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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.     

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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

The Securities and Exchange Commission recently brought its first two enforcement actions against issuers of non-fungible tokens (NFTs), resulting in cease-and-desist orders, penalties and other remedies, finding that the NFTs were investment contracts and that each of the issuers had engaged in an offering of securities without registration in violation of Section 5 of the Securities Act of 1933.  These enforcement actions create legal ambiguity and risk for NFT developers regarding the marketing, transferability and royalty generating capacity of NFTs.

Continue Reading SEC’s First Two NFT Enforcement Actions Cast Shadow of Ambiguity

Judge Analisa Torres’ greatly anticipated Order in the SEC’s lawsuit against Ripple is a split decision.  The Order basically finds that Ripple’s digital token XRP is a security when sold privately to individuals and institutional investors pursuant to purchase agreements, but is not a security when sold on a digital asset exchange where sellers don’t know who’s buying and buyers don’t know who’s selling.[1]  Although the Order should be perceived as at least a partial victory for crypto, it perversely upends a fundamental tenet of the securities laws which is that the laws are designed to protect those who cannot fend for themselves.  Moreover, the finding that digital tokens sold anonymously on digital asset exchanges is not a security also seems to contradict the “fraud on the market” theory of securities liability.

Continue Reading Parting the Crypto Sea:  Ripple’s XRP Ruled to be a Security When Sold to Private Investors, But Not When Sold on an Exchange
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The anti-child trafficking thriller “Sound of Freedom” just opened in theatres on July 4th.  Based on a true story, it stars Jim Caviezal as former Homeland Security special agent Tim Ballard who quits his job with the agency and embarks on a mission to rescue children from traffickers in Latin America.  Another true story relating to the film is that the cost of marketing it has been funded through an equity crowdfunding campaign under Regulation CF.  What makes it even more interesting is that the investment instrument issued in this crowdfunding offering was not your typical stock, convertible note or SAFE, but rather something called a revenue participation right.

Continue Reading Revenue Participation Rights as a Crowdfunding Instrument Alternative