When negotiating convertible notes, parties typically focus on the terms of conversion upon an equity financing, most notably the discount and valuation cap.  This is understandable inasmuch as the not-so-hidden secret of convertible notes is that no one wants the notes to ever get paid.  The investors are not seeking interest on their investment.  The goal is for the company to attract venture capital investors in the near future, do a priced round and then to have the notes convert into that round at a discount.

Not enough attention, however, is paid to what happens upon maturity, assuming a qualified financing, non-qualified financing or corporate transaction has not occurred that would result in conversion prior to maturity.  As a general matter, three possible scenarios could occur upon maturity of a convertible note: conversion into common, repayment of the note and extension of the maturity date. 

A recent case in Delaware involves a dispute between a company and its convertible note investors over the noteholders’ rights upon maturity.  The case serves as a cautionary tale to investors and companies alike as to the importance during the negotiation process of paying close attention to what happens upon maturity. At the risk of getting tedious, the background details are worth reviewing.

Background

The case involves Vistar Media, Inc., an advertising technology company in the out-of-home advertising space.  In 2012, it raised approximately $500,000 through the sale of convertible notes, primarily to friends and family (the “First Round Notes”).  The First Round Notes provided for conversion upon the maturity date of January 31, 2014 into shares of common stock at a price per share based on a pre-money valuation equal to $5 million.  Indeed, the First Round Notes did convert into common without controversy on the maturity date.

In late 2013, Vistar needed additional funding.  It initially received term sheets from two venture funds for equity funding but the deal fell apart over valuation and dilution.  So Vistar pivoted to doing another round of convertible notes, this time targeting strategic ad-tech investors as well as VCs and angels.  Vistar offered the same terms as the First Round Notes, including conversion on maturity, but increased the valuation cap from $5 million to $6 million.

In the negotiation that followed, Valhalla Partners II, L.P. emerged as the de facto lead investor.  Valhalla rejected Vistar’s proposed terms regarding maturity (conversion into common) for the new notes (the “Second Round Notes”), asserting that conversion into common at maturity wasn’t market, and instead countered that upon maturity, the holders would have the option either to have the notes repaid or to extend the maturity date.

Vistar counter-offered with a revised draft of the note, which it circulated under cover of an email that said the revised draft “included the changes requested by Valhalla”.  The revised draft, however, provided that if no equity financing would occur first, the holder at maturity would have the option either to have the note repaid or to convert into common.  Unlike Valhalla’s counter-offer, there was no right to extend in Vistar’s revised draft.

Valhalla then countered with a final draft under cover of an email stating it had just “cleaned up some of the language”, but its actual draft removed the option to convert upon maturity, and instead provided that, subject to the conversion provisions (mandatory upon a prior Qualified Financing and optional upon a prior Non-Qualified Financing), the note would be simply “payable” on the earlier of maturity, sale of the company and an event of default. Valhalla’s final draft had no option at maturity to convert or extend. Here’s the relevant excerpt from the redlined version of Valhalla’s revised draft:

“This Note shall have a maturity date of September 30, 2014. If a Non Qualified Financing has occurred but the Notes have not yet been converted, then at maturity (the Maturity Date”). Subject to the provisions related to the conversion of this Note, the outstanding principal and interest underbalance of this Note will convert into the Non Qualified Financing Securities as defined below. If a Non Qualified Financing has not occurred, then at maturity the outstanding principal and interest under this Note will, at the discretion of the Holder, be repaid in full or convert into shares of common stock at a price per share equal to a pre money valuation equal to $6.0 million. If the Holder elects to be repaid in full, the Holder must provide written notice to the Maker by July 1, 2014., together with interest accrued and unpaid to date shall be payable the earlier of (x) the Maturity Date, (y) a Sale (as defined below or (z) an Event of Default (as defined below).”

Valhalla’s final draft was accepted by Vistar and the other investors. The maturity date of the Second Round Notes was identified as September 30, 2014.  The initial closing of the Second Round Notes occurred in December 2012 with additional closings in 2013.

In October 2014, Vistar emailed the noteholders to seek an extension of the September 30, 2014 maturity date.  The email attributed the absence of any equity round to the company’s “growing revenue which has exceeded our projections”, as a result of which it “burned very little cash and [had] not needed to raise a qualifying financing”.  The absence of an equity round, however, meant it needed to extend the maturity of the note by 12 months to September 2015.  The requisite noteholders approved the maturity date extension, and later approved a second extension to March 31, 2016.

In February 2017 (i.e., following the March 31, 2016 maturity date), Vistar’s board approved the repayment of the Second Round Notes.  It also approved a new debt financing and the use of the proceeds of the debt financing to repurchase common stock through a tender offer.  In that same month, Vistar closed on a $20 million debt financing and launched the tender offer.

The following month, on March 16, 2017, Vistar notified the holders of the Second Round Notes of its intention to pay down the notes as required under their terms.  The Noteholders responded by contesting Vistar’s right to do so and expressed an expectation that the notes would convert to equity.  On or about March 30, 2017, Vistar nevertheless sent checks to the noteholders in repayment of the notes.  The noteholders rejected payment and returned the checks, claiming they had the right to hold the Second Round Notes until they converted into an equity financing.

The Noteholders’ Lawsuit and Vice Chancellor Glasscock’s Rulings

The noteholders commenced a lawsuit against Vistar in March 2019 in the Delaware Court of Chancery, seeking a declaratory judgment that they maintained a right to convert their notes beyond the maturity date, and brought alternative claims for breach of the implied covenant of good faith and fair dealing, promissory estoppel, equitable estoppel and reformation, arguing the Second Round Notes could not be unilaterally repaid by Vistar in 2017.  Vistar counterclaimed for breach of contract, alleging that the noteholders’ rejection of repayment was a breach of the Second Round Notes.

The noteholders then amended their complaint in 2022 after Vistar closed on a Series B round.  In their amended complaint, the noteholders alleged that the Series B round constituted a Qualified Financing and that the declaratory judgment they were seeking should state that the notes allowed them to convert into that Series B round.

The Court of Chancery issued two rulings.  On December 9, 2024, Vice Chancellor Glasscock ruled on the contract claims, finding that the notes required repayment without the holders having a right to convert, but reserved decision on whether principles of equity offered relief in light of Vistar’s post-issuance actions and statements. 

On January 17, 2025, Vice Chancellor Glasscock also ruled against the noteholders on their claims for equitable relief.

On the contract claims, Vice Chancellor Glassgock denied the parties’ cross motions for summary judgment because of the ambiguity associated with the operative language in the notes that principal and interest shall be “payable” on the earlier of the maturity date, sale of the company and an event of default.  The court ruled that Vistar’s interpretation that “payable” confined the noteholders’ rights at maturity to repayment, and the noteholders’ position that “payable” gave them an option other than to receive payment consistent with their business model, were each plausible.  The court then held a trial to decide the issue.

At trial, the noteholders argued that their removal of the option to convert or get paid at maturity (Vistar’s offer), in favor of mandatory payment, was due to a scrivener’s error and that they had the right to extend the term of the notes until a Qualified Financing. The court found the drafting history didn’t support this interpretation.  It further determined that the course of trade argument (i.e., that VCs’ and angels’ business model is to take equity in companies, not interest on debt) was not helpful here because the language was specifically negotiated by the parties and drafted by Valhalla.

Having disposed of the noteholders contract claims in the December 2024 opinion, Vice Chancellor Glasscock then addressed in the January 2025 decision whether equity offered the noteholders relief in light of Vistar’s actions post-issuance.  In this context, the noteholders argued that, during the post-issuance period, Vistar conveyed to the noteholders that an equity financing (triggering conversion) was imminent, on which the noteholders relied when they approved the two extensions requested by Vistar.  Presumably, the detriment to the noteholders was in keeping their capital in Vistar rather than redeploying it more profitably elsewhere.  As evidence of such implicit promise of an equity funding, the noteholders pointed to Vistar’s financial statements delivered to the noteholders which recorded the Second Round Notes as “purchase of stock”, as well as statements by Vistar to third parties that the notes were “basically an equity instrument”. But Vice Chancellor Glasscock determined it wasn’t reasonable for the noteholders to rely on Vistar’s accounting treatment of the notes, or on statements made by Vistar to third parties that the notes were “basically an equity instrument”, and so equitable principles would not justify imposing a contractual term that doesn’t exist. 

The noteholders also pointed to Vistar’s explanation to the noteholders at the time it sought the two extensions as to why an equity round had not already occurred (which would have triggered  conversion) – that it exceeded budget and had not needed to raise equity – but then as a result did need to extend the maturity date.  The noteholders argued that Vistar’s statements regarding its success and resulting lack of need for equity was an implicit promise that an equity round was coming upon which the noteholders relied in agreeing to extend the notes.  Vice Chancellor Glasscock didn’t buy it.  He attributed the extension request instead to a simple effort by Vistar to avoid paying down the notes, which it could do only if the maturity date was extended. The statements about success were insufficient to establish an implicit promise that an equity round was coming, and so the noteholders request for promissory estoppel was denied.

Key Takeaways

Investors in convertible note rounds don’t invest for the interest on their money.  Their business model involves taking equity in startups; they’re not banks.  Their expectation is that the notes will convert and the investors will benefit from the upside potential of the portfolio companies that succeed.  Investors need to be mindful of what the notes provide as to what happens at maturity.  They should negotiate for the option to convert or extend.  In the Vistar case, the noteholders lost out because the notes clearly provided that the notes were payable at maturity (assuming a sale of the company or event of default had not previously occurred, and assuming further that an equity financing had not occurred thereby triggering conversion), with no option to convert or extend.  The lesson for issuers is to be very careful not to promise that an equity funding would occur, and to try to negotiate for conversion upon maturity.

I’m often asked whether employees should have access to the company’s cap table.  The cap table is one of the most sensitive and critical documents in any startup.  At its most basic level, it lays out who owns what – founders, investors, employees, consultants. It typically contains information about outstanding shares, convertible instruments, pricing, valuation and ownership dilution. More complex cap tables may include formulas that model out various hypothetical transactions such as new funding rounds, sales of the company or public offerings, and may provide details on the holdings of each individual owner and each individual type of security. Traditionally, access to the cap table is tightly controlled, with only a select few in the company being privy to its contents. However, as demands are made for more transparency, the question arises as to whether employees should have access to the cap table.

The Case for Employee Cap Table Access

The arguments in favor of access focus on the advantages of transparency.  First and foremost, transparency breeds trust.  Lack of access to the cap table may lead to suspicions on the part of equity compensated employees about lack of fairness in compensation and value.

Sharing cap table information can help align the interests of employees with those of the founders, investors and the company in general. Employees who understand the equity structure are more likely to feel connected to the company’s long-term vision and their role in its success.

For employees holding restricted stock, stock options or other forms of equity-based compensation, access to the cap table also provides clarity. It enables those employees to evaluate the real value of their compensation packages and how their value might grow over time. This is particularly important in startups, where equity is often a significant component of total compensation.

Cap table transparency can help motivate employees.  Seeing their stake in the company’s success can motivate employees to think and conduct themselves like owners, rather than merely employees, which in turn could encourage them to work harder and become more committed to the company’s long-term goals.

Finally, in a competitive job market, cap table transparency may be a differentiator. Companies that are open about their equity structure may attract top talent who value transparency and want to make informed decisions about the value of their equity-based compensation.

The Case Against Employee Cap Table Access

The main argument against cap table transparency for employees is confidentiality.  The cap table contains sensitive information about fellow stock optionees, shareholders and outside investors.  Disclosing equity information to optionees is the equivalent of publishing salary details, which can lead to workplace comparisons and tensions, and harm employee morale. Broad access could lead to potential leaks or misuse of the data, jeopardizing the privacy of equityholders and the company’s strategic interests.  Startups would typically want to maintain the confidentiality of this information, particularly from competitors.

Second, cap tables can become fairly complex documents. Without proper context or financial literacy, employees might misinterpret the information, leading to confusion or misplaced concerns about equity distribution or company valuation.

Third, allowing employees to access the cap table may also create certain administrative or legal burdens. Maintaining and updating access for employees can be time consuming, especially for startups with limited resources. Companies might need to update the cap table frequently or provide education to help employees understand it. Additionally, there could be legal implications to a leak or misuse of the data, especially in regulated industries.

Striking a Balance

Instead of full access, companies should consider adopting a middle-ground approach of tiered limited access for equity compensated employees.  For example, rather than sharing the full cap table, companies can create streamlined reports highlighting key metrics such as total shares outstanding, employee ownership percentages and vesting schedules, but without revealing individual ownership details.  Each equity compensated employee could be given limited personal information consisting of only their own equity information, namely share ownership, vesting schedule and current value.  Key employees and executives may be given more detailed information about the company’s capitalization but not full access to the entire cap table.  Under this approach, full cap table access providing complete visibility into all equity ownership details could be reserved just for founders, board members and perhaps the CFO and counsel.  Companies should also consider providing employees with resources to better understand equity compensation and cap table basics.

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.

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.

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.

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.     

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

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.