Why not bank loans to EU startups?

Guest post by Rafael González-Gallarza and Álex Pujol, partners at Garrigues Corporate Department

One way to boost the digital economy in the EU would be to help banks making loans to new businesses. To do this, the institutions themselves need to know about venture debt and other possible products, and the European and national authorities need to support a stable legal framework adapted to the business environment including the area of bank finance.

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New Massachusetts Noncompetition Law Will Impact PE Investors

Guest post by Richard William Kidd, Edward Holzwanger, and Matthew D. Keiser – Kirkland & Ellis LLP

On October 1, 2018, a new Massachusetts noncompetition statute went into effect that will impact PE investors with offices or portfolio companies located in Massachusetts. The key provisions of the new law are set forth below.

Definition Of “Noncompetition Agreement”

The new law broadly defines “Noncompetition Agreements” as any agreement in which an employee or independent contractor “agrees that he or she will not engage in certain specified activities competitive with his or her employer after the employment relationship has ended.”  

The new law does not apply to:

  • confidentiality and intellectual property protection provisions;
  • employee nonsolicitation and no-hire provisions;
  • covenants not to solicit or transact business with customers, clients or vendors;
  • restrictions during the employment/contracting relationship;
  • sale-of-business noncompetition provisions where the restricted party is a “significant owner of, or member or partner in, the business entity” and will receive “significant consideration or benefit” from the transaction;
  • noncompetition provisions that are outside of an employment relationship, which seems to imply that partnership, limited liability company, stockholder and other similar agreements in which an individual is a partner, member or owner, rather than an employee, may be exempt from the new law under this exception (particularly where employees of one entity (e.g., a management company) are partners in, or members or owners of, a different entity (e.g., a limited partnership)); or
  • covenants negotiated and entered into at the time of a separation from service, so long as the person is expressly given seven business days to rescind acceptance.

Forfeiture-For-Competition Clauses Are Covered Noncompetition Agreements

The new law covers any “agreement that by its terms or through the manner in which it is enforced imposes adverse financial consequences on a former employee as a result of the termination of an employment relationship if the employee engages in competitive activities.”1

Limits on Noncompetition Period

Noncompetition Agreements may not exceed one year, unless the individual breached his or her fiduciary duty or unlawfully obtained or retained property belonging to the company, in which case the duration may not exceed two years.

Must Be Consideration

Noncompetition Agreements entered into at the inception of the relationship must be supported by garden leave (which is simply severance) or “other mutually-agreed upon consideration,” which is not defined (but initial employment may satisfy this requirement).

Noncompetition Agreements entered into during the relationship must be supported by “fair and reasonable consideration independent of continuation of employment,” which is also not defined.

Until there is further clarity regarding what satisfies the alternative consideration requirements under the new law, consideration other than a provision for the payment of garden leave during the restricted period runs some risk of being deemed to be insufficient.

Garden Leave

Under the new law, a “garden leave” clause is sufficient consideration so long as it requires a company to pay the individual during the restricted period at least 50% of the individual’s highest annualized base salary within the preceding two years.

If garden leave is provided as consideration, it should be paid for the length of the noncompetition period, up to one year.

Individuals Terminated  Without Cause or Laid Off and Nonexempt Employees Cannot Be Bound to Noncompetition Agreements

Any individual who is either (i) a nonexempt employee under the Fair Labor Standards Act or (ii) terminated “without cause” or “laid off” (with both terms being undefined in the law) cannot be subject to a Noncompetition Agreement. The new law is unclear regarding whether a company can still have noncompetition provisions with these individuals so long as the company is providing garden leave.

Alternatively, it may still be possible to secure noncompetition provisions from these employees either by structuring an employment agreement where an employee must give six months or a year of notice prior to terminating his or her employment or as negotiated at the end of the relationship, as both of these situations are not “Noncompetition Agreements” under the new law.

The Law Is Not Retroactive

The new law only applies to agreements entered into on or after October 1, 2018. However, the new law does not address whether amended agreements or evergreen renewals on or after October 1, 2018, trigger the law.

Very Technical Requirements Must Be Satisfied To Have A Valid Noncompetition Agreement

If entered into at the inception of the employment relationship, the employer must provide the candidate with the Noncompetition Agreement either at the time of a formal offer of employment or 10 business days prior to the commencement of employment, whichever is earlier.

If entered into during the employment relationship, the employee must have 10 business days to review the agreement before it becomes effective.

The Noncompetition Agreement must be in writing and signed by the employer and the individual.

The Noncompetition Agreement must explicitly state that the individual has the right to consult with counsel prior to signing.

The Law Covers Employees and Independent Contractors

The new law covers employees and independent contractors who are employed or engaged in Massachusetts — but does not explicitly cover partners, members or owners.

Choice-of-Law Clauses

The new law severely limits the parties’ ability to circumvent its application by choosing another state’s law to govern the agreement.2

*          *          *

Companies with employees in Massachusetts should review and update their form Noncompetition Agreements in light of the new law.  


1. In many states, such as New York, court will not scrutinize the reasonableness of a noncompetition provision so long as the only result of a breach is the loss of some benefit. Massachusetts appears to have foreclosed this legal construct by holding that such forfeiture clauses also need to conform to the parameters of the new law. 


2. All civil actions relating to Noncompetition Agreements must be brought in the Massachusetts county where the individual resides (the new law does not specify that this must be in state court) or, if mutually agreed upon, in Suffolk County in Massachusetts (in the superior court or the business litigation session of the superior court).


Richard William Kidd, Partner, New York

Richard Kidd primarily practices transactional labor and employment law by assisting clients on national and international corporate transactions, negotiating and drafting complex employment-related agreements, onboarding executives, conducting reductions-in-force, and managing executive separations. Read More…

Edward Holzwanger, Partner, Washington, D.C.

Edward Holzwanger concentrates his practice in the areas of employment and labor counseling and transactional due diligence. Read More…

Matthew D. Keiser, Partner, Washington, D.C.

Matthew Keiser is a partner in Kirkland’s Washington, D.C. office. He concentrates his practice in employment law counseling and compliance training, investigations, employment litigation, and employment law aspects of corporate transactions and private equity. Read More…

Kirkland & Ellis LLC

We are a law firm that serves a broad range of clients around the world in private equity, M&A and other corporate transactions, litigation, white collar and government disputes, restructurings and intellectual property matters. We offer the highest quality legal advice coupled with extraordinary, tailored service to deliver exceptional results to our clients and help their businesses succeed. Read More…

CFIUS Reform: How Private Equity Funds Are Affected

Guest post by Rod Hunter, Sylwia A. Lis, and Karl Paulson Egbert, Partners at Baker McKenzie LLP

With the signature of President Trump on August 13, 2018, the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) became law. FIRRMA represents the most significant changes to the law governing the Committee on Foreign Investment in the United States (CFIUS or Committee) since the creation of the U.S. foreign investment regime in 1988. Although prompted primarily by national security concerns with Chinese investments, the legislation will affect investments by all non-U.S. investors, including investors in private equity and other funds. The changes reflect a trend across advanced markets for greater scrutiny of investments made via fund vehicles.

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Tail-End Funds: Should End Of Life Be A New Beginning?

Guest post by Julia D. Corelli, Partner, Pepper Hamilton LLP

This article sponsored by Pepper Hamilton originally appeared in The Legal Special 2018 by PEI in April 2018.

The top challenges of the private equity business model have always been threefold: replenishing the coffers every four to five years, deploying capital successfully in the investment period and harvesting investments at the peak of their valuations. Underlying these concerns is one salient fact: the fund usually has a finite term. Since nothing goes perfectly in life or investment management, this article considers the challenges faced by fund managers as the fund approaches the end of its term.

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Venture Capital Fundamentals: Three Basic Rules-Dilution, Dilution, Dilution

Written by: Joseph W. Bartlett, VC Experts Founder

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stageinvestments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securitiesoptions and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.


 

Snap Judgment: Unicorns Under Pressure and Addressing Risks of Private Lawsuits

 

 

By: Joshua M. NewvilleWilliam Dalsen and Alexandra V. Bargoot of Proskauer

The recent IPOs of Snap, Inc. and Blue Apron indicate that while the IPO pipeline continues to flow, there may be a cautionary tale for “unicorns” – venture-backed companies with estimated valuations in excess of $1 billion.

After Snap went public in March, it posted a $2.2 billion loss in its first quarter, yielding a 20% same-day drop in stock price that erased much of the company’s gains since its IPO. A snapshot of Snap’s stock price shows the obvious risks faced by late-stage investors in unicorns.  High valuations are not a guarantee of continued success, particularly where historical performance and profitability are lacking.  Although one commentator recently asked: “Are Blue Apron and Snap the worst IPOs ever?”, there is plenty of time for those stock prices to recover, especially in the months after their insider lockup periods expire.

Less well-known is how those risks can create conflicts that lead to litigation in the private fund space. The unicorn creates a dilemma for the private fund backing it.  On the one hand, an exit through a public offering is desirable as demonstrating cash-on-cash return is generally better than maintaining an illiquid holding, particularly when the company is facing the potential for down round funding to survive.  On the other hand, going public puts the unicorn’s financials in public view, and employees and private funds risk losing big if the company cannot sustain its predicted value.

Ultimately, a choppy IPO outlook for unicorns will lead to tightening of markets. As more unicorns linger and fall into distress, some will fail, leading to litigation.  Overly optimistic valuations lead to inflated expectations, especially those of employees expecting a payout and investors expecting gains.  Below are some types of disputes that can arise.

Employee claims: Employees paid in common stock may sue in the event of a dissolution or bad sale ahead of a public offering.  As in the case of former unicorn Good Technology, a bad sale may involve a payout on the common stock that amounts to only a fraction of its estimated value.  Employees of Good Technology (who held common shares) filed claims asserting that the company’s board breached its fiduciary duties by approving the sale.  They alleged that the board (whose members represented funds that owned preferred shares) favored the preferred over common shareholders.  While the case has been slow to progress, its outcome will inform the market whether such suits will provide viable recourse when employee shareholders believe their interests have been disadvantaged.

SEC Scrutiny: As we’ve previously noted, valuation-related regulatory risks increase as the time lengthens between purchase and exit. The SEC’s exam and enforcement staff have been focused on valuation of privately held companies for years. Further, the SEC sees itself as a protector of investors, even when those investors are employees of a private startup.   We are likely to see a disclosure case against a pre-IPO issuer relating to Rule 701 under the Securities Act.  That rule requires disclosure in certain circumstances of detailed financial information to employees in connection with certain stock or option grants.  This would lead to a spillover effect for funds that have supported those companies.

Claims arising in an acquisition: If the company is fortunate enough to reach some liquidity in a private sale, the acquiring company may pursue litigation against the board or other investors. The buyer may later allege fraudulent inducement and breach of contract on the grounds that the company and its investors misrepresented the company’s value.  In addition, investors can often break even in a merger by holding preferred shares with liquidation preferences.  However, like employees, investors still may sue the board or the company to try to recover a better return on their investment.

Fund LP/GP disputes: Unicorns are no different than other portfolio companies, in that when they fail, there may be disputes between a fund’s GP and its LPs. Those claims may vary.  For example, the fund’s designee on a failed unicorn’s board of directors will typically owe fiduciary duties to both the portfolio company and the LPs.  An LP may allege that the board representative favored the interests of the company over the interests of the LPs, or failed to adequately address or disclose concerns raised to the board level.  Furthermore, LPs may allege that the fund manager failed to address the potential for conflicts between the adviser and the funds.

While unicorns can generate extraordinary returns for early investors, they may also carry increased litigation risk even when they are successful. In addition, as more unicorns linger and fail to achieve successful exits, there is a higher likelihood that investors or employees will seek to recoup losses through litigation.  Fund managers should keep in mind the potential for these conflicts before a unicorn stumbles.  Addressing these relationships at early stages of the investment can help minimize litigation risk.