West,Bangal,,India,-,July,13,,2023,:,X,Ai

The Wall Street Journal recently reported that xAI, the artificial intelligence startup founded by Elon Musk, completed a funding round of $5 billion at a pre-money valuation of $45 billion ($50 billion post-money). Rumored to participate in the round according to the Journal were Sequoia Capital, a16z and Valor Equity Partners.  One could hardly blame these Silicon Valley heavyweights for wanting to make a big bet on artificial intelligence and Elon Musk’s record of success.  But one may wonder whether in their eagerness to do so, they’ve overlooked xAi’s corporate structure as a benefit corporation, which allows it to pursue stated societal goals in addition to purely financial returns.

xAI’s structure as a benefit corporation is noteworthy, but far from unusual for an AI startup.  xAI typifies a growing trend of AI startups adopting governance frameworks that prioritize societal impact alongside profit.  For example, Anthropic organized as a public benefit corporation with a stated purpose of “the responsible development and maintenance of advanced AI for the long-term benefit of humanity”.   Similarly, OpenAI has reportedly adopted plans to restructure itself as a benefit corporation. 

So why are AI startups like xAI embracing the benefit corporation structure, and are investors overlooking the risks?

What Is a Benefit Corporation?

A benefit corporation is a legal structure that allows a company to pursue social and environmental goals in addition to profit. Unlike traditional corporations whose directors are bound by fiduciary duties to maximize shareholder value, benefit corporations are mandated to consider the interests of all stakeholders: employees, customers, communities and the environment. This dual-purpose framework gets memorialized in a benefit corporation’s charter and often monitored through transparency and accountability measures, such as periodic impact reporting.

For example, Section 362 of the Delaware General Corporation Law defines a “public benefit corporation” as “a for-profit corporation … that is intended to produce a public benefit … [and is] managed in a manner that balances the stockholders’ pecuniary interests, the best interests of those materially affected by the corporation’s conduct, and the public benefit … identified in its certificate of incorporation.  A public benefit corporation is required to identify in its certificate of incorporation one or more specific public benefits to be promoted by the corporation.

Why AI Companies Are Adopting the Benefit Corporation Model

AI is an industry at the crossroads of innovation, ethical considerations and societal impact. This makes the benefit corporation model particularly appealing to AI startups for several reasons.

AI systems wield tremendous influence, from shaping public opinion to making critical decisions in healthcare and justice. The benefit corporation structure allows AI companies to incorporate ethical principles into their operations.

With growing scrutiny of AI’s potential misuse, such as biases in algorithms and surveillance concerns, benefit corporation status signals to the public that a company is committed to “doing good”. It builds trust with consumers, partners and regulators who value transparency and accountability.

Many talented professionals want to work for companies whose missions align with their values. Similarly, impact-driven investors are drawn to organizations that can deliver both financial returns and demonstrable societal benefits. Structuring as a benefit corporation provides a competitive edge when competing for talent and investors.

Governments worldwide are passing regulations intended to ensure AI technologies are developed and deployed responsibly. By adopting a benefit corporation model, AI startups align themselves with this regulatory trend by demonstrating a commitment to ethical AI governance.

What Risks are Faced by Benefit Corporations and their Stockholders?

Benefit corporations are required to produce a public benefit and balance their stockholders’ pecuniary interests, the interests of other stakeholders and the public benefit identified by their charters.  Hence, they face the risk that they will not achieve their stated public benefit purpose or that the expected positive impact from being a benefit corporation will not be realized.  That in turn could have a negative effect on a benefit corporation’s reputation, which in turn could negatively impact a company’s business and financial results.

Benefit corporations are also required to disclose publicly their overall public benefit performance and assess whether they’ve achieved their identified public benefit purpose.  Benefit corporations run the risk of not reporting on a timely basis or being unable to provide the report at all.  If a report is not viewed favorably by regulators, investors or others, the reputation and status of a benefit corporation could be harmed.

Unlike traditional corporations whose directors have a fiduciary duty to focus exclusively on maximizing stockholder value, directors of benefit corporations have a fiduciary duty to consider not only maximizing value for stockholders but also the company’s specific public benefit and the interests of other stakeholders. Consequently, benefit corporations may take actions they believe will be in the best interests of stakeholders affected by the corporation’s specific benefit purpose, even if those actions don’t maximize financial results.  Pursuit of longer-term or non-pecuniary benefits may not materialize within expected timeframes or at all, yet may have an immediate negative effect on any amounts available for distributions to stockholders and cause the stock price to decline.

Benefit corporations are less attractive as takeover targets than traditional companies would be, and stockholders’ opportunities to realize their investment through an acquisition may be limited. Under Delaware law for example, a benefit corporation may not merge with another entity if the surviving entity’s charter “does not contain the identical provisions identifying the public benefit or public benefits,” unless the transaction receives approval from two-thirds of the target public benefit corporation’s outstanding voting shares. Benefit corporations may also not be attractive targets for activists or hedge fund investors because new directors would still have to consider and give appropriate weight to the public benefit along with stockholder value, and stockholders committed to the public benefit can enforce this through derivative suits. It may also be more defensible for a benefit corporation’s board to reject a hostile bid, even where the takeover would provide the greatest short-term financial yield to investors.

Unlike traditional corporation boards which must focus exclusively on stockholder value, benefit corporation directors are obligated to consider the stated public benefit and the interests of other stakeholders. In case of a conflict between the interests of stockholders and the interests of the specific public benefit or other stakeholders, there is no guarantee such a conflict would be resolved in favor of the stockholders, which could have a material adverse effect on the corporation’s business and cause the stock price to decline.

Stockholders of a Delaware benefit corporation (if they, individually or collectively, own at least two percent of the outstanding shares) are entitled to file a derivative lawsuit claiming the directors failed to balance stockholder and public benefit interests. This potential liability does not exist for traditional corporations. Such litigation could be costly and divert the attention of management.

Key Takeaway

The adoption of the benefit corporation structure by AI startups like xAI signals a shift in corporate priorities, emphasizing long-term societal impact alongside financial returns. However, this innovative approach is not without risks. From heightened accountability and reputational vulnerability to the potential for stockholder conflict, benefit corporations face unique challenges in balancing their dual mission. Yet, as the AI industry grapples with profound ethical and societal questions, this model provides a governance framework that aligns corporate operations with broader public interests.

Group,Of,Diverse,Software,Developers,Having,A,Meeting,In,A

I’m often asked by clients whether startups should have a separate stockholders’ agreement among the founders.  The answer largely depends on whether they have or will have certain other startup documents in place. 

First, some background on stockholders’ agreements.  These are contracts entered into by owners of privately held companies to manage the following governance and ownership issues:

  • Board Composition:  Every corporate statute provides that the business affairs of a corporation are to be managed by a board of directors, which sets policy, makes major decisions and appoints officers to whom the day-to-day management of the company is delegated.  So it makes sense to determine in advance the size of the board, who the directors will be and how those directors could be removed and replaced.  Without an agreement, the default standard would be majority rule, meaning that one or more stockholders with a majority of the outstanding shares would be able to elect the entire board.  A stockholders’ agreement ensures board participation in the manner envisioned by the founders.
  • Vesting:  Vesting is the mechanism by which the founders and other service providers receiving shares in the company in exchange for services actually earn those shares.  If a person owning shares subject to vesting leaves before any portion of the shares has vested, the company would have the right to repurchase the unvested shares, usually for the amount paid by the stockholder for the shares or for par value if the shares were issued without cash consideration.  A standard vesting schedule for growth companies is four years, with 25% vesting after one year and the remainder vesting pro rata on a monthly basis over the following three years.  Without vesting, a person could walk away with all shares intact, even those shares not yet earned, which is unfair to the company and the other stockholders.
  • Restrictions on Transfer:  Companies have a legitimate interest in keeping tight control over share ownership.  This is accomplished through various restrictions on transfer.  If a founder dies, is incapacitated, leaves the company or becomes divorced, the other founders and/or the company should have the right to buy the exiting founder’s shares at a price or price mechanism that is pre-determined.  If a founder wants to sell his shares, the other founders and/or the company should have a right of first refusal.  The other founders may choose to be sellers rather than buyers, in which case there should be tag-along or co-sale rights in favor of those other founders which if exercised would obligate the primary selling founder to require his buyer to also by the shares of the other exercising founders, if necessary on a pro rata basis.  Without transfer restrictions, shares may wind up in the hands of someone undesirable, such as a competitor, heir or ex-spouse.
  • Decision-Making:  As mentioned above, the board of directors is tasked with managing a corporation’s affairs.  Nevertheless, the law requires certain fundamental transactions, such as mergers, to be approved by the stockholders.  The founders may also decide in advance that certain additional major decisions require some vote threshold of the founders.  These could include issuing preferred stock, borrowing money, sale of the company and conflict transactions.

So given the protections and predictability that stockholders’ agreements provide, why shouldn’t a startup have one for its founders?  There are a number of reasons.

First, as to corporate governance, the corporate statutes of most states have a decent set of default rules covering most governance basics.  Gaps in these statutory default rules with respect to governance can generally be filled by a corporation’s by-laws.

Second, restrictions on transfer of shares in a startup should already be covered in restricted stock purchase agreements between the company and each of its founders (as well as employees and other service providers who receive stock for services).  These stock purchase agreements will usually contain vesting provisions under which the company will have a repurchase option to buy back unvested shares from departing stockholders. Similarly, provisions governing intellectual property to be used or created by the company should be covered in IP assignment agreements.

Third, venture capital investors will almost always insist on various governance and transfer restriction agreements which would necessitate amending or terminating any preexisting stockholders’ agreements.  Depending on the circumstances, it may be difficult to satisfy the consent threshold needed to approve the amendment or termination, for example if the amendment section of the agreement requires unanimity and particularly if one of the founders who was party to the original agreement has left the company but still owns shares and is not being cooperative.

Fourth, a well-drafted restricted stock purchase agreement will likely contain several helpful features not typically found in most stockholders’ agreements, such as escrow of unvested shares, 83(b) elections and lock-up periods following a public offering. 

Key Takeaway

A typical growth startup need not go through the trouble and expense of a separate stockholders’ agreement because the corporate statute and other standard startup documents provide a solid governance structure and the company is better served by saving the cost of preparing a stockholders’ agreement.  On the other hand, startups that do not enter into restricted stock purchase and intellectual property assignment agreements should seriously consider entering into a stockholders’ agreement.

Kazan,,Russia,-,Jan,18,,2022:,Activision,Blizzard,Logo,On

The board of directors of any Delaware corporation proposing to merge is required under Delaware law to adopt a resolution approving the merger agreement.  In the real world of M&A practice, however, the version of the merger agreement presented to and approved by the board is typically still in draft or nearly-final draft form but not yet final.  Does this practice violate Delaware law?

A recent amendment to the Delaware General Corporation Law (“DGCL”) provides that any agreement that must be approved by the board under Delaware law must be in “final or substantially final” form when approved.  The DGCL amendment was adopted in reaction to an earlier Delaware Chancery Court ruling in favor of a stockholder that claimed that the board violated Delaware law when it approved only a draft version of the merger agreement.  These developments underscore the need for boards to consider whether a merger agreement draft submitted for approval is substantially final before approving it.

Statutory and Practice Background

DGCL Section 251(b) provides that the board of directors of each corporation that desires to merge must adopt a resolution approving an agreement of merger and declaring its advisability. It also specifies certain provisions that must be included in the merger agreement being approved, including the terms and conditions of the merger, the mode of carrying it into effect and the changes in the certificate of incorporation of the surviving corporation proposed to be effected in the merger.

In the normal rhythm of an M&A deal, the target board is asked to approve the merger at some point before the merger agreement is finalized.  In most deals, final insertions are made and schedules and exhibits are completed between board approval and execution of the agreement.

The Activision Case

On January 17, 2022, the board of directors of Activision Blizzard, Inc. approved a merger agreement for the merger of Activision with Microsoft Corporation.  The version of the merger agreement approved by the board did not include the company disclosure letter, the disclosure schedules or the certificate of incorporation for the surviving corporation. The draft merger agreement also did not state the amount of merger consideration, and included a placeholder (“[●]”) for later identification of the target (Activision). 

Also missing from the draft merger agreement was a dividend covenant. The parties knew that it might take years to obtain antitrust clearance which was a condition to closing.  The dollar amount of dividends that Activision would be allowed to pay between signing and closing was identified as a “key open issue” to be resolved after the January 17 board meeting, presumably in an ordinary course covenant of the merger agreement which was missing from the draft approved by the board.

The Activision board did not review or approve any version of the merger agreement after January 17, 2022. In final form, the agreement contained several key components missing from the previously approved draft version, including disclosure schedules, exhibits and a dividend covenant.

An Activision stockholder commenced a lawsuit in November 2022 against the Activision directors (as well as against Activision itself, Microsoft and its directors) for, among other claims, violating Section 251(b) of the DGCL by approving a not-yet final draft rather than an execution copy of the merger agreement. 

In their motion to dismiss, the defendants argued that requiring the board to approve an execution-version of a merger agreement would run contrary to market practice and would lead to uncertainty; that given the practical realities of negotiating merger agreements, boards commonly adopt resolutions approving a merger agreement in draft or near-final draft form and declaring its advisability before the agreement has been finalized. This is especially true with respect to disclosure schedules and other ancillary documents.

In her Memorandum Opinion ruling on the defendants’ motion to dismiss, Chancellor Kathaleen McCormick determined there was no need to resolve the tension between the plaintiffs’ execution-version approach to Section 251(b) and the defendants’ market practice argument.  For the sake of analysis, the court assumed the defendants’ interpretation that Section 251(b) does not require approval of an execution-version of a merger agreement. 

So what exactly did Section 251(b) require?  At a minimum, the court ruled that Section 251(b) mandates that a board approve a merger agreement that is “essentially complete”.  The court reasoned that absent an essentially complete draft, Section 251(b)’s board approval requirement would make no sense inasmuch as board approval of a merger agreement would serve no purpose if the ultimate merger agreement was altered in essential ways, and that a board could not legitimately declare the advisability of the merger absent a review of essential terms.  According to the court, the defendants’ market practice argument fails under an “essentially complete” interpretation of Section 251(b).  The court further stated that requiring a board to approve an essentially complete merger agreement entails the “basic exercise of fiduciary duties” and “good corporate hygiene”, is not commercially unreasonable and would not lead to uncertainty.

Having ruled that Section 251(b) required that boards approve a substantially complete merger agreement, the court next considered whether the merger agreement approved by the Activision board was in fact “essentially complete”.  The court concluded it was reasonably conceivable that the merger agreement that was approved by the Activision board was not essentially complete because it was missing “a lot of important stuff”.  The merger consideration was essential. The disclosure letter was referenced 45 times in the merger agreement and contained information that was important to the agreement. Section 251(b) specifically includes the surviving company’s certificate of incorporation in the list of six items a merger agreement must include. The dividend covenant was a “key open” issue.  On the issue of the disclosure schedules, however, the court conceded that reasonable minds could differ.

This being a ruling at the pleading stage, the court refused to delve into exactly what missing information was required for an “essentially complete” merger agreement.

Legislative Reaction

In reaction to the Activision case, the Delaware legislature adopted amendments to the DGCL that became effective August 1, 2024. The amendments added a new DGCL Section 147 which provides that any agreement, instrument or document that is statutorily required to be approved by a board must be in “final or substantially final form” when approved. While new Section 147 does not explicitly describe what constitutes “substantially final”, the legislative synopsis indicates that all materials terms of the merger must be either (i) set out in the agreement, instrument or document, or (ii) determinable through other information or materials presented to or known by the board.

Key Takeaways

In light of the Activision case and the DGCL amendment addressing it, it is important that a Delaware board consider whether a merger agreement draft submitted to it for its approval is in substantially final form (including potentially all disclosure schedules and exhibits referenced in the merger agreement) before approving the agreement.  If there is any uncertainty as to whether or not the merger agreement is in substantially final form, directors should insist on receiving information or materials from which the material terms of the merger could be determined. Drafters of board resolutions approving a merger agreement should also consider adding self-serving language in recitals preceding the authorizing resolutions to the effect that the directors have determined that the merger agreement in the form presented contains all of the material terms of the merger and is in substantially final form, and/or that the directors have received documents from which to determine the material terms of the merger.

New Section 147 also provides a mechanism for the board to ratify a statutorily required agreement, instrument or document (including a merger agreement) after board approval and up until the time of filing with the Secretary of State. The ratification can serve as evidence that the initially approved agreement, instrument or document was in substantially final form.

Angel,Statue,Isolated,On,White,Background.,White,Stone,Sculpture,Of

In the world of early stage investing, there exists a range of structures from the most founder friendly to the most investor friendly. 

The most investor-friendly structure involves some type of a priced round in which the investor receives shares of a class of preferred stock with a negotiated set of enhanced economic, management and exit rights.  These rights and other terms are memorialized in a group of governance documents and agreements among the company, the investors and the founders.

On the other hand, the most founder-friendly investment structure is the simple agreement for future equity, or SAFE, which is similar to a convertible note but notably lacks an interest component and a maturity date.  Next along the range of investor friendliness is the convertible note, which contains several investor protections, including interest, maturity, some reps and warranties and (sometimes) security.  In the real world, however, more sophisticated investors routinely augment their protection under both SAFEs and convertible notes by negotiating side letters that provide them with more enhanced rights.

Documentation for priced rounds and SAFEs have benefited from standardization.  The National Venture Capital Association website open sources a set of standard Series A documents which are a convenient starting point for initial VC rounds.  Ted Wang of Fenwick & West developed a set of standard Series Seed documents in 2010 for use in lower dollar amount priced rounds.  Gust Launch, a SaaS platform for founding, operating and investing in startups open sources a slightly more elaborate set of Series Seed documents.  And Y Combinator, which created the SAFE, open sources its several varieties of the SAFE on its website.  Only convertible notes have lacked standardization and the efficiencies that come with it.

Recently, however, the Angel Capital Association published a convertible note (the “ACA Note”) and related term sheet which is intended to do for convertible notes what the NVCA did for venture rounds, what Ted Wang and Gust did for Series Seed deals and what Y Combinator did for SAFEs.  Its mandate was “to create an enhanced model convertible promissory note that would combine common convertible promissory note provisions with ‘best practice’ provisions often found in side-letters…and [balance] the rights of founders and investors”.

The ACA Note has several key provisions that are not typically found in most early stage convertible notes but are often negotiated for in side letters by more sophisticated investors. These include:

  • Expanded representations and warranties.  The intention here is to include useful information that early stage investors want but which does not require significant time for a company to compile, but avoid reps and warranties that are more appropriate for later stage deals.
  • Participation rights in future financings.  Interestingly, participation rights are the only rights included in Y Combinator’s standard side letter for use with SAFEs.
  • Select information rights.  The information rights provision in the ACA Note includes unaudited annual and quarterly GAAP financials, progress updates, cap tables (upon request), information required by Section 4(a)(7) of the Securities Act (private resales of restricted securities), and inspection rights as provided under Section 220 of the Delaware General Corporation Law. Investors may consider also negotiating for a requirement that the company execute a management rights letter upon conversion of the note to ensure that investors continue to have access to company information after a conversion notwithstanding “major investor” ownership requirements.
  • Most favored nation rights.  MFN clauses in convertible notes protect the interest of investors and ensures that the terms of their convertible note will always be at least as favorable as those contained in any convertible notes subsequently issued by the company.  For example, if the company agrees to a lower valuation cap or a higher discount rate with a subsequent investor, the first investor with the MFN clause will automatically receive those same terms.
  • Board observer rights.  The ACA Note includes observer rights with a board representation alternative.  Board representation and/or observer rights are more common in larger convertible note rounds.  Board representation rights should be coupled with a requirement for indemnification of directors and D&O insurance.
  • Protective provisions.  These are provisions requiring majority noteholder approval for select corporate acts while the notes are outstanding.  Most convertible note rounds do not have protective provisions for the noteholders.  The ACA Note seeks a balanced approach that limits the veto right to those matters that would otherwise directly adversely affect the noteholders but for which a veto would not result in extensive control of company affairs.
  • IP agreements. This is a requirement that all employees and independent contractors whose services are related to the company’s IP sign confidentiality and proprietary information and inventions assignment agreements. This is an important aspect of due diligence in angel investment rounds that is often missed.

Despite the ACA’s stated objective of balancing the rights of founders and investors, the ACA Note does favor investors with the addition of certain pro-investor provisions as outlined above.  Companies using the ACA Note will need to consider these investor enhancements carefully, for example the requirement to provide GAAP financials.  Thankfully missing from the ACA Note, however, is a representation by the Company and the Investor (which is included in Y Combinator SAFEs) that neither one has modified the form, except to fill in blanks and bracketed terms, which means the ACA Note does leave open the possibility of some negotiation.

Nevertheless, the ACA Note could achieve for convertible notes what the NVCA documents have done for venture, Gust Launch for Series Seed and Y Combinator for SAFEs.  The ACA Note could help set achievable expectations, encourage negotiation transparency, reduce confusion and cut expenses, all of which could boost early stage investment. 

I had a chance to sift through Pitchbook’s U.S. VC Valuations Report for the first quarter of 2024.  The data point that really jumped out at me was the increase in down rounds.  The number of flat and down rounds as a proportion of all VC deals has been rising consistently since the first quarter of 2022, reaching 27.4% of all VC deals in Q1 2024, the highest level in ten years. 

Startling, but predictable.  Companies raised capital during the venture frenzy of 2020 and 2021 at high valuations.  Many startups that had since failed to reduce their cash burn when the fundraising market turned sour in mid-2022 are now facing the prospect of having to raise capital at a discount to their last valuation.

This trend has implications for founders, investors and companies, as down rounds can trigger anti-dilution provisions, dilute existing shareholders and create challenges for companies seeking to raise additional funding.  And there’s reason to believe the worst is not yet behind us.  The incidence of down rounds during historic bear markets indicates there is still plenty of room for valuations of venture-backed companies to fall further.  The rate of down rounds in the aftermath of the 2008 financial crisis rose to nearly 36% of venture deals, which was actually dwarfed by the 58% of deals during the dot-com bust.

Downside of Down Rounds

A down round occurs when a company raises capital at a lower valuation than the previous round.  Unlike the case with public company price dips which are mostly deemed to be buying opportunities, private company valuation declines are negatively perceived for a number of reasons.    

The first is psychological.  Investments in, and employment with, private startups is risky, which means it’s critical that these companies produce evidence of rapid growth to attract investors and talent.  A down round sends a signal of desperation that the company is willing to raise money at a lower valuation which tends to dampen employee morale and shake investor confidence.

The second relates to the VC business model.  VCs report the value of their portfolio to their limited partners on a periodic basis.  A down round means that the VC fund will need to write down the value of its portfolio, which in turn may negatively impact fundraising prospects as well as distributions and fees to the VC sponsor from the fund.

Finally, a down round almost always triggers conversion price adjustments under anti-dilution provisions from previous rounds, as a result of which the investors would be entitled to receive more shares upon conversion, resulting in significant percentage dilution to the founders and other common shareholders.

Alternatives to Down Rounds

As a practical matter, companies needing to raise capital while facing the specter of lower valuations do have alternatives to effecting a down round. The objective of these alternatives would be to avoid triggering anti-dilution provisions.

A company may try to negotiate a waiver from its existing investors of their antidilution rights.  One factor that may motivate existing investors to do so is if they believe the disproportionate dilution to founders and key employee shareholders that would otherwise be triggered by the antidilution adjustment would be so massive that they would no longer be sufficiently incentivized to remain with the company and work hard to help it grow and achieve a successful exit.  The consent mechanics may be such that some vote threshold would be enough to bind all preferred investors or all those in a particular series.

Another approach would be to negotiate away more favorable non-price terms in exchange for a higher valuation that avoids a down round.  Some examples would be a greater than 1x liquidation preference, participating preferred, redemption rights, accruing dividends and warrant coverage.  

A third approach would be foregoing a priced round altogether in favor of a bridge financing structured as either a convertible note or a SAFE where the instrument converts into the security issued in the next round at a discount.  Doing so would avoid having to agree to a lower valuation.  I would note the valuation issue is not avoided entirely if the conversion price of the convertible note or SAFE is determined at least in part by a valuation cap, which tends to be based on an approximation of the then current valuation; however, a valuation cap does not trigger conversion price adjustments under the terms of typical anti-dilution provisions.

So given these alternatives and the negative consequences of a down round, what should a company do in an unfavorable valuation environment?  Generally speaking, a bridge round in the form of convertible notes or SAFEs would be the best short-term approach, although this would likely only postpone the valuation problem rather than fix it.  If existing investors won’t consent to a bridge round (or it is not otherwise viable), and won’t agree to waive their antidilution rights, the company would need to evaluate the relative harm of the down round against that of the enhanced non-price terms the investors in the new round would demand in exchange for a higher valuation.  This would require careful analysis with the assistance of competent counsel.     

Toned,Portrait,Of,Adorable,Baby,Boy,Having,Bath,Time

Last month, the Federal Trade Commission voted 3-2 along party lines to impose a general ban on non-competes, claiming these arrangements stifle innovation, limit employee mobility and suppress wages. I blogged about the issue when the FTC proposed the ban last year.  So far, there have been three separate lawsuits seeking to block the ban, each asserting that the FTC has exceeded its authority and that the ban itself is arbitrary and capricious. Unless any of the legal challenges are successful, the ban will become effective on September 4, 2024.

While the FTC’s intentions to promote a more dynamic labor market are commendable, the blanket ban on non-competes is akin to throwing the baby out with the bathwater because it disregards its own acknowledgment that non-competes also have the effect of promoting innovation. Non-compete agreements, when used appropriately, play a crucial role in fostering training and research and development, thereby promoting innovation. A more balanced approach is needed to address the legitimate concerns while preserving the benefits non-competes offer.

Continue Reading FTC Ban on Non-Competes: Throwing the Baby Out with the Bathwater

There are generally two ways you can control a corporation.  One is by owning a majority of the stock, in which case you control the board of directors.  The other is to secure control contractually, through agreements and charter provisions that provide protections such as board representation or vetos over major transactions.  But what happens when those contractual and charter provisions interfere with the statutory authority of a board of directors to manage a company’s affairs as mandated by state corporate law?  A recent Delaware Chancery Court decision in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co. invalidated provisions of a stockholders agreement because they constituted an impermissible delegation of the board’s managerial authority in contravention of Delaware law. The decision throws into question the enforceability of corporate governance provisions routinely included in stockholder agreements, investor rights agreements and voting agreements.

Statutory Authority of Board of Directors

Section 141(a) of the Delaware General Corporation Law (the “DGCL”) provides that:

“the business and affairs of every [Delaware] corporation … shall be managed by or under the direction of a board of directors, except as may be otherwise provided [under the DGCL] or in its certificate of incorporation.”

Section 141(c)(2) empowers the board to designate one or more committees and to determine the composition of those committees.

Continue Reading Stay in Your Lane! Delaware Court Invalidates Stockholder Agreement Provisions that Encroach on Board Authority
SEC

Identifying potential investors is one of the most difficult challenges facing early-stage companies.  The range of amounts sought at this stage is typically greater than what could be provided by the founders and friends and family, but below what would attract a VC or a registered broker-dealer.  The problem is even more acute in geographic regions with weak investor networks. 

Finders play an important role in filling this gap.  But many finders choose to operate without being licensed because the existing securities broker regulatory regime, appropriate for full-service broker-dealers, is disproportionately complex for those merely acting as finders.  The resulting uncertainty is a problem for companies, unregistered finders, lawyers and regulators. 

A few states have adopted their own exemptions or limited registration regimes for finders, but the vast majority have not.  The SEC in 2020 proposed a new exemption for finders who comply with certain conditions, but ultimately never acted on the proposal.

In its 2023 Annual Report, the SEC’s Office of the Advocate for Small Business Capital Formation included in its official policy recommendations that the SEC provide regulatory clarity for finders.

It’s time for the SEC to adopt common sense rules to create a realistic regulatory framework for finders.

Regulatory Background

Federal and state law prohibit any person from engaging in the business of effecting transactions in securities unless the person is registered as a broker-dealer with the SEC and is a member of FINRA. Any person who accepts a commission or other form of transaction-based compensation for raising capital is deemed to “engage in the business” and thus required to register. There’s a limited exception for introducing a potential investor to an issuer and accepting a “finder’s fee” irrespective of whether an investment occurs, but it’s the position of the SEC and most state securities administrators that anyone accepting a fee for investor introductions more than once is probably “engaged in the business of selling securities for compensation” and thus required to register as a broker-dealer. The JOBS Act of 2012 also included a limited exemption for persons brokering Rule 506 transactions provided they don’t receive transaction-based compensation.

Risks to Issuers

Using an unregistered broker to help raise capital could result in investors having a right of rescission under federal securities law, which if successfully exercised would require the company to return funds to investors.   Section 29(b) of the Securities Exchange Act provides that any contract made in violation of the Exchange Act is void as to the rights of any person in violation of the relevant provision.  Section 29(b) is broad enough that it can be interpreted to void a purchase agreement with any investor located through a finder that was acting in violation of the Exchange Act’s broker-dealer registration requirement.  The right of rescission may be exercised until the later of three years following the date of issuance of the securities and one year from the date of discovery of the violation.

For companies that have used unregistered finders in the past, the risk of potential rescission rights often raises significant risks in future rounds because of the uncertainty as to how long rescission rights may be exercised.  Companies that use unregistered broker-dealers could also be hit with SEC enforcement actions for aiding and abetting an Exchange Act violation.

Risks to Finders

Issuers may have rescission rights against unregistered finders.  Issuers could claim their obligations to a finder under a finder’s engagement letter are void if the finder acted in violation of the Exchange Act’s broker-dealer registration requirements.  A finder acting as an unregistered broker-dealer may also be at risk of an SEC enforcement action, the most common of which is a temporary or permanent injunction barring the finder from participating in the purchase or sale of securities. The SEC has the power to impose more severe sanctions, including disgorgement of funds, which are no longer limited to cases just involving fraud.

Finder Issues Unique to Early-Stage Companies

So why don’t finders just register as broker-dealers and become members of FINRA?  The problem is that broker-dealer registration and the FINRA membership application process are disproportionately complex for someone acting only as a finder. The ongoing regulatory requirements – appropriate for a full-service broker-dealer, i.e., one that engages in market making, over-the-counter trading for customers, proprietary trading, holding customer funds or securities, making margin loans, etc. – are similarly overwhelming for a finder.

Most startups raise early-stage rounds from angel investors in the range of $100,000 to a few million dollars.  Connecting with angels, particularly outside of the major investment hubs is particularly challenging for entrepreneurs, so finders could theoretically serve a critical role in bridging this gap.  But registered broker-dealer placement agents are generally not interested in these deals because the success fees, which are a function of deal size, are too low.  Also, the risks associated with small deals are similar to those of larger ones, but without the upside.  Early-stage companies usually lack internal recordkeeping and controls, and their financials are rarely audited, which means more work and risk for the intermediary in preparing offering materials.

2020 Proposed Exemption

In October 2020, the SEC issued a proposal that would have allowed individuals to engage in certain limited finder activities without registering with the SEC. I blogged about it at the time here.

The exemption would have applied to natural persons and only be applicable with respect to accredited investors. The finder would not be allowed to engage in general solicitation, help structure a deal, negotiate terms, handle customer funds or securities, have authority to bind the issuer, participate in preparing offering materials, engage in due diligence, provide or arrange for financing or render valuation advice. Any finder satisfying the applicable requirements would be permitted to receive transaction-based compensation.

The proposal would have created two classes of finders, Tier I and Tier II, based on the type of finder activities, with exemption conditions tailored to the scope of activities.

The activity of Tier I finders would have been limited to providing contact information of potential investors for only one capital raise by a single issuer within a 12-month period, but no contact with the potential investor about the issuer, i.e., no solicitation.

A Tier II finder satisfying the above conditions would have been allowed to engage in certain solicitation activities on behalf of an issuer. Those activities would have been limited to identifying and contacting potential investors, distributing offering materials, discussing information in the materials (but no investment advice) and arranging or participating in meetings between the issuer and investor.  Tier II finders would have been required to make certain disclosures, including the compensation arrangement and any conflicts of interest.

The SEC has not acted on the proposal and, consequently, it may not be relied upon.

Need for Reform

The absence of regulatory clarity on the role of finders in facilitating introductions between companies and investors harms both investors and issuers. The lack of a clear framework makes it easier for unscrupulous intermediaries to solicit investors without disclosing hidden conflicts of interest. Unregistered broker-dealer activity could expose a company to rescission rights, which could require the company to return to investors their investment plus interest. Market participants deserve clarity here.

The 2020 SEC proposal promoted a meaningful dialogue regarding the proper role of finders in the startup ecosystem and offered a good starting point for addressing the problem of unregistered finders.  I would expand the exemption beyond natural persons to include entities as well.  The SEC should also consider allowing Tier II finders some leeway for making recommendations, which is what is at least implicitly happening when they are allowed to contact prospective investors and participate in meetings between issuers and investors.  The SEC should also allow finders to solicit non-accredited investors, perhaps with an investment cap to address the investor protection concern.  Finally, finders within the exemption should be allowed to engage in due diligence, inasmuch as a finder should be encouraged to be reasonably well-informed about the terms of the investment and the suitability of prospective investors. 

A finder exemption in the form of the SEC’s 2020 proposal, especially with the foregoing modifications, would result in a more realistic regulatory framework for finders.

Takeaway:

Early-stage companies often struggle to identify potential investors, with ‘finders’ playing a key role in bridging this gap. However, the current regulatory framework for finders is complex and unclear, causing uncertainty and potential legal risks for companies, finders, and investors. It’s crucial for the SEC to adopt clear, common-sense rules to regulate finders and facilitate startup investment.

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Process still matters.  That’s the main takeaway from the Delaware Court of Chancery’s 200-page opinion striking down Tesla’s 2018 incentive package awarded to Elon Musk.  The court rescinded the incentive package mainly because Musk was found to control Tesla and the process, the directors authorizing the package were not independent and the stockholder vote approving it was not properly informed.  The ruling is a stark reminder of the importance of both director independence and an informed stockholder vote when transacting with a control stockholder.

The 2018 Stock Option Grant

In 2018, the Tesla board approved a new stock option package for Elon Musk and then submitted the proposal for stockholder approval. At a special meeting of stockholders, 81% of the shares voted in favor (or 73% without counting Musk’s and his brother’s shares). If exercised in full, the option package would have allowed Musk to purchase a number of shares constituting 12% of Tesla’s outstanding stock, subject to both milestone and leadership-based vesting.  The options vested in 12 tranches, with each tranche vesting on Tesla achieving one capitalization milestone and one operational milestone, and only if Musk continued serving as either CEO or both executive chairman and chief product officer at each vesting juncture.  In the most optimistic case, if Tesla’s capitalization grew from $59 billion at the time of the grant in 2018 to $650 billion by 2028 (the option expiration), all the options would vest and be worth approximately $56 billion.  As things turned out, Tesla’s market cap did hit $650 billion by the end of 2020 and all the options vested in full. 

Was Musk a Controlling Stockholder?

Normally, corporate boards may compensate their executives however lavishly as they wish because Delaware courts will show tremendous deference to board decisions under the business judgment rule and not second guess them.  The exception to the general rule is when the compensation is being paid to a controlling stockholder, in which case the compensation or transaction is evaluated under the stricter entire fairness standard which demands a fair price and fair process.  The threshold issue then is whether Elon Musk was a controlling stockholder at the time of the 2018 grant.

Control can be established either through mathematical voting control or effective operational control.  On the surface, Musk’s 22% ownership stake at the time of the 2018 grant did not constitute mathematical voting control.  But perhaps it did when combined with Tesla’s supermajority vote requirement for any amendment to its bylaws governing stockholder meetings, directors, indemnification rights and the supermajority vote requirement itself.  The court’s main focus, however, was on Musk’s “outsized influence” over Tesla’s business affairs in general and over the compensation package in particular.

As to general control, the court found Musk exerted significant influence over Tesla’s board, and that as founder, CEO and chairman he “occupied the most powerful trifecta of roles”. Musk also frequently exercised managerial authority over all aspects of Tesla, in many cases ignoring the Board’s authority such as when he appointed himself Tesla’s “Technoking”, disclosed in a Form 8-K, without consulting the Board.  The Court was also swayed by Musk’s “Superstar CEO” status, which it said resulted in shifting the balance of power toward himself and away from the board, which was supposed to exercise authority over him.

The court also found Musk exerted transaction-specific control.  He almost unilaterally controlled the timing of the grant. There was no negotiation between Musk and the Board over the size of the grant, and no meaningful negotiation over the other terms.  Neither the compensation committee nor the board engaged in any benchmarking analysis.  Directors testified at the trial that they viewed the process as “cooperation”, not a negotiation.

Musk’s controlling stockholder status meant that the applicable standard of review would be the entire fairness standard.  As a procedural matter, the defendants have the burden of proving fair price and fair process.  But defendants (in this case, Musk, the other directors and Tesla) can shift the burden to the plaintiff if the transaction was approved by either a well-functioning committee of independent directors, or an informed vote of the majority of the minority stockholders.  As a practical matter, burden of proof in these cases is determinative; the party with the burden almost always loses.

Continue Reading Out of Control!  What the Elon Musk Compensation Case Reminds Us about Transactions with Controlling Stockholders
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Starting January 1, 2024, virtually all private companies will be required to report information about their beneficial owners to the Treasury Department’s Financial Crimes Enforcement Network “FinCEN”) under the Corporate Transparency Act (the “CTA”).  But the CTA presents unique analytical and reporting challenges for startups and venture backed companies because of the special economic and governance rights negotiated with investors in early stage and venture funding rounds.

Continue Reading Corporate Transparency Act Risks for Startups and Venture-Backed Companies