2024

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

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

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

So why are AI startups like xAI embracing the benefit corporation structure, and are investors overlooking the risks?Continue Reading From Algorithms to Altruism: Risks and Rewards of xAI’s Benefit Corporation Strategy

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

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

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

  • Board Composition:  Every corporate statute provides that the business affairs of a corporation are to be managed by a board of directors, which sets policy, makes major decisions and appoints officers to whom the day-to-day management of the company is delegated.  So it makes sense to determine in advance the size of the board, who the directors will be and how those directors could be removed and replaced.  Without an agreement, the default standard would be majority rule, meaning that one or more stockholders with a majority of the outstanding shares would be able to elect the entire board.  A stockholders’ agreement ensures board participation in the manner envisioned by the founders.

Continue Reading Stockholders’ Agreements for Startups: When to Sign, When to Skip

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

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

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

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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.Continue Reading Planting Seeds:  New Standard Convertible Note Could Disrupt Angel Investing

Stuttgart,,Germany,-,07-26-2023:,Smartphone,With,Logo,Of,American,Analytics

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.Continue Reading Navigating the Downside: The Rise of Down Rounds in 2024 VC Deals

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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…

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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

June,16,,2023,,Brazil.,In,This,Photo,Illustration,,The,United

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