Structuring a U.S. Real Estate Fund: A How-To Guide for Emerging Managers – Part One

By Michael A. Bloom and Sung H. Hwang – Venable LLP (New York)

1 Introduction.

There is always a line at Starbucks.  That line means steady rents for landlords leasing to Starbucks tenants.  A common real estate fund model is to “roll up” multiple freestanding, single-tenant commercial properties, like Starbucks, into a single asset that accomplishes an economy of scale, diversifies risks, and achieves a portfolio size that is palatable to investors with real money.  These funds can offer investors steady cash flows, capital appreciation, tax-sheltered returns from depreciation deductions, and portfolio diversification away from stocks and bonds.

For emerging fund managers in this space, the structuring legalese can be confusing; but it is important.  Legal structures directly impact investor returns and risk management profile.  In general, tax considerations are foundational to any real estate fund legal structure.  The goal of these tax considerations is simple: minimize taxes on investor earnings and management compensation without undue complexity.  This article walks the reader through a basic structuring analysis.[1]

2 The Economics of Real Estate Funds.

Before we wade into the tax pond, let’s review a typical real estate fund’s economics in broad strokes.

A typical U.S. real estate fund will have a limited life span of not more than 10 years.  Its life cycle will comprise an initial investment-reinvestment period during which the fund will seek out and purchase real property that meets the investment criteria set out by its sponsor (a/k/a “general partner” and/or “managing member”), followed by a longer holding period, during which the fund will seek to increase the value of the real property (whether by mere passage of time or through improvements made to the real property) and, last, a liquidation period when the properties are disposed of and the cash is distributed to investors.  Often, the fund will have one or more optional extension periods to deal with unexpected changes in investment values or disposition strategies.

The limited life of a U.S. real estate fund often is ascribed to the fact that real estate is very illiquid, not homogeneous, typically cyclical, and sensitive to economic conditions and investor sentiments.  A sponsor generally will identify what he perceives to be a niche in the real estate valuation for a particular type of property during a particular period, and devise an investment strategy to exploit the niche.

Given the characteristics of real estate noted above, however, a real estate fund will be able to identify only so many investment opportunities that fit the fund’s investment strategy during any given period.  For example, some funds will attempt to exploit perceived valuation distortions, while some will seek to increase the property value through turn-around strategies, and others will seek stable, income-producing properties.  In addition, investing in real estate takes a significantly greater amount of time and money compared with other assets, especially liquid securities.

Because of this “lead-in” and “lead-out” nature of a U.S. real estate fund’s activities, a U.S. real estate investment fund rarely changes its investment strategy midcourse, barring unforeseen circumstances, such as a radical shift in asset values.  Often a fund will not be able to change its investment strategy without investor consent, since investors invested on the basis of that strategy.  Thus, when the real estate investment landscape changes significantly after a fund is formed, the sponsor typically will simply cease making investments from one fund and form a new fund rather than try to change the direction of an existing fund.

The same peculiarities of real estate investment also require that a sponsor heavily regulate the cash flows into and out of a fund to manage the fund’s liquidity and valuation.  A typical real estate fund will raise funds through subscriptions made by investors in one or more closings of limited partnership interests (or limited liability company membership interests) over a limited period, once the sponsor identifies an investment strategy and makes his business case to potential investors through the offering materials (e.g., the “Private Placement Memorandum” or PPM).  The PPM lays out the terms of the offering.  The PPM is often presented to potential investors at meetings and presentations – called “road shows,” subject to the applicable requirements of the securities law (e.g. the general solicitation and advertising rules).

The first one or two investors often get preferential treatment and are called “seed investors.”  Investors coming in through later closings typically pay an interest factor to compensate the early birds for footing the bill for the first investments.  New investors will not be allowed into the fund after the investment-reinvestment period has ended.

Investors will not fund all of their capital commitments in their subscriptions upfront.  Instead, they gradually fund the investments as they are identified and purchased in accordance with the fund’s investment criteria.  Once invested, investors typically will not see the bulk of their funds until the back end and, therefore, typically will expect a minimum rate of return to compensate for the time value of their invested money, generally known as the “preferred return.”

An investor generally will not be able to receive distributions, or redeem its interests in the fund, or withdraw from it, ahead of other investors, unless a compelling legal or regulatory justification (often the tax status of the investor being jeopardized without the withdrawal) exists.  An investor will not be able to sell or otherwise transfer its interest in the fund without the consent of the sponsor.

While there are a myriad of ways to “slice and dice” the way investment proceeds are distributed among the investors and the sponsor, often a real estate fund will allocate cash pursuant to a distribution “waterfall” (either on a per-investment or the aggregate basis) that identifies the timing, amount, and priority of each distribution.  Generally, a fund will pay investors, first, a preferred return on the invested capital, then a return of capital, and then divide the remaining funds between the investors and the sponsor.

The sponsor’s share of these remaining proceeds is often called “carry” or “promote,” which sometimes is subject to a “holdback” or “clawback” obligation to ensure appropriate promote sharing based on the economic performance of a fund during its entire life cycle.  This right to carry or promote often is called “carried interest” or “promote interest” or “sweat equity” and, in tax jargon, “profits interest.”

Often, because of the complexity of tax rules, actual tax liability of an investor for an investment in a U.S. real estate fund will differ from the investor’s actual amount and timing of cash receipts.  Therefore, frequently, a fund will build in the concept of a “tax distribution” to help investors pay their taxes on taxable income allocated to them ahead of the actual receipt of corresponding cash.  Such tax distribution is generally structured as an advance against the recipient’s share of regular distribution that will come later, similar in concept to loaning to self-employed individuals to pay their estimated taxes during the course of a year before reconciliation through the year-end tax return.

A sponsor typically will earn this promote, plus a management fee (to pay for and reimburse its management and operating expenses).  The management fee is typically computed as a percentage of the capital commitment during the investment-reinvestment period and, afterward, as a percentage of the invested capital, which may or may not include any leverage employed in making the investments.  In addition, investors may ask the sponsor to make its own capital investment on the same terms as the investors, to have some “skin in the game.”

3 Hypothetical Example.

Let’s assume a hypothetical example.  Alejandro Java, a 35-year-old graduate of the Michigan Ross School of Business, wants to leave his job at Blue Corners Capital to launch his own U.S. real estate fund – “the Coffee Fund.”

Alejandro has identified 30 properties in Illinois and Michigan under long-term leases with Dunkin Donuts tenants.  Alejandro believes he can add immediate value by the purchase and consolidated management of all 30 properties.  To do so, Alejandro needs capital.  Specifically, he needs $150MM because he has valued the 30 properties at an average of $5MM each.  Assuming that he can finance the acquisition price with 60% bank debt, Alejandro needs to raise $60MM of equity capital.

Alejandro prepares the PPM and other offering materials and travels on a road show around the world to meet with select investors.  He meets privately with potential investors and finally reaches commitments with the following three investors, the “seed investors,” for the first closing of his offering:

  1. Jay Gatsby, a resident of Long Island, NY – $24MM
  2. Silvio Bellini, a resident of Italy – $24MM
  3. Maple Leaf Pension, a Canadian pension fund – $12MM

Because of his stellar presentation, Alejandro will not be required to contribute his capital to the Coffee Fund (thus, no “skin in the game”) and will receive a 20% promote and a 2% management fee.

The Coffee Fund will have a life of 10 years, with two 1-year extensions at the sponsor’s disposal.  The first 3 years will be its investment-reinvestment period, during which it intends to acquire the 30 Dunkin Donuts properties.  The fund will hold the properties for appreciation due to traffic increase in their geographic areas and plans to start their sales in year 8 of the fund’s life until all of the investments are sold and the fund is liquidated in year 10.

Alejandro is elated, but does not want to pursue further capital through additional capital commitments at this point and wants to begin working right away.  How should the Coffee Fund be structured to make his business case as enticing as it was? Let’s look at the most often used legal structure for U.S. real estate funds.

Part Two posted 3/21/2017.


Footnotes

[1] This writing was prepared for marketing purposes and does not constitute tax opinion or advice to any taxpayer.  Each taxpayer should consult its own tax advisor for the application of the tax laws to its own facts.  In addition, this writing is based on current U.S. federal income tax law, and the authors will not update any reader on any future changes, including those with retroactive effect, in U.S. federal income tax law.  This article does not address any state, local, foreign, or other tax laws, except as used in the writing for illustrative purposes only.

Authors

Michael Bloommbloom@venable.com

Michael Bloom is counsel in Venable’s Tax and Wealth Planning Group, where he provides tax advice on all types of corporate transactions, such as mergers & acquisitions, restructurings, and venture capital investments. He is based in New York. In particular, Michael’s tax practice focuses on advising emerging fund managers on fund formation and portfolio acquisitions.

Sung H. Hwang shhwang@venable.com

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice, based in New York. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. Mr. Hwang has significant experience in domestic and cross-border transactions involving real estate partnerships and funds, private equity funds, hedge funds, asset managers, family offices, and financial institutions. Mr. Hwang also has significant experience in the tax credit space, including the energy-based tax credit area.

Venable LLP

Venable (www.venable.com) has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

What Not To Say In a Business Plan

Guest Post by: Barry Moltz

The following is an excerpt from his e-book entitled, Growing Through Rants and Raves. Barry Moltz is also the writer of a book entitled You Have to Be a Little Crazy, which delivers irreverent, straight talk about the complex intersection of start-up business, financial health, physical well-being, spiritual wholeness and family life. This title and other publications by Barry can be viewed at his website, http://www.barrymoltz.com.

Sometimes I find that the company’s founder is so far ‘outside the box’ that they ‘stretch the envelope.’ As an angel investor, I review more than 500 business plans each year. Unfortunately, many are so riddled with economy lingo, business jargon and clichés, that they do not communicate any real business value. In my opinion, terminology, such as disintermediation, sweet spot, ASP, best of breed, and win-win should be outlawed for the next 100 years. For building a real business, these terms are meaningless. Another challenge when reviewing business plans is that the introductory sentences sometimes stretch for an entire paragraph as the entrepreneur looks for that all-encompassing way to describe their business. Forget it! There isn’t one. Many times I want to strangle the writer to simply tell me what they do in five words or less. Poor choice of words: This business makes mechanical gasoline fueled devices, used for transportation, more efficient by periodically sending them through an applied for patent machine to loosen the terra firma from these vehicles to make them more conducive at performing their task. Solid choice of words: We run a car wash. Another frequently used practice is to create a business plan using template software or by working from an existing plan. I do not recommend this practice and like to refer to William Sahlman in his Harvard Business case study “Some Thoughts on Business Plans.” This case study has continuously inspired me to see beyond clichés and catchphrases and better interpret misleading statements within business plans.

If the plan says: “Our numbers are conservative.” I read: “I know I better show a growing profitable company. This is my best-case scenario. Is it good enough?” Since all numbers are based on assumptions, projections in business plans are by their very nature a guess and are not conservative.

If the plan says: “We’ll give you a 100 percent internal rate of return on your money.” I read: “If everything goes perfectly right, the planets align, and we get lucky, you might get your money back. Actually, we have no idea if this idea will even work.” No one can predict what an investor’s return will be. Let them decide.

If the plan says: “We project a 10 percent margin.” I read: “We kept the same assumptions that the business plan software template came with and did not change a thing. Should we make any changes?” Ensure you have developed your financial projections from the ground up.

If the plan says: “We only need a 5 percent market share to make our conservative projections.” I read: “We were too lazy to figure out exactly how our business will ramp up.” Know what it will cost to acquire customers. Gaining 5 percent market share is not an easy task in a large market.

If the plan says: “Customers really need our product.” I read: ” We haven’t yet asked anyone to pay for it.” or “All our current customers are our relatives” or “We paid for an expensive survey and the people we interviewed said they needed our product.” The definition of a business is when people pay you money to solve their problems. This is the only way to prove people “need it.”

If the plan says: “We have no competition.” I read: Actually … I stop reading the plan. Always beware of entrepreneurs that claim they have no competitors. If they are right, it’s a problem and if they are wrong, it is also a problem. Every business has competitors or else there is a current solution to this customer need. If there are no competitors for what the entrepreneur wants to do, there is a good chance there also is no business. So what should an entrepreneur do? Write the plan in plain and proper English. Please understand that the reader comes to the plan with no knowledge of your business. No fancy words, clichés or graphs will make them want to invest. Understand every part of your plan and be able to defend it. Use your own passion to describe your plan. Make your plan your own.

The 11 things that matter in a business plan:

  • What problem exists that your business is trying to solve. Where is the pain?
  • What does it cost to solve that problem now? How deep and compelling is the pain?
  • What solutions does your business have that solve this problem?
  • What will the customer pay you to solve this problem? How solving this problem will make the company a lot of money.
  • What alliances can you leverage with other companies to help your company?
  • How big can this business get if given the right capital?
  • How much cash do you need to find a path to profitability?
  • How the skills of your management team, their domain knowledge, and track record of execution will make this happen.

Please remember, the business plan is basically an “argument” where you need to state the problem and pain, then provide your solution with supporting data and analogies.

After a Down Round: Alternatives for Employee Incentive Plans

*Excerpt from VC Experts Encyclopedia of Private Equity & Venture Capital

Employee Incentive Plans for Privately-Held Companies

Despite the recent improvement in capital markets activity, many small, privately-held technology companies continue to face reduced valuations and highly dilutive financings, frequently referred to as “down rounds.” These financings can create difficulties for retention of management and other key employees who were attracted to the company in large part for the potential upside of the option or stock ownership program. When down rounds are implemented, the investors can acquire a significant percentage of the company at valuations that are lower than the valuations used for prior financing rounds. Lower valuations mean lower preferred stock values for the preferred stock issued in the down round, and as preferred stock values drop significantly, common stock values also drop, including the value of common stock options held by employees.

Consequently, reduced valuations and “down round” financings frequently cause two results: (i) substantial dilution of the common stock ownership of the company and (ii) the devaluation of the common stock, particularly in view of the increased aggregate liquidation preference of the preferred stock that comes before the common stock. The result is a company with an increasingly larger percentage being held by the holders of the preferred stock and with common stock that can be relatively worthless and unlikely to see any proceeds in the event of an acquisition in the foreseeable future.

In the face of substantial dilution of the common stock and significant devaluation in equity value, companies are faced with the difficulty of retaining key personnel and offering meaningful equity incentives. Potential solutions can be very simple (issuing additional options to counteract dilution) or quite complex (issuing a new class of stock with rights tailored to balance the concerns of both investors and employees). Intermediate solutions range from effecting a recapitalization that will result in an increase in the value of the common stock to implementing a cash bonus plan for employees that is to be paid in the event of an acquisition. Each approach has its advantages and disadvantages, and each may be appropriate depending on the circumstances of a particular company, but the more complex alternatives can offer companies greater flexibility to satisfy the competing demands of employees and investors. This article briefly reviews three of the solutions that can be implemented-the use of additional options, recapitalizations and retention plans (cash and equity based).

Granting Additional Options

The simplest solution to address the dilution of common stock is to issue additional employee stock options. For example, assume that, prior to a down round, a company had 9,000,000 shares of common and preferred stockoutstanding and the employees held options to purchase an additional 1,000,000 shares. Also assume that, in the down round, the company issued additional preferred stock that is convertible into 10,000,000 shares of common stock. On a fully-diluted basis (i.e., taking into account all options and the conversion of all preferred stock), the employees have seen the value of their options reduced from 10% of the company to 5%, or by 50%. In this case, the company might issue the employees additional options to increase their ownership percentage. It would require additional options to purchase in excess of 1,000,000 shares to return the employees to a 10% ownership position, although a smaller amount would still reduce the impact of the down round and might be enough to help entice the employees to stay.

If the common stock retains significant value, the grant of additional options can be an effective solution. It is also relatively straightforward to implement; at most, stockholder approval may be required for an increase in the optionpool. In many cases, however, the aggregate liquidation preference of the preferred stock is unlikely to leave anything for the common holders following an acquisition, particularly in the short term. In that event, the dilution of the common stock becomes less relevant – 5% of nothing is the same as 10% of nothing. Companies with this kind of common stock devaluation will need to consider more intricate solutions.

Recapitalizations

If the common stock has been effectively reduced to minimal value by the down round, a company could increase the common stock value through a recapitalization. A recapitalization can be implemented through a decrease in the liquidation preferences of the preferred stock or a conversion of some preferred stock into common stock, thereby increasing the share of the proceeds that is distributed to the common stock upon a sale of the company. This solution is conceptually straightforward and certainly effective in increasing the value of the common stock. In most cases with privately-held venture capital backed companies, however, the holders of the preferred stock are the investors who typically fund and implement the down rounds and in nearly all cases the preferred stockholders have a veto right over any recapitalization. Accordingly, implementing a recapitalization would require the consent of the affected preferred stockholders, which may be difficult to obtain, particularly because the preferred stockholders may not like the permanency of this approach. In addition, a recapitalization can be quite complicated in practice, raising significant legal, tax and accounting issues.

Retention Plans

Another approach is the implementation of a retention plan. Such plans can take a number of forms and can use cash or a new class of equity with rights designed to satisfy the interests of both the investors and employees. These solutions are more complicated, but also more flexible.

Cash Bonus Plan

In a cash bonus plan, the company guarantees a certain amount of money to employees in the event of an acquisition. This amount can equal a fixed sum or a percentage of the net sale proceeds, to be allocated among the employees at the time of the sale, or it can be a fixed amount per employee, determined in advance. Allocations can be based on a wide variety of parameters, enabling a high degree of flexibility. Often these plans have a limited duration (such as 12 to 24 months, or until the company raises a specified amount of additional equity).

A cash bonus plan is easy to understand, provides the employees with cash to pay any taxes that may be due and can be flexible if the allocations are not determined in advance. However, there are a number of hurdles. Many acquisitions are structured as stock-for-stock exchanges (i.e., the acquiring company issues stock as payment for the stock of the target company) because such exchanges may be eligible for tax-free treatment. A cash bonus plan may interfere with the tax-free treatment and, thus, may reduce the value of the company in the sale or may be a barrier to the transaction altogether.

A cash bonus plan can also be problematic in that it requires cash from a potential acquirer in the event there isn’t sufficient cash on hand in the target company. A mandatory cash commitment from an acquiror may also make the company less attractive as a target. Typically, a cash bonus plan can be adopted (and amended and terminated prior to an acquisition) by the board of directors, although a cash bonus plan creates an interest that may in effect be senior to the preferred stock, which requires consideration as to whether the consent of the preferred holders is required.

New Class of Equity

A stock bonus or option plan utilizing a new class of equity, although more complicated, shares many of the benefits of the cash bonus plan, but avoids some of the major disadvantages. A newly created class of equity, such as senior common stock or an employee series of preferred stock, permits the use of various combinations of rights. The new class of equity can be entitled to a fixed dollar amount, a portion of the purchase price or both. These rights can be in preference to, participating with or subordinate to any preferred holders, and the shares may be convertible into ordinary common stock at the option of the holders or upon the occurrence of certain events. Referring to our earlier example, the company might return the employees to their pre-down round position by issuing them senior common stock entitled to 10% of the consideration (up to a certain amount) in any sale of the company. Although a return of the employees to their pre-down round position may not be acceptable to the preferred stockholders and may not be necessary to keep the employees incentivized, the new class of equity can be tailored to fit whatever balance is acceptable to the investors.

This type of approach has several advantages. First, unlike a simple issuance of additional options, it gives real value to employees that were affected by a devaluation of their common stock. Second, unlike a cash bonus plan, it does not require an acquiror to put up cash when they purchase the company and the acquirer is less likely to discount the purchase price. Third, unlike a cash bonus plan, it will not affect the tax-free nature of many stock-for-stock acquisitions. Finally, it provides certainty to the participants, who know exactly what they will be entitled to receive upon a sale of the company.

The main disadvantage of creating a new class of equity, at least from the employees’ standpoint, is that the employee will either have to pay fair market value for the stock when it is issued or recognize a tax liability upon such issuance, when they may not have the cash with which to pay the taxes. This disadvantage can be partially ameliorated by the use of options for the new class of equity, rather than issuing the new equity up front, which at least allows the employee to control the timing of the tax liability by deciding when to exercise. Moreover, for many employees an option may qualify as an incentive stock option under federal tax law, thus allowing the employee to defer taxation until the sale of the underlying stock. A new class of equity will also be somewhat more difficult for most employees to understand, at least when compared to traditional common stock options.

In addition, a new class of equity adds complexity from the company’s perspective. It may raise securities and accounting issues, and shareholder approval of an amendment to the company’s charter will be required. At a minimum, it will require more elaborate documentation than some of the simpler alternatives, such as a cash bonus plan, and thus it will likely be more expensive to implement at a time when the company may be particularly sensitive to preserving its cash. A new class of equity may also result in future complications such as separate class votes or effective veto rights in certain circumstances. As with the other solutions that address the devaluation problem, there may be resistance from the existing preferred holders, whose share of the consideration upon a sale of the company would thereby be reduced.

These complexities are surmountable and companies may find that they are more than balanced by the advantages that a new class of equity provides over other solutions in addressing issues of reduced common stock valuations and dilution.

A Founder’s Guide to Making a Section 83(b) Election

Guest Post by: Kevin E. Criddle, Associate, DLA Piper

One of the more important tax decisions founders of early-stage companies will face is whether or not to make an election under Section 83(b) of the Internal Revenue Code for stock awards or other acquisitions of shares subject to vesting. By making this decision promptly upon acquiring the shares, founders can avoid missing the 83(b) filing deadline and protect themselves from significant tax consequences down the line. Below, we have set out six of the most commonly asked questions by our clients:

1) What is a Section 83(b) election?

Section 83(b) of the Internal Revenue Code allows founders, employees and other service providers to accelerate the time for determining taxable income on restricted stock awards or purchases subject to vesting. A Section 83(b) election is made by sending a letter (a sample form can be found here) to the Internal Revenue Service requesting to be taxed on the date the restricted stock was granted or purchased rather than on the scheduled vesting dates.

Founders that decide to make an 83(b) election need to do so promptly to ensure that they do not miss the 83(b) filing deadline. An 83(b) election must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock. The last possible day for filing is calculated by counting every day (including weekends and holidays) starting with the day after the grant date.

 2) What are the benefits of an 83(b) election?

There are several reasons why filing an 83(b) election may be beneficial for a founder. Most notably, Section 83(b) of the Internal Revenue Code allows founders to accelerate the determination of taxable income on an award or purchase of restricted stock to the date it was granted rather than on the date(s) the shares vest. If the restricted stock is purchased for an amount equal to its fair market value, an 83(b) election will result in no recognition of income as of the purchase date. Additionally, an 83(b) election advances the beginning of the one-year long-term capital gain holding period, often resulting in preferential capital gain rather than ordinary tax treatment upon sale (long-term capital gain tax rates are 0, 15 and 20 percent for most taxpayers). Simply stated, an 83(b) election can result in significant tax savings under the right circumstances.

3) What happens if a founder does not file an 83(b) election?

If a Section 83(b) election is not filed by the deadline, a founder would pay taxes on restricted stock grants at each vesting date. The founder’s tax would be assessed at ordinary income rates on the amount by which the stock’s value on the vesting date exceeds the purchase price, if any. This may result in a significant tax obligation if the value of the shares has increased substantially over time.

4) What are the risks of an 83(b) election?

Despite its benefits, the 83(b) election is not without risk. Making a Section 83(b) election accelerates the date that taxable income is recognized from the vesting date to the date the restricted stock is granted or purchased. This means that if a founder makes an 83(b) election, pays taxes on income based on the fair market value of the shares on the grant date, and then later forfeits his or her shares, the founder may have paid tax on unrealized income.

5) What scenarios could make an 83(b) election more or less advantageous?

All things considered, a Section 83(b) election will likely be more (or less) advantageous for a founder in the following scenarios:

Section 83(b) Election is More Advantageous Section 83(b) Election is Less Advantageous
  • the amount of income reported at grant is small
  • the amount of income reported at grant is large
  • the stock’s growth prospects are moderate to strong
  • the stock’s growth prospects are low to moderate
  • the risk of stock forfeiture is very low
  • the risk of stock forfeiture is moderate to high

6) What are the steps to filing an 83(b) election?

To make an 83(b) election, the following steps must be completed within 30 days of the grant date:

  1. Complete a Section 83(b) election letter—a sample form can be found here.
  2. Mail the completed letter to the IRS within 30 days of your grant date:
  • Mail to the IRS Service Center where you file your tax return—the address for your IRS Service Center can be found here.
  • Preferably send the letter by certified mail and request a return receipt.
  1. Mail a copy of the completed letter to your employer.
  2. Retain one copy of the completed and filed letter for your records and retain proof of mailing.

As always, founders should consult with their tax advisors to determine how a Section 83(b) election applies to their individual circumstances.


Kevin E. Criddle, Associate, DLA Piper

Kevin Criddle’s practice focuses on securities and corporate finance, mergers and acquisitions, venture capital and private equity investments and general corporate counselling.

 

What Will VC’s Want For A Security: Common Stock? Preferred Stock? Debt? Warrants?

Written by: Joseph W. Bartlett/VC Experts Founder

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer. In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity (“equity” meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle (“Keep it Simple, Stupid”). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may “pay up” for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends. On the other hand, the issuer of the security can deduct interest payments for tax purposes–interest is paid in pre-tax dollars–but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less–more money for less equity–by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in “locking in” a return will want a fixed rate on debt securities instead of a variable rate; the ultimate “lock-in” occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or “hybridizing” securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel “securities,” equity and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of “junk” or “fluffy debt has been the focus of popular attention of late; however, junk bonds debt securities which are less than investment grade and, therefore, unrated are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer‘s financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, “true” debt in the sense that the holder is opting for security of investment and “buying” that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the “high-speed equity.” The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco‘s current cash flows and the proceeds of a sale or liquidation of the entire enterprise.

The variables open to the planners include the following:

  • a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders;
  • a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term “subordinated” opens, in and of itself, a variety of possibilities);
  • a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common);
  • an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right;

Redemption can be at the option of the issuer, the holder, or both; and the issuer‘s obligations to make periodic payments with respect to a debt security can range from the simple to the exotic–monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in “alphabet stock”). The utility of this structure is that it gives Newco time to fulfill the promises in its pitch book.

All that said, in today’s universe, the market standard is common stock to the founder founders, plus the friends and family. The next round, with the exception noted, is convertible preferred stock. The jump balls are participating versus non-participating, cumulative dividends, etc. But the security is convertible preferred, even in the angel round, which used to be common. The exception is a convertible note in the bridge round, next round pricing. See the Buzz article, The Next Round Pricing Strategy.

For more information on Venture Capital and Private Equity, please visit VC Experts.

What are Registration Rights?

To many investors, registration rights are one of the most important issues in a financing. If an investor is in a minority position in a nonpublic company, his exit possibilities depend on decisions made by others. Thus, some founders are proud that they have turned down entreaties from investment bankers to take their companies public. They claim that public shareholders might cramp their style and interfere with their ability to run the company according to their own tastes. Well and good for the founder, but not so comforting to a minority investor locked into the founder’s company. Even if the investors as a group are in control of the company, there may be differences of opinion as to when an exit strategy should be implemented; indeed, each investor may have a different sense of timing on the issue, based on facts peculiar to that investor.

The decision to sell the company as a whole is almost always dependent on at least a majority of the shareholders approving the sale. To be sure, the shareholders could by contract agree to sell out at the election of the minority, but such contracts, while common in Shareholders Agreements styled on drag-along rights, are seldom enforced in practice, in accordance with their terms. [1] The shareholders, however, can implement one primary exit strategy, in theory at least, singly and seriatim. The company can only sell its assets once, but it can have as many public offerings of its securities as the market will bear, and a public offering will eventually make the investors liquid.

However, the decision to go public in the first instance is often difficult; there are considerations on both sides. Moreover, even if a company is already public, the election to float another offering requires thought and discussion; any offering “dilutes” existing shareholders. Some shareholders may feel the currently obtainable price accurately reflects value and some may violently disagree.

As a technically legal matter, the decision to affect an IPO is a majority decision. Even if the company is not planning to sell any stock, only the company can file a registration statement; [2] a minority shareholder cannot register his stock for sale without the company’s consent. As the registrant, [3] the company sets the terms of the offering, including the question of how many insider shares to include. Accordingly, investors seek to bolster their position by securing that consent in advance, by insisting that there exist, as part of or allied to the Stock Purchase Agreement, an agreement called the Registration Rights Agreement. It is important to recall that a company “going public” does not undergo an instant transformation, with all its stock ipso facto turned into liquid instruments; the only shares which become truly public-that is, are released from resale restrictions [4] -are those registered for sale [5] and sold at the time. And the company ordinarily issues those shares; the investors’ share of the “action” in an IPO is severely limited because the market’s appetite for stock in an IPO is generally confined to those transactions in which most of the money raised is going to work inside the company. Nonetheless, an IPO is the most significant step on the road to liquidity, even for those investors not selling in the offering.

[2]-Categories of Registration Rights

Registration rights fall into two categories: “demand” and “piggyback.” Piggyback rights, as the name implies, give the shareholders a right to have their shares included in a registration the company is currently planning on behalf of itself (a “primary” offering) or other shareholders (a “secondary” offering). [6] Demand rights, as the name implies, contemplate that the company must initiate and pursue the registration of an offering including, although not necessarily limited to, the shares proffered by the requesting shareholder(s). Since demand rights are more controversial, the following discussion focuses principally (but not exclusively) on that variety.

It should be noted that there are various types of stock issuances, albeit registered, which should not be subject to piggyback rights by their nature-that is, issuance of shares in the course of acquiring another company or the registration of shares pursuant to an employee stock benefit plan. Moreover, the practical difference between demand and piggyback rights can be slight; the investors make a noise about demanding an IPO, the issuer (thus prodded) elects to go forward on its own and then the investors seek to piggyback on what has been, in effect, an offering they “demanded.” Thus, the discussion of “haircuts,” stand asides,” and “lock-ups” applies to all types of registration rights, not just demand rights.

[3]-The Principles Underlying Registration Rights

To comprehend adequately the various issues involved, a discussion of basic principles is in order. The first is that registration rights are seldom used in accordance with their terms, and yet some investors and their counsel view them as a central element of the deal. The actual use of the demand rights, for example, could prove very awkward: a group of minority shareholders insisting on registration, the CEO agreeing only because he has to, but saying, in effect, to the minority, “Find your own underwriter; conduct your own road shows; [7] do not bother me with questions from large institutional purchasers; in a word, sell the stock yourself.” Such would make for a disorderly marketing effort, and the price per share would suffer.

On the other hand, as stated, registration rights are often the only exit vehicle, which, as a practical matter, the minority shareholders can compel. A start-up may issue shares redeemable at the option of the holder, but the instances in which that privilege has been successfully exercised are few. A company still in the development stage may not have the legal power, let alone the cash and/or the agreement of its creditors, to redeem stock. If a controlling founder is content to sit in his office, play with his high-tech toys and does not need more money from his investors, the investors need leverage. Other than through the threat of enforcing the registration rights agreement, there is no legal way to compel the company to go public. Therefore, it is important to keep in mind that liquidating the investors’ shares through a public offering can be not only a promise but also a benchmark, meaning that the remedy, if the founder refuses to cooperate, need not be a lawsuit. Reallocation of stock interests can be triggered if an IPO fails to materialize on time.

The second interesting feature of the registration rights agreement is that it is a three-way agreement, but only two of the three parties negotiate and sign it. With a minor exception for “self-underwritten offerings,” a primary or secondary offering of securities requires an issuer, selling shareholders and an underwriter, either on a “firm” or “best-efforts” basis. However, the underwriter is usually not present when the registration rights agreement is signed, and the parties themselves have to anticipate what the underwriter will require. Following that point, underwriters as a rule do not favor secondary offerings for early-stage companies.

Given a choice, the market likes to see the proceeds of the sale go into the company’s treasury to be used for productive purposes, rather than released to outsiders. Moreover, whenever stock is being sold, the underwriter wants the number of shares issued to be slightly less than its calculation of the market’s appetite. An underwriting is deemed successful if the stock price moves up a bit in the after-market. If the price goes down, the buyers brought in by the underwriter are unhappy; if it moves up smartly, the company is upset because the underwriter underpriced the deal. Consequently, the underwriter does not want to see new shares coming into the market shortly after the underwritten offering is sold, creating more supply than demand. These imperatives account for terms in the registration rights agreement known as the “haircut” and the “hold back.”

Finally, including one’s shares in a publicly underwritten offering is not the only way shares can be sold. A holder of restricted securities can sell his shares, albeit at a discount attributable to illiquidity, in a private transaction; more importantly, he can “dribble” out the shares into the market once the company has become public, under Rule 144. Registration rights for the holder of restricted shares in an already public company are, therefore, redundant unless the holder wants to sell before the required holding period in Rule 144 has expired or the block is so large that it cannot be “dribbled” out under the “volume” or “manner of sale” restrictions set out in that Rule.

The “points” in a registration rights negotiation (points being a slang term for contested issues) [8] are of varying degrees of intensity. Some are standard. Thus, the issuer rarely agrees to register convertible preferred stock, convertible debt or other rights to purchase common stock. The market in the hybrid securities themselves can be messy and confusing to analysts of an emerging-stage issuer‘s IPO; indeed, the mere existence of a class of senior security may cloud the outlook for the common stock‘s participation in future earnings. [9] Hence, the holders of convertible securities must convert before they can include their stock in the offering and/or must convert in any event so as to “clean up” the balance sheet. Some “points” on the other hand, are potential battlefields. For example, a minority shareholder will want the right to threaten exercise of his rights (and thus bully the company into registration) at any time of his choosing. The company will fight to limit the permissible timing of the shareholder’s election-no less than, say, five nor more than seven years after he makes his investment. The shareholder will want to be able to transfer his registration rights if he transfers his shares-they are part of the bundle of rights for which he bargained. The company will fight to keep the rights personal to the holder-a right to force registration is a formidable weapon if the timing is totally inappropriate. A disgruntled shareholder-for example, a founder recently terminated as president-may wave the rights around like a club to win some unrelated concession.

Following that thought, the company needs to limit the number of fingers on the trigger, so to speak. Assume, for example, 10 investors who each hold 10 percent of the class of convertible preferred stock. If each investor enjoyed his personal trigger-that is, could demand registration-the company might find itself in the path of a stampede, helping neither itself nor the investors generally. Moreover, if the company agrees to pay all or a part of the cost of the registration, multiple demands could be expensive. It is, therefore, in the interest of the company and the major investors to vest control of the trigger in the shareholders acting in concert, at least to insist that most of them agree internally before the issue is brought before the company. In addition, the amount of stock they are willing to sell should also be substantial, both because of expense (a small registration is almost as expensive as a large one) and because a buoyant public market depends on “float,” enough shares in circulation to interest institutional investors. From the investor’s standpoint, of course, the situation is reversed. He wants the trigger to be one share less than the shares he holds. This issue becomes more difficult when an issuer goes through multiple rounds of financing, selling off registration rights in each round. If all the shares are of the same class and series, what does one do with a 51 percent shareholder in round one who becomes a 35 percent shareholder when round two is completed? Does he “lose” his solo finger on the trigger because he did not elect to participate in the second round or because the second round involved the acquisition of another company for stock in a transaction in which he was not eligible to participate?

Indeed, the question of inconsistent registration rights provisions occasioned by separate agreements for each round is a thorny one. If the company’s norm is that the rights are not meant to mature for three years from the date of investment, what is to be done with investors in earlier rounds who have held shares for almost three years? Will they have first and exclusive chance at the gateway to public securities? If series A preferred was sold last year (with a 51 percent trigger) and series B preferred is being sold currently, is there any way to compel the series A holders to join in with the series B (assuming the number of shares in each series is the same) to avoid a situation in which the trigger is suddenly held by 25.1 percent (versus 51 percent) of the outstanding preferred stock? Is the language of the agreement such that investors in the earlier rounds can claim to have a first priority for including their shares in a piggyback registration?

The fact is, when the later round occurs, most practitioners attempt to induce the prior holders (who often overlap with the investors in the later round) [10] to cancel the earlier agreement and accept a new provision that affects all the existing holders, old and new, equally. Alternatively, counsel for the early-round investors may bargain for provisions that constrain the issuer in agreeing to register shares of subsequent purchasers-either an absolute prohibition without the consent of the earlier investors or a priority in their favor.


[1] There is nothing conceptually impossible in the notion of “drag along” rights. If all the stockholders agree in advance, the board could be bound, at the instigation of the minority, to retain an agent and authorize it to negotiate the best terms possible for a sale or merger of the entire company. There could be problems in binding the board in advance to vote for a transaction to occur well in the future-one which passes a given hurdle, for example-but, if the majority refuses the agent’s recommendations, there could be other remedies: a control “flip,” for example, or more stock for the minority.

[2] Section 6(a) of the ’33 Act provides that the issuer, the CEO, the CFO, the comptroller or principal accounting officer, and a majority of the board must sign the registration statement.

[3] The term ‘Registrant’ means the issuer of the securities for which the registration statement is filed. ’33 Act, Rule 405.

[4] Even publicly registered shares may not be freely resold; the privilege of investors holding nonregistered shares in a public company to “dribble” out shares pursuant to Rule 144 is limited by the provisions of that Rule and may be further limited by a “hold back” imposed by underwriters, the NASD, and/or state securities administrators.

[5] ’33 Act, Rule 415, adopted in November 1983, permits underwritten shelf registrations, i.e., the registration of shares for later sale at the option of the holder for (1) mature public companies and (2) for secondary issues. See, e.g., Palm, “Registration Statement Preparation and Related Matters,” in Mechanics of Underwriting (PLI Course Handbook Series No. 547, 1987). The problem is that underwriters are reluctant to allow investors to include their shares in the registration statement for delayed sale under Rule 415 since that creates an “overhang” over the market. If the investor’s stock is registered “on the shelf” under Rule 415, it must be “reasonably expected” it will be sold within two years. Rule 415(a)(2).

[6] A “reverse piggyback” right occurs when the investors exercise a demand right, compel a registration that (under the agreement) is at their expense, and the company seeks the right to “piggyback” some newly issued shares on the investors’ registration. See Frome & Max, Raising Capital: Private Placement Forms and Techniques, 673 (1981).

[7] Road shows are meetings between the company, the underwriters, and potential buyers of the company’s stock held around the country after the registration statement has been filed and before it becomes effective. If a CEO wants to be obstreperous, not agreeing with the concept of an IPO, he can be less than enthusiastic about the company’s near-term prospects at the road show, thereby effectively chilling the offering.

[8] When negotiators want to show an increase in the fervor that they or their clients feel about a given issue, they label it a “deal point” or a “deal breaker.” The way experienced negotiators respond to a litany of “deal points” is to create an “escrow file,” meaning that the issue is left for later consideration. After a deal point sits in the escrow file for a bit, it often defuses itself. See generally, Fisher & Ury, Getting to Yes: Negotiating Agreements Without Giving In (1981).

[9] Since the existence of a convertible senior security can muddy the investing public’s perception of the common stock, conversion is usually mandated no later than the evening of an IPO.

[10] Investors in the early rounds are expected to follow on with fresh capital in late rounds to show their faith in the company; however, the existing investors often insist that the founder find at least one new investor, “new blood,” to join in late rounds, if only to avoid a situation in which the investors are negotiating on price and other issues with themselves.