Strictly Business http://www.strictlybusinesslawblog.com A Business Law Blog for Entrepreneurs, Startups, Venture Capital, and the Investment Management Industry. Wed, 09 Jul 2014 15:11:04 +0000 en-US hourly 1 http://wordpress.org/?v=3.9.1 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/?utm_source=rss&utm_medium=rss&utm_campaign=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, and 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/?utm_source=rss&utm_medium=rss&utm_campaign=time-jobs-act-part-two http://www.strictlybusinesslawblog.com/2014/06/30/time-jobs-act-part-two/#respond 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/?utm_source=rss&utm_medium=rss&utm_campaign=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/?utm_source=rss&utm_medium=rss&utm_campaign=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/#respond 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/?utm_source=rss&utm_medium=rss&utm_campaign=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/?utm_source=rss&utm_medium=rss&utm_campaign=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/#respond 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.

The post Venture Capital Term Sheet Negotiation — Part 8: Carve-Outs to Anti-Dilution Provisions and “Pay to Play” Provisions appeared first on Strictly Business.

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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/?utm_source=rss&utm_medium=rss&utm_campaign=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/?utm_source=rss&utm_medium=rss&utm_campaign=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.

The post Venture Capital Term Sheet Negotiation — Part 7: Anti-dilution Provisions appeared first on Strictly Business.

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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/?utm_source=rss&utm_medium=rss&utm_campaign=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/#respond 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/?utm_source=rss&utm_medium=rss&utm_campaign=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/?utm_source=rss&utm_medium=rss&utm_campaign=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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Thoughts on the Proposed Crowdfunding Regulations http://www.strictlybusinesslawblog.com/2013/12/30/thoughts-proposed-crowdfunding-regulations/?utm_source=rss&utm_medium=rss&utm_campaign=thoughts-proposed-crowdfunding-regulations http://www.strictlybusinesslawblog.com/2013/12/30/thoughts-proposed-crowdfunding-regulations/#respond Mon, 30 Dec 2013 17:12:02 +0000 http://www.strictlybusinesslawblog.com/?p=1691 On October 23, 2013, the Securities and Exchange Commission issued proposed regulations to implement Title III of the JOBS Act, which will allow for the public sale of securities using crowdfunding under an exemption from registration under securities laws. Since it has been some time since the regulations were proposed, I won’t attempt to summarize […]

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On October 23, 2013, the Securities and Exchange Commission issued proposed regulations to implement Title III of the JOBS Act, which will allow for the public sale of securities using crowdfunding under an exemption from registration under securities laws.

Since it has been some time since the regulations were proposed, I won’t attempt to summarize them in this post.  There are a number of great summaries of the regulations out there; here are two: (1) Kiran Lingam of SeedInvest’s summary and (2) Kevin Laws of Angelist’s summary.  In addition, all 585 pages of the proposed regulations can be found here.

Here are some of my thoughts on the proposed regulations.  I have six main points I’ll highlight in this post.  I’ve ordered the points from most optimistic/positive to more pessimistic/negative.  As you can see there is a lot to like and a lot to dislike.

  1. The SEC was not hostile to the concept of crowdfunding in its implementation of Title III.  My biggest fear was that the SEC, being hostile to the concept of deregulating securities markets, would make the crowdfunding regulations as difficult to use as possible.  The crowdfunding section of the JOBS Act is very poorly drafted, leaving many ambiguities.  The SEC could have, at every turn and every attempt to resolve these ambiguities, taken a more restrictive approach, but it didn’t.  For example, Sec. 302(a) provides for caps on the amount that an investor can invest in crowdfunding offerings in any 12-month period.  It is poorly drafted, making terrible use of the word “or,” causing the amount of the investment caps to be unclear in many situations.  The SEC resolved these ambiguities using interpretations that allow for larger rather than smaller amounts.  Another example is that the SEC had to decide whether to allow companies to use crowdfunding while also raising money through other types of offerings (i.e., using other exemptions, such as Rule 506).  The SEC decided to allow companies to raise money using crowdfunding and other exemptions simultaneously.[1]  These are just two of many examples showing that the SEC had real opportunities to make life more difficult for users of crowdfunding but declined to take advantage of them.

  2. The SEC may have improved upon Title III.  People who followed the passage of the JOBS Act know that the crowdfunding provisions were completely rewritten at the eleventh hour.  Prior to the rewrite, the crowdfunding provisions originally written by Rep. Patrick McHenry provided that funding portals had to provide communication channels to allow users of the site to discuss the offering.  The premise is that the “wisdom of the crowd” (i.e., the sheer number of people on the internet who would be willing to debate the merits of an investment) would help distinguish the good investments from the bad.  The version of the crowdfunding exemption that eventually passed omitted this provision.  However, in its proposed rules, the SEC has restored this provision, which arguably will help make the exemption more effective.

  3. Funding portals may actually have a workable business model…  One aspect of the proposed regulations that I found particularly surprising was that the SEC will allow funding portals to accept transaction-based compensation.  The SEC has long taken a hard line against anyone other than a registered broker-dealer taking compensation for raising capital if that compensation is contingent on money being raised or is proportionate to the amount actually raised.  Therefore, I fully expected the SEC to take the position that funding portals would not be permitted to accept such compensation.  Since startups would be very reluctant to pay a large fee for a capital raise that may or may not be successful if the fee wasn’t structured as some kind of contingent fee based on the amount raised, I previous had a lot of difficulty seeing how funding portals could actually make money.  To my surprise, the SEC has no issue with funding portals taking a percentage of the amount actually raised as a fee.  The SEC reasoned that funding portals actually are brokers under the Securities Exchange Act, but are not required to register as such because they can register as funding portals.  Since they are brokers, they can take the same fee that brokers customarily take: transaction-based compensation.

  4. …or they may not.  Funding portals may be subject to considerable potential liability that, over the long run, may make it too expensive for them to stay in business.  Rule 301 of the proposed regulations requires that funding portals have a reasonable basis for believing that an issuer seeking to offer and sell securities in reliance on the crowdfunding exemption through the funding portal’s platform complies with the requirements of the exemption.  It also requires funding portals to deny access to its platforms to issuers when the platform “[b]elieves that the issuer or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection.”  In addition, if a funding portal becomes aware of information after it has granted access to its platform that causes it to believe that the issuer or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection, the funding portal must remove the offering from its platform.  Thus, the proposed rules require funding portals to take an active role in screening for fraud and impose upon them a duty to protect investors.  At the same time, under the JOBS Act, funding portals are prohibited from offering investment advice.  The SEC has interpreted this to limit the ability of funding portals to curate the offerings conducted through their sites.  The SEC has further interpreted the regulations as imposing liability on funding portals for fraud.  Thus the SEC is asking them to use a significant amount of discretion to protect investors (and to face liability if they fail to do so), but at the same time is prohibiting them from having much discretion in the first place.  All of this could put funding portals in a no-win situation. If all of these items remain in the final rule, funding portals may find that the mere risk of operating is just too high.

  5. There is an awful lot of disclosure required.  The JOBS Act itself requires that issuers (and consequently intermediaries) provide a significant amount of disclosure to potential investors, including narrative descriptions and discussions of the issuer’s business plan, financial condition, intended use of proceeds, and capital structure.  The SEC further added to this burden by requiring disclosure of other small items such as biographical information about the issuer’s officers and directors.  The regulations also flesh out the required disclosure items listed in the statute.  Upon reading these it becomes quite apparent that a crowdfunding offering will have a lot more required disclosure than your typical small Rule 506 or Rule 504 offering.  This equates to potentially high legal bills.  This isn’t really the fault of the SEC, as most of this is mandated by Congress, but reading the proposed regulation really hammers home that the use of this exemption will not be simple and routine (as many who advocate for crowdfunding hope).

  6. This whole thing may still prove to be too expensive to make it worth anyone’s while.  My main concern about the crowdfunding exemption has always been that the cost of compliance with the exemption may not be justified by its benefits.  This still remains the case after the release of the proposed regulations.  Kiran Lingam of SeedInvest posted a really great spreadsheet that illustrates this point.  It can be found here.  Kiran essentially has tallied up all of the costs associated with using the crowdfunding exemption, such as commissions, legal fees, accounting fees, insurance, and other costs, so that a potential issuer can see the amount of proceeds the offering will actually yield and how much of the proceeds will be used to incur the additional expenses associated with pursuing a crowdfunding campaign.  The results are not pretty.  Let’s say a issuer wanted to raise $100,000.  Under Kiran’s calculations, it would actually cost more than $100,000 to raise the money.  Under his projections a $500,000 offering would net around $351,650, which would mean that about 42% of the proceeds will ultimately be used for expenses.  At $1,000,000, his calculations estimate that 25% of the proceeds will be used for expenses.  If true, this really limits the utility of crowdfunding and places an unacceptably high cost of capital on startups using it.  I can’t quibble with Kiran’s estimates, as he works at a crowdfunding site, and I don’t think he’s overestimated the expenses to “be conservative,” given that he estimates only $5,000 in initial legal costs (see point 5 above on why the legal costs won’t be insignificant).  He estimates a 10% commission going to the funding portal.  Perhaps some platforms will offer a lower commission.  At the same time, since compliance work that is required to be done in future years is included in his costs, there may be some economies of scale realized by having multiple rounds of $1,000,000 raised using crowdfunding over a period of years.

The comment period on the proposed regulations is open until February 3, 2014.  Given their complexity, I would expect we will not have a working crowdfunding exemption in place until late summer of 2014 at the earliest and most likely not until fall 2014.


Footnotes

[1] However, the SEC did caution that the exemptions could not be used in clearly incompatible ways.  For instance, if a company were to engage in a crowdfunding campaign and simultaneously engage in a Rule 506(b) offering, which cannot make use of public advertising, it couldn’t accept investors into the Rule 506(b) offering who were found through the crowdfunding campaign.


© 2013 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 4: Liquidation Preferences http://www.strictlybusinesslawblog.com/2013/12/26/venture-capital-term-sheet-negotiation-part-4-liquidation-preferences/?utm_source=rss&utm_medium=rss&utm_campaign=venture-capital-term-sheet-negotiation-part-4-liquidation-preferences http://www.strictlybusinesslawblog.com/2013/12/26/venture-capital-term-sheet-negotiation-part-4-liquidation-preferences/#comments Thu, 26 Dec 2013 19:44:43 +0000 http://www.strictlybusinesslawblog.com/?p=1686 This post is the fourth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.   In the prior three 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, […]

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

In the prior three 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, and discussed dividends on preferred stock.  This post will focus on liquidation preferences.

The liquidation preference is essentially what makes preferred stock “preferred.”  It is the most important economic provision in a venture capital financing transaction other than the valuation. The liquidation preference provisions govern how the proceeds will be distributed to shareholders when and if the company is actually liquidated or is sold in an M&A transaction (called a “deemed liquidation”).  Shareholders with a liquidation preference receive the proceeds of liquidation or deemed liquidation before the common shareholders, and may, depending on the exact terms of the liquidation preference, receive a percentage of the proceeds that is greater than their percentage ownership of the company (resulting in other shareholders receiving a percentage of the proceeds that is less than their percentage ownership).  The liquidation preference does not come into play if the company goes public, as the preferred stock issued to investors converts to common stock and the liquidation preference goes away.

The amount of a liquidation preference can vary, but is usually linked to the purchase price of the stock itself. For instance, if a VC buys the preferred stock for $1 per share, then the liquidation preference will be equal to $1 per share.  This is known as a 1x liquidation preference.  However, liquidation preferences can be equal to multiples of the purchase price, resulting in 2x, 3x, or higher liquidation preferences.  They can also be combined with preferred dividends.  For example, a VC term sheet could provide for a 2x liquidation preference plus an 8% cumulative non-compounding preferred return.  After three years, the liquidation preference would be 224% of the original purchase price (2x the purchase price plus three 8% returns).  High liquidation preferences combined with preferred dividends can easily wipe away any economic reward for the common shareholders, so it’s important for a startup not to give away too much in this area.

There are two basic types of liquidation preference provisions: participating preferred and non-participating preferred.  Holders of participating preferred shares receive the liquidation preference applicable to those shares and also receive a portion of the proceeds after all liquidation preferences have been paid out as if they had converted their preferred stock to common stock.  Holders of non-participating preferred shares receive only the liquidation preference and cannot “participate” as common shareholders.  However, since preferred shareholders can usually convert their shares to common shares at any time, in practice, this means that holders of non-participating preferred shares receive the greater of their liquidation preference or what they would have received if they were common shareholders.  Participating preferred shareholders receive more than their percentage ownership of the company on an as-converted-to-common-stock basis (and consequently cause common shareholders to receive less), whereas with non-participating preferred shares, the liquidation preference will become meaningless if the company sells for a high enough amount.

Founders prefer that investors receive non-participating preferred shares while investors prefer to receive participating preferred shares.  This point can be particularly contentious in a term sheet negotiation.  One potential compromise is to issue participating preferred shares subject to a cap on participation. A cap on participation limits the amount received by the preferred shareholders to a fixed amount. The cap is often set as a multiple of the original investment amount, such as 2x or 3x. Once the preferred shareholders have received the cap amount, they stop participating in distributions with the common shareholders.  Consequently, if the exit event amount is high enough, the holders of preferred shares would be better off converting them to common shares, similar to the way they would be if they held non-participating preferred stock with a liquidation multiple.

Let’s take a look at an example.  Let’s say that a venture capital fund takes a 20% interest in Company X for $2.0 million (an $8.0 million pre-money and $10.0 million post-money valuation).  The price is $1 per share with a 1x liquidation presence and no preferred dividends.  Assuming there are 8 million common shares outstanding, the VC fund would receive 2 million preferred shares.

Let’s say Company X is sold a few years later for net proceeds of $30 million.  The results would be as follows upon liquidation:

lpchart1

In an alternative scenario, if Company X sold for a disappointing $3 million, the results would be as follows:

lpchart2

As you can see, how a liquidation preference is structured can make a big difference when the proceeds of a sale of the company are divvied up.  Therefore, founders of startups should pay particular attention to this provision when negotiating term sheets.

In the next post, we’ll discuss the conversion features of preferred stock.


© 2013 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 3: Dividends http://www.strictlybusinesslawblog.com/2013/11/17/venture-capital-term-sheet-negotiation-part-3-dividends/?utm_source=rss&utm_medium=rss&utm_campaign=venture-capital-term-sheet-negotiation-part-3-dividends http://www.strictlybusinesslawblog.com/2013/11/17/venture-capital-term-sheet-negotiation-part-3-dividends/#comments Sun, 17 Nov 2013 23:44:19 +0000 http://www.strictlybusinesslawblog.com/?p=1683 This post is the third in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.  In the prior two posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and price per share.   This post […]

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

In the prior two posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and price per share.   This post will focus on dividends on the preferred stock issued in a venture deal.

Dividends are one of the rights often which make preferred stock “preferred” (relative to common).  In short, dividends increase the total return to the preferred stockholders and decrease the total return to the common stockholders.  Dividends are often stated as a percentage of the original issue price for the preferred stock (e.g. a dividend may be stated as 5.0% of the “Series A Original Issue Price”; the original issue price is simply the price paid for the stock by the preferred investors).  There are at least three common ways dividends are structured in venture capital deals, which are as follows:

  • Cumulative dividends
  • Non-cumulative dividends
  • Dividends on preferred stock only when paid on the common stock

Cumulative dividends are the most beneficial to the preferred stock and the most burdensome on the common.  Cumulative dividends accrue on the original issue price and are typically paid on liquidation of the startup or upon redemption of the preferred stock (most startups do not have funds to pay dividends currently, so that’s the reason for payment upon liquidation or redemption).  The accruing dividends represent a future obligation of the startup to the preferred stockholders which reduces funds available for common stockholders.  Cumulative dividends may be structured on a simple basis, where the accruing dividend is calculated on the original issue price but not on any previous accrued and unpaid dividends, or on a compound basis, where all prior accrued and unpaid dividends are taken into account in determining future dividends (the same concept as simple versus compound interest).

Non-cumulative dividends, on the other hand, are paid on the preferred stock only if the Board of Directors declares them; if they are not paid, they do not accrue and do not result in a future obligation to the preferred stockholders.  So you may have an 8.0% dividend preference for the preferred stock; however, if the Board of Directors does not declare the dividend, then it’s forfeited.  This is a significantly better structure for the common stockholders.

The third common method of structuring dividends in a venture deal is to have a dividend paid on the preferred only if paid on the common. In this scenario, the preferred is treated as if it had been converted into common at the time the dividend is declared and the preferred and common stock share in the dividend as if all shares were converted to common.  This is the least beneficial to the preferred stock (this structure does not result in a dividend preference to the preferred stock at all) and the most beneficial to the common stock.

For a sample term sheet containing these three options, see the National Venture Capital Association’s term sheet here.

For startups negotiating a venture deal, you should understand the various ways dividends can be structured and consider (i) the likelihood that cash flow will be available to pay dividends currently (as opposed to upon liquidation, for example) and (ii) the dividend structure’s impact on the total return to the preferred stockholders and the diminution in total return to the common stockholders.  Cumulative dividends can particularly affect the returns if the holding period is relatively long (and this is even more true if the unpaid dividends are compounded).

In the next post, we’ll discuss another item which makes the preferred stock “preferred,” which are the liquidation provisions.


© 2013 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.

The post Venture Capital Term Sheet Negotiation — Part 3: Dividends appeared first on Strictly Business.

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Venture Capital Term Sheet Negotiation — Part 2: Valuation, Capitalization Tables, and Price per Share http://www.strictlybusinesslawblog.com/2013/10/14/venture-capital-term-sheet-negotiation-part-2-valuation-capitalization-tables-price-per-share/?utm_source=rss&utm_medium=rss&utm_campaign=venture-capital-term-sheet-negotiation-part-2-valuation-capitalization-tables-price-per-share http://www.strictlybusinesslawblog.com/2013/10/14/venture-capital-term-sheet-negotiation-part-2-valuation-capitalization-tables-price-per-share/#comments Mon, 14 Oct 2013 23:10:04 +0000 http://www.strictlybusinesslawblog.com/?p=1679 This post is the second in a series giving practical advice to startups on understanding and negotiating a venture capital term sheet.  Previously, we provided a general overview of venture capital terms sheets and some of the pitfalls a startup may encounter when it comes to “binding” vs. “non-binding” provisions. In this post, we will […]

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

Previously, we provided a general overview of venture capital terms sheets and some of the pitfalls a startup may encounter when it comes to “binding” vs. “non-binding” provisions. In this post, we will discuss the issue that is usually in the forefront of most founder’s minds: the valuation of the company.

Valuation in the context of a venture capital transaction can be expressed in terms of pre-money valuation or post-money valuation. Pre-money valuation refers to the valuation of the company prior to the investment whereas post-money valuation refers to the value after an investment has been made. Most founders, when they think of the concept of valuation are referring to pre-money valuation. Calculating pre-money valuation is not intuitive or straightforward. When most people talk about a venture capital investment, usually the investor will say “I’ll give you $1.2 million for 10% of the company.” What is the implied pre-money valuation in this example? You might think the answer is $12 million, but that is actually the post-money valuation, not the pre-money valuation. To get the pre-money valuation, you need to first calculate post-money valuation and then back into the pre-money valuation.

Post-money valuation is pretty straightforward to calculate. You take the dollar amount of the investment and divide it by the percent that the investor is getting. In our example above $1.2 million is divided by 10% yielding a post-money valuation of $12 million. But prior to the $1.2 million investment, the company is not worth $12 million. This is because once you add $1.2 million worth of cash on to the company’s balance sheet the company has just increased in value by $1.2 million. Therefore to calculate pre-money valuation you need to take a second step which is to subtract the amount of investment from the post-money valuation. In the example above, the company is being valued at $10.8 million. This is calculated by taking the $12 million post-money valuation and subtracting the amount of the investment ($1.2 million).

Once we calculate the valuation, we need to figure out how many shares the investor gets for its investment and this is determined using a capitalization table. This also is not always as straightforward as you might think, because there may be holders of options or warrants in the company and there may be an employee stock pool as well. So if the founders have 4.5 million shares of the company they might think that giving the investor 10% in the company involves selling investor 500,000 shares. But venture capital firms often consider more than just the shares issued to founders and previous investors. They will often also include, in the capitalization table, the employee stock pool and any outstanding warrants. This is what is referred to as the fully diluted post-money capitalization. In our sample capitalization table below, you can see that the company must issue more than 500,000 shares to give our potential venture capital investor 10% in the Company.

Pre and Post-Financing Capitalization

Pre-Financing

Post-Financing

Security

# of Shares

%

# of Shares

%

Common – Founders

4,500,000

83.33%

4,500,000

75%

Common – Employee Stock Pool
                  Issued

0

0%

0

0%

                  Unissued

900,000

16.66%

900,000

15%

Common – Warrants

0

0%

0

0%

Series A Preferred

0

0%

600,000

10%

Total

5,400,000

100%

6,000,000

100%

Because even the unissued employee stock is considered in the fully diluted post-money capitalization, in order to give the investor 10% of the company, 600,000 shares must be issued.

The final issue we’ll tackle in this post is the per share price.  Calculating this is relatively straightforward.  Once you know how many shares the company will be issuing to the investor, just divide the amount of the investment by the number of shares issued.  In the example above, the share price would be $2 per share calculated by dividing the investment amount ($1.2 million) by the number of shares issued (600,000).

While valuation and share price may be the most basic and fundamental item on the term sheet, they are not always as straightforward as you might think.  Aspects such us outstanding warrants and employee stock pools affect the pricing of the deal when the valuation is calculated on a fully diluted basis.  Having a full understanding of how these concepts work together will help you understand the economics of the deal being proposed.

Next time we’ll cover preferred dividends.


© 2013 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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