A recent Delaware Chancery Court decision provides important guidance on what types of defective corporate acts may be ratified under Section 204 of the Delaware General Corporation Law (the “DGCL”), and what types may not.  Paul Nguyen v. View, Inc. also underscores the importance of focusing on whether to opt out of the class vote required by DGCL Section 242(b)(2) for changes in authorized capital, which effectively gives the common stock a veto over future funding rounds.

The facts of the case are as follows. View, Inc. develops smart windows that allow the light, heat, shade and glare properties of the glass to be controlled manually or electronically, thus enhancing comfort and reducing energy consumption and greenhouse gas emissions. After closing on a Series A round, View replaced its founder, Paul Nguyen, as CEO and CTO. While in mediation over the termination, View proposed a new Series B round of funding, which under Section 242(b)(2) of the DGCL required the consent of Nguyen as holder of a majority of the common. The parties then signed a settlement agreement in which Nguyen consented to the Series B, subject to a seven day revocation right. When Nguyen discovered the terms of the Series B would materially diminish his rights, he revoked his consent within the revocation period. Unbeknownst to him, View had already closed on the Series B. Nguyen then brought an arbitration proceeding against View, seeking a declaration that the revocation was valid and the Series B funding invalid. While the arbitration was pending, View closed on additional rounds C through F in an aggregate amount of over $500 million. After View filed two certificates of validation under DGCL Section 204 seeking to ratify the increase in authorized capital, Nguyen commenced the Chancery Court suit, which the parties agreed to stay pending the arbitrator’s decision on the validity of the consent revocation.

The arbitrator ruled that the revocation was valid and the Series B invalid. The ruling effectively meant that all of the related transaction documents were likewise invalid and void because Nguyen had not consented to them either. And since each of the subsequent rounds of financing rested on the Series B funding, the invalidation of the Series B effectively invalidated the Series C through Series F rounds as well, basically blowing up View’s capital structure. The Series A stockholders responded by seeking to resurrect the funding rounds through the ratification provisions of Section 204, initially by converting their preferred shares into common (thus becoming the majority holders of the class) and then by authorizing the filing of certificates of validation with the Delaware Secretary of State under Section 204.

The key issue in the case was whether an act that the holder of a majority of shares of a class entitled to vote deliberately declined to authorize, but that the corporation nevertheless determined to pursue, may be deemed a “defective corporate act” under Section 204 that is subject to later validation by ratification of the stockholders, an issue of first impression.

In 2014, the Delaware legislature created two alternative pathways for corporations to cure defective corporate acts. Section 204 provides that “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided [in Section 204] or validated by the Court of Chancery in a proceeding brought under Section 205.” Previously, acts deemed “voidable” could be subsequently ratified, but acts deemed “void”, such as the issuance of shares beyond what is authorized in a company’s charter, were deemed invalid. Prior to Sections 204 and 205, corporations had no way to remedy “void” corporate acts, even if the failure to properly authorize the act was inadvertent. The ability to cure defective acts is critical. Startups often need to clean up such acts prior to a funding round or acquisition, both to satisfy investor or acquirer due diligence issues and to enable counsel to issue opinion letters.

The court found that the Series B round was not a “defective corporate act” that is subject to ratification under Section 204 and ruled that View should not be allowed to invoke ratification to validate a deliberately unauthorized corporate act. As the holder of a majority of the outstanding common which was entitled to a class vote, Nguyen’s vote was required in order to authorize the Series B. The failure to obtain such authorization was not an oversight; it was the result of an affirmative rejection by Nguyen. Thus, the distinction here is between a defective corporate act that results from an oversight, which is curable under Section 204, and a defective corporate act resulting from an affirmative rejection by the stockholders, which is not curable under Section 204 (or 205).

One obvious takeaway is that companies should respect arbitrators’ rulings and should not proceed with a transaction, let alone a series of transactions, until stockholder authorization has been secured. View’s pursuit of the Series B round during the revocation period, and thereafter of the Series C through F rounds while the arbitrator’s ruling on the consent revocation was pending, was reckless to say the least. As the court put it, “[o]ne must presume that View understood that if the arbitrator found in favor of Nguyen on the consent issue, then the later rounds of financing that rested on the Series B Financing would collapse when that block was removed from the tower of blocks that comprised the Company’s preferred stock offerings”.  One can only presume further that it did so against the advice of counsel or despite counsel’s warning of the risk.

The other takeaway here is that companies should consider carefully whether to opt out of the class vote requirement under DGCL Section 224(b)(2) for changes in capital structure. Section 224(b)(2) requires any increase or decrease in authorized shares to be approved by holders of a majority of each class of stock entitled to vote, but allows corporations to opt out by providing as much in the charter. The National Venture Capital Association’s model amended and restated certificate of incorporation has an optional provision that states that the common and preferred will vote together as a single class on all proposals to increase or decrease the authorized capital, irrespective of the provisions of Section 242(b)(2). Failure to opt out effectively provides the common stockholders with a veto over future capital raises because each subsequent round requires an amendment to the charter not just to create the new series of preferred, but also to increase the number of authorized common to accommodate conversion of the preferred. Failure to eliminate the class vote requirement will force the company to have to seek the consent of holders of a majority of the common, providing them with unintended leverage in connection with a deal that’s presumably in the best interests of the company and its shareholders.

It’s never easy to take an entire business day out of the office, but the annual Cornell Entrepreneurship Summit is well worth it.  The 2014 edition, dubbed “Beyond the Horizon”, was no exception.  One thing that struck me about this year’s summit was that, unlike previous years, none of the entrepreneur speakers were Cornell alums, demonstrating that the summit has evolved from a Cornell entrepreneurship event to a Cornell event about entrepreneurship.  As to the speakers, here are some of the more memorable and meaningful takeaways for me.

Skybox CEO Tom Ingersoll
How did a startup succeed in creating a real-time Google-Earth?  Skybox Imaging CEO Tom Ingersoll asked the audience, “Have you looked at your house on Google Earth? Disappointed it was two years old?” Because satellites are so expensive to build and launch, most of the pictures that we see are of poor quality and years out of date. Until now. Skybox knew that real-time satellite imaging would require dozens of satellites, a prohibitively expensive endeavor with the cost of a single satellite being around $850 million.  So Skybox needed to find a way to build satellites for a fraction of that, and created a lightweight, nimble satellite in-house for about $10 million.  Ingersoll insisted that the key to Skybox’s success is in execution, and evoked the line mostly attributed to Thomas Edison (also a favorite of Steve Jobs):  “Vision without execution is hallucination”.  Ingersoll said that another key to Skybox’s success is that it has had a patient board of directors, which enabled Skybox to say “no” to Google twice, before finally agreeing to be acquired earlier this year.

If a company offered its employees unlimited vacation time, would anyone show up to work?  Return Path CEO Matt Blumberg revealed that when his company instituted that policy it experienced no higher vacation rates.   The author of “Start-Up CEO” said that his employees are encouraged to take as much time off as they can while maintaining high performance and achieving milestones.  “We don’t count the hours they work, so why should we count the hours they don’t?”

Sols CEO Kegan Schouwenburg

“We went from the cobbler to standardized mass manufacturing and now today we are going to change all that with digital manufacturing”, announced Kegan Schouwenburg, CEO of Sols Systems.  Sols captures a 3-D model of a patient’s foot, makes therapeutic adjustments in a web-based app and manufactures a final product with a 3-D printer.  Schouwenburg also demonstrated the direct to consumer version of the service where a customer can scan his or her own foot with a smartphone and order a custom fit insert.  “One super cool thing about digital manufacturing: no waste”, Schouwenburg said.

Despite recent mega-exits like WhatsApp, Tumblr and Waze, billion-dollar exits are rare, so much so that they’ve been designated the name of a mythical creature, a unicorn.  Every VC chases them.  “Birthing a unicorn is hard”, proclaimed CB Insights CEO Anand Sanwal.  Sanwal’s data shows that only one percent of exits are unicorns, while 72% are below $200 million.  Sanwal said that we may not be in a bubble yet, but valuations are “frothy”.  Although billion dollar valuations require lots of capital raising, some of the recent unicorns raised money late at higher valuations, or never, including Shutterstock and former Cornell Entrepreneurship Summit presenter Wayfair, and Anand said that “these are the companies we should celebrate”.

Your company is invited by a local meetup group to present at demo day with other startups, and you accept.  The group announces the demo day lineup of startups in an e-blast, on its website, on its Facebook page and through banner ads on a tech e-zine.  On demo day, the room is packed and you nail your presentation.  The following month, you close on an investment with a few angels who attended your demo day presentation.  Have you just violated the securities laws?

For years, startups and emerging companies have been presenting at capital raising forums organized by accelerators, meetup groups, professional organizations and other similar groups and securing funding from investors they met at such events. But it has never been clear to securities lawyers how issuers could do so without violating the ban on general solicitation in private offerings.

Historically, startups and emerging companies looking to raise capital in the private markets have relied overwhelmingly on Rule 506 of Regulation D, primarily because there is no limit on the amount that may be raised and because the shares offered and sold are deemed “covered securities” and thus exempt from the most onerous requirements under state securities laws.  The ban on general solicitation in Reg D offerings is contained in Rule 502 of Reg D, which states explicitly that:

“[N]either the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

  • Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
  • Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising”

Despite the popularity of Rule 506 offerings, growing criticism of the Rule’s prohibition on general solicitation as an antiquated and overly burdensome impediment to capital raising led to the passage in 2012 of the JOBS Act, which in part called on the SEC to promulgate final rules that would lift the general solicitation ban (among other reforms).  In September 2013, the SEC issued final rules on a new exemption under Rule 506(c) that permits general solicitation so long as certain additional requirements are met, but also left intact as new Rule 506(b) the traditional private offering exemption with no general solicitation (but without the additional requirements).  See my post on the general solicitation rules here.

Accordingly, companies making private offerings of securities under Rule 506 now have two alternatives:

  • Offerings without general solicitation: May sell to up to 35 non-accredited investors and to an unlimited number of accredited investors, with accredited investors being allowed to self-verify (generally by filling out a standard questionnaire).
  • Offerings with general solicitation:  All purchasers must be accredited investors, and the company must use reasonable methods to verify status.  The Rule includes a non-exclusive, non-mandatory list of documents that a company could review to verify accredited investor status.  These include tax returns, bank statements, brokerage statements and credit reports.  The Rule also allows a company to rely on a written statement provided by a lawyer, CPA, investment advisor or broker dealer.

Now that they have a choice, companies will need to consider carefully which route to take.  General solicitation clearly allows the company to reach a far greater audience.  But there are drawbacks.  The additional accredited investor verification requirements could turn off potential investors because of the intrusiveness associated with having to present tax returns or brokerage statements.  There are increased transaction costs (primarily higher lawyers’ fees) and a slowdown in the deal process.  The additional burdens will get even worse if proposed SEC rules are adopted, which would require companies using general solicitation to file a Form D in advance (currently it must be filed within 15 days following the first sale) and include solicitation materials in the filing.

As mentioned above, it is unclear on what basis companies were able to present at demo day events before September 2013 without violating the general solicitation ban.  The SEC may have chosen to look the other way because the events contribute to economic growth and are typically managed by credible organizers, and thus there has not been any urgency for anti-fraud enforcement.   But it stands to reason that now that there is a legitimate path to general solicitation private offerings, albeit with additional requirements, the SEC may begin scrutinizing demo day events more closely to ensure that those additional requirements are satisfied.  Companies may find themselves on the wrong side of an SEC investigation if:

  • they actually sell shares or their presentation is deemed to be an “offer” of securities;
  • the demo day event is deemed to be a form of general solicitation; and
  • not all purchasers are accredited or the company failed to use reasonable verification methods.

So whether or not a demo day presentation could result in securities exposure will depend on the content of the presentation and the manner in which the event is promoted.

The securities laws define the term “offer” fairly broadly to include every attempt or offer to sell a security for value.  Referring in a presentation to the terms of an ongoing offering, to an offering generally or even to the need and/or desire to raise capital would likely be deemed to be an offer to sell securities, even though under the contract laws of most states it would probably be construed as simply an invitation to make an offer or to begin negotiations.  The SEC has long held that statements are deemed to be “offers” if  they may have the effect of conditioning the market or arousing public interest in an issuer or its securities.

Assuming the presentation is an “offer”, the next question is whether it involved general solicitation.  Demo day organizers typically promote such events on their public website, in print, online or broadcast media and in postings to their social media accounts.  Determining whether or not a communication is a general solicitation requires a facts and circumstances inquiry.  Announcing the event on a medium that is accessible to everyone, such as an unrestricted website or a print or online newspaper, is per se general solicitation under Rule 502(c) (see above).  As to social media, even though the universe of people with access to a social media account may be much more limited than an unrestricted website, there is always the danger that a posting on Facebook or tweet on Twitter could be freely forwarded, and therefore in all likelihood would be considered general solicitation.

As mentioned above, there are solid reasons why companies would choose to structure an offering as one without general solicitation under Rule 506(b).  Doing so would avoid the extra compliance hassle and cost associated with a 506(c) offering (with general solicitation), as well as the difficulty of securing from purchasers the bank or brokerage statements or tax returns, or a third party certification, needed to verify status.

In conclusion, the following could be used as rules of thumb when considering an invitation to present at an event:

  • If the demo day is promoted on an open access website, through any print, online or broadcast media or in postings to social media accounts, the presenting company should either refrain from making any references to capital raising (i.e., limit the presentation to its products and services) or treat the effort as a Rule 506(c) offering by limiting sales of securities to accredited investors and obtaining copies of tax returns, or bank or brokerage statements.
  •  If the demo day is by invitation-only, or promoted through a password-protected website, and directed solely to persons with whom the organizers or the company have a financially substantive preexisting relationship, the company should be free to speak about its securities offering or capital raising needs generally and treat the effort as a Rule 506(b) offering.

Building  a successful startup is challenging.  But the chances of success could be greatly enhanced through participation in a startup accelerator program.  Entrepreneurially minded universities and research institutions have run incubators on or near campus where startups receive office space, shared facilities and services, but no capital.  Over the last several years, a new breed of startup incubator has emerged, commonly referred to as a startup accelerator, which combines space and back-office services with hands-on mentoring, access to valuable  networks and seed money.  The money is not free of course, but rather provided in exchange for a small amount of equity in the company, sometimes in shares and sometimes as a convertible note priced at or discounted to the next round of funding.  Another distinguishing feature of accelerators is the intensive duration of their program, typically three months rather than the multiple year model of the traditional incubator.  Admission has become enormously competitive, with the top accelerators accepting as few as only 1% of applicants.  It’s harder to get admitted to some of these programs than it is to an Ivy League business school.

Incubators

Accelerators 

Duration: Long term: multiple years Intensive: 3-4 months
Funding: None Seed money for some equity
Mentoring: Limited; no formal program Strong ongoing program
Investor   Access: None Demo days
Admission: Less competitive Extremely competitive

The first modern accelerator was Y Combinator, formed by entrepreneur Paul Graham in 2005 after selling his startup Viaweb to Yahoo for $49 million a few years earlier.  Since its inception, YC  has helped launch over 600 companies, including multibillion dollar startups Dropbox, a cloud storage and sharing company reportedly valued at $10 billion, and Airbnb, an on-line booking service for short-term stays at private residences also reportedly valued at $10 billion.  The startups in the YC program move to Silicon Valley for three months, during which the mentors work intensively with them to get the companies into shape and refine their pitch to investors.  Each cycle culminates in Demo Day, where the startups present their business plans to a carefully selected, invite-only audience of investors.  In exchange for 7% of the equity, YC provides each startup with $120,000, a portion of which comes from a fund YC manages which has limited partners.

Another nationally known accelerator is Techstars, which runs programs in seven major startup cities: Boston, Boulder, Chicago, New York City, Seattle, London, and Austin.  It boasts as its mentors such startup superstars as Foundrey Group Managing Director Brad Feld, Union Square Ventures Partner Fred Wilson and Twitter CEO Dick Costolo.  Techstars’ website offers a helpful set of practical ground rules for the application process that entrepreneurs violate at their peril.  For example, entrepreneurs should not apply and then immediately email Techstar’s mentors.  According to the website, doing so in order to try to influence the mentors before being accepted into the program will hurt the entrepreneur because the mentors will complain about it. Entrepreneurs should also not visit Techstars’ offices without an appointment because it’s “not a good example of persistence … and it will negatively influence [the] application”.

Even Disney is getting in on the act.  Last February, the creator of Mickey Mouse, Goofy and Donald Duck launched its first-ever startup accelerator, a three-month program pairing ten teams of entrepreneurs with mentors including  CEO Bob Iger, and giving them access to the company’s IP.  Disney’s accelerator is accepting applications through April 16, will be hosted in Los Angeles and be managed by Techstars, which has run similar corporate programs for Sprint, Barclays and Nike.