REVISED RULE 504: ANOTHER TOOL IN THE TOOLKIT TO RAISE CAPITAL

Written By: Daniel DeWolf and Brian Novell of Mintz Levin

If there is one common theme that entrepreneurs tend to have, it is fire – meaning, many entrepreneurs are passionate about an exciting idea that they seek to turn into a business.  However, entrepreneurs often quickly realize that, in order to make their fire glow high and bright for the world to see, they need fuel – meaning, capital.  While bootstrapping is a smart practice that can keep the embers burning for a period of time, even fantastic ideas will likely sooner or later need a major capital injection – thereby adding fuel to the fire – to take the venture to the next level.  This is where the newly revised Rule 504 of Regulation D may be a good option for early stage companies.  For qualifying companies, Rule 504 provides an exemption from the registration requirements of the Securities Act of 1933, thereby facilitating the ability of startups to raise capital.  Often well-suited for friends and family or seed rounds of funding, Rule 504 provides flexibility to smaller companies seeking assistance with capital formation.

The Rule and the Changes.

On October 26, 2016, the SEC adopted final rules that amend Rule 504, thereby increasing the maximum offering amount permitted to be raised from $1 million to $5 million, which will be effective as of 60 days following publication in the Federal Register.  The SEC noted in the adopting release that Rule 504 had been underutilized due to the previous low offering amount limitation.  The main benefit of this new increase is that more small businesses will be able to rely on Rule 504, as it will now be in the consideration set for certain companies seeking funding of up to $5 million.  Entrepreneurs may then find themselves asking:  Is our company eligible for exemption under Rule 504, and does Rule 504 make sense for us?

The Fine Print.

In order to be eligible for Rule 504, a company must not yet be required to file reports under the Securities Exchange Act of 1934, and must not be a “blank check company”, meaning that most early-stage companies with a plan for an operating business are eligible.  What is unique about Rule 504 is that it provides (i) significant freedom in how one goes about raising the capital, and (ii) permits resales of shares with less friction.  Offerings under Rule 504 permit, under certain circumstances, general advertising and solicitation; and, further, the requirement that the securities be restricted from subsequent resale will not apply to offers and sales of securities when following certain requirements.

Is Rule 504 the Right Choice?

While potentially a new tool to raise capital, Rule 504 should be evaluated in comparison to other options for exemption.  Over the last decade, the use of Rule 504 offerings had been in decline, both in absolute terms and relative to Rule 506 of Regulation D.  Rule 506 provides two potential exemptions from registration.  First, Rule 506(b) has no limit on the amount of money that may be raised or the number of accredited investors that may be purchasers, though general solicitation or advertising may not be used and a company may not sell securities to more than 35 non-accredited investors, among other requirements.  Second, under Rule 506(c), the SEC eliminated the prohibition against general advertising, provided that all purchasers are accredited investors and the issuer takes reasonable steps to verify so, among other requirements.

What Does It Mean For Entrepreneurs?

The increase in the maximum amount that may be offered and sold under Rule 504 allows for more companies potentially to leverage Rule 504 for their capital raising needs.  In light of this recent development, Rule 504 may be a good choice for many early stage companies.  It is another tool in the toolkit to consider when raising capital.


Daniel I. DeWolf, Member Chair, Technology Practice Group, Co-Chair, Venture Capital and Emerging Companies

Daniel is Co-chair of the firm’s Venture Capital & Emerging Companies Practice Group and Chair of our Technology Practice Group. In addition to his active legal practice, he is an adjunct professor of law at the NYU Law School and he has a wealth of experience in private equity and venture capital, having co-founded Dawntreader Ventures, an early stage venture capital firm based in New York.

Biography

Brian J. Novell, Associate, Technology Practice Group

Brian applies his past experience as an associate in the banking and credit group of a large international law firm to his corporate and securities practice, having counseled domestic and international borrowers and lenders in acquisition financings, project financings, syndicated leveraged financings and other commercial lending transactions. His past firm experience also includes advising companies in complex mergers and acquisitions and capital markets transactions and leading a confidentiality agreement team on behalf of a prominent private equity firm client. Brian was recognized for his outstanding pro bono legal services as the recipient of The Legal Aid Society’s 2015 Pro Bono Publico Award.

Biography

 

 

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Antidilution Explained: Full-Ratchet and Weighted-Average Provisions

There are two principal ways to formulate antidilution provisions, capitalizing the terms to make it clear we are talking about the ones which have substantive bite—the “Full Ratchet” and the “Weighted Average.” Full Ratchet provisions are the real killers, at least from the founder’s point of view. They provide that, if one share of stock is issued at a lower price, or one right to purchase stock is issued at a lower aggregate price (exercise price plus what is paid, if anything, for the right), then the conversion price of the existing preferred shares [1] is automatically decreased, that is, it “ratchets down,” to the lower price. [2] Depending on how many shares (or rights) are included in the subsequent issue, this can be strong medicine. A brief example will illustrate.

Assume Newco, Inc. has one million common shares and one million convertible preferred shares outstanding, the founder owns all the common, and the investors own all the preferred, convertible into common at $1 per share. Newco then issues 50,000 shares of common at $ .50 per share because it desperately needs $25,000 in cash. To make the example as severe as possible, let us say the investors control the board and they make the decision to price the new round of financing at $.50. Suddenly the preferreds’ conversion price is $.50, the founder goes from 50 percent of the equity to under 33.3 percent, and all the company has gained in the bargain is $25,000. Indeed, a Full Ratchet would drop the founder from 50 percent of the equity to 33.3 percent if the company issued only one share at $.50. This is a harsh result, indeed. When a really dilutive financing occurs, say shares have to be sold at MO per share, the founder drops essentially out of sight. The company takes in $5,000 and the founder goes down under 9 percent, never to recover because he does not have the cash to protect himself in subsequent rounds. In the jargon of venture capital, he has been “burned out” of the opportunity. There is no other provision so capable of changing the initial bargain between the parties with the dramatic effect of Full Ratchet dilution. When venture capitalists are referred to as “vulture capitalists,” it is likely the wounded founders are talking about dilutive financings and a Full Ratchet provision. [3]

The more moderate position on this issue has to do with Weighted Average antidilution provisions. There are various ways of expressing the formula but it comes down to the same central idea: The investors’ conversion price is reduced to a lower number but one which takes into account how many shares (or rights) are issued in the dilutive financing. If only a share or two is issued; then the conversion price does not move much; if many shares are issued—that is, there is in fact, real dilution—then the price moves accordingly.

The object is to diminish the old conversion price to a number between itself and the price per share in the dilutive financing, taking into account how many new shares are issued. Thus, the starting point is the total number of common shares outstanding prior to the dilutive financing. The procedure to achieve the objective is tomultiply the old conversion price per share by some fraction, less than one, to arrive at a new conversion price; the latter being smaller than the former, the investors will get more shares on conversion and dilute the common shareholders (the founder) accordingly. The fraction is actually a combination of two relationships used to “weight” the computation equitably. The first relationship is driven by the number of shares outstanding, the weighting factor, meaning that the calculation should take into account not only the drop in price but the number of shares involved—the significance of the dilution, in other words. [Call the number of shares outstanding before the transaction—A.]

The fraction, then, takes into account the drop in price and expresses that drop in terms that can be mathematically manipulated with the first number to get a combined, weighted result. The relationship is between the shares which would have been issued for the total consideration paid if the old (i.e., higher) conversion price had been used versus the shares actually issued (i.e., the shares issued at the new price.) [Call these two numbers—C and D.]

The combination of these two relationships—number of shares outstanding and the comparative effect of the step down in price (expressed in number of shares)—is a formula:

((A + C) ÷ (A + D)) x Old Conversion Price

If the shares which would have been issued at the old (i.e., higher) price is (as indicated) the number in the numerator, the fraction or percentage will be less than one. This fraction (say 1/2 or .50) is multiplied by the existing (or initial) conversion price to obtain a lower conversion price, which means in turn that more shares will be issued because the conversion price produces the correct number of shares by being divided into a fixed number, usually the liquidation preference of the preferred stock.

It is open for theorists to argue about the fairness of that result, but the above formula has the advantage of economy of expression. If one wants to use a Weighted-Average antidilution formula, the above is one commonly used (albeit expressed in different terms).

There, are, of course, different ways of expressing the formula. In the case of warrants and options, for example, the contract is often expressed in terms of a specific number of shares obtained at a fixed exercise price. Simply adjusting the exercise price may mean that a holder gets the same number of shares but pays a little (or a lot) less. In such an instance, the trick is to continue the exercise price as is but to adjust upwards the number of shares resulting from exercise, which can easily be done by reversing the formula—(A plus D) divided by (A plus C).

The calculations get more complex, as rounds of financing multiply. If the investors in round one (holding series A preferred) enjoy a conversion price of $1, and the price for the round two (series B) investors is $1.50, and the round three (series C) preferred is convertible at $4 and there then occurs a dilutive financing at $.50, all the conversion prices are affected, but it takes a computer to figure out who is entitled to what number of shares, particularly since investors in the various rounds will tend to overlap. (In this connection, one occasionally encounters a formula which keys off accumulated dilution. Thus, in the example cited, and depending on the amount raised in each instance, only the series C preferred holders would get an adjustment in their conversion price; the earlier investors would hold fast because the Weighted Average price of all subsequent rounds, taken together, is above their price.)

There are a number of other confusions which can easily creep into the drafting of the section. For example, can the conversion price go up? The answer is ordinarily no, at least by virtue of cheap stock antidilution. Does the exercise price which is ratcheted down always mean the original conversion price or the conversion price immediately preceding the dilutive event? The answer can vary but usually the latter is meant. If the conversion price goes down from $10 to, say, $5, a subsequent round at $7 doesn’t budge it again. An adjustment in the conversion price is usually pegged to the issuance of cheap stock or the right to buy cheap stock, say another convertible or an option. If the option lapses, is the adjustment reversed? Ordinarily, no. Other dilutive events are referenced in conventional financing documents, including extraordinary dividends. Absent care in drafting, a distribution of cash or property can ratchet the conversion price down to a negative number.

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Stock Options and Their Effect on Capital Structure

Excerpt from Chapter 7 of VC Experts Encyclopedia of Private Equity & Venture Capital

Brief Overview

Competitive stock option programs are an integral part of a private or public organization’s compensation policy. As such, stock option programs are a significant part of a company’s capital structure and an important part of the valuation discussion and analysis that investors undergo.

As companies expand their headcount, their cash flow and, typically, capital needs increase for some period. Attendant with any increase in headcount presumably is the need to increase a company’s option pool. The need for any increase in capital not only places dilutive pressure on a company’s overall capital structure, but also erodes the percentage holding of employees who are members of a company’s stock option program.

Balancing Financing Needs with Competitive Best Practices

The extent to which an option pool can be a significant source of discussion and consternation is directly tied to cost of equity capital for a company. Options are dilutive to investors. Whereas founders and angel investors often hold important positions in the capital structure of any early-stage company, a company’s capital needs and the valuation tied to any equity investment assume significant needs in terms of options and compensation going forward. Few companies can run, scale, and generate handsome returns to investors without increasing their headcount and management team over time.

Companies that can point to compelling investment opportunities and command the interest of strong, established, and experienced equity investors should be able to agree to reasonable expectations on the part of prospective investors about the size of the future option pool and to what extent it will need to grow. The elements that any competent analysis of an option program need to have taken into account include defining the competitive market for compensation – specifically, the cash and equity components. Established accounting and law firms with a strong venture practice can be as strong a source of information as compensation consultants. Key to a company’s success in both generating financing and remaining competitive is a strong commitment to reviewing current equity holdings of key management and assessing them in the context of the competitive marketplace. Investors will want to see a stock option grant strategy in place and are likely to make some quite definitive assumptions of their own regarding the size and growth of the option pool during the life of their investment in the company.

It is important to note that some investors – and strategic investors, in particular – may not realize market norms for option grants in small, high-risk companies. In many cases, their more conservative assumptions can pose a real challenge for management teams that are not compensated well enough, but realize that only after precedents have been set. Employees, too, have a lot to learn about stock option levels, but a board should assume that eventually employees will have to be closely aligned with the marketplace or, otherwise, should be prepared to compensate managers mostly in cash.

Employee expectations with regard to the number of options vary significantly. Interestingly enough, many employees are satisfied with a specific number of shares in a company without placing value on how that number of shares may translate in percentage terms. It may seem logical enough for an employee to assume, if the most recent price of preferred stock was $1, the employee is awarded 250,000 shares of options, and investors expect to sell the company for $4 per share, that his or her shares could be worth $1 million. What employees often lose sight of is the amount of capital a company may require, as conditions change, to meet its goals and how many additional shares may need to be issued. Whereas astute investors protect themselves from dilution through the use of preferred stock, employees are diluted as additional stock is issued, unless they are awarded additional options along the way.

Some employees focus instead on percentage ownership. There are obvious pitfalls to emphasizing or agreeing to employment contracts that tie options grants to a fixed percentage ownership in a company. This becomes a significant liability and a continued drag on the options pool as a company seeks to raise additional capital. But it is appropriate to consider awards set against some percentage benchmark for senior levels of management. I have seen wide ranges in ownership in many companies that are not yet profitable. The range for CEOs, some of whom own founders shares, can vary from 3 percent to 13 percent and for CFOs from 1 percent to 2.5 percent. I have seen the range for key executives, including vice president and director level staff, from .5 percent to 1.5 percent. Often geographic regions will have their own unique profiles, and so it is appropriate to ask experienced executive search professionals, attorneys, and accountants for a sense of the local market when it comes to options.

Dilution and the Protections Investors May Require

Investors are fully aware of the dilutive effect of a financing on an option pool. VC investors especially are typically keenly aware of market parameters and standards regarding stock option compensation. Strategic investors may not be as up to date as they are more familiar with options plans in much larger companies. It is not uncommon, therefore, that strict expectations for the size and profile of a stock option pool will be set at the time of a financing, enumerated and outlined in a section titled “Reserved Shares.” Consider the passage below from a term sheet related to a financing:

Reserved Shares: The Company currently has or will have 3,000,000 shares of Common reserved for issuance to directors, officers, employees, and consultants upon the exercise of outstanding and future options (the “Reserved Shares”).

 

The Reserved Shares will be issued from time to time to directors, officers, employees and consultants of the Company under such arrangements, contracts or plans as are recommended by management and approved by the Board, provided that without the unanimous consent of the directors elected solely by the Preferred, the vesting of any such shares (or options therefore) issued to any such person shall not be at a rate in excess of 25% per annum from the date of issuance. Unless subsequently agreed to the contrary by the investors, any issuance of shares in excess of the Reserved Shares will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the investors’ first offer right as described below. Holders of Reserved Shares will be required to execute stock restriction agreements with the Company providing for certain restrictions on transfer and for the Company’s right of first refusal.
Right of First Offer for Purchase of New Securities: So long as any of the Preferred is outstanding, if the Company proposes to offer any shares for the purpose of financing its business (other than Reserved Shares, shares issued in the acquisition of another company, or shares offered to the public pursuant to an underwritten public offering), the Company will first offer a portion of such shares to the holders of Preferred so as to enable them to maintain their percentage interest in the Company.

 

The purpose of the “Reserved Shares” clause in a term sheet is to set in place certain expectations that define exactly how large an option pool will grow before those preferred shareholders may benefit from any protection outlined in the clause. In the example above, the investors proposing the term sheet outlined that the financing would assume that up to 3,000,000 shares of common could be reserved “for issuance to directors, officers, employees, and consultants upon the exercise of outstanding and future options.” The clause clearly places a ceiling on the number of shares of common that can be issued upon exercise of options by these constituencies. The clause goes on to detail that unless the investors agree otherwise, any issuance of shares as a result of additional options will need to result in full anti-dilution protection and an adjustment to the conversion price of the shares held by the investors who propose this round of financing. The clause clearly states, “Unless subsequently agreed to the contrary by the investors, any issuance of shares in excess of the Reserved Shares will be a dilutive event requiring adjustment of the conversion price as provided above and will be subject to the investors’ first offer right as described below.” The “Right of First Offer for Purchase of New Securities” language that follows the “Reserved Shares” clause in effect proposes that the investors proposing the financing be allowed to maintain their ownership percentage and in effect purchase more shares in the company if additional options issued result in the need to issue more than 3,000,000 shares of common stock.

The full range of an investor’s potential tools in stock incentive planning includes the ability to require founders to bind some number of shares of common stock under a stock restriction agreement. In so doing, an existing ownership position can be treated as restricted stock that is earned over a period of years. This in effect resets the clock on the stock founders may own at the time of an early-stage financing. When market conditions and company progress indicate to investors that founders’ option packages are either too rich or are in line with the market but owned outright, requiring that these individuals agree to extend the time frame they will need to work to fully own stock is one mechanism that can keep employees motivated, but not require a company to issue more options to do so.

 

So You Want To Raise Capital

Mary Jones, a biochemist, has stumbled across an interesting piece of science and has been given the opportunity to license the same by the university for which she works, for a nominal up-front fee, an ongoing royalty, plus a gratis equity position in the company. The principal condition of the license is that the science be exploited commercially. The science, if proven to perform as early indications suggest, will greatly reduce the need for insulin injections by patients suffering from juvenile and adult-onset diabetes. Since diabetes is growing at an alarming rate, particularly among adults, Jones is excited and prepared to quit her job. She is intimidated, however, by the fact the development of the drug through FDA animal and clinical trials may, she understands from individuals who have “been there,” cost upwards of $30 to $40 million. Indeed, simply to fund testing to get a new drug ready for the FDA will require several hundred thousands of dollars of additional work in the lab.

Jones goes to the Internet and downloads some of the existing literature on early-stage finance; she puts together a business plan seeking to raise the entire amount necessary to get her product on the market. At this point, the case study is interrupted by a supervening fact: Jones is almost certain to fail. With exceptions with which I am not personally familiar (other than a few extraordinary Internet-related examples), it is impossible to raise a multimillion-dollar amount of capital for a start-up in one lump sum. If one sets out to do so, time and money are wasted. The successful examples, accordingly, divide the fund-raising process into small bites. The first amount of capital raised (a “tranche” in VC jargon) is $500,000. There is no magic in that number but it has repeated itself often enough that it has become part of the canon. Five hundred thousand dollars takes the startup to the point where indications of success have become strong. There is, perhaps, even a so-called beta test, meaning a working prototype of the product or technology and, in the biotech arena, successful phase-one trials. The next tranche is, therefore, $3 million. (Again, there is no magic to the number, but it repeats itself so often it has become part of the culture.) The $3 million also may come from high net worth individuals, often those acquainted with the founder (and here the jargon is that the founder is going through his or her “Rolodex offering”), but also may include a venture fund, turning the financing into the “first venture round.” Getting ahead of the story, the $3 million does not arrive in one lump sum, ordinarily, but in increments. Recognizing that $3 million is only a fraction of the $30 to $40 million needed, the founder and her advisers, perhaps including a boutique placement agent at this stage, are coincidentally searching for strategic investment, for example, a minority tranche from an ethical drug company in exchange for stock, marketing, and distribution rights to the technology if it clicks. Again, the case study indicates the rules of thumb in the trade. The strategic investor invests at a 25 percent more favorable valuation than the financial partners, a number validated by reliable survey materials. But the bad news is that it takes about twice as long for a strategic investor to make up its mind as a financial partner.

The company is then up and operating, slogging its way through the FDA gauntlet of phase-one, phase-two, and phase-three trials, and burning money at a rate of several hundred thousand dollars a month. As the science arrives at the early stages of FDA scrutiny and trials, the VCs and the founder start talking about a mega-financing by tapping the public equity markets—an initial public offering (IPO).

Again, referencing current fashion, serious investment bankers (and not those firms of questionable pedigrees sometimes known as the “Boca Raton” bankers) express an interest conditional on the company having at least one, and preferably more, applications of its science in phase-three trials. The minimum size of the offering is $30 million for somewhere around one-third of the company, meaning a total post-IPO company valuation of $100 million. A financing takes about six months from start to finish and is fraught with risk, including the possibility of a “fail” on the eve of the effective date if the market turns against biotech stocks, as it does episodically for reasons which can be totally unrelated to Jones and her firm. Assuming a successful public offering, $30 million still may not be enough to get to cash-flow break-even, since the company is taking on other scientific projects, which burn money at a rapid rate, in order to justify the expectations of the market that it is a real company and not just a line of one or two products. The IPO is then followed by another primary offering some six months later, assuming the stock holds up well and the market continues to stay in love with the company’s prospects. This time the valuation is advanced to, say, $150 million and the company again puts $30 million in its pocket. The period between the first and the second financing is stressful for Jones because she is not only managing her firm but also, once the company has become public, continually spending time cozying up to stockholders, analysts, and other members of the investment community so that the popularity of her company, as measured by the trading price of her stock, remains strong. Jones has been told that the “road show” (that presentation she made to the investment community and investment bankers immediately prior to the IPO) “never ends.” The irony is that at a company valuation anywhere under $300 to $500 million, the company risks a visit to the so-called growing orphanage, meaning that cohort comprising 70 percent of the 12,000 companies currently public which are not followed by the investment analysts, and, therefore, are not liquid in any true economic sense, with a stock price reflecting an efficient market. Jones is advised, accordingly, to pursue a so-called rollup or platform strategy, meaning using her public company as the platform to absorb other public and private companies which have not been able to make it on their own but which house interesting science and have brought their intellectual property to the brink of commercial exploitation. By rolling up those companies into her platform, she is able to increase her market capitalization to one-half billion dollars and finally take a one-week vacation in the Bahamas.

After all the dilution she still owns about 7 percent of her company personally, which translates, on paper at least, into $35 million. She cannot get out at that price because she is contractually obligated to “lock up” (i.e., not sell) for various periods of time so as not to create undue selling pressure. And, she has been living for four or five years on a salary which is somewhat less than half of what she could have earned had she not entered into this enterprise in the first place. However, she beat the odds. She will ultimately have some liquidity, together with the priceless satisfaction of having grown a major public firm and served mankind in the process. She will no longer, incidentally, be chief executive officer. That post was filled shortly after the first venture round, with Jones continuing as chair and chief scientific officer. The first individual hired having not worked out, there have been two CEOs since: the last one a grizzled veteran of the pharmaceutical industry and a long-time favorite of Wall Street. The office of chief financial officer has also changed hands a few times, the law and accounting firms are new, and a major-bracket investment bank long ago replaced the placement agent. Alleged dissident shareholders have sued Jones twice, in fact stimulated by underemployed plaintiffs’ counsel for allegedly keeping good news (or bad news, depending on how the stock price performed) under wraps for too long. Was it worth it? The answer, of course, depends on the individual. This game is not for everybody.

Term Sheets: Important Negotiating Issues

Excerpt from VC Experts Encyclopedia of Private Equity & Venture Capital

It is customary to begin the negotiation of a venture investment with the circulation of a document known as a term sheet, a summary of the terms the proposer (the issuer, the investor, or an intermediary) is prepared to accept. The term sheet is analogous to a letter of intent, a nonbinding outline of the principal points which the Stock Purchase Agreement and related agreements will cover in detail. The advantage of the abbreviated term sheet format is, first, that it expedites the process. Experienced counsel immediately know generally what is meant when the term sheet specifies “one demand registration at the issuer‘s expense, unlimited piggybacks at the issuer‘s expense, weighted average antidilution,” it saves time not to have to spell out the long-form edition of those references.

Important Negotiating Issues

Entrepreneurs who are in the process of effecting a venture capital financing for their start-up or emerging companies will negotiate with one or more venture capital firms on a number of fundamental and important issues. These issues are generally initially set forth in a “Term Sheet” which will serve as the basic framework for the investment. It is important that the company anticipate these issues and that the Term Sheet reflect the parties’ understanding with respect to them.

The following are some of the more important issues that arise:

  • The Valuation of the Company. While valuation is often viewed as the most important issue by the company, it needs to be considered in light of other issues, including vesting of founder shares, follow-on investment capabilities by the venture investors, and terms of the security issued to the investors. Significant financial and legal due diligence will occur and entrepreneurs should ensure that their companies’ financial projections are reasonable and that important assumptions are explained. Venture investors will consider stock options and stock needed to be issued to future employees in determining a value per share. This is often referred to as determining valuation on a “fully diluted” basis.
  • The Amount and Timing of the Investment. Venture investors in early stage companies often wish to stage their investment, with an obligation to make installment contributions only if certain pre-designated milestones are met.
  • The Form of the Investment by the Venture Investors. Venture investors often prefer to invest in convertible preferred stock, giving them a preference over common shareholders in dividends and upon liquidation of the company, but with the upside potential of being able to convert into the common stock of the company. There are strong tax considerations in favor of employee-shareholders for use of convertible preferred stock, allowing the employees to obtain options in the company at a much reduced price to that paid by the venture investors (a pricing of employee stock options at 1/10th of the price for preferred stock is common among Silicon Valley companies). Often times, venture investors will seek to establish interim opportunities to realize a return on this investment such as by incorporating a current dividend yield or redemption feature in the security. [Redemption rights allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.]
  • The Number of Directors the Venture Investors Can Elect. The venture investors will often want the right to appoint a designated number of directors to the company’s Board. This will be important to the venture investors for at least two reasons: (1) they will be better able to monitor their investment and have a say in running of the business and (2) this will be helpful for characterization of venture capital fund investors as “venture capital operating companies” for purposes of the ERISA plan asset regulations. Companies often resist giving venture investors control of, or a blocking position on, a company’s Board. A frequent compromise is to allow outside directors, acceptable to the company and venture investors, to hold the balance of power. Occasionally, Board visitation rights in lieu of a Board seat is granted.
  • Vesting of the Founders’ Stock. Venture investors will often insist that all or a portion of the stock owned or to be owned by the founders and key employees vest (i.e., become “earned”) only in stages after continued employment with the company. The amount deemed already vested and the period over which the remaining shares will vest is often one of the most sensitive and difficult negotiating issues. Vesting of founder stock is less of an issue in later stage companies. Another issue with the founders can arise if the VC insist that the founders lock-up the issuer‘s representatives and warranties. Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. [Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders.
  • Additional Management Members. The investors will occasionally insist that additional or substitute management employees be hired following their investment. A crucial issue in this regard will be the extent to which the stock or options issued to the additional management will dilute the holdings of the founders and the investors.
  • The Protection of Conversion Rights of the Investors from Future Company Stock Issuances. The venture investors will insist on at least a weighted average anti-dilution protection, such that if the company were to issue stock in the future based on a valuation of the company less than the valuation represented by their investment, the venture investors’ conversion price would be lowered. The company will want to avoid the more severe “ratchet” anti-dilution clause and to specifically exempt from the anti-dilution protection shares or options that are issued to officers and key employees. It is also sometimes desirable from the company’s perspective to modify the anti-dilution protection by providing that only those investors who invest in a subsequent dilutive round of financing can take advantage of an adjustment downward of their conversion price, a so-called “pay to play” provision. If the formula states that if the number of shares in the formula is “broadest” based, this helps the common shareholder. [If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.]
  • Pre-emptive Rights of the Investors to Purchase any Future Stock Issuances on a Priority Basis. The company will want this pre-emptive right to terminate on a public offering and will want the right to exclude employee stock issuances and issuances in connection with acquisitions, employee stock issues, and securities issuances to lenders and equipment lessors.
  • Employment Agreements With Key Founders. Management should anticipate that venture investors will typically not want employment agreements. If they are negotiated, the key issues often are: (1) compensation and benefits; (2) duties of the employee and under what circumstances those duties can be changed; (3) the circumstances under which the employee can be fired; (4) severance payments on termination; (5) the rights of the company to repurchase stock of the terminated employee and at what price; (6) term of employment; and (7) restrictions on post-employment activities and competition.
  • The Proprietary Rights of the Company. If the company has a key product, the investors will want some comfort as to the ownership by the company of the proprietary rights to the product and the company’s ability to protect those rights. Furthermore, the investors will want some comfort that any employees who have left other companies are not bringing confidential or proprietary information of their former employer to the new company. If the product of the company was invented by a particular individual, appropriate assignments to the company will often be required. Investors may require that all employees sign a standard form Confidentiality and Inventions Assignment Agreement.
  • Founders Non-Competes. The investors want to make sure the founders and key employees sign non-competes.
  • Exit Strategy for the Investors. The venture investors will be interested in how they will be able to realize on the value of their investment. In this regard, they will insist on registration rights (both demand and piggyback); rights to participate in any sale of stock by the founders (co-sale rights); and possibly a right to force the company to redeem their stock under certain conditions. The company will need to consider and negotiate these rights to assure that they will not adversely affect any future rounds of financing.
  • Lock-Up Rights. Increasingly, venture investors are insisting on a lock-up period at the term sheet stage where the investors have a period of time (usually 30-60 days) where they have the exclusive right, but not the obligation, to make the investment. The lock-up period allows the investors to complete due diligence without fear that other investors will pre-empt their opportunity to invest in the company. The company will be naturally reluctant to agree to such an exclusivity period, as it will hamper its ability to get needed financing if the parties cannot reach agreement on a definitive deal.

Form of Term Sheet

Term sheets are intended to set forth the basic terms of a venture investor’s prospective investment in the company. There are varying philosophies on the use and extent of Term Sheets. One approach is to have an abbreviated short form Term Sheet where only the most important points in the deal are covered. In that way, it is argued, the principals can focus on the major issues and not be hampered by argument over side points. Another approach to Term Sheets is the long form all-encompassing approach, where virtually all issues that need to be negotiated are raised so that the drafting and negotiating of the definitive documents can be quick and easy. The drawback of the short form approach is that it will leave many issues to be resolved at the definitive document stage and, if they are not resolved, the parties will have spent extra time and legal expense that could have been avoided if the long form approach had been taken. The advantage of the short form approach is that it will generally be easier and faster to reach a “handshake” deal. The disadvantage of the long form approach from the venture investors’ perspective is that it may tend to scare away unsophisticated companies.

Lagniappe Terms:

The Charter: (Certificate of Incorporation) is a public document, filed with the Secretary of State of the state in which the company is incorporated, that establishes all of the rights, preferences, privileges and restrictions of the Preferred Stock.

Accrued and unpaid dividends are payable on conversion as well as upon a liquidation event in some cases. Most typically, however, dividends are not paid if the preferred is converted.

PIK” (payment-in-kind) dividends: another alternative to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value.

“Opt Out”: For corporations incorporated in California, one cannot “opt out” of the statutory requirement of a separate class vote by Common Stockholders to authorize shares of Common Stock. The purpose of this provision is to “opt out” of DGL 242(b)(2).

Preferred Stock: Note that as a matter of background law, Section 242(b)(2) of the Delaware General Corporation Law provides that if any proposed charter amendment would adversely alter the rights, preferences and powers of one series of Preferred Stock, but not similarly adversely alter the entire class of all Preferred Stock, then the holders of that series are entitled to a separate series vote on the amendment.

The per share test: ensures that the investor achieves a significant return on investment before the Company can go public. Also consider allowing a non-QPO to become a QPO if an adjustment is made to the Conversion Price for the benefit of the investor, so that the investor does not have the power to block a public offering.

Blank Check Preferred: If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.

Redemption rights: allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.

Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders. Note that Founders/management sometimes also seek limited registration rights.

Registration: The Company will want the percentage to be high enough so that a significant portion of the investor base is behind the demand. Companies will typically resist allowing a single investor to cause a registration. Experienced investors will want to ensure that less experienced investors do not have the right to cause a demand registration. In some cases, different series of Preferred Stock may request the right for that series to initiate a certain number of demand registrations. Companies will typically resist this due to the cost and diversion of management resources when multiple constituencies have this right.

Break Up Fee: It is unusual to provide for such “break-up” fees in connection with a venture capital financing, but might be something to consider where there is a substantial possibility the Company may be sold prior to consummation of the financing (e.g., a later stage deal).

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