What is a management rights letter and why is my investor asking for it?

Guest post by DLA Piper

What are they?

A letter agreement between a company and an investing venture capital fund which provides the fund with certain “management rights” that allow it to substantially participate in, or substantially influence the conduct of, the management of the portfolio company.

Why are they important?

A management rights letter is critical for any venture capital fund that is seeking to rely upon the venture capital operating company (VCOC) exemption in order to avoid its assets from being subject to the Employee Retirement Income Security Act of 1974 (ERISA) and the onerous requirements that would be imposed thereunder (which would include managers of the fund becoming personal fiduciaries under ERISA with respect to any private pension plans that invest in the fund and becoming subject to a set of strict prohibited transaction rules and conflict of interest and self-dealing issues as a result of the fund manager’s receipt of performance fees in the form of its carried interest).

As background, private pension plans constitute a meaningful percentage of the investors in venture capital funds. The assets of such pension plans are subject to ERISA. When a venture capital fund takes in investors who are themselves subject to ERISA, the fund will want to avoid the assets of the fund from also becoming subject to ERISA. There are two exemptions that a venture capital fund can seek to rely upon in order to avoid such an outcome:

1. The Not Significant Participation Exemption (ie, the 25 percent test)

  • If less than 25 percent of each class of equity interests of the venture capital fund (and a fund typically only has one class of equity interest) is held by investors who are subject to ERISA, then the assets of the fund will not be subject to ERISA.
  • In determining whether the 25 percent threshold has been surpassed, investments by public pension plans and non-US pension plans are not counted towards the threshold.

2. The VCOC Exemption

  •  If the venture capital fund qualifies as a VCOC, then the assets of the fund will not be subject to ERISA.
  • In order to qualify as a VCOC:
    • at least 50 percent of the fund’s assets must be invested in operating companies in which the fund has direct contractual management rights (which is where the management rights letter comes into play) and
    • the fund must exercise such management rights with respect to at least one operating company that it holds an investment in
  • The 50 percent requirement must be met on the date the venture capital fund makes its first investment.
  • The securing of a management rights letter by a venture capital fund is critical in that it is the means through which the fund has direct contractual management rights in its underlying portfolio companies.

What should they contain?

A management rights letter should secure as many of the following rights as possible for the investing venture capital fund:

  • The right to appoint one or more directors to the board of the portfolio company
  • The right to regularly informally consult with and advise the management team of the portfolio company
  • The right to receive quarterly and annual financial statements of the portfolio company, including the annual auditor’s report
  • The right to examine the books and records of the portfolio company
  • The right to receive copies of all documents, reports, financial data and other information that the fund may reasonably request and
  • The right to appoint a person to serve as the corporate officer of the portfolio company

Potential traps

  • Rights that a venture capital fund secures and shares with other investors do not count as management rights for purposes of meeting the VCOC exemption (ie, the rights must be individual to the fund). Thus parallel funds or related co-investment funds should each obtain separate management rights letters.
  • Portfolio company investments, which are made by a venture capital fund indirectly through a special purpose vehicle, which is not wholly owned by such fund can be an issue in situations where the special purpose vehicle only holds a minority position in the underlying portfolio company. In that scenario, the special purpose vehicle will not be treated as an operating company for purposes of the VCOC exemption due to the fact that it is not primarily engaged, directly or through a majority owned subsidiary, in the production or sale of a product or service other than the investment of capital.
  • If a venture capital fund seeking to rely on the VCOC exemption makes an investment which does not qualify as an investment in an operating company prior to making its first investment in an operating company, then such fund can never qualify as a VCOC.

Takeaway

A management rights letter is a key aspect for venture capital funds when investing in companies, as it enables funds to raise capital without subjecting the activities of the fund to the various restrictions imposed under ERISA. Requests for management rights letters are fairly common in today’s market and do not impose significant burdens on the companies from whom such letters are sought.


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Capitalization Tables Demystified

Guest post by Kevin Learned and Denise Dunlap, Boise Angel Alliance

Originally post on Angel Insights Blog, The Angel Capital Association

Terms like “warrants, waterfalls and preferences” can be confusing and intimidating when attempting to understand a capitalization table (aka cap table); it is no wonder we are often asked for a simple way to understand them! This article will give a brief overview of why cap tables are important and introduce a simple model to use early in the due diligence process.

As fund administrators and instructors for the Angel Capital Association (ACA)’s educational programs,  Loon Creek founders Kevin and Denise sometimes develop tools to help investors understand the concepts presented in the courses they teach. Many years ago Kevin developed a simple spreadsheet to model basic cap tables for use by our local angels as part of their regular due diligence process. He introduced this model during his presentation at a recent national webinar for the ACA discussing the basics of cap tables. You can download a copy of that cap table model as well as access the webinar archive from our Resources page.  

For those who would like a brief primer, a capitalization table is a document that lists all of the owners of equity and potential equity, the shares they own and the percentage ownership those shares represent.  Typically, the cap table is organized by type of security and/or by investment round.

We believe it is important for angel investors to understand cap tables.  It is part of our regular diligence process to first construct our own summary cap table before we decide to invest.  

Here’s what a rudimentary cap table can help you answer:

  • Founders’ ownership. What percentage of the company do the founders own now and will be likely to own at exit?  As investors, we want to be sure the founders have adequate incentive to continue to work very hard right through the exit.
  • Stock options. How many shares are set aside for the stock option pool, and is the pool set up before or after we make our investment (pre or post money)?  We know the company will not be able to pay market salaries in its early years and that a stock option pool will be needed to attract quality staff.  If the pool is set up before we invest, then the dilution associated with the stock option pool goes against the previous investors; if the pool is set up after our investment, then we are diluted as well at the time we make our investment.
  • Valuation. What is the impact of the agreed upon pre-money valuation?  This allows us to see what percentage of the company we will own now as well as projecting that through to exit to see if a) an exit at the required valuation is achievable, b) the likely exit will be sufficiently rewarding.
  • Subsequent rounds. What is the impact of subsequent investment rounds in terms of dilution, share price, and required exit valuation?
  • Exits. At various exit amounts what will our return likely be?

We have also found this simple model to be a helpful tool when working with entrepreneurs who are new to the process – often cap tables are confusing to them as well! In our experience, many entrepreneurs rely on a third party such as an attorney to maintain the schedule for them and only understand it at a high level.

Admittedly cap tables can become very complicated when they take into account convertible notes, warrants, preferences, waterfalls and other terms and instruments that may impact our return.  But we argue that if the simple cap table doesn’t show you that it is possible for this investment to make stellar returns, then you need go no further with negotiations or due diligence.

The ACA has a wonderful advanced course on cap tables that teaches the audience to deal with the myriad of possible return-reducing conditions.  Information on this and other ACA courses is available from their website.  

Opportunity and Risk Reduction: The Startup Two-Step

Guest post by Paul A. Jones, Of Counsel, Michael Best & Friedrich LLP

Most entrepreneurs really enjoy talking about the prodigious opportunity at the end of their startup’s rainbow. The reward side of the high-risk/reward equation. And that’s good, to a point. The point at which the prospective investor buys into the reality of the opportunity and the entrepreneur’s team for capturing it. Unfortunately, it’s not a point at which most prospective investors are willing to write a check.

Continue reading

Silicon Valley Venture Capital Survey – Fourth Quarter 2017

 

By Cynthia Clarfield Hess, Mark A. Leahy and Khang Tran

View the full report.

Background
This report analyzes the terms of 190 venture financings closed in the fourth quarter of 2017 by companies headquartered in Silicon Valley.

Overview of Results
Valuation Results Remain Strong
Valuation results continued to be strong in Q4 2017, but the percentage price increases declined moderately compared to the prior quarter, following three consecutive quarters of increases.

Internet/Digital Media Scores Highest Valuation Results
The internet/digital media industry recorded the strongest valuation results in Q4 2017 compared to the other industries, with an average price increase of 179% and a median price increase of 51%, both up from the prior quarter.

Valuation Results Down for Series D Financings
Series D financings recorded the weakest valuation results in Q4 2017 compared to the other financing rounds, with the highest percentage of down rounds and the lowest average and median price increases of all the financing rounds.

 

FULL REPORT

 

View the original post by Fenwick & West LLP

Term Sheets: Important Negotiating Issues

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, redemptionrights 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.

They 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 CorporationLaw 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).

The Prime Unicorn Index Announces Quarterly Reconstitution

The Prime Unicorn Index, the first index to track the share price performance of privately-funded U.S. companies, today announces its quarterly reconstitution. The index, which gives equal-weighting to its constituents, has added nine companies that qualify as Unicorns or Approaching Unicorns to its previous list of 85 privately funded companies.

The companies added to the index include AvidXchange Inc., Proterra Inc., WellTok Inc., Health Catalyst Inc., Flatiron Health Inc., Urban Compass Inc., Pindrop Security Inc., Bolt Threads Inc. and Discord Inc. The reconstitution was effective at market close on Jan. 17, 2018.

With investor appetite for companies that have not yet made their shares available via IPO soaring, companies that have surpassed $1 billion valuations are given Unicorn status, while companies that have achieved $500 million valuations are classified as Approaching Unicorns in the Prime Unicorn Index. Reconstitution of the index relies heavily on Lagniappe Labs’ proprietary research and difficult-to-source, objective data to determine true valuations of privately-funded companies in a measurable and verifiable way.

“The Prime Unicorn Index serves to benchmark the performance of private companies in line with how the S&P 500 Index tracks publicly traded companies,” noted Barrett. “We are excited to be the primary resource for investors and help them better understand how to assign the true valuation of private companies as they look to go public.”

The new constituents join the index’s well-known companies, including Uber, WeWork and AirBnB. The newly added components are market leaders in technology, software and healthcare and all have excellent investor bases.  

“Taken as a whole the Prime Unicorn Index achieved a positive return of 9.3% in 2017 and provides a unique way for institutional investors to access the private markets, whether they want to go long or short,” added Barrett.

For more information, please visit PrimeUnicornIndex.com.

About The Prime Unicorn Index

The Prime Unicorn Index is an equally-weighted price return index that measures the share price performance of U.S. private companies valued at $500 million or more. The Index was launched by Lagniappe Labs and Level ETF Ventures. The index uses Lagniappe Labs’ proprietary research and difficult-to-source, objective data to determine true valuations for privately-funded companies in a measurable and verifiable way.

About Lagniappe Labs

Lagniappe Labs uses state, federal and difficult-to-acquire corporate filings in a fully configurable platform that allows users to analyze the value of privately held companies. The technology provides tools and data to build financial models on specific sectors, people, industries, investors and more. Lagniappe Labs federates disparate sources of information to drive objective analysis on private company investments.

Lagniappe Labs replaces subjective and error-prone ‘wiki’ data with actual corporate documents and data so investors and potential investors in privately held companies have true and accurate information to drive decision making.