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
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
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
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
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
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