Snap IPOThe just completed IPO of Snap Inc. has received enormous buzz and plenty of press coverage, mostly about its eye-popping valuation and offering proceeds, the big winners among the founders and early investors and the millennials who bought shares. But not nearly as much attention has been given to Snap’s tri-class capital structure and the nature of the shares that were actually issued in the IPO: the shares of Class A Common Stock sold in the IPO are non-voting. By its own admission, Snap may have pulled off the first ever IPO of non-voting stock.

Snap’s capital now consists of the non-voting Class A shares held by public investors, Class B shares snapIPO2with one vote per share held by early round investors, employees and directors and Class C shares with ten votes per share held by the founders. As a result of the Class C common stock that they hold, co-founders Evan Spiegel and Robert Murphy will be able to exercise voting rights with respect to an aggregate of 215,887,848 shares, representing approximately 88.5% of the voting power immediately following the offering. Consequently, Spiegel and Murphy, and potentially either one of them alone (see below), have the ability to control the outcome of all matters submitted to stockholders for approval, including election, removal, and replacement of directors and any merger or sale of all or substantially all of the assets.

Multiple class structures are not unusual, and several high profile companies went public with them in recent years. What’s unusual here is that whereas the shares sold in those other multiple class structure IPOs had at least some voting rights (typically, one vote per share vs. 10 for the founder class), Snap’s public offering shares have no voting rights. Technically, Delaware law would permit holders of Snap’s Class A non-voting stock nevertheless to vote with one vote per share on any proposal to amend the certificate of incorporation in any way that would adversely affect the holders of the Class A. For example, if a proposed amendment provided for the Class A to rank junior to the Class B and Class C with respect to dividends or acquisition proceeds, a Class A vote would be required and the holders of a majority of Class A shares could defeat that amendment. Such a proposal would be extremely rare, however, and the Class A holders would have no say in the much more typical matters of board elections and any proposed sale of the company.

Multiple share classes are especially useful to public technology companies because they give them the freedom to innovate without the constraints of “short termism” and also serve as a deterrence to takeover bids because of activists’ inability to manipulate the voting machinery for election of directors.

Snap’s Class A common stock will be its only class registered under Section 12 of the Securities Exchange Act, and because the Class A is non-voting, Snap will not be required to file proxy statements except for a rare case where a vote of the Class A common stock is required (see above). Nevertheless, Snap indicated in its S-1 that it will provide Class A holders any information that it provides voluntarily to Class B and Class C holders.

What makes Snap’s structure even more unusual is survivability and portability.  According to Snap’s S-1, If Spiegel’s or Murphy’s employment is terminated (which, because of their control, could only happen if they turn on each other), they will continue to have the ability to exercise the same significant voting power and continue to control the outcome of all matters submitted to stockholders for approval. A founder’s Class C shares will automatically convert into Class B shares, on a one-for-one basis, nine months following such founder’s zuckerbergdeath or on the date on which the number of outstanding Class C shares held by such holder represents less than 30% of the Class C (or 32,383,178 shares) held by such holder at the time of the IPO. Facebook, on the other hand, amended its certificate of incorporation so that Mark Zuckerberg’s majority voting control is good only while he is an executive at the company.

Snap’s capital structure has drawn some criticism. In a New York Times piece, Cal Berkley law professor Steven Davidoff Solomon referred to Snap’s IPO as “the most stockholder-unfriendly governance in an initial public offering, ever.” In the Harvard Law School Forum on Corporate Governance and Financial Regulation, Rob Kalb and Rob Yates of Institutional Stockholder Services cited a 2016 ISS study that showed that controlled companies had weaker governance standards and tended to underperform “with respect to total stockholder returns, revenue growth, return on equity, and dividend payout ratios.” And the Council of Institutional Investors sent a letter to Snap’s co-founders objecting to the capital structure and urging them to adopt a single class structure. While acknowledging that similar emerging companies with dynamic leadership and promising products have successfully raised capital despite having dual class structures, Snap’s structure is unusual in that the investors would have no voting rights and dual class company performance has been mixed at best.

When Google, Facebook and Under Armour went public, they each did so with a dual-class share structure that at least afforded public stockholders one vote per share. Nevertheless, each company subsequently requested stockholder approval for the issuance of a third class of non-voting shares. In each case, the purpose of creating a new non-voting class was to maintain founder voting control while simultaneously providing insider liquidity.

Despite the overall positive outcomes achieved by Google and Facebook for their stockholders, going public as a controlled company with an unequal-voting-rights structure is no guaranty for financial success. Groupon, Zynga and GoPro each went public with a dual-class structure, received poor ISS corporate governance scores indicating the highest levels of governance risk, and the share price of all three dropped precipitously since their respective IPOs.

Adding salt to the corporate governance wound, Snap is taking advantage of emerging growth company status under the JOBS Act, meaning that it is not required to comply with the auditor attestation requirements under Sarbanes-Oxley and the reduced executive compensation disclosure requirements and may delay adoption of new public-company accounting principles.

In the final analysis, investors will need to decide which Mark the Snap founders better resemble, Facebook’s Zuckerberg or Zynga’s Pincus. And looking beyond Snap, it remains to be seen whether other emerging companies adopt the Snap IPO playbook by launching IPOs with multiple-class structures that preserve founder control and give public stockholders little or no governance voice.

2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

The market for venture backed IPOs in the U.S. in the first quarter of 2015 was box IPOthe weakest in two years, both in terms of number of deals and aggregate proceeds, according to pre-IPO institutional research firm Renaissance Capital, as well as a separate exit poll report by Thomson Reuters and the National Venture Capital Association. There were only 17 IPOs of venture-backed companies, compared with 30 in Q4 of 2014 and 40 in Q1 2014.  Venture backed IPOs raised only $76 million in average proceeds in Q1 2015, compared with $147 million and $80 million in Q4 and Q1 of 2014, respectively.

So what’s the reason for the overall weakness in venture backed IPOs?  According to Emily Chasan of the Wall Street Journal, venture backed companies are resisting going public because they’re receiving better offers in the form of late-stage private equity funding.  She cites a survey performed by BDO USA in which over half of the investment bankers surveyed attributed the IPO decline to widespread availability of private funding for companies at attractive valuations.  Basically, all the funding but without the hassle of being public.  This would be especially true of venture backed technology companies.  The $1.2 billion that technology companies raised in first quarter IPOs pales in comparison to the estimated $10 billion raised in private equity rounds during the same period of last year.

Another contributing factor may be a section of the JOBS Act that allows companies to stay private longer.  Title V of the JOBS Act passed in 2012 generally increases from 500 to 2,000 the threshold number of shareholders of a class of equity securities that triggers registration and reporting requirements under Section 12(g) of the Securities Exchange Act of 1934 for companies with more than $10 million in assets.  This generally allows companies with fewer than 2,000 shareholders to choose to stay private longer, enabling them to defer the cost, public scrutiny and increased liability of being publicly-traded and increasing their ability to time their initial public offerings based on market conditions.

Deliberately postponing an IPO until some point down the road could be risky.  IPO markets have short windows which often close quickly and are unpredictable.  A company opting for late-stage private equity funding and deferring an IPO may find the IPO market closed later on when the company is otherwise ready.

Another explanation for the relative weakness in small company IPOs is a series of reforms by the SEC generally referred to as decimalization. The regulatory efforts by the SEC to modernize the securities trading system beginning in 1997 may have had the unintended consequence of removing the financial incentive for underwriters, analysts, market makers and others to transact in and provide support services for issuers of small company stocks.  This is a theory long asserted by leading capital markets reform advocate David Weild.  My previous blog about decimalization and David’s theory could be found here.

It remains to be seen whether the weakness in venture-backed IPOs will have any short or long term impact on VC fund investments in startups and emerging companies.  Investors need to be confident that there’s a strong likelihood they’ll be able to exit their investments successfully.  The traditional VC exit strategy consists of either an IPO or an acquisition.  Making matters worse for VCs is that total exits for venture-backed companies, including mergers and acquisitions, in North America also dropped in the first quarter to 181 deals totaling $4.91 billion from 255 deals totaling $14.07 billion in value in the first quarter of last year, a 65% decline, according to PitchBook Data Inc..

Part I of this two-part series on technology licensing dealt with the non-financial terms of a typical microsoft samsungtechnology license agreement: subject matter, scope, territory, exclusivity, sublicensing and improvements.  This Part II of the series will deal with the most contentious aspect of any license agreement, the financial terms, which are usually negotiated last.  The reason that the terms that the parties probably care most about are negotiated last is that it is only after issues like subject matter, scope and exclusivity are defined that the parties know exactly what they’re pricing.

In terms of perspective, the licensor should know at the outset of negotiations how much it will need in order to achieve a positive return on its investment in research and development for the technology.  The licensee, on the other hand, will need to figure out how much it could afford to pay the licensor after taking into consideration the production and other costs it will incur and in the context of what the market will bear (i.e., what it could charge for the finished product).

Technology license payments fall generally into one of two categories, lump sums and royalties, with licensing deals often consisting of a combination of both.

Lump Sums

lump sumLump sum payments can be made at one time (e.g., at closing) or on a periodic basis (e.g., on designated anniversaries), and can also be made contingent upon achievement of certain milestones. For example, in a biotech licensing deal, typical milestones might be designation of a lead compound, filing a new drug application, completing a clinical trial or consummating a first commercial sale. A lump sum payment is often thought of as the licensee’s cost of admission, and a way for the licensor to recoup some of its investment.  These payments could also be made creditable against future royalties, which could in turn justify higher royalty rates.

Royalties

Royalties are a function of the use of the technology and for that reason are more prevalent than lump sums in licensing deals. Royalties have two components: base and rate.

Royalties could be based on things like manufacturing cost, units produced or net profit, but these are seldom used.  Manufacturing cost and profit are deemed to be sensitive proprietary information that the licensee would rather not reveal.  Basing royalties on units produced is simple from an accounting standpoint: count the units made and multiply by the fixed royalty amount per unit.  The problem with units produced from the licensee’s perspective, however, is that the licensee may produce lots of product but not sell much.

For the foregoing reasons, royalties are more often based on sales, either units sold or the dollar amount of such sales.  Units sold has the appeal of simplicity: just count the number of units sold and apply the applicable rate per unit.  In this case, the licensor may consider negotiating for a periodic adjustment of the rate based on some index such as the producer price index.  Royalties could also be based on the dollar amount of sales.  The most prevalent measure of sales in license agreements is gross sales minus those costs that are unrelated to the technology such as packaging and shipping .

royaltiesThe second component of every royalty arrangement is the rate.  The key to success of most licensing deals is choosing a royalty rate that is high enough to enable the licensor to earn a return on its investment, but low enough to make it profitable for the licensee.  Too low a rate could lead the licensor to reduce or eliminate further investment in research and development.  Too high a rate will leave the licensee with little or no incentive to produce and sell licensed product.

The royalty rate need not remain constant.  The rate could start out relatively low and increase either over time or as sales grow.  This would help enable the licensee to develop a market or achieve profitability as it builds market share.  Alternatively, the rate could also decrease as volume increases; this would incentivize a licensee to sell lots of product and get out from under the burden of the higher royalty rates.

Licensors very often negotiate for minimum royalties, particularly when the license is exclusive.  If the exclusive licensee is underperforming, the licensor will want to have the right to take back the license or terminate exclusivity; otherwise the licensed technology may never reach its potential.  The minimum could also be variable, increasing over time, e.g., $250,000 in the first year and increasing by $50,000 each year thereafter.  The licensee could try to negotiate for a license that becomes fully paid-up upon the payment of some agreed upon amount of aggregate royalties over the life of the agreement.

If you’re developing a product that requires certain technology that can’t be developed in-house (because of cost, time, human resources or complimentary assets), it might make good business sense to use technology that has already been developed by others and is available on the market. 

A technology license is essentially an agreement between the licensor (the owner of technology) and the licensee (the party that wants to use that technology), in which the licensee gets the right to use the technology and the licensor gets something of value in return.  I’ll deal with the value in return side in Part II of this two part blog series.

Technology licensing only occurs when one of the parties owns intellectual property, which gives that party the legal right to prevent others from using it, and so a technology license can be viewed as a consent by the owner to use the IP in exchange for something of value.

Although the key terms of a technology license agreement vary depending on what sort of technology is being licensed, similar issues arise in all transactions in which technology containing intellectual property rights is being licensed.  This Part I of a two part series on technology license agreements will cover non-financial terms.  Part II will cover financial terms.

Subject Matter

What exactly is the thing that’s being licensed?  This sounds pretty obvious, but it’s an underestimated issue that could lead to disputes if not identified accurately.  The technology being licensed could be a product, software program, formula, specification, protocol, documentation or a combination of these. The licensor will generally seek to narrow the definition of what’s being licensed, while the licensee will typically seek a broad definition of the technology.  In approaching this issue, think about whether you need only a patent license or rather the right to use a particular product or technology that practices the patent?  Also, if you need a license to use the name or logo of the technology or product in connection with the sale and distribution of your product, then you’ll need a trademark license in addition to the patent license.  This would be the case, for example, where the technology or product alone is not as valuable as the product distributed with a familiar trademark.

Scope

Scope deals with what it is that you’ll be permitted to do with whatever it is you’re licensing.  A broad scope will give you greater flexibility; a narrower scope will be less expensive.  The grant may include the right to reproduce the technology, display it, modify it, make derivative works from it, make it or have it made, distribute or sell it or sub-license it to others who may do any or all of the above. 

The scope of the license should conform to your needs. You may only need the right to distribute the technology in its existing form, for example a distribution license for a commodity product. On the other hand, you may need to make fundamental changes to the licensed technology, create new versions and distribute the new versions to groups of sub-licensees who will also have the right to reproduce and customize the technology.

Territory

IP rights are territorial, and the license agreement must specify whether your rights are worldwide or specific to designated countries or regions. In negotiating the territory, you need to consider where you plan to manufacture and sell. Also, where do you plan to distribute products bearing the mark or logo? The license agreement should be clear that you have the right to display the mark “in connection with” the sale of products throughout the territory.  If you plan to distribute products electronically or on the Internet, the license agreement needs to provide as much.

Exclusivity

Exclusivity is one issue on which it’s tough to reconcile the interests of the licensor and licensee.  The licensor will generally resist “putting all his eggs in one basket” with an exclusive license because it limits his freedom to expand through, and earn royalties from, other licensees.  It may also result in the technology never becoming commercially successful if the exclusive licensee underperforms. 

An exclusive license could be justified, however, when the licensee is making a significant investment to commercially exploit the technology, and where the investment cannot be used for a different purpose.  This would be the case, for example, if the licensee is investing in custom equipment, hiring specialized labor or setting up a business in a new territory.  In these situations, there are ways to mitigate against the exclusivity risk to the licensor. For example,exclusivity could be conditioned on the licensee achieving certain minimum royalty payments or product sales.  Also, exclusivity need not be made coterminous with the license period; instead, a “head start” provision can limit exclusivity to a shorter time period during which the licensee can establish his business. 

Somewhere in between exclusive and non-exclusive is a “sole license”, in which the licensor will not license any other licensees but has the right to continue using the technology himself. 

Sub-Licensing

The licensee may want the right to grant sub-licenses in the territory, particularly in an exclusive license. If so, this needs to be specifically negotiated and stated in the agreement. Two aspects of this issue that often get hotly negotiated are whether the licensor’s prior written approval is required for granting any sub-licenses (and the circumstances under which such prior approval would not be required), and whether or not the sub-license comes to an end when the primary license is terminated or expires for any reason.

Improvements

Very often, the licensor will continue research and development efforts during the term of the license agreement, which may lead to new versions, enhancements or new models of the technology.  The licensee would have legitimate concern that the licensor may come out with another release, version or product and offer it to a competitor of the licensee, or that the licensor’s new offering will render the “old” licensed technology product obsolete.

It’s important for the license agreement to define what is an “improvement”, and therefore covered by the license, and what is a new technology or new intellectual property, which is not covered and which may necessitate a new license agreement. Coverage for improvements could occur automatically, or the agreement could provide that there would be an option in favor of the licensee.

In Part II of this two part blog series, I’ll discuss the financial terms of license agreements.