Reverse Mergers Hinge on Due Diligence and Cleaning Up Public Shells

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

When a publicly traded company “goes dark” and becomes delinquent in its filing requirements, it generally becomes a public shell and is no longer quoted on the Over the Counter Bulletin Board Exchange (OTCBB). However, with the assistance of an experienced securities attorney, the shell company can be restored so that a merger candidate can be introduced.

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Going Public Transactions For Smaller Companies: Direct Public Offering And Reverse Merger

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

Introduction

One of the largest areas of my firms practice involves going public transactions.  I have written extensively on the various going public methods, including IPO/DPOs and reverse mergers.  The topic never loses relevancy, and those considering a transaction always ask about the differences between, and advantages and disadvantages of, both reverse mergers and direct and initial public offerings.  This blog is an updated new edition of past articles on the topic.

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Completing A Name Change Without Shareholder Approval

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

Generally a name change is completed through an amendment to a company’s articles of incorporation.  Moreover, amendments to articles of incorporation generally require shareholder consent, which can be time-consuming and expensive and become even more so if the company is subject to the reporting requirements of the Securities Exchange Act of 1934.

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The Business Plan And Private Placement Memo

Since a private placement memorandum, usually abbreviated as the PPM, is the norm in most deals, the founder should familiarize himself with the standards for memorandum preparation, keeping in mind that, like any legal document, there are various audiences. The audience composed of potential plaintiffs (and, theoretically at least, the SEC enforcement staff) will read the document against the requirements contained in the cases imposing liability. The audience composed of investors will read the document for its substantive content: “What are the terms of the deal?” To professional investors interested enough to become potential buyers, the private placement memorandum is a handy collection of only some of the information they are interested in, plus a lot of surplus verbiage (the empty language about suitability standards, for example). To the issuer, it is a sales document, putting the best face possible on the company and its prospects. To the managers, the memorandum is a summary of the business plan. Indeed, it may incorporate the business plan as an exhibit or be “wrapped around” the plan itself—a memorialization of how the business is to be conducted.

The first page of the PPM, the cover page, contains some of the information one might see on the front of a statutory prospectus: name of the issuer, summary description of the securities to be sold, whether the issue is primary (proceeds to the issuer) and/or secondary (proceeds to selling shareholders), the price per share, the gross and net proceeds (minus selling commissions and expenses), and a risk factor or two (that is, the offering is “highly speculative” and the securities will not be liquid). Some would argue a date is important, because, legally, the document speaks as of a certain date. However, if the memo becomes substantively stale between the offer and the closing, it is critical that the issuer update and circulate it; omission of material information as of the closing is not excusable on the theory that the memo displays an earlier date. Moreover, a dated memorandum will appear just that—dated—if a few months elapse and the issue is still unsold. A related issue is whether to specify a minimum amount of proceeds that must be subscribed if the offering is to go forward. If the financing is subject to a “minimum,” a reference belongs on the cover page. It makes common sense that there be a critical mass in most placements; however, a stated requirement that X dollars be raised or all subscriptions returned inhibits an early-closing strategy—the ability to “close,” if only in escrow—with the most eager of the issuer‘s potential investors. Such “closings ” may not be substantively meaningful; the deal may be that the “closing” will be revisited if more money is not raised. However, a first closing can have a salubrious shock effect on the overall financing; it can bring to a halt ongoing (sometimes interminable) negotiations on the terms of the deal and create a bandwagon effect.

The cover page should be notated, a handwritten number inscribed to help record the destination of each private placement memorandum. It is also customary to reflect self-serving, exculpatory language (of varying effectiveness in protecting the issuer), that is:

1. The offer is only an offer in jurisdictions where it can be legally made and then only to persons meeting suitability standards imposed by state and federal law. (The offer is, in fact, an “offer” whenever and to whomsoever a court designates.)

2. The memorandum is not to be reproduced (about the same effectiveness as stamping Department of Defense papers “Eyes Only,” a legend understood in bureaucratese to mean, “may be important … make several copies”).

3. No person is authorized to give out any information other than that contained in the memo. (Since the frequent practice is for selling agents to expand liberally on the memo’s contents, it would be extraordinary if extraneous statements by an authorized agent of the issuer were not allowed in evidence against the issuer, unless perhaps they are expressly inconsistent with the language of the memo.)

4. The private placement memorandum contains summaries of important documents (a statement of the obvious), and the summaries are “qualified by reference” to the full documentation. (A materially inaccurate summary is unlikely to be excused simply because investors were cautioned to read the entire instrument.)

5. Each investor is urged to consult his own attorney and accountant. (No one knows what this means; if the legally expertised portions of the private placement memorandum are otherwise actionably false, it would take an unusually forgiving judge to decide the plaintiff should have obeyed the command and hired personal counsel.)

6. The offering has not been registered under the ’33 Act and the SEC has not approved it.

The foregoing is not meant as an exercise in fine legal writing and the avoidance of excess verbiage. Certain legends are mandatory as a matter of good lawyering—a summary of the “risk factors”; a statement that investors may ask questions and review answers and obtain additional information (an imperative of Reg. D); and, of course, the language required by various state securities administrators. A recitation tipping investors that they will be required in the subscription documents to make representations about their wealth and experience is generally desirable, particularly in light of cases finding against plaintiffs who falsified their representation. However, in my opinion, a cover page loaded with superfluous exculpations may cheapen a venture financing, signaling to readers that the deal is borderline, in a league with “double write-off” offerings in the real estate and tax-shelter areas.

A well-written private placement memorandum will follow the cover page with a summary of the offering. This section corresponds to a term sheet, except that the language is usually spelled out, not abbreviated. The important points are covered briefly: a description of the terms of the offering, the company’s business, risk factors, additional terms (i.e., anti-dilution protection, registration rights, control features), expenses of the transaction and summary financial information. The purpose of the summary is to make the offering easy to read and understand. As stated, suppliers of capital are inundated with business plans and private placement memoranda; the sales-conscious issuer must get all the salient facts in as conspicuous a position as possible if he hopes to have them noticed.

At this juncture, it is customary to reproduce investor suitability standards, identifying and flagging the principal requirements for a Reg. D offering, that is, the definition of “accredited investor.”

Issuers should approach offerings that have stated maximums and minimums with caution. The SEC has made its position clear. If the issuer elects to increase or decrease the size of the offering above the stated maximum/minimum, each of the investors who have signed subscription agreements must consent to the change in writing. It is not open to the issuer to send out a notice to the effect that “We are raising or lowering the minimum and, if we do not hear from you, we assume you consent.” The issuer must obtain the affirmative consent of each investor, which may be a bit difficult if the investor is, at that point, somewhere in Katmandu.

Investors should be aware that issuers sometimes do not want the investors to know certain information. For example, some issuers elect to code the numbers on the private placement memorandum so that no investor knows he is receiving, say, number 140; he is, instead, receiving “14-G.”

Finally, the current trend is to prepare both a full placement memo as well as a brief summary, such as the so-called “elevator pitch”, a concise summary that can be read while riding in an elevator. Venture capitalists are chronically short on time and a 40-page document is likely to be left unread if this is the only pitch material available.

Are You Savvy on Restricted Stock Units?

Written by: Joseph W. Bartlett, Co-Chair of VC Experts

A structure is creeping into the process of rewarding and motivating managements of public and private companies with equity awards. [1]

Although the subject of discussion in this article is not new, nonetheless my experience is that a significant percentage of the parties involved in the capital markets … particularly the private capital markets where emerging growth companies are organized to travel the Conveyor Belt, [2] from the embryo to the IPO … are unfamiliar with restricted stock units (“RSUs”).

The grant of a restricted stock unit (“RSU”) by a corporation to an employee gives the employee the right to receive a share of the corporation‘s stock, or if the RSU agreement so provides, its cash value equivalent, upon satisfaction of one or more specified vesting conditions.

The vesting conditions may be either time-based (completion of a specified period of employment following the date of grant) or performance based (achievement of performance goals over a specified measurement period), or both.

To the extent the RSUs granted to the employee become vested, the employee will receive either the number of shares that have vested, or if the RSU agreement so provides, a cash amount equal to the shares’ fair market value.

In the usual case, the RSU’s are “settled” by the delivery of the shares or payment of the cash amount at the time the RSUs vest. However, an RSU agreement can, and often does, provide for the payment or delivery of shares to be deferred until the occurrence of some later specified date or event; but if payment is to be delayed beyond March 15 of the year following vesting, then the payment-triggering event must be one permitted under Section 409A of the Internal Revenue Code.

Under Section 409A rules, the payment event could be termination of employment, or it could be the occurrence of a change in control , as defined for Section 409A purposes [3], which would be a typical private company exit event when cash can be realized to enable the employee to sell enough shares to pay the tax … and keep the rest. An IPO, another typical exit event, would not be a 409A-permissible payment event for an already vested RSU. But an RSU agreement could provide for the RSUs to both become vested and payable upon the first to occur of an IPO, a change in control (including one not meeting the Section 409A definition), termination of employment, or at some specified date corresponding to the investors’ expected exit and realization date, e.g., the 7th anniversary of the date of grant.

For federal income tax purposes, an employee is not taxed with respect to a grant of RSUs either at the time of grant or at the time of vesting. He is subject to tax only upon his receipt of the shares or their cash equivalent at the time the RSUs are settled. At that time, he is taxed, at ordinary income rates, on the then fair market value of the shares he receives, or the amount of the cash he receives.

In a number of respects, RSUs compare favorably with other forms of equity grants, as a medium for delivering incentive compensation to a private company’s employees.

    • A grant of RSUs delivers full share value to the employee. It provides him not only with upside potential but also downside protection. He can realize value from the grant even if the date of grant value of the RSUs should later decline. In contrast, with an option grant the employee will realize value only if and to the extent that the shares covered by the option increase in value after the grant date.

 

    • A grant of restricted shares also delivers full share value to the employee, and in addition, provides the employee with an opportunity for capital gains treatment on eventual sale of the shares. In contrast, when RSUs are settled, the then value of the shares is subject to tax at ordinary income rates. But as indicated above, RSUs are not taxed at the time of grant, nor at the time of vesting if settlement of the RSUs does not occur until a later date. As a result, it should be possible in most cases to structure an RSU grant so as to delay settlement, and thus, taxation, until a realization event occurs. This may not be the case with a restricted stock grant. The employee would have to pay tax, at ordinary income rates, on the value of his restricted shares either at the time of grant if he makes a Code section 83(b) election, or at the time the shares vest if he doesn’t make the election. He may therefore be subject to tax, at ordinary income rates, with respect to a substantial portion of the ultimate value of his restricted shares well before an exit event occurs permitting a sale of the shares.

 

  • Like an RSU grant, an employee is not taxed with respect to a stock option at the time of grant or at the time of vesting. He is subject to tax at the time he exercises the option, if it is a nonqualified stock option (“NQSO”), or if it is an incentive stock option (“ISO”), at the time he sells the shares acquired on exercise of the option. [4] In either case, the grant of a stock option, whether an NQSO or an ISO, would permit tax to be delayed until the occurrence of a realization event, since a stock option grant can permit the option to be exercised at any time during its term after it becomes vested. Although in the case of an NQSO, tax would be at ordinary income rates, as is so with an RSU, in the case of an ISO, the increase in value of the shares from date of grant to date of sale could qualify for tax at capital gains rates, subject to certain limits and conditions. However, there are several negatives to be considered in connection with a stock option grant.

(i) Valuation Issues. Tax law requirements [5] mandate that the exercise price of a stock option not be less than the fair market value of the underlying shares at date of grant. Failure to comply with this requirement could result in significant adverse tax consequences for the employee under Section 409A. Share valuations for a private company are an inherently uncertain matter. To minimize the exposure to adverse treatment under Section 409A, the exercise price for the option usually would be established based on an independent third party valuation.

(ii) Dilution. Because an option delivers value to the employee only to the extent that the fair market value of the shares at the time of exercise exceeds the option exercise price, it would be necessary for an option grant to cover a greater number of shares than a grant of RSUs or restricted stock, in order to deliver an equivalent economic value to the employee. As a result, an option grant would mean more dilution for the investors as compared with an economically equivalent grant of RSUs or restricted stock.

(iii) Limits on Capital Gain treatment for ISOs. Capital gain treatment for an ISO is available only if the shares acquired on exercise are held for at least 1 year following the date of exercise of the option, and 2 years following the date of grant of the option. In the usual case, an employee holding an option on shares of a private company would not want to exercise his option until there is an IPO or other realization event, and will want to sell the shares he acquires on exercise of the option as soon as practicable after that event occurs, in order to (a) fund his payment of the exercise price for the shares, and (b) avoid loss of value in the shares in a highly volatile market that could bring a significant drop in share price prior to the end of the ISO-required holding periods. If the employee does sell the shares before the end of the ISO required holding periods, the increase in value of the shares since date of grant will be taxed at ordinary income rates, instead of capital gain rates. [6]

All things considered, for many private companies the grant of RSUs may be the best vehicle for delivering incentive compensation to the company’s executives, despite the fact that the values so delivered will be subject to tax at ordinary income rates.

After all, the objective is to give an incentive to the executives which pays them for navigating the company’s trip from “the embryo to the IPO” or to a trade sale. And, if the tax is at ordinary income rates the answer is ‘so what?’… as long as the executives receive and are able to sell enough shares to make a big difference in the executive’s life.


[1] See, Perkins, “Equity Compensation Alphabet Soup- ISO, NSO, RSA, RSU and More,” Contributing Author, the Venture Alley at DLA Piper, LLP, Buzz, on VC Experts (www.vcexperts.com)

[2] Bartlett, “From the Embryo to the IPO, Courtesy of the Conveyor Belt (Plus a Tax-Efficient Alternative to the Carried Interest), ” The Journal of Private Equity Winter 2011, Copyright (c) 2011, Institutional Investor, Inc.

[3] The definition would include the acquisition by a third party of more than 50% of the total fair market value or voting power of the company’s shares, or more than 40% of the total gross fair market value of the company’s assets.

[4] However, the “spread” at the time of exercise of an ISO might be subject to the alternative minimum tax (“AMT”) in the year of exercise.

[5] Code section 409A and the regulations issued thereunder in the case of a nonqualified stock option, and Code section 422(b)(4) in the case of an incentive stock option (“ISO”).

[6] Other limits on capital gains treatment for ISOs: (i) ISO treatment is available only for shares with a total grant date value of up to $100,000, in respect of all of the employee’s ISOs that first become exercisable in any calendar year; and (ii) ISO treatment is available for an option only if exercised by the employee during employment or by the end of the 3rd month following termination of employment. If an exit event has not occurred before the end of the 3 month post-termination exercise period and the employee wants to wait until an exit event does occur to exercise his option, doing so will result in loss of ISO status for his option and taxation at ordinary income rates, instead of capital gain rates, for the “spread” when he does exercise the option.

Let’s Finally Fix Crowdfunding!

Guest Post by: Christopher G. Froelich of Sheppard Mullin

On April 5, 2012, President Obama signed into law the landmark Jumpstart Our Business Startups Act (JOBS Act), for the purpose of encouraging the funding of startups and small businesses throughout the United States.  Title III of the JOBS Act, otherwise known as Regulation Crowdfunding or Reg CF, received the most attention because it legalized investment crowdfunding.  The purpose of Reg CF was to make it easier for startups and small businesses to access capital, to give more people the ability to participate in investment opportunities, and ultimately, to create jobs and stimulate economic growth. Crowdfunding is the practice of funding a business by raising small amounts of money from a large number of investors, typically via the Internet.  Prior to Reg CF, generally only accredited investors – those who earn an annual income of at least $200,000 (or $300,000 if married), or those with a net worth of at least $1 million (excluding one’s primary residence) – could invest in startups and small businesses, usually through Rule 506 of Regulation D.  Reg CF created a new exemption to the Securities Act of 1933 that allows ordinary people the opportunity to invest in startups and small businesses alongside angel investors and venture capitalists.
So how does Reg CF work?  In general, Reg CF allows startups and small businesses to raise up to $1 million in a rolling 12-month period from any investor, including non-accredited investors.  Issuers are required to use online intermediaries known as “funding portals.”

Reg CF officially went into effect in May 2016, but has been off to a slow start.  This is due to several factors that make it difficult for potential issuers to utilize the new law.  The primary difficulty is that  Reg CF imposes high regulatory burdens and costs on startups and businesses attempting to raise funds.  For example, Reg CF requires that businesses raising more than $500,000 have GAAP standard financial statements ready to share with potential investors.  While transparency in investing is important, few startups and small businesses have funds available to pay the accountant fees necessary to prepare GAAP financials.

Moreover, Reg CF requires issuers to file a Form C with the SEC prior to raising funds.  Form C is a complicated document that in most cases requires legal review.  The fact is that very few startups and small businesses have the money to cover the legal fees associated with such review.  Reg CF itself is long and complex, requiring further expensive legal assistance to make sure its requirements are followed.  To make matters worse, Reg CF prohibits issuers from making any offering, or any announcement about an offering (including any general announcement or tombstone statement), without first making the required disclosures with the SEC, including Form C.  This rule prohibits potential issuers from “testing the waters” – i.e., from soliciting non-binding indications of interest from potential investors prior to an issuance, thereby minimizing the risk of paying accounting and legal fees, among other expenses, for an offering that may turn out to be unsuccessful.

There are additional problems with Reg CF.  The $1 million cap on yearly fundraising is a nonstarter for small businesses in industries that require larger sums of startup capital.

There have been efforts to make Regulation Crowdfunding more useful to issuers.  In June 2016, the House of Representatives approved the “Fix Crowdfunding Act” bill (HR 4855).  While the original bill sought to remedy the shortcomings discussed above, the legislation was significantly amended prior to being passed by the House.  HR 4855, however, died in the Senate.

Any new bill should try to address the following issues.

First, the issuer cap should be raised from $1 million to $5 million and the investor caps should be modified by basing the percentage caps on the “greater of” net worth/income, not the “lesser of.”  These higher caps would vastly improve the capital raising capabilities of startups and small businesses.

Second, potential issuers should be able to “test the waters,” permitting them to solicit interest before actually spending money on accountants and lawyers.  Allowing potential issuers to test the waters would reduce the upfront cost of conducting a Reg CF offering and the risk of paying accounting and legal fees for an unsuccessful offering.

Finally, the burden on funding portals to vet the Reg CF offerings they post should be reduced to encourage the development of these new facilities.  Currently, Reg CF requires portals to act as gatekeepers of the offerings they post by imposing significant liability on portals for misstatements or omissions of the issuer, even if the portals are not aware that the information is false.  While the due diligence obligations of the portals should be retained, the new rule should clarify that portals would not be liable under Reg CF unless they knowingly allowed material issuer misstatements or omissions or otherwise engaged in or aided fraud.

It has been nearly 5 years since the passage of the JOBS Act, and the most anticipated portion of the landmark legislation, crowdfunding, has been a bust.  It is finally time to fix the problem, make it easier for startups and small businesses to access capital and democratize access to startup investment opportunities for the every-day investor.


Christopher G. Froelich, Special Counsel at Sheppard Mullin

Chris advises public and private companies and private equity funds in domestic and cross-border transactions, including mergers and acquisitions, private equity investments, joint ventures, divestitures, restructurings, recapitalizations and transactions involving distressed or bankrupt targets or sellers. He counsels clients through all stages of the deal process, including drafting and negotiating letters of intent, stock and asset purchase agreements, merger agreements, shareholder and joint venture agreements, partnership agreements, financing documents, confidentiality agreements, escrow agreements, due diligence reports and corporate governance documents.


 Sheppard Mullin is a full service Global 100 firm with 750 attorneys in 15 offices located in the United States, Europe and Asia. Since 1927, companies have turned to Sheppard Mullin to handle corporate and technology matters, high stakes litigation and complex financial and property transactions. In the U.S., the firm’s clients include half of the Fortune 100. For more information, please visit www.sheppardmullin.com.

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