect its facilities, and request information; and
  • If the investor is not represented on the board, the right to receive material the company provides to directors and to address the board about significant business issues.

Some of the rights listed in the management rights letter may overlap with rights granted to investors generally, such as the information rights discussed below. Under ERISA regulations, however, the venture capital investor must have its own specific contractual rights; rights that all of the investors happen to share do not qualify.

The letter will generally provide that these rights terminate when the investor no longer holds shares, when the company’s securities are sold in a registered public offering, or upon a merger or consolidation of the company.

Management rights letters are common practice in U.S. venture capital deals and are not usually heavily negotiated. However, founders should pay attention to the specific rights requested and make sure they will not be overly burdensome. As noted above, not all of the rights set forth in the DOL guidance need to be granted to exempt the venture fund from the ERISA rules.

Information Rights

The NVCA’s term sheet also includes a sample information rights provision. This provision grants investors access to the company’s facilities and personnel as well as the right to receive certain reports from time to time. The provision can limit these rights to only certain investors, such as major investors who hold at least a certain number of shares of preferred stock or those who are not competitors of the company. The provision contains limits to make it less burdensome to the company: investors can access the company’s facilities and personnel only during normal business hours and with reasonable advance notice. The reports comprise annual and quarterly financial statements as well as a budget for the next year’s monthly revenues, expenses, and cash position. They could also include monthly financial statements and a quarterly updated cap table, and other information as negotiated by the parties.

Information rights are customary in venture capital deals. However, as with management rights, founders should pay attention to the specific rights requested and make sure they will not be overly burdensome.

In the next post, we’ll discuss preemptive rights.


© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 10: Registration Rights http://www.strictlybusinesslawblog.com/2014/05/07/venture-capital-term-sheet-negotiation-part-10-registration-rights/ http://www.strictlybusinesslawblog.com/2014/05/07/venture-capital-term-sheet-negotiation-part-10-registration-rights/#comments Wed, 07 May 2014 19:05:53 +0000 http://www.strictlybusinesslawblog.com/?p=1731 This post is the tenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior nine posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, […]

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This post is the tenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior nine posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, and described redemption rights. In this post, we will discuss registration rights.

For a sample set of registration rights provisions, see the National Venture Capital Association’s (NVCA) term sheet here. These typical registration rights provisions pertain to a defined class of registrable shares, in this case, the common stock issuable upon conversion of the preferred stock. It can also include other common stock held by the venture capital investors. (Note that stockholders other than the preferred stockholders, such as founders, may also negotiate for registration rights.)

Before diving into a discussion of registration rights, it is important to remember the significance of registering stock. Stock that has not been registered with the Securities and Exchange Commission and applicable state authorities cannot be freely resold, and so represents a relatively illiquid investment for the stockholders. Federal securities regulations do permit the resale of unregistered stock to the public upon certain conditions, including a holding period of a certain length (at least six months depending on the circumstances) and other factors depending on whether the company is a public company and whether the stockholder is a company affiliate. A stockholder who wishes to sell or transfer shares at a particular time, however, may find that these conditions are not met and it is stuck holding the stock until the conditions are met or until the stock is registered. In addition, even if the regulatory conditions for a resale are met, venture capital investors often want the public, underwritten offering that accompanies a registration. Thus, venture capital investors will expect the term sheet to contain rights enabling them to require or participate in the registration of the company’s stock, transforming their investment into a liquid (and perhaps more valuable) one. Registration, however, is not a simple or cheap process; it demands considerable resources from the company, and results in extensive ongoing compliance and reporting requirements.

There are two types of registration rights, demand registration and “piggyback” registration. Demand registration rights allow the holders of a certain percentage of registrable securities to require that the company register its shares after a certain period of time, typically three to five years after the investment or six months after an IPO. The number of times the investors can make this demand can be negotiated; one or two is usual. Piggyback registration rights, as the name implies, enable holders of registrable shares to participate in the registration of any other class of shares by the company.

A set of registration rights provisions typically also contains a few other elements, including —

  • The right of holders of a certain percentage of registrable securities to require the company to register shares using Form S-3 (a simpler form than that required for an initial registration) for a certain total offering price from time to time;
  • A provision allocating the payment registration expenses (often to the company);
  • A “lock-up” agreement of investors and other stockholders to hold their shares after an IPO for a period of typically 180 days plus any number of days required to meet regulatory requirements (this postpones the date the investment becomes liquid, but is required by underwriters); and
  • Termination of registration rights upon a liquidation event, when all of an investor’s shares may be sold without restriction on resale, or on an anniversary of the IPO.

Founders should be aware that although having registration rights is important to venture capital investors, negotiating the details of the provisions in the term sheet is generally not something worth devoting a great deal of time to. When the time comes for an actual registration, the company’s investment bank and the underwriter will decide upon the terms they believe will maximize the success of the offering, which may or may not match the provisions agreed to in an earlier venture capital financing. Terms that are worth paying attention to are how many times the investors are entitled to demand registration, because of the expense and employee time required to pull off a registered offering, and the size of registration the investors may demand.

In the next post, we’ll discuss management and information rights.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 9: Redemption Rights http://www.strictlybusinesslawblog.com/2014/04/21/venture-capital-term-sheet-negotiation-part-9-redemption-rights/ http://www.strictlybusinesslawblog.com/2014/04/21/venture-capital-term-sheet-negotiation-part-9-redemption-rights/#comments Mon, 21 Apr 2014 16:40:54 +0000 http://www.strictlybusinesslawblog.com/?p=1728 This post is the ninth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior eight posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed […]

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This post is the ninth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior eight posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, and looked at anti-dilution carve-outs and “pay to play” provisions. This post will discuss redemption rights.

For a sample redemption rights provision, see the National Venture Capital Association’s (NVCA) term sheet here. This typical redemption rights provision provides that a certain percentage of holders of a series of preferred stock have the right, after a certain length of time has passed (five years is common), to cause the company to redeem all shares of that stock for its original purchase price and possibly accrued and unpaid dividends. It thus functions as a put right. The redemption price can also be keyed to another measure, such as the fair market value of the stock at the time of redemption, but this is less common and should be resisted by founders.  The redemption price can be required to be paid in a lump sum or in installments over some period of time.

Redemption rights will be limited by any applicable state law governing distributions to stockholders. That is, a corporation may generally not redeem shares when the payment would cause the corporation to be insolvent.

A redemption right appears to be, on its face, an exit option for investors. However, in practice, such redemption rights are rarely exercised. Remember the reason venture capitalists choose to invest in a given company — they are not hoping to merely recoup their investment, but rather looking for a big payoff — and within a short time frame, as VC funds generally have a limited life. This usually comes in the form of a sale of the company or an initial public offering. Investors usually won’t want to get out of the game entirely if they are only getting a return of their original investment and maybe dividends.

However, there are scenarios in which venture capital investors might want to cut their losses, regain their investment, and look elsewhere. For example, if a company is hobbling along, not doing too badly but not growing either — what many refer to as a “sideways situation” — neither a sale nor an IPO are likely. Or perhaps if the investors think the company is tanking.  These are both scenarios where investors may want to exercise their put rights, which could cripple a company needing cash.

Another thing redemption rights can do for venture capital investors is give them some leverage over the company during the period when redemption rights are exercisable.  For example, the NVCA term sheet points out that venture capital investors may try to include provisions giving them extraordinary powers such as electing a majority of directors or the right to consent to cash expenditures until the redemption price is paid in full.

Founders should be aware that venture capital investors may expect the term sheet to include redemption rights. And while redemption rights are infrequently exercised, they should be thoroughly considered. Founders should beware in particular of any provisions that give investors the right to a price greater than their original investment or that trigger the redemption right early or under unusual conditions, as well as any burdensome provisions that would apply when redemption rights are exercisable.

In the next post, we’ll discuss registration rights.


© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 8: Carve-Outs to Anti-Dilution Provisions and “Pay to Play” Provisions http://www.strictlybusinesslawblog.com/2014/04/13/venture-capital-term-sheet-negotiation-part-8-carve-outs-anti-dilution-provisions/ http://www.strictlybusinesslawblog.com/2014/04/13/venture-capital-term-sheet-negotiation-part-8-carve-outs-anti-dilution-provisions/#comments Mon, 14 Apr 2014 00:00:00 +0000 http://www.strictlybusinesslawblog.com/?p=1721 This post is the eighth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior seven posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed […]

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This post is the eighth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior seven posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, and analyzed anti-dilution provisions. This post will discuss carve-outs to anti-dilution provisions that typically do not trigger dilution adjustments and also examine “pay to play” provisions.

Anti-Dilution Provisions

As we discussed in a previous post, dilution refers to the phenomenon of a shareholder’s ownership percentage in a company decreasing because of an increase in the number of outstanding shares, which can happen for various reasons. Dilution is not always a negative but can be a concern for venture capital investors because of the possibility a company may engage in a “down round,” or a later issuance of stock at a price that is lower than the price the venture capital investors paid. Anti-dilution provisions protect against the consequences of a down round by adjusting the conversion price of their preferred stock upon new issuances at lower per-share prices, so as to partially or completely protect the venture capital investor’s investment from a decrease in value resulting from the down round.

For examples of different types of anti-dilution provisions, see the National Venture Capital Association’s (NVCA) term sheet here.

Customary Carveouts

An anti-dilution provision generally lists certain issuances of stock that do not trigger adjustment of the conversion price. These carve-outs comprise various common situations that are distinct from the typical capital raise, including the following:

  • stock issued upon the conversion of any preferred stock or as a dividend or distribution on preferred stock;
  • stock issued upon conversion of any debenture, warrant, option, or other convertible security;
  • common stock issued upon a stock split, stock dividend, or any subdivision of shares; and
  • common stock or options issued to employees, directors, or consultants as part of an equity compensation plan.

In addition, other issuances that do not trigger conversion can be negotiated by the parties. Other possible exclusions include the following issuances of common stock, options, or convertible securities:

  • to banks or other financial institutions pursuant to a debt financing;
  • to equipment lessors pursuant to equipment leasing;
  • to real property lessors pursuant to a real property leasing transaction;
  • to suppliers or service providers in connection with the provision of goods or services;
  • in connection with an M&A transaction, reorganization, or joint venture; and
  • in connection with sponsored research, collaboration, technology license, development, OEM, marketing, or similar.

Any of these exclusions can contain a limit on the number of shares or underlying shares that can be issued, and can require the approval of the director(s) appointed by preferred stockholders or even the vote of the preferred stockholders. Founders should be careful to review the carve-outs and make sure that the customary ones are contained in the term sheet. In addition, if the founders anticipate that the company may need to make use of any of the optional carve-outs described above, they should consider asking for those as well. Investors shouldn’t find the most typical of these carve-outs to be particularly problematic.

Pay to Play Provisions

“Pay to play” provisions work together with anti-dilution provisions to encourage venture capital investors to participate in subsequent rounds of financing. When such a provision is in effect, if an investor does not participate in a subsequent round, the anti-dilution provision does not apply. (The investor may lose other rights of a preferred stockholder as well, depending on how the provision is structured.) Because the investor will want that protection, it has an incentive to participate. Such a provision is favorable for the company because it prevents the investor simply from sitting out a down round and passively receiving the benefits of the anti-dilution provisions without committing more capital to the company. A pay to play provision is certainly something that a company can ask for when negotiating a term sheet, though the company should expect to receive some push back. A company is only likely to get a pay to play provision if it has considerable leverage going into a deal.

In the next post, we’ll discuss redemption rights.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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SEC’s Reg. A+ Proposal Has the Potential to Actually Be Useful http://www.strictlybusinesslawblog.com/2014/03/16/secs-reg-proposal-potential-actually-useful/ http://www.strictlybusinesslawblog.com/2014/03/16/secs-reg-proposal-potential-actually-useful/#respond Sun, 16 Mar 2014 21:23:47 +0000 http://www.strictlybusinesslawblog.com/?p=1717 On December 13, 2013, the SEC issued a proposed rule, which contains a draft of the long-awaited regulations implementing Section 401 of the Jumpstart Our Business Startups Act (JOBS Act), creating a new securities registration exemption commonly known as “Reg. A+.” The rule is actually a revision to an existing exemption called Regulation A.  Reg. […]

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On December 13, 2013, the SEC issued a proposed rule, which contains a draft of the long-awaited regulations implementing Section 401 of the Jumpstart Our Business Startups Act (JOBS Act), creating a new securities registration exemption commonly known as “Reg. A+.”

The rule is actually a revision to an existing exemption called Regulation A.  Reg. A currently exempts small public offerings of up to $5 million in one year from federal securities registration requirements. To make use of the exemption, issuers must file an offering statement, which is a simpler version of the prospectus required in a registered offering.  The offering statement must be cleared (or “qualified” in the language of Reg. A) by the SEC. Issuers can “test the waters”[1] with potential investors before filing the offering statement.  Reg. A permits general solicitation and general advertising, and the securities issued are not “restricted securities” and thus not subject to limitations on resale.  In addition, purchasers need not be accredited investors.  Although Reg. A offerings are simpler and less costly than registered offerings and more permissive in scope than private placements, Reg. A has rarely been used compared to registered offerings or private placements under Rule 506 of Regulation D. This is largely because the Rule 506 exemption is less expensive to comply with and preempts state securities law (so issuers do not need to comply with costly and complicated state requirements) and allows issuers to raise an unlimited amount as opposed the $5 million allowed under Reg. A. The increased costs associated with a Reg. A offering (both the SEC qualification and the state-by-state requirements) are rarely justified in an offering under $5 million.  Consequently, Reg. A has not offered a useful alternative to issuers.

Section 401 of the JOBS Act may change that. It added a new section to the Securities Act instructing the SEC to increase exemption eligibility for small offerings of up to $50 million of securities in any one year. This larger exemption has been dubbed “Reg. A+,” though that is not an official name.  The proposed rule bifurcates Reg. A, creating a “Tier 2” offering exemption for offerings up to $50 million in addition to the existing Reg. A exemption for $5 million, now called a “Tier 1” offering. Changes to the rule comprise issuer eligibility requirements, requirements for the content and filing of offering statements, and ongoing issuer reporting requirements. Use of Tier 2 will trigger:

  • Enhanced disclosure requirements, including a requirement to provide audited financial statements.
  • Electronic filing of annual and semiannual reports and updates and other reporting requirements so long as stock is held by at least 300 record holders or until the issuer begins reporting under the Exchange Act.
  • A requirement that the investors’ purchase in the Reg. A offering be no more than 10% of the greater of their net worth or net income.
  • Preemption of state securities law registration.

In my view, the last item on that list is the most significant element of the proposed rules. The JOBS Act amended the Securities Act to add securities sold in a Tier 2 offering to the category of securities exempt from state registration if they were either offered or sold on a national securities exchange or offered or sold to a “qualified purchaser,” as defined by the SEC. The SEC took a very expansive approach to preemption, as the proposed rules do not require that the Tier 2 securities be listed on a national exchange, but rather that they be offered or sold to “qualified purchasers,” and define that term as all purchasers in a Tier 2 offering. If adopted, this would mean that all Reg. A Tier 2 offerings would have preemption, just as Rule 506 offerings do. Without preemption, issuers in a Tier 2 offering would have to either register or seek an applicable exemption in each state in which they wished to offer securities. With state preemption, issuers may find the new exemption an effective alternative for capital formation.

I’m generally supportive of the SEC’s approach, which if adopted as proposed will contribute to making Reg. A a meaningful capital raising tool for small issuers.  Perhaps predictably, the leadership of the North American Securities Administrators Association (NASAA) has issued a formal objection to the proposed rules’ preemption of state registration requirements. NASAA’s position is that because state authorities are closer to resident issuers and investors, they are better equipped to monitor offerings to prevent and punish securities laws violations as well as to improve the overall quality of offerings. It points out that many violations resulting in incarceration and restitution stem from Reg. D offerings. It proposes a new coordinated, multi-state review program under which issuers would make central filings which are then distributed electronically to all states for a 10-day review. Issuers would interact solely with “lead examiners,” who make a binding determination to clear each application. The entire process should take a minimum of 30 days.

If all states buy into the coordinated review program, it could prove a workable alternative to preemption, although it does add some time and some extra expense to the process. In its request for public comment, the NASAA notes that issuers need to select which states it intends to apply to upfront; it may not be possible to add states later. This means an issuer must be certain about the scope of the offering when it makes the initial filing. Given that Reg. A offerings permit general solicitation and advertising, they are likely to be conducted nationwide. In that case, issuers will want to select all states. If all states don’t sign on to the program, however, issuers will still have to consider the registration requirements and any applicable exemptions in those states that don’t utilize the program, or try to avoid those states, rendering the review program a far less desirable alternative to state preemption. I certainly understand the position of state regulators and investor advocates, but the disclosure and reporting regime required by Reg. A already provides a good deal of investor protection.

The one major downside of the proposed rule is that companies that use a Tier 2 offering are still subject to the ongoing Exchange Act reporting requirements which kick in when an issuer’s total assets exceed $10 million and its security holders reach 2,000 people or 500 who are not accredited investors (who must have a certain net worth or income or meet other conditions).  This will almost certainly be the case, since the issuer’s shares will likely be more widely held. This requirement may reduce the attractiveness of the exemption, as such reporting constitutes an expensive and time-consuming burden for the issuer. In my view, the SEC should consider exempting securities issued in a Reg. A offering from Exchange Act reporting requirements for a limited time (e.g., two years), especially since the proposed rules already have a more modest but thorough reporting regime built-in.

With that said, while it has gotten the least amount of coverage in the press, Reg. A+ may turn out to be the most useful of the three major new exemptions under the JOBS Act (the other two being Rule 506(c) and crowdfunding).  As proposed, it allows for (a) general solicitation, (b) purchase by non-accredited investors, and (c) state preemption, a combination that no other exemption currently features.  Of course, in response to the concerns expressed by NASAA, the SEC may water down or eliminate preemption completely, which would greatly curtail the usefulness of the exemption, though perhaps not eliminate it completely.  In either event, we are likely to see a greater frequency of the use of Reg. A offerings in the near future.


Footnotes

[1] Essentially, testing the waters means talking to investors prior to the qualification of the offering statement.  In most cases, testing the waters is prohibited in a registered offering.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 7: Anti-dilution Provisions http://www.strictlybusinesslawblog.com/2014/03/08/venture-capital-term-sheet-negotiation-part-7-anti-dilution-provisions/ http://www.strictlybusinesslawblog.com/2014/03/08/venture-capital-term-sheet-negotiation-part-7-anti-dilution-provisions/#comments Sat, 08 Mar 2014 15:15:59 +0000 http://www.strictlybusinesslawblog.com/?p=1714 This post is the seventh in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.  In the prior six posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed […]

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This post is the seventh in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

 In the prior six posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, and examined voting rights and investor protection provisions. This post will discuss anti-dilution provisions.

Dilution

Dilution refers to the phenomenon of a shareholder’s ownership percentage in a company decreasing because of an increase in the number of outstanding shares, leaving the shareholder with a smaller piece of the corporate pie. The total number of outstanding shares can increase for any number of reasons, such as the issuance of new shares to raise equity capital or the exercise of stock options or warrants.

However, all dilutive issuances are not harmful to the existing shareholders.  If the corporation issues shares but receives sufficient cash in exchange for the shares, the shareholders’ ownership percentages may be reduced but the value of the corporation has increased enough to offset the lower ownership percentage.  On the other hand, if the cash received is insufficient, the increase in the value of the corporation will not be enough to offset the reduction in ownership percentages.

In venture capital deals, the transaction documents typically include negotiated provisions designed to deal with a dilutive issuance that would otherwise reduce the value of the preferred investors’ shares (relative to the price the preferred investors paid for their shares).  These provisions are referred to as “anti-dilution provisions.”

Anti-dilution

In venture capital terms, dilution becomes a concern for preferred stockholders when confronted with a “down round” — a later issuance of stock at a price that is lower than the preferred issue price.  Anti-dilution provisions protect against a down round by adjusting the price at which the preferred stock converts into common stock.  We previously discussed the concept of the preferred stock being convertible into common here, noting that many of the preferences of the preferred stock are based on the number of shares of common into which the preferred converts (e.g., voting rights, dividend rights, liquidation).

There are three common alternatives for anti-dilution provisions described in the NVCA’s model term sheet: full ratchet, weighted average, and no price-based anti-dilution protection.

Full Ratchet

A “full ratchet” provision is the simplest type of anti-dilution provision but it is the most burdensome on the common stockholders and it can have significant negative effects on later stock issuances.  Full ratchet works by simply reducing the conversion price of the existing preferred to the price at which new shares are issued in a later round. So if the preferred investor bought in at $1.00 per share and a down round later occurs in which stock is issued at $0.50 per share, the preferred investor’s conversion price will convert to $0.50 per share.  This means each preferred share now converts into 2 common shares.

Full ratchet is easy and it’s the most advantageous way to handle dilution from the preferred investor’s standpoint but it is the most risky for the holders of any common stock.  With this approach, the common stockholders bear all of the downside risk while both common and preferred share in the upside.

Full ratchet can also make later rounds more difficult.  If the corporation needs to issue a Series B round and the stock price has decreased, it may be difficult to get the Series A investors to participate because they are getting a full conversion price adjustment.  In essence, the Series A investors are getting more shares without putting more cash in the Series B round.  In addition, the full ratchet provision will reduce the amount the Series B investors will be willing to pay in a down round (simply because full ratchet results in more shares outstanding on an “as converted” basis).

Weighted Average

A second and more gentle method for handling dilution is referred to as the “weighted average” method. [1]  Following is the calculation for a typical weighted average anti-dilution provision presented by the NVCA’s term sheet (it looks a little intimidating at first glance but it’s actually pretty simple):

CP2 = CP1 * (A+B) / (A+C)

CP2    =     Conversion price immediately after new issue

CP1    =     Conversion price immediately before new issue

A        =     Number of shares of common stock deemed outstanding immediately before new issue [2]

B        =     Total consideration received by company with respect to new issue divided by CP1

C        =     Number of new shares of stock issued

Let’s suppose a company has 1,000,000 common shares outstanding and then issues 1,000,000 shares of preferred stock in a Series A offering at a purchase price of $1.00 per share.  The Series A stock is initially convertible into common stock at a 1:1 ratio for a conversion price of $1.00.

Next, the company conducts a Series B offering for an additional 1,000,000 new shares of stock at $0.50 per share. The new conversion price for the Series A shares will be calculated as follows:

CP2 = $1.00 x (2,000,000 + $500,000) / (2,000,000 + 1,000,000) = $0.8333.

This means that each of the Series A investor’s Series A shares now converts into 1.2 shares of common (Series A original issue price/conversion ratio = $1.0 /$0.8333 = 1.2).

Under the discussion of full ratchet above, we noted that the preferred shares became convertible into 2 common shares post-issuance.  Under weighted average, the preferred shares became convertible into 1.2 shares.  This simple example illustrates that the weighted average approach is much less beneficial for the preferred investor but much less onerous for the common stockholders.

However, to provide a little more context, let’s assume our hypothetical company is sold and liquidated for $10,000,000 after the Series B round.  We’ll also assume, for simplicity, that there was no dividend preference for the preferred shares and that we’re using a non-participating structure.  Here’s how the cash gets distributed with full ratchet and weighted average, respectively:

anti-dilution full rachet

 

 

 

 

anti-dilution weighted average

 

 

 

 

 

Note how much more the Series A investors get with full ratchet and how much this reduces the amounts distributable to Series B investors and common stockholders.

No Price-Based Anti-dilution Protection

The third alternative for anti-dilution in the NVCA’s term sheet is no price-based anti-dilution protection.   In this scenario, the preferred investor bears the risk of a down round along with the common stockholders.  This is the fairest from the standpoint of the common stockholders but many preferred investors will not agree to take the down round risk without any anti-dilution protection.

In the next post, we’ll continue discussing anti-dilution and focus on some of the carve-outs that typically don’t trigger dilution adjustments as well as “pay to play” provisions.


Footnotes

[1] Note that there are variations on weighted average formulas.  For a discussion of “broad-based” and “narrow-based” formulas see this post: http://www.startupcompanylawyer.com/2007/08/04/what-is-weighted-average-anti-dilution-protection/

[2] The number of shares of common stock deemed to be outstanding immediately prior to new issue includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing.


© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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SEC Provides Exemption from Broker-Dealer Registration Requirements for M&A Brokers http://www.strictlybusinesslawblog.com/2014/03/02/sec-provides-exemption-broker-dealer-registration-requirements-ma-brokers/ http://www.strictlybusinesslawblog.com/2014/03/02/sec-provides-exemption-broker-dealer-registration-requirements-ma-brokers/#comments Sun, 02 Mar 2014 20:39:14 +0000 http://www.strictlybusinesslawblog.com/?p=1704 On January 31, 2014 (revised February 4, 2014), the SEC issued a no-action letter to a group of attorneys who requested assurance on an issue that has long been on the minds of securities lawyers: are people who facilitate the sale of a controlling interest in a business involving a transfer of stock — which the […]

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On January 31, 2014 (revised February 4, 2014), the SEC issued a no-action letter to a group of attorneys who requested assurance on an issue that has long been on the minds of securities lawyers: are people who facilitate the sale of a controlling interest in a business involving a transfer of stock — which the Supreme Court has held to be a sale of securities under federal securities laws — required to register as broker-dealers under the Securities Exchange Act of 1934, with all of the attendant expenses and obligations?

Who is Affected

The attorneys requesting the no-action letter used the term “M&A Broker” to describe a person engaged in facilitating mergers, acquisitions, business sales, and business combinations. In its no-action letter, the SEC defined the term as follows:

 a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company (as defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company. A buyer could actively operate the company through the power to elect executive officers and approve the annual budget or by service as an executive or other executive manager, among other things.

A “privately-held company” is one that isn’t a reporting company under the Exchange Act; it must be an operating company and not a “shell” company.

What M&A Brokers Can Do

Generally, the no-action letter gives assurance that the SEC staff would not recommend enforcement action if an M&A Broker effected securities transactions in connection with the transfer of a privately held company without registering as a broker-dealer by engaging in the following specific activities:

  1. Represent the buyer, seller, or both, as long as both receive disclosure and give written consent.
  2. Facilitate a transaction with a buyer or buyer group that, upon completion of the transaction, will control the business.
  3. Facilitate a transaction involving the purchase or sale of a privately-held company no matter its size.
  4. Advertise a company for sale with information such as the description of the business, general location, and price range.
  5. Advise the parties to issue securities or accomplish the transaction by means of securities, and assess the value of any securities sold.
  6. Receive transaction-based compensation, which generally means a commission or compensation the receipt of which depends on whether a transaction is successful, and/or the amount of which is determined by the size of the transaction. This is significant because the SEC has previously taken a hard line on transaction-based compensation (see this 2010 denial of a no-action letter), stating that transaction-based compensation is a “hallmark” of broker-dealer activity, requiring registration. The new no-action letter is a partial reversal of that position.
  7. Participate in negotiations.
  8. Receive “restricted securities,” which are securities acquired from the issuer or an affiliate in a transaction not involving any public offering (see prohibition on public offerings below). Restricted securities can’t be sold freely; in order to sell them, the recipient must qualify for an exemption from securities registration requirements, typically by holding the securities for one year and meeting other conditions.

What M&A Brokers Can’t Do

In issuing the no-action letter, the SEC noted the requesters’ representations that an M&A Broker would not do any of the following:

  1. Bind a party to a transaction.
  2. Directly or indirectly provide financing for a transaction.
  3. Handle funds or securities issued or exchanged in connection with a transaction or other securities transaction for the account of others.
  4. Be involved in a public offering of securities.
  5. Assist in forming a buyer group.

In addition, the M&A Broker and its officers, directors, and employees must not have been suspended or barred from association with a broker­dealer by the SEC, any state, or any self-regulatory organization.

Implications for State Broker-Dealer Registration

Federal securities law is not the only law that requires broker registration. State “blue sky” securities laws typically require registration of brokers who transact business in that state — whether they have an office in that state or do business with buyers or sellers in that state — and these laws aren’t affected by the SEC’s no-action letter. M&A brokers must determine whether their activities require registration in any given state or whether any exemptions from registration apply in that state, and perhaps confine their activities to the scope allowed by such exemptions. California, for example, does not require broker-dealer registration for “merger and acquisition specialists,” or those who effect securities transactions in California only in connection with mergers, consolidations, or asset purchases and do not receive, transmit, or hold for customers any funds or securities.  As an example of an exemption that applies to brokers doing business in a state other than where its office is located, Kentucky law exempts from registration a broker-dealer with no place of business there that during any period of 12 consecutive months does not direct more than 15 offers to sell or to buy into Kentucky to persons other than the issuers of the securities involved, other broker-dealers, or certain listed financial institutions or institutional buyers. This exemption may apply to some M&A brokers, especially given that the no-action request letter contemplates that such brokers may participate in only one or several transactions per year. In any event, state registration may turn out to be less burdensome than SEC registration because some states do not require FINRA or SIPC membership as part of the registration process.

Conclusion

The SEC’s new stance that business brokers do not need to register to conduct a broad range of M&A activities or receive transaction-based compensation would seem to open up new opportunities in the industry. In order for business brokers to take full advantage of these opportunities, however, states need to craft exemptions or adopt guidance that mirrors the M&A Broker definition and permitted activities in the no-action letter, or else brokers may still need to undertake the expensive and time-consuming process of registering and maintaining their registration in any states in which they hope to do deals.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 6: Voting Rights and Protective Provisions http://www.strictlybusinesslawblog.com/2014/02/09/venture-capital-term-sheet-negotiation-part-6-voting-rights-protective-provisions/ http://www.strictlybusinesslawblog.com/2014/02/09/venture-capital-term-sheet-negotiation-part-6-voting-rights-protective-provisions/#comments Mon, 10 Feb 2014 01:42:20 +0000 http://www.strictlybusinesslawblog.com/?p=1702 This post is the sixth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. In the prior five posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed […]

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This post is the sixth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.

In the prior five posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, and discussed the conversion rights and features of preferred stock.  This post will explain how voting rights are typically addressed in a venture capital transaction as well as describe customary investor protection provisions.

Voting Rights

Delaware corporate law, by default, requires that each class of stock vote and approve any amendment to a corporation’s certificate of incorporation.  The NVCA model legal documents override this, and provide that generally all the shares vote together as a single class on an “as-converted basis” (see our previous post on what that means).  The most important application of this is that no separate approval of the preferred stockholders is necessary to approve an increase in the number of authorized common shares as long as a majority of all stockholders approve the change.  However, venture capital investors typically require that they have the power to elect a certain number of seats on the company’s board of directors.  The number of board seats is typically a matter of negotiation and depends on the overall size of the board as well as the size of the investment being made.

Protective Provisions

In addition to the right to appoint a certain number of board seats, in venture capital deals investors often secure other rights that protect them from changes being made that could potentially harm them or reduce the value of their investment.  These provisions typically require that a certain percentage (often a majority, but sometimes a supermajority) of the preferred stockholders vote to approve certain actions.  The actions typically included are:

  • dissolving the company;
  • making any changes to the certificate of incorporation or bylaws that adversely affect the preferred stockholders;
  • authorizing or issuing new stock on parity with or senior to the preferred stock;
  • purchasing or redeeming any stock prior to the preferred stock;
  • taking on debt;
  • engaging in certain transactions involving subsidiaries of the company; and
  • changing the size of the board.

In addition, you will also typically find provisions that require the vote of one or more of the directors appointed by the investors in order for the board to take any of the following actions:

  • making any investments (either debt or equity) in any other companies;
  • extending any loans to any persons, including employees and directors;
  • guaranteeing any debt;
  • making investment decisions inconsistent with approved policies;
  • incurring indebtedness in excess of a certain amount other than in the ordinary course of business;
  • entering into any other transactions with any director, officer, or employee;
  • hiring, firing, or changing the compensation of executive officers;
  • changing the principal business of the company;
  • selling, assigning, licensing, or using as collateral to a loan any of the company’s material intellectual property, other than in the ordinary course of business; and
  • entering into any strategic relationship involving any payment or contribution in excess of a certain amount.

The protective provisions are often overlooked by founders when they negotiate term sheets, perhaps with the exception of the number of board seats the investors are getting.  Since they don’t impact the economics of the deal in any direct way, they are often deemed unimportant.  Most of the protective provisions involve company decision-making in one way or another and at least initially, the founders typically envision involving their investors in major decision-making.  Early on, it would usually be unthinkable for the company to take a major action that its largest investor opposes.  However, after a number of investment rounds, there could be any number of potential vetoes of company actions and the governance process may become unwieldy.  Some of the protective provisions, such as a requirement to get the investor-appointed director’s approval for any strategic relationship involving a payment or contribution in excess of $X, may give one particular investor too much ability to veto new opportunities for the company that were not envisioned early in its life.

In addition, founders should pay attention to how the protective provisions interact when there have been multiple rounds of financing.  For instance, if there have been five rounds (e.g., Series A, B, C, D, and E), it would probably not be appropriate to require the approval of a director appointed by each series to approve every license of material intellectual property.  Therefore, when a company takes on a new investment round, the company’s management should look at making appropriate changes to the previous round’s investor’s protective provisions.  Often, the new investor can be helpful in this process by making such changes a condition of closing the new round.

In the next post, we’ll discuss anti-dilution provisions.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Venture Capital Term Sheet Negotiation — Part 5: “As Converted” and Conversion Rights of Preferred Stock http://www.strictlybusinesslawblog.com/2014/01/31/venture-capital-term-sheet-negotiation-part-5-converted-conversion-rights-preferred-stock/ http://www.strictlybusinesslawblog.com/2014/01/31/venture-capital-term-sheet-negotiation-part-5-converted-conversion-rights-preferred-stock/#comments Fri, 31 Jan 2014 17:54:28 +0000 http://www.strictlybusinesslawblog.com/?p=1698 This post is the fifth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.  In the prior four posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed […]

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This post is the fifth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. 

In the prior four posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, and explained how liquidation preferences work. This post will explain what “as converted” means and discuss conversion rights and features of preferred stock.

“As Converted”

When reviewing the National Venture Capital Association’s (NVCA) Model Legal Documents, you’ll notice use of the phrase “on an as-converted basis” in several areas.  For example, the NVCA term sheet section on dividends provides under Alternative 1 that dividends will be paid on the preferred “on an as converted basis when, as, and if paid on the common.”  Similarly, under the discussion of voting rights, the NVCA term sheet provides that the preferred votes together with the common “on an as-converted basis.”

This “as converted basis” concept means that, when determining the right or benefit of the preferred stock, it is assumed that the preferred shares have been converted into some number of common shares. To determine the number of common shares into which the preferred shares are deemed to convert, you simply multiply the number of shares of preferred stock in question by the conversion ratio.  The conversion ratio is the price paid for the shares of preferred stock (e.g. the Series A Original Issue Price) divided by the then current conversion price.  Initially, the conversion price is usually set to equal the issue date price so that the initial conversion ratio is 1:1.

As an example, assume 25,000 shares of Series A Preferred stock is initially purchased for $10.00 per share (the “Series A Original Issue Price”) and has a $10.00 per share Series A Conversion Price so that the initial conversion ratio is 1:1.  If there have been no adjustments to the Series A Conversion Price after the issuance of the Series A, then 25,000 shares of Series A Preferred will be deemed to convert into 25,000 shares of common stock for purposes of determining the rights or benefits of the preferred stock (e.g. voting rights).

However, if there have been diluting events, the conversion price may have been adjusted downward (we’ll discuss anti-dilution calculations more specifically in a future post).  If we assume a conversion price of $8 per share due to dilution adjustments, the new conversion ratio would be 1.25, which equals $10 (the Series A Original Issue Price) / $8 (the current Series A Conversion Price).  This means our 25,000 shares would be deemed to convert into 31,250 shares of common for purposes of determining the right or benefit of the preferred stock (again, if we are determining voting rights, for example, this will mean the 25,000 shares of preferred stock receive 31,250 votes).

Optional and Mandatory Conversion

The “as converted” concept is fictional in the sense that the preferred shares have not actually been converted.  Instead, we are assuming conversion simply to calculate the quantity of votes or dividends or some other right of the preferred stock.

However, the preferred stock may convert into common stock upon certain events.  As noted in the NVCA term sheet, there is a section called “Optional Conversion” which simply states that preferred stock may be converted into common stock at any time at the option of the stockholder and notes the initial 1:1 conversion ratio.

Why would a stockholder convert his or her shares from preferred to common?  Depending on the structure and economics of the deal, the stockholder may receive more cash upon liquidation if the shares are converted into common shares.  For example, a common structure on liquidation might be for the preferred stockholder to either (i) receive a liquidation preference equal to return of its initial investment (or some multiple thereof) or (ii) to convert to common and give up the liquidation preference (i.e. this is a non-participating preferred structure, which we’ve discussed previously).  If the sale price is high enough, the stockholder will receive more by giving up its liquidation preference and participating as a common stockholder.  To reuse our example from our post on liquidation preferences, let’s say that a venture capital fund takes a 20% interest in Company X for $2.0 million.  The price is $1 per share with a non-participating 1x liquidation presence and no preferred dividends.  Assuming there are 8 million common shares outstanding, the VC fund would receive 2 million preferred shares.  If Company X is sold a few years later for net proceeds of $30 million, the VC would receive $2.0 million if it chooses not to convert, but would receive $6.0 million if it converted its shares to common stock.

The NVCA term sheet also provides for mandatory conversion upon an initial public offering, provided certain minimum thresholds are achieved, or upon written consent of the Series A stock.  In this model term sheet, the minimum thresholds for conversion upon an IPO are that the IPO stock be sold for some minimum multiple of the initial preferred purchase price and that the company receives some minimum amount of proceeds.  These thresholds provide some assurance to the holders of preferred stock that it receives a reasonable return before being forced to convert its shares to common stock.

In negotiating the term sheet, founders should press for a relatively low multiple of the original purchase price (perhaps 2x to 3x) and total proceeds required to be received to minimize disruption of an IPO by the preferred stockholders.

In the next post we’ll discuss voting rights and protective provisions.


© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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