A major theme of this Blog has always been ongoing legislative, regulatory and market initiatives to reform capital markets by targeting unreasonable or outdated impediments to capital formation to make it easier for early-stage companies to raise capital.  These impediments are not always obvious or direct.  One such indirect impediment has been the venture capital adviser exemption under the Investment Advisors Act of 1940, the eligibility requirements of which disincentivize VC investment in secondary transactions and in other VC funds, thereby unnecessarily hampering liquidity in the innovation ecosystem.  If a new piece of proposed legislation passed by the House Financial Services Committee becomes law, however, this impediment will be eliminated.


Before Dodd Frank, venture capital fund advisers didn’t have to worry seriously about Investment Advisors Act regulation.  That’s because the Advisers Act exempted any investment advisor that had fewer than 15 clients and didn’t hold itself out to the public as an investment adviser.  For the purpose of the 15-client cap, the SEC treated each fund as one client. As a result, investment advisers could advise up to 14 private funds, regardless of the total number of LPs investing in a fund or the amount of assets in the funds, without the need to register with the SEC.

But as part of Dodd Frank, Congress repealed the exemption for advisers with fewer than 15 clients and replaced it with three more limited exemptions under the Advisers Act, one of which is an exemption for investment advisers that solely advise “venture capital funds”.  The SEC definition of “venture capital fund” contains five components, one of which is that the fund may not invest more than 20% of its aggregate capital contributions and uncalled committed capital in assets that are not “qualifying investments”. Qualifying investments are generally direct investments in qualifying portfolio companies, which exclude private funds or other pooled investment vehicles. Secondaries and fund-of-fund investments are considered non-qualifying investments because the assets obtained through such transactions are not acquired directly from a qualifying private company.  

The “directly acquired” requirement means that secondary investments, i.e., purchases from non-issuers such as founders, employees and other investors, do not constitute qualifying investments.  Also, investments in other VC funds are excluded from the definition of qualifying investments.  That means VCs must carefully monitor their secondary and investment vehicle investments to make sure they don’t exceed 20% of committed capital, and I suspect some VCs as a matter of policy avoid these transactions entirely to avoid the compliance headache.

Secondary Transactions

The SEC’s stated rationale for the direct investment rule is its desire to distinguish between VC funds, which are the subject of the investment advisor exemption, and other investment funds which are not. The SEC observes that one of the features of VC funds that distinguishes them from hedge funds and private equity funds is that they invest capital directly in portfolio companies for the purpose of funding expansion and development of a company’s business rather than buying out existing security holders.

The inclusion within non-qualifying investments of secondary and fund-of-funds investments, however, has been perceived by many in the VC space as contributing to an unnecessary impediment to liquidity in the innovation ecosystem.

Secondary transactions have become increasingly common in the venture capital industry.  As companies remain private longer and defer exits, the desire for liquidity grows among founders and other shareholders.  Founders and employees typically have most of their net worth tied up in their company’s shares and have an understandable desire to diversify and generate some liquidity currently.  Angel investors seek liquidity to be able to fund new investment opportunities.  Syndicate members often just get tired and want out. 

VCs often make secondary purchases of shares from founders and other holders to increase their ownership. The additional shares purchased by VC funds in secondary transactions often serve as a critical bridge between the needs of a fund to obtain sufficient ownership in a portfolio company to generate enhanced returns for LPs and the concerns of entrepreneurs and angel investors over the dilution they would experience if such additional shares were purchased directly from the company. Without secondary transactions, many venture funds and prospective portfolio companies may be unable to bridge that gap, resulting in a decline in VC investing in early-stage companies. Secondary transactions also serve to align the goals of VC funds and founders to continue to grow the company rather than selling it early to achieve founder liquidity.

VC Investment in VC and Other Vehicles

It’s become common for VC funds to allocate some of their investment to other VC funds as well as other investment vehicles such as “feeder”, “incubator”, “accelerator” or “micro-VC” funds. These seed or seed-type funds in turn invest at the very earliest stages of a portfolio company’s life and then rely on larger VC funds to participate in follow-on Series A or other future rounds.  Seed funds are a great asset to both startups and larger VCs, as they allow for a significantly larger pool of companies to receive seed funding and form a larger universe of investable companies for larger VCs.

Another group of VC funds that receives investment from larger VC funds is emerging funds.  Emerging fund manager sponsored funds tend to invest in startups developing new disruptive technologies, and thus play an important role in the venture economy.  Investing in these emerging VC funds is perceived by many asset managers as posing higher risk but offering greater upside potential than more established funds with track records.  

Institutional LPs are often interested in higher risk, higher reward emerging funds but may be constrained by their own minimum investment requirements which typically exceed the round size of a typical emerging fund.  Other interested institutional LPs may want to mitigate against the risk of investing in a smaller emerging fund by taking a diversified approach to their investment in the space.  For such institutional LPs, it would make sense to allocate some investment to a fund-of-VC funds that invests partly in emerging VC funds and partly in traditional VC funds.

VCs make investments in still other types of investment vehicles.  One example is technology incubators that create and spin out start-ups.  Another is companies that are in the “invention business” whose assets consist almost entirely of patent portfolios.  VCs also sometimes invest in investment vehicles whose other members are well-connected technology entrepreneurs who help VCs identify prospective portfolio companies and then invest in them side by side with the VCs through the vehicle.

All these indirect investments currently fall within the 20% limitation, resulting in impediments to both capital formation and liquidity in the innovation ecosystem.

The DEAL Act

Last month, the House Financial Services Committee passed and introduced to the full House of Representatives a focused piece of legislation to revise the definition of “qualifying investment” for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act.  Called the Developing and Empowering our Aspiring Leaders Act of 2023 or the “DEAL Act of 2023” (Congress loves catchy acronyms), it specifically orders the SEC to revise the venture capital fund adviser exemption’s definition of a “qualifying investment” to include secondary acquisitions and investments in other venture capital funds.  Under the new rule, shares purchased by VC funds in secondary transactions or in other venture capital funds will no longer be deemed non-qualifying investments and thus not included in the portion of a VC fund’s investment portfolio that may not exceed 20% of committed capital. 

If passed by Congress and signed into law, this reform of the venture capital fund exemption could lead to greater investment in early-stage companies and significantly more liquidity for founders and other early investors.  The bill is part of a larger piece of legislation called the Expanding Access to Capital Act of 2023 and now moves through the legislative process.

The collapse of Silicon Valley Bank will have enormous repercussions for startups and VCs in ways seen and unseen.  As for the unseen, SVB had deep relationships among the various players in the venture ecosystem.  Founders and investors established banking relationships with SVB in part because of the opportunities SVB provided to network within the space.  It will be difficult for other lenders who don’t have these deep relationships to replace SVB in this capacity and fill this valuable role.

But SVB’s downfall will impact startups in tangible ways as well.  SVB was the largest provider of venture debt, a niche category of lower cost financing that was tailored for early stage, venture backed companies.  Venture debt provides an attractive means for startups to extend runway with less dilution, at lower interest rates than with standard commercial loans (typically, 50 basis points above prime) and looser credit protection mechanisms.  Less dilution rather than no dilution (as is the case with most loans) because venture debt almost always involves an equity kicker in the form of warrants. Venture debt is predicated on venture investors providing equity in subsequent rounds to take out the earlier venture loans.  Interest rate and loan size tend to vary based on the scale of the company, the amount of equity previously raised and the use of proceeds.  Venture lenders typically agree to lend between 25% to 35% of the amount raised in the most recent equity round.  

Interestingly, it’s possible that SVB borrowers breached their loan covenants as a result of their run on the bank that precipitated its collapse.  Most venture debt loan agreements mandate that the lender be the borrower’s principal depository and disbursement bank, and require the borrower to conduct all of its primary banking business with the lender, including primary deposits. SVB’s loan agreements typically included this banking relationship covenant, which would have been breached by the withdrawing depositors absent a waiver from SVB.  In any event, with SVB’s collapse, venture debt will now be more expensive and scarce.

The anticipated contraction in the venture debt market will also likely result in lower valuations.  In a recent research brief, the good folks at CB Insights picked up on two telling statements contained in SVB’s mid-quarter update for first quarter 2023.  The first of these quotes is that “[c]lients [of SVB] continue to opt for debt over raising equity at pressured valuations.”  As to “pressured valuations”, CB Insights offers data illustrating a tangible disconnect between public and private tech company valuations.  According to CB Insights, the combined market cap of the companies that went public in the 50 largest tech IPOs since 2020 is down 59% as compared with their combined market cap at the time of their respective IPOs. On the other hand, Series C and Series D valuations were actually up 20% and 30%, respectively, as compared with 2020.  CB Insights’ theory on the disconnect is plausible:  many venture backed companies would have faced down rounds, but avoided a lower valuation by opting for venture debt.  Further, CB Insights also believes the fittest companies were the ones securing equity funding at lofty valuations, while the weaker ones were being funded with venture debt to avoid down rounds, further feeding the disconnect between public and private company valuations.  With venture debt now harder to come by, however, it stands to reason that more companies will need to seek equity funding and that, with VCs far more discerning than they were a year ago, such rounds will necessarily be at lower valuations, meaning more down rounds.

The headwinds in the venture debt market may also impact headcount.  Another telling quote in SVB’s mid-quarter update for first quarter 2023 was that “[c]lient cash burn remains ~2x higher than pre-2021 levels.”  CB Insights’ analysis bears this out, finding that 86% of unicorns increased headcount since Q1’22, and that 37% of unicorns have grown headcount by more than 50%.  Hence, it seems that companies have been able to avoid tough headcount decisions either by closing equity rounds at valuations that thus far have remained persistently high (in the case of the stronger companies) or by securing venture debt (in the case of weaker companies).  Consequently, with the coming challenges in venture debt, coupled with the already contracting venture equity market, it stands to reason that, in addition to lower valuations, we’ll also likely be seeing increasing layoffs.  Looks like a bumpy road ahead for startups.

A new federal law goes into effect March 29, 2023 that conditionally exempts from broker-dealer registration persons who solely intermediate small, private company M&A deals.  Persons who intermediate larger private company M&A transactions will not be eligible for the new exemption and will need to continue to rely on the SEC’s 2014 no-action letter.  The new Federal legislation also does not preempt the states, so M&A intermediaries will need to continue to be mindful of state registration requirements.


Most brokers are required to register with the SEC and join a “self-regulatory organization” such as FINRA.  Section 3(a)(4)(A) of the Securities Exchange Act generally defines a “broker” broadly as any person engaged in the business of effecting transactions in securities for the account of others.  Ordinarily, it’s fairly easy to determine whether someone is a broker.  A person who executes transactions for others on a securities exchange is clearly a broker.   Less clear is whether a person who intermediates only private M&A transactions, often structured as acquisitions of stock or as mergers in which securities get converted, is also a broker and required to register.

When you look at the general rationale for regulating broker dealers, it’s tough to justify applying such regulation on private company M&A brokers. Broker-dealer regulation is generally designed to prevent abuses involving high pressure selling tactics and custody of funds, two features that typically don’t apply to private company M&A deals. In a typical M&A transaction, unlike a stock trade, the acquiror usually engages in its own exhaustive due diligence of the target, and the intermediary does not typically custody funds. Nevertheless, the U.S. Supreme Court in 1985 opined that an M&A transaction involving a target’s stock is deemed to be a securities transaction. Consequently, many M&A advisors began registering with the SEC as broker dealers following the 1985 opinion.

2014 No-Action Letter

Since 2014, M&A brokers have sought to rely on an SEC no-action letter (the “NAL”), in which the SEC’s Division of Trading and Markets stated that it would not recommend enforcement action to the SEC if the M&A broker who requested the letter were to intermediate the transfer of ownership of privately-held companies and refrain from engaging in certain activities identified in the NAL. The NAL listed a bunch of deal activities that would make the relief unavailable, however, including providing financing for the deal, custodying funds or securities, arranging for a group of buyers and intermediating a sale to a “passive” buyer.  All buyers would be required to control and actively operate the company or the business conducted with the assets of the acquired business. 

But reliance on SEC no-action letters generally has risks.  No-action relief is provided to the requester based on the specific facts and circumstances set forth in the request.  In some cases, the SEC staff may permit parties other than the requestor to rely on the no-action relief to the extent that the third party’s facts and circumstances are substantially similar to those described in the underlying request, but the SEC staff always reserves the right to change the positions reflected in prior no-action letters.

NASAA Model Rule

The NAL also did not preempt state regulation, however, and in 2015 (the year after the NAL was issued) the North American Securities Administrators Association adopted a model state rule intended to codify the NAL.  Only a handful of states have adopted the model rule, while a few others have enacted exclusions from the broker definition for brokers who transact solely with institutional investors or with a de minimis number of annual transactions.

New Federal Exemption

The new Federal exemption appears on page 1080 of the Consolidated Appropriations Act.  It amends Section 15(b) of the Securities Exchange Act by providing an exemption for “M&A brokers”.

M&A Brokers

M&A broker is defined as a broker engaged in the business of effecting securities transactions solely in connection with the transfer of ownership of an “eligible privately held company”.  Accordingly, a broker who intermediates private company M&A deals as well as other types of strategic transactions involving securities would not qualify.

The broker also has to reasonably believe that, as required in the NAL, the buyer in each intermediated transaction will “control” and “actively manage” the acquired company or business.  Finally, in any transaction in which the seller receives securities of the buyer as acquisition currency, the broker must reasonably believe that the seller receives, or has reasonable access to, mandated financial information of the buyer.

Control and Active Management

Exempt M&A brokers must reasonably believe the seller in each intermediated transaction will control and actively manage the target post-closing. Control is defined as the power to direct the management or policies of a company, whether through ownership, by contract or otherwise.  There is a presumption of control if the buyer has the right to vote or sell 25% or more of a class of the target’s voting securities, or in the case of a partnership or LLC, the right to receive 25% or more of the capital upon dissolution.  Although not defined, “active management” can be established if the buyer elects officers, approves the annual budget or serves as an officer.

Eligible Privately Held Company

To qualify for the exemption, brokers may only intermediate acquisitions of “eligible privately held companies”.  To qualify, the privately held company must not have any class of securities registered, or be required to file periodic reports, with the SEC.  Also, in the fiscal year ending immediately before the fiscal year in which the broker was engaged, the company must either have EBITDA of less than $25 million or gross revenues of less than $250 million.  This EBITDA and gross revenue cap is the most significant difference between the new statutory exemption and the NAL, which did not have a size of company test.  The dollar caps are subject to an inflation adjustment every five years.

Excluded Activities

To qualify and maintain the exemption, an M&A broker has to avoid engaging in each of the following activities, any of which would lead to forfeiture of the exemption: taking custody of funds, participating in a public offering of securities, engaging in a transaction involving a shell company (other than acquisition vehicles), providing acquisition financing, arranging for acquisition financing without complying with applicable regulations or disclosing compensation therefor, representing both buyer and seller in a transaction without written consent from each, facilitating the formation of a buyer group, intermediating a transfer to a passive buyer or binding a party to a transaction.

Primary Takeaways

The new federal exemption is welcome relief for middle market M&A dealmakers.  It removes the uncertainty associated with reliance on the NAL.  But the federal exemption’s utility is unfortunately somewhat limited by the arbitrary size of target limitation, which will limit the range of transactions an M&A broker will be permitted to intermediate without forfeiting exemption eligibility.  Eligible M&A brokers will also need to continue to be mindful of state registration requirements.

Will employment non-competes soon be banned nationally?  Perhaps, if the Federal Trade Commission gets its way.  Last month, the FTC issued a Notice of Proposed Rulemaking (the “NPRM”) that would prohibit just about all employment non-competes. The proposal is now going through a 60-day comment period.  If ultimately adopted in anything close to its current form and survives inevitable legal challenges, the ban will significantly impede the ability of employers to safeguard proprietary information.

Once upon a time, non-competition covenants were imposed only on senior executives and limited others who had access to proprietary company information.  But over time, employers have expanded the use of non-competes and imposed them on rank-and-file employees as well.  According to the FTC, 30 million workers are subject to non-competes.  Many of these employees don’t even know it applies to them.  The clauses are often buried in on-boarding documents which are often glossed over or not read at all.  Even if employees are mindful of it, they typically don’t have the leverage to do anything about it.

There are certain limited exceptions built into the proposed rule.  Most notably, the ban would not apply in the context of a sale of a business, a concession that non-competition covenants from sellers of a business may be necessary to protect the value of the business acquired by the buyer.  But the exception is limited to “substantial” owners of the business entity being acquired. The rule would define “substantial” as owning at least a 25% ownership interest.  The NPRM states that designating a percentage provides more certainly to selling business owners and their buyers but provides no rationale for the arbitrary percentage threshold other than to say that “51% may be too high” and that 25% strikes the right balance.  Sounds like Goldilocks.

The ban would also except out those in franchiser/franchisee relationships, certain banks, savings and loan institutions, federal credit unions, common carriers, air carriers, non-profits and state and local governments.

In reaction to the proposed ban on non-competes, employers may seek to protect their proprietary information through other post-termination restrictive covenants.  These include non-disclosure agreements, non-solicitation agreements and no-business agreements, the latter of which prohibit an employee from doing business with former clients or customers of the employer, whether or not solicited by the employee. These other restrictive covenants affect the way an employee may compete with a former employer post-termination, but don’t prevent the employee from competing with the former employer altogether or other employers from competing for that employee.  Nevertheless, the FTC in the NPRM expressed concern that some employers may seek to evade the requirements of the proposed rule by implementing other restrictive covenants that are so restrictive as to constitute “de facto non-compete clauses”. Accordingly, under the proposed rule, these “functional equivalents” would also be included within the scope of the ban, whether drafted for purposes of evasion or not.

Notably, there would be no grandfathering of existing agreements.  The proposed rule would also prohibit maintaining existing non-compete covenants and require companies to rescind any previously executed non-compete agreements. If companies do not do so, they would be found to be engaged in unfair competition.   To lessen the burden of the rescission requirement, however, the FTC is proposing a safe harbor under which employers would satisfy the requirement by notifying relevant employees that their non-compete is no longer valid, and offers the following proposed language that could be included in the notice:

“A new rule enforced by the Federal Trade Commission makes it unlawful for us to maintain a non-compete clause in your employment contract. As of [180 days after date of publication of the final rule], the non-compete clause in your contract is no longer in effect. This means that once you stop working for [Employer Name]:

· You may seek or accept a job with any company or any person—even if they compete with [Employer Name].

· You may run your own business—even if it competes with [Employer Name].

· You may compete with [EMPLOYER NAME] at any time following your employment with [Employer Name].

The FTC’s new rule does not affect any other terms of your employment contract.

For more information about the rule, visit [link to final rule landing page].”

The proposed rule is not unanimously supported within the FTC.  In her dissenting statement, Commissioner Christine S. Wilson questioned the FTC’s authority to issue the rule and asserted the proposed federal ban would constitute a sharp departure from hundreds of years of precedent for fact-specific inquiry.  Only three states – California, North Dakota and Oklahoma – have made employment non-competes unenforceable for nearly all workers.  The other 47 states apply a fact specific reasonableness analysis and recognize as a legitimate interest the protection of an employer’s trade secrets.  These states generally recognize an employer’s interest in protecting its investment in training or in preventing a worker who provides “unique” services from working for a competitor.  On the other hand, courts in these states will generally not enforce non-competes that prohibit a greater scope of activity than necessary to protect the employer’s legitimate interests, generally when the covenants cover a geographic area more extensive, or last longer than needed, to protect those interests.  Some states, including Illinois and Washington, have passed laws limiting the use of non-competes among low-wage workers.

The substantive arguments cut both ways.  The FTC contends that non-compete clauses decrease competition for workers resulting in lower wages, prevent new businesses from forming and stifle entrepreneurship and innovation.  According to dissenting Commissioner Wilson, however, studies in this area are scant and have produced mixed results. The FTC also contends that employers can use NDA’s and non-solicitation covenants to protect proprietary information which don’t generally prevent workers from competing with former employers.  But NDAs and non-solicitation covenants in the absence of non-competes are largely effective only in theory.  In the real world, proprietary information could be disclosed by a former employee to a competitor long before the former employer discovers it, if he discovers it at all.

The public is encouraged to communicate comments to the FTC during the comment period which expires March 10, 2023.  Comments may be submitted here.  The FTC appears to have the necessary majority to adopt the new rule and will likely do so with some modifications based on submitted comments.  Litigation will certainly follow, if not commenced even before adoption.  Nevertheless, employers should perform a review of their employment agreements and other documents containing restrictive covenants to determine what modifications will need to be made in light of the proposed non-compete ban.  Employers should also be mindful that NDAs and non-solicitation covenants may also be prohibited if they are deemed too restrictive under the standards set forth in the rule.

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” Such was the lament of John Ray, the legendary restructuring executive tasked with the unenviable assignment of serving as the caretaker CEO of bankrupt FTX Trading Ltd.  As the criminal and civil cases by the DOJ, SEC and CFTC against FTX founder and former CEO Sam Bankman-Fried play out in the courts, what does the “complete failure of corporate controls” at FTX teach us about corporate governance, unchecked founder control and the importance of proper oversight?

Factual Background

In 2017, Sam Bankman-Fried aka SBF co-founded Alameda Research LLC, a quantitative trading firm specializing in crypto assets.  Two years later, he founded FTX Trading Ltd. to operate a global crypto asset trading platform.  FTX then raised nearly $2 billion in four preferred stock funding rounds, during which it and SBF represented to prospective investors that FTX had appropriate controls and risk management mechanisms to protect customer assets, that those assets were safe and that Alameda was just another platform customer with no special privileges.  It turns out that Alameda was exempt from whatever risk mitigation measures were put in place and was given significant special treatment on the FTX platform, including a virtually unlimited line of credit unwittingly funded by the platform’s customers. Also unbeknownst to FTX’s investors and trading customers was that SBF improperly diverted billions of dollars of customer assets to Alameda, and then used those funds to make risky venture investments, purchase Bahamian real estate for himself, his parents and other FTX executives, extend big loans to FTX executives (including SBF himself) and make large political campaign donations (he was the second largest donor to Democrat campaigns in 2022 behind only George Soros).  None of this was disclosed to FTX investors or customers.

According to the SEC’s complaint, SBF’s “house of cards” began to crumble in May when crypto asset prices plummeted.  Lenders demanded repayment of loans made to Alameda, and SBF directed Alameda to draw down billions of dollars from its “line of credit” from FTX to repay some of those loans.  He also used those proceeds for additional venture investments and loans to himself and other FTX executives.  In November, Binance, the world’s largest crypto exchange by volume, announced it will sell off its substantial holdings of FTX’s native token FTT (received in connection with the buyout of Binance’s 2021 investment in FTX), which caused the price of FTT to crater.  FTX then entered into an LOI with Binance for Binance to acquire FTX, subject to due diligence.  The next day, Binance announced it wasn’t going to proceed with the transaction because of issues it uncovered as part of its due diligence which were beyond its ability to help, as well news reports regarding mishandled customer funds and alleged Federal agency investigations.  Faced with billions of dollars in customer withdrawal demands that FTX could not fulfill, FTX, Alameda and their affiliated entities filed for bankruptcy.

Related Party Transactions

From time to time, a company may have opportunities to do business with other entities that happen to be controlled by a director, officer or large stockholder of the company.  Such related party transactions pose inherent risks to a company, namely that the related party will receive favored terms to the detriment of the company and its stockholders.  Investors typically seek to guard against this risk in two general ways.  First, by identifying at the outset during due diligence whether any related party transactions exist and whether adequate safeguards are in place to ensure that the terms of any such transactions are no less favorable to the company than could be secured in arms’ length transactions.  Second, by negotiating for enhanced safeguards going forward to ensure that any such proposed transactions are properly vetted.

Two of the most effective mechanisms that investors negotiate for to mitigate against the risk of related party transactions are board representation and director vetos.  As to the former, board representation proportionate to equity ownership is generally considered fair.  For example, if a VC owns 25% of a company’s outstanding shares and the board consists of eight seats, it would be fairly typical for that VC to have the right to designate two directors on that eight person board.  That board representation right would be set forth in the company’s amended and restated certificate of incorporation.  Director vetos are typically set forth in an investors’ rights agreement between the investors and the company, which identifies a list of designated transactions that require the affirmative vote of the investor’s board designee(s).  A typical director veto provision of this sort would look like this:

Matters Requiring Investor Director Approval.  So long as the holders of Series A Preferred Stock are entitled to elect a Series A Director, the Company hereby covenants and agrees with each of the Investors that it shall not, without approval of the Board of Directors, which approval must include the affirmative vote of the Series A Director,…enter into or be a party to any transaction with any director, officer, or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such Person.”

Looking the Other Way?

John Ray’s Declaration in the FTX bankruptcy case identifies “unprecedented” breakdowns in governance, oversight and controls.  Among these were the absence of investor representation on the board, which in turn meant FTX was not required to obtain investor director approval for related party transactions.  How did the VCs allow for this?

According to Bloomberg, the preferred stock investors in FTX included such VC luminaries as Sequoia Capital, Lightspeed Venture Partners, Iconiq Capital, Insight Partners, Thoma Bravo and SoftBank Group Corp., none of whom served as lead investor.  With no lead investor, none of the VCs had the leverage to dictate terms.  Also, all of the VCs made their investment in FTX when investor fervor for cryptocurrency startups hit an all-time high, giving those startups significant leverage. 

It appears that FTX used its leverage to thwart any meaningful due diligence that could have identified the existing conflict with Alameda, as well as any effort to negotiate for board representation and director vetos.  According to The Wall Street Journal, when Sequoia and other VCs “asked for a seat on the company’s board of directors, Mr. Bankman-Fried repeatedly pushed back, telling them their ownership in the company was too small to warrant it”.  Maybe the VCs didn’t press the issue.  Or maybe they did, but SBF was too busy playing League of Legends during the meeting at which the board representation proposal was made, just as he reportedly did while originally pitching Sequoia.

Or maybe the VCs were too smitten with SBF that they didn’t want to know.  SBF had cultivated an image of a responsible, visionary leader of the crypto industry. He characterized FTX and himself as playing an important role in stabilizing the industry, and seemingly backed that up by providing credit to and taking over other failing crypto firms.  During SBF’s pitch to Sequoia, a Sequoia partner reportedly typed “I LOVE THIS FOUNDER” to his colleagues. An inspiring founder can overwhelm otherwise cautious investors who end up abstaining from due diligence.  Also, as I mention above, SBF was a top campaign contributor to Democrats. He also hired multiple former regulators to serve in senior positions at FTX, and his parents are both professors at Stanford Law School.

For its part, Sequoia insists that it performed adequate due diligence and that, in any event, its fund that invested in FTX had $7.5 billion worth of gains and that the FTX investment accounted for less than 3% of the committed capital for that fund.  Fair enough.  The damage may not be material to Sequoia and its limited partners.  But the FTX debacle is devastating to tens of thousands of individuals who may have viewed Sequoia’s and the other VCs’ investment in FTX as a seal of approval. 

In Noam Wasserman’s The Founder’s Dilemmas, he describes a key tradeoff that entrepreneurs face: they can be rich or they can be king. By that he meant that if an entrepreneur insists on maintaining complete control, his company is less likely to grow because he’ll have trouble raising capital, attracting key employees and achieving growth. If he raises capital to maximize growth potential, he’ll need to give up some control.  Wasserman shows how all parties benefit from a proper growth-control tradeoff.  Founders benefit from oversight because it makes the company more credible and thus more investable and ultimately more valuable.  For the same reasons, oversight also helps investors and employees.  As we see from the FTX fiasco, unchecked founder control runs the risk of value destruction.  

Just last week, special purpose acquisition company The Music Acquisition Corporation (“TMAC”) called a special meeting of its stockholders.  It wasn’t the special meeting it originally envisioned.  TMAC was launched in February 2021 by long-time Geffen Records President Neil Jacobson to acquire a music business with the $230 million of SPAC IPO proceeds it raised.  The special meeting it envisioned at that time was one to approve an acquisition of a music company.  Instead, the special meeting to be held on November 30 is for the stockholders to approve an early liquidation of the SPAC and the return of remaining IPO proceeds to the stockholders.

TMAC is not alone in calling for early liquidation.  CNBC reports that 27 SPACs worth $12.8 billion have been liquidated so far this year through mid-October.  Along with this spate of SPAC liquidations, 143 SPAC IPOs have withdrawn this year and 46 de-SPAC transactions (acquisitions of operating companies by SPACs) were terminated.  This is an incredible turn of events from the SPAC hysteria we went through in 2020 and most of last year, when SPACs constituted more than half of the record number of IPOs.

One way that SPAC sponsors got lots of investors to invest in SPACs in the first place is by giving them redemption rights.  A SPAC investor may opt out of a proposed de-SPAC transaction and be entitled to his pro rata share of the IPO proceeds which are required to be held in trust.  Another investor protection is that a SPAC must liquidate and distribute those proceeds to the SPAC investors if it fails to complete a de-SPAC acquisition within a set timeline, typically two years. That two-year deadline has proven to be a ticking time bomb:  too many buyers chasing too few viable targets.

The increasing propensity of SPAC investors to seek redemption has created multiple problems for SPACs and their sponsors.  A standard condition to a target’s obligation to close a de-SPAC transaction is that there be a minimum amount of combined cash available from the trust account and from PIPE investments (private investments in public equity).  When aggregate redemptions get too big, the SPAC may fail to satisfy the cash condition, causing the de-SPAC transaction to crater.  Even if a de-SPAC transaction is able to close, excessive redemptions may threaten the financial viability of future operations of the post de-SPAC operating company because of the lack of available cash.  And more redemptions also mean a smaller stockholder base, which results in reduced liquidity in the surviving company’s stock.

The sponsor faces significant losses as well.  First, the transaction fees associated with effecting the IPO, sourcing, performing due diligence on, negotiating and documenting potential de-SPAC deals and getting them past the SEC regulatory process is an enormously expensive process and represents sunk costs to the sponsor; those expenses are not paid out of the trust account. These transaction fees have been estimated to average approximately $5-$10 million.  Second, the typical 20% promote to the sponsor in the form of shares in a de-SPAC’ed company is only worth something if an acquisition deal gets done.  If the SPAC fails to acquire an operating company and is forced to liquidate, the SPAC’s public shareholders at least get the IPO proceeds back with interest; the sponsor neither shares in the trust proceeds nor benefits from the 20% share allocation.  

But redemptions aren’t the sole cause for the recent string of SPAC liquidations. Another reason being cited by sponsors for liquidating now is the new excise tax under the Inflation Reduction Act, which imposes a 1% excise tax on any domestic corporation that repurchases its stock after December 31, 2022.  TMAC cited the excise tax as the primary reason it was seeking stockholder approval for a charter amendment to accelerate its liquidation.  Under its certificate of incorporation, TMAC could not otherwise liquidate until after the designated two-year deadline for completing a deal, or February 5, 2023.

A sponsor facing excessive redemptions has few options.  Sponsors will be loath to let a possible deal fall through and will thus have every incentive to negotiate with individual investors in an effort to change their minds regarding redemption.  This likely means some kind of concession from the sponsor, often in the form of a cut-back in the sponsor’s share allocation, typically 20%, in the company post-acquisition.  In fact, sponsors are getting squeezed on both ends as competition has been stiff among SPAC sponsors for targets.  This means sponsors are also under pressure to sweeten the pot for potential target companies by offering to decrease the 20% promote even further. Alternatively, the sponsor could seek supplemental funding to make up for the redemptions, either in the form of additional acquisition financing or as a line of credit post-closing to fund ongoing operations.

2022 was predicted by many to be the year of the red wave (turned out to be more of a red ripple).  It may be better remembered for another wave beginning with the letter “R”: a redemption wave.  Over the next few weeks, I expect to see those sponsors who are sitting on signed merger agreements trying to negotiate with SPAC shareholders to stem the tide of redemptions in an effort to satisfy cash closing conditions and close their de-SPAC transactions.  On the other hand, sponsors further away from consummating a de-SPAC transaction will have few good options and will be under enormous pressure to liquidate this year before the excise tax kicks in.

Elon Musk has lobbed in two additional termination letters since his original July 8 letter seeking to terminate his agreement to acquire Twitter for $44 billion.  Each termination letter cites alleged false representations and blown covenants by Twitter in the merger agreement, purportedly justifying termination.  Twitter’s response to each letter has been the equivalent of saying: “So what?”.

Musk’s first termination letter alleged that Twitter overstated the number of its monetizable users, understated the percentage of users that are fake accounts or bots and failed to provide information Musk needs to complete the transaction or to secure financing.

Musk’s second termination letter was sent after the Washington Post published a whistleblower report to Congress, the SEC, the FTC and the DOJ filed by Peiter “Mudge” Zatko, Twitter’s former chief security officer, on July 6, 2022.  The second letter asserts that the allegations in the whistleblower report, if true, would demonstrate Twitter violated several provisions of the merger agreement.  The allegations include that Twitter has been violating an FTC consent decree requiring the company to maintain a comprehensive information security plan (purported breach of the representation that Twitter is in compliance with applicable laws), that it failed to disclose in SEC documents the significant privacy, data protection, safety and cybersecurity risks Mr. Zatko alerted the board to (purported breach of the representation that Twitter’s SEC filings were truthful), that Twitter’s CEO presented false information to the board to cover up vulnerabilities in Twitter’s security and data protection infrastructure (purported breach of the representation regarding disclosure controls and procedures), that Twitter is facing multiple regulatory investigations relating to privacy and cybersecurity (purported breach of the representation that there are no threatened lawsuits that would constitute a material adverse effect), and that Twitter never acquired the rights to its core machine learning models (purported violation of the representation that Twitter was not infringing on anyone else’s intellectual property).

The third termination letter, dated September 9, 2022, asserts that Twitter’s $7.75 million severance payment to Mr. Zatko (the whistleblower) violated Twitter’s merger agreement covenant not to make any severance payments prior to closing other than in the ordinary course of business and consistent with past practice, in each case without Musk’s consent.

Normally, you don’t get to pile on to a previously delivered termination letter by sending subsequent letters with additional or alternative allegations.  Musk is maintaining in his second and third termination letters, however, that new facts have come to light since the previous termination letter(s) (i.e., the whistleblower allegations and severance payment) that provide additional and distinct bases to terminate the merger agreement.

Twitter’s responses to the second and third termination letters begin with a perfunctory denial of the allegations that it is in breach of the merger agreement.  But the thrust of its response to each of the letters is the same:  that the purported termination by Musk is invalid because (even if the allegations about Twitter are true) Musk himself has violated numerous obligations under the merger agreement, which serves to contractually prevent him from terminating the agreement.  Under Section 8.1(d) of the merger agreement, Musk’s right to terminate over a breach by Twitter of any representation or covenant is conditioned on one major requirement: that Musk himself not be in material breach of any of his representations, warranties or covenants in the agreement.

And what obligations does Twitter allege Musk breached?  First, his obligation to use reasonable best efforts to complete the merger.  Second, his “hell-or-high-water” covenant requiring him to do all things necessary to consummate and finalize the acquisition financing.  Third, to provide Twitter with information regarding the status of debt financing.  Fourth, to refrain from unreasonably withholding consent to operational decisions (e.g., by unreasonably withholding consent for employee retention programs).  Fifth, to seek Twitter’s consent for public comments about the deal.  Sixth, to refrain from disparaging Twitter or its representatives in tweets about the merger.  And finally, not to misuse Twitter’s confidential information.

It will be interesting to see how all this plays out in the trial, expected to begin October 17.  Although Chancellor McCormick denied Musk’s motion to delay the start date, she did allow him to add the whistleblower claims to his countersuit.  There will be a lot of arguing about whether any of the allegations by Musk constitute misrepresentations by Twitter and if so whether any such misrepresented matters would have a material adverse effect on the company.  His best shot would seem to be the $7.7 million severance payment to Mr. Zatko if Musk could prove it was not in the ordinary course of business or consistent with past practice.  That would be a covenant breach, and unlike representation breaches, he would not need to also prove material adverse effect.  In any event, Twitter will then invoke the unclean hands provision of Section 8.1(d) by seeking to establish that Musk himself is in violation of his own covenants, which seemingly would deny Musk the ability to terminate over any Twitter breach.

Two startups with competing, equally compelling technologies at the same stage of development are pitching venture capital investors for Series A funding.  One startup is led by a serial entrepreneur founder, the other by a novice.  Assume each will get funded.  In all likelihood, the deal will happen quicker and the amount funded and pre-money valuation will be higher for the serial entrepreneur led startup than its novice competitor.  That according to Pitchbook’s latest report (the “Report”) on the impact of entrepreneurial experience on the venture capital ecosystem, which finds that founder experience has a material impact on VC fundraising.  Moreover, this disparity among serial and novice entrepreneurs actually grows as startups progress through the capital raising lifecycle.  But does this apparent advantage enjoyed by serial entrepreneurs come at any cost?

To build a successful startup, an entrepreneur needs to be able to assemble and manage a strong team, raise capital and execute a business plan.  Some of the skills necessary to pull this off an entrepreneur may be born with, while other skills may be acquired in the classroom.  But much of what characterizes a successful entrepreneur is intangible and learned in the process of doing, and for that reason an entrepreneur who has previously started up is perceived to have a more complete set of skills and more likely to build a successful startup.  In the course of building his first company, an entrepreneur has also likely developed relationships with a diverse community of professionals whose services will be important in building a subsequent company as well, such as angel and venture capital investors, corporate finance lawyers, scientific advisers and human resource experts.  And if he’s previously executed an exit, the entrepreneur’s contacts would also include exit specific professionals such as investment bankers, underwriters and mergers and acquisitions lawyers.

So it should come as no surprise that the Report finds that serial entrepreneurs (repeat entrepreneurs with one or more previous exits) raise VC rounds earlier in each stage of the startup’s corporate life than novices or even unproven serial entrepreneurs (repeat entrepreneurs who have not yet exited).  The median number of years between founding and first VC round for serial entrepreneurs remained at 1.13 years as compared with Pitchbook’s 2019 study, and the median period of time for unproven and novice founders increased to 1.34 and 1.92 years, respectively.

Serial entrepreneurs also enjoy an advantage in terms of deal size.  Median angel and seed[1] deal sizes for serial entrepreneurs in 2022 year-to-date were 2.5 times larger than novice-led deals, while early- and late-stage rounds led by serial entrepreneurs were roughly 3.4 times larger.

Valuations are also progressively higher for serial entrepreneur-led startups.  Pre-money valuations for serial entrepreneur-led startups had median valuations that were 1.9 times higher than those of novice-led companies, with the variances between serial and novice entrepreneurs increasing to 2.5 times for early stage rounds and 3.7 times for late stage deals.

The larger divergence in deal size and pre-money valuations between serial and novice entrepreneurs in later stages vs. the angel and seed rounds suggests that even the emergence of objective performance metrics in later rounds such as market proven products and demonstrated revenue growth cannot overcome the inherent investor confidence afforded to serial entrepreneurs.  The Report also suggests that the seed stage fundraising momentum that serial entrepreneurs benefit from could be allowing their startups to mature more quickly and display stronger financial performance than novice-led companies, thus leading to an even greater deal size disparity in later stage rounds.  The exit track record of a serial entrepreneur may be even more valued in later rounds as exit comes more into focus.

Earlier, larger and higher valuation rounds enable serial entrepreneur-led startups to scale and exit faster.  But the Report points out that this advantage comes with a price: dilution.  Bigger deal sizes in early rounds when valuations are lower than they would be in later rounds means larger amounts of equity are being issued to investors, resulting in greater dilution to the founders.   During angel and seed funding stages, serial entrepreneurs are giving up a greater percentage of the equity in their company, nearly 2% more than unproven entrepreneurs and 6% more than novices. This trend is maintained in early stage deals (Series A and B).  Apparently, the higher pre-money valuations given to serial entrepreneur-led startups are not enough to offset the effect of larger amounts being raised at low-valuation points in the corporate cycle.  The trend reverses course in late stage rounds, however, as much higher pre-money valuations result in less equity being issued to the investor for any given amount of investment in late stage rounds and less dilution to the founder.

A related question is whether prior exits alone are a reliable predicter of startup success.  In a 2016 Harvard Business Review piece entitled “Why Serial Entrepreneurs Don’t Learn from Failure”, the authors focus on the concept of overoptimism in relation to failure.  The authors find that overoptimism is a trait shared by most entrepreneurs, but that serial entrepreneurs are just as likely to be overoptimistic after failure as before, which poses a significant risk for investors who fund serial entrepreneur-led startups.  Although overoptimism is generally helpful in founding a startup, it can also help cause it to fail if it is associated with a greater tendency to commit to and overinvest in risky projects, to neglect to plan for the unexpected and to throw good money after bad while postponing the inevitable.  The authors argue that experiencing failure helps temper this overoptimism among some entrepreneurs, but not serial entrepreneurs.


[1] Here’s how Pitchbook generally identifies the stages of startup funding:

    • “angel round”: if there are no VC funds on the company’s cap table and it’s unclear whether any VC fund participated in the round, or if a press release identifies the round as an angel round or only mentions individuals as investors.
    • “seed round”: if the investors and/or press release state that a round is such, or if it is for less than $500,000 and is the first round as reported by a government filing.
    • “early stage”: Series A or B.
    • “late stage”: Series C or higher.

What do founders, employees and investors in privately held companies all have in common?  Limited opportunity to sell their shares.  That’s because of various legal, contractual and market factors that impede the sale of such securities, so liquidity is usually limited to acquisition of or public offering by the company. In recent years, there’s been a push to facilitate secondary market trading of private securities, and the Securities and Exchange Commission’s Small Business Capital Formation Advisory Committee has scheduled a meeting for August 2 to discuss how to improve liquidity in private companies.

So what are those legal, contractual and market impediments?

Securities Laws

All sales of securities in the United States, whether by companies in primary offerings or by shareholders in secondary offerings, must either be registered with the SEC or satisfy the requirements for an exemption from registration.  With rare exceptions (basically resales by institutional investors (e.g., venture capital funds) with leverage to negotiate registration rights in advance), SEC registration is too expensive and time consuming to be a viable alternative.

The most obvious resale exemption is under Section 4(a)(1) of the Securities Act of 1933 for sales by anyone other than an issuer, underwriter or dealer.  A founder, employee or investor is clearly not an issuer, and would not be deemed a dealer so long as he or she isn’t buying and selling securities as a business.  The real issue is whether the seller is an “underwriter”, broadly defined as anyone who has “purchased from an issuer with a view to … the distribution of any security”.

Because of the ambiguity in the definition of “underwriter”, the SEC promulgated Rule 144, a safe harbor, meaning if the specific requirements of the rule are satisfied the seller will not be deemed to be an underwriter for the purpose of Section 4(a)(1).  The rule applies differently to different sellers, depending on whether or not they are affiliates of the issuer and depending on whether the issuer is an SEC reporting company.  A non-affiliate seller need only satisfy the holding period, which for restricted securities is six months for shares in a reporting company and one year for a non-reporting company.  An affiliate, on the other hand, must satisfy the holding period, volume limitation, manner of sale and information requirements.

Contractual Restrictions

Private issuers typically require shareholders to sign agreements containing various restrictions on transfer.  These may include prohibitions on transferring shares without company consent, rights of first refusal in favor of other shareholders and/or the issuer and tag along or co-sale rights in favor of other investors allowing them to sell their shares pro rata with any sale by the shareholder.  Many companies also impose restrictions on insiders selling shares while in possession of material non-public information.  Any Seller seeking to comply with such insider trading restrictions by providing company information to a buyer would need to be mindful of impediments under confidentiality agreements.  In addition to making it harder to sell, these contractual restrictions tend to depress price for selling holders and increase cost for companies, which must monitor compliance with applicable law, gather and provide information, review transfer documentation and provide legal opinions.

Market Factors

Despite the proliferation of funding portals and other platforms for issuers and investors to find each other, secondary markets remain underdeveloped.  Much of that I suspect has to do with the lack of transparency in secondary market transactions.  As I mention above, non-affiliates selling under Rule 144 need not satisfy the rule’s information requirement.  That’s good for the seller, but the lack of transparency makes the shares less attractive to potential buyers.  Even if a seller would be inclined to volunteer company information, his ability to do so would largely depend on the company’s willingness to cooperate in providing the information and waiving disclosure restrictions.

Small Business Capital Formation Advisory Committee

The SEC’s Small Business Capital Formation Advisory Committee last week released the agenda for its virtual meeting on Aug. 2, which will address liquidity challenges for investors in private companies.  Under the released agenda, the Committee will explore (i) what exit opportunities exist for investors in Regulation A and Regulation Crowdfunding deals where the companies continue to provide ongoing reports, (ii) what secondary market liquidity challenges private and smaller public companies and their investors encounter, and (iii) what changes could help facilitate secondary liquidity for these investors.

Another week, another chapter in the Elon Musk-Twitter saga.  Last month, Musk posted tweets questioning longtime Twitter claims that automated “spambots” make up fewer than 5% of monetizable daily active users.  But on June 6, Musk upped the ante by having his lawyers at Skadden send a demand letter to Twitter reiterating his demand for data he claims is necessary to facilitate his independent evaluation of spam and fake accounts on the company’s platform, which he asserts the company is required to provide under the merger agreement.

So what are those merger agreement provisions that would require Twitter to provide the requested information?  There are two relevant provisions.

Section 6.4, Access to Information, obligates Twitter to provide Musk with “all information concerning the business … of the Company … as may reasonably be requested … for any reasonable business purpose related to the consummation of the transactions contemplated by this Agreement”.  One plausible way to link the information needed to evaluate the prevalence of spam and fake accounts to consummation of the closing is through Twitter’s representation in the agreement regarding its SEC filings.  Twitter represented that its SEC filings since January do not contain any material misstatements or omissions.  Twitter disclosed in its most recent 10-Q, that based on its internal review of a sample of accounts, it estimated that false or spam accounts represented fewer than 5% of its monetizable daily active users.  Twitter carefully hedges that estimate by stating that in making that determination, it “applies significant judgment, so [its] estimation of false or spam accounts may not accurately represent the actual number of such accounts, and the actual number of false or spam accounts could be higher than … estimated”.  Musk’s suggestion that the percentage of spambots may be significantly higher is an indirect allegation that Twitter has breached its SEC filing representation in the merger agreement.  In any event, a condition to Musk’s obligation to consummate the transaction is that all of Twitter’s representations be materially true as of the closing.  Hence, the information requested by Musk is arguably “related to the consummation” of the merger because it enables Musk to determine whether Twitter has breached one its representations, and consequently whether Musk may terminate the agreement.

The other provision of the merger agreement that Musk’s lawyers assert obligates Twitter to provide the requested fake account analysis information is Section 6.11, Financing Cooperation.  That section of the agreement generally obligates Twitter to “provide any reasonable cooperation reasonably requested by [Musk] in writing in connection with [his] … debt financing”.[1]

The Skadden letter ends ominously by stating that Musk reserves his rights resulting from Twitter’s alleged information covenant breach, including his right to terminate the merger agreement and not proceed with the acquisition.  Musk has the right to terminate the agreement if Twitter breaches any of its obligations in the agreement (including the covenant to provide information) and the breach is not cured within thirty days following notice.  The Skadden letter could be deemed to be such notice, which means Musk, assuming he prevails in his allegations of breach, may be able to terminate the agreement on or about July 6.

Or maybe not.  Built into the information and cooperation covenants are a bunch of carveouts which Twitter may be able to rely on as a defense.  Most relevant is that Twitter has no obligation to provide the information required under Section 6.4 if doing so would cause significant competitive harm to Twitter if the acquisition doesn’t close.  In the past, Twitter CEO Parag Agrawal has said he “doesn’t believe that the … [bot] estimation can be performed externally, given the critical need to use both public and private information (which we can’t share).”  Similarly, the financing cooperation covenant in Section 6.11 provides that Twitter is not required to disclose any material, non-public information except under agreed upon confidentiality arrangements.  The Skadden letter, for its part, makes a point of saying that anyone reviewing the data would be bound by a non-disclosure agreement, and that Musk would not use any competitively sensitive information if the acquisition doesn’t close.

Ironically, it’s possible Musk may have breached the merger agreement by prematurely alleging a violation by Twitter of the financing cooperation covenant.  Section 6.11 states that Twitter will be deemed to be in compliance with the covenant unless Musk’s failure to obtain the debt financing was due solely to a material breach by Twitter of its obligations under that section.  It also states that Musk may not even allege that Twitter is not in compliance with Section 6.11 unless the same condition applies, i.e., that Musk’s failure to obtain the debt financing was due solely to a material breach by Twitter of its obligations under the section, which implies that he can’t even make the allegation unless the debt financing has fallen through, which it hasn’t.

[1] The Skadden demand letter states the contractual obligation to provide cooperation in connection with the debt financing includes “providing information ‘reasonably requested’ by Mr. Musk”, but I don’t see that specific requirement in Section 6.11 of the merger agreement.