Two startups with competing, equally compelling technologies at the same stage of development are pitching venture capital investors for Series A funding.  One startup is led by a serial entrepreneur founder, the other by a novice.  Assume each will get funded.  In all likelihood, the deal will happen quicker and the amount funded and pre-money valuation will be higher for the serial entrepreneur led startup than its novice competitor.  That according to Pitchbook’s latest report (the “Report”) on the impact of entrepreneurial experience on the venture capital ecosystem, which finds that founder experience has a material impact on VC fundraising.  Moreover, this disparity among serial and novice entrepreneurs actually grows as startups progress through the capital raising lifecycle.  But does this apparent advantage enjoyed by serial entrepreneurs come at any cost?

To build a successful startup, an entrepreneur needs to be able to assemble and manage a strong team, raise capital and execute a business plan.  Some of the skills necessary to pull this off an entrepreneur may be born with, while other skills may be acquired in the classroom.  But much of what characterizes a successful entrepreneur is intangible and learned in the process of doing, and for that reason an entrepreneur who has previously started up is perceived to have a more complete set of skills and more likely to build a successful startup.  In the course of building his first company, an entrepreneur has also likely developed relationships with a diverse community of professionals whose services will be important in building a subsequent company as well, such as angel and venture capital investors, corporate finance lawyers, scientific advisers and human resource experts.  And if he’s previously executed an exit, the entrepreneur’s contacts would also include exit specific professionals such as investment bankers, underwriters and mergers and acquisitions lawyers.

So it should come as no surprise that the Report finds that serial entrepreneurs (repeat entrepreneurs with one or more previous exits) raise VC rounds earlier in each stage of the startup’s corporate life than novices or even unproven serial entrepreneurs (repeat entrepreneurs who have not yet exited).  The median number of years between founding and first VC round for serial entrepreneurs remained at 1.13 years as compared with Pitchbook’s 2019 study, and the median period of time for unproven and novice founders increased to 1.34 and 1.92 years, respectively.

Serial entrepreneurs also enjoy an advantage in terms of deal size.  Median angel and seed[1] deal sizes for serial entrepreneurs in 2022 year-to-date were 2.5 times larger than novice-led deals, while early- and late-stage rounds led by serial entrepreneurs were roughly 3.4 times larger.

Valuations are also progressively higher for serial entrepreneur-led startups.  Pre-money valuations for serial entrepreneur-led startups had median valuations that were 1.9 times higher than those of novice-led companies, with the variances between serial and novice entrepreneurs increasing to 2.5 times for early stage rounds and 3.7 times for late stage deals.

The larger divergence in deal size and pre-money valuations between serial and novice entrepreneurs in later stages vs. the angel and seed rounds suggests that even the emergence of objective performance metrics in later rounds such as market proven products and demonstrated revenue growth cannot overcome the inherent investor confidence afforded to serial entrepreneurs.  The Report also suggests that the seed stage fundraising momentum that serial entrepreneurs benefit from could be allowing their startups to mature more quickly and display stronger financial performance than novice-led companies, thus leading to an even greater deal size disparity in later stage rounds.  The exit track record of a serial entrepreneur may be even more valued in later rounds as exit comes more into focus.

Earlier, larger and higher valuation rounds enable serial entrepreneur-led startups to scale and exit faster.  But the Report points out that this advantage comes with a price: dilution.  Bigger deal sizes in early rounds when valuations are lower than they would be in later rounds means larger amounts of equity are being issued to investors, resulting in greater dilution to the founders.   During angel and seed funding stages, serial entrepreneurs are giving up a greater percentage of the equity in their company, nearly 2% more than unproven entrepreneurs and 6% more than novices. This trend is maintained in early stage deals (Series A and B).  Apparently, the higher pre-money valuations given to serial entrepreneur-led startups are not enough to offset the effect of larger amounts being raised at low-valuation points in the corporate cycle.  The trend reverses course in late stage rounds, however, as much higher pre-money valuations result in less equity being issued to the investor for any given amount of investment in late stage rounds and less dilution to the founder.

A related question is whether prior exits alone are a reliable predicter of startup success.  In a 2016 Harvard Business Review piece entitled “Why Serial Entrepreneurs Don’t Learn from Failure”, the authors focus on the concept of overoptimism in relation to failure.  The authors find that overoptimism is a trait shared by most entrepreneurs, but that serial entrepreneurs are just as likely to be overoptimistic after failure as before, which poses a significant risk for investors who fund serial entrepreneur-led startups.  Although overoptimism is generally helpful in founding a startup, it can also help cause it to fail if it is associated with a greater tendency to commit to and overinvest in risky projects, to neglect to plan for the unexpected and to throw good money after bad while postponing the inevitable.  The authors argue that experiencing failure helps temper this overoptimism among some entrepreneurs, but not serial entrepreneurs.


[1] Here’s how Pitchbook generally identifies the stages of startup funding:

    • “angel round”: if there are no VC funds on the company’s cap table and it’s unclear whether any VC fund participated in the round, or if a press release identifies the round as an angel round or only mentions individuals as investors.
    • “seed round”: if the investors and/or press release state that a round is such, or if it is for less than $500,000 and is the first round as reported by a government filing.
    • “early stage”: Series A or B.
    • “late stage”: Series C or higher.

What do founders, employees and investors in privately held companies all have in common?  Limited opportunity to sell their shares.  That’s because of various legal, contractual and market factors that impede the sale of such securities, so liquidity is usually limited to acquisition of or public offering by the company. In recent years, there’s been a push to facilitate secondary market trading of private securities, and the Securities and Exchange Commission’s Small Business Capital Formation Advisory Committee has scheduled a meeting for August 2 to discuss how to improve liquidity in private companies.

So what are those legal, contractual and market impediments?

Securities Laws

All sales of securities in the United States, whether by companies in primary offerings or by shareholders in secondary offerings, must either be registered with the SEC or satisfy the requirements for an exemption from registration.  With rare exceptions (basically resales by institutional investors (e.g., venture capital funds) with leverage to negotiate registration rights in advance), SEC registration is too expensive and time consuming to be a viable alternative.

The most obvious resale exemption is under Section 4(a)(1) of the Securities Act of 1933 for sales by anyone other than an issuer, underwriter or dealer.  A founder, employee or investor is clearly not an issuer, and would not be deemed a dealer so long as he or she isn’t buying and selling securities as a business.  The real issue is whether the seller is an “underwriter”, broadly defined as anyone who has “purchased from an issuer with a view to … the distribution of any security”.

Because of the ambiguity in the definition of “underwriter”, the SEC promulgated Rule 144, a safe harbor, meaning if the specific requirements of the rule are satisfied the seller will not be deemed to be an underwriter for the purpose of Section 4(a)(1).  The rule applies differently to different sellers, depending on whether or not they are affiliates of the issuer and depending on whether the issuer is an SEC reporting company.  A non-affiliate seller need only satisfy the holding period, which for restricted securities is six months for shares in a reporting company and one year for a non-reporting company.  An affiliate, on the other hand, must satisfy the holding period, volume limitation, manner of sale and information requirements.

Contractual Restrictions

Private issuers typically require shareholders to sign agreements containing various restrictions on transfer.  These may include prohibitions on transferring shares without company consent, rights of first refusal in favor of other shareholders and/or the issuer and tag along or co-sale rights in favor of other investors allowing them to sell their shares pro rata with any sale by the shareholder.  Many companies also impose restrictions on insiders selling shares while in possession of material non-public information.  Any Seller seeking to comply with such insider trading restrictions by providing company information to a buyer would need to be mindful of impediments under confidentiality agreements.  In addition to making it harder to sell, these contractual restrictions tend to depress price for selling holders and increase cost for companies, which must monitor compliance with applicable law, gather and provide information, review transfer documentation and provide legal opinions.

Market Factors

Despite the proliferation of funding portals and other platforms for issuers and investors to find each other, secondary markets remain underdeveloped.  Much of that I suspect has to do with the lack of transparency in secondary market transactions.  As I mention above, non-affiliates selling under Rule 144 need not satisfy the rule’s information requirement.  That’s good for the seller, but the lack of transparency makes the shares less attractive to potential buyers.  Even if a seller would be inclined to volunteer company information, his ability to do so would largely depend on the company’s willingness to cooperate in providing the information and waiving disclosure restrictions.

Small Business Capital Formation Advisory Committee

The SEC’s Small Business Capital Formation Advisory Committee last week released the agenda for its virtual meeting on Aug. 2, which will address liquidity challenges for investors in private companies.  Under the released agenda, the Committee will explore (i) what exit opportunities exist for investors in Regulation A and Regulation Crowdfunding deals where the companies continue to provide ongoing reports, (ii) what secondary market liquidity challenges private and smaller public companies and their investors encounter, and (iii) what changes could help facilitate secondary liquidity for these investors.

Another week, another chapter in the Elon Musk-Twitter saga.  Last month, Musk posted tweets questioning longtime Twitter claims that automated “spambots” make up fewer than 5% of monetizable daily active users.  But on June 6, Musk upped the ante by having his lawyers at Skadden send a demand letter to Twitter reiterating his demand for data he claims is necessary to facilitate his independent evaluation of spam and fake accounts on the company’s platform, which he asserts the company is required to provide under the merger agreement.

So what are those merger agreement provisions that would require Twitter to provide the requested information?  There are two relevant provisions.

Section 6.4, Access to Information, obligates Twitter to provide Musk with “all information concerning the business … of the Company … as may reasonably be requested … for any reasonable business purpose related to the consummation of the transactions contemplated by this Agreement”.  One plausible way to link the information needed to evaluate the prevalence of spam and fake accounts to consummation of the closing is through Twitter’s representation in the agreement regarding its SEC filings.  Twitter represented that its SEC filings since January do not contain any material misstatements or omissions.  Twitter disclosed in its most recent 10-Q, that based on its internal review of a sample of accounts, it estimated that false or spam accounts represented fewer than 5% of its monetizable daily active users.  Twitter carefully hedges that estimate by stating that in making that determination, it “applies significant judgment, so [its] estimation of false or spam accounts may not accurately represent the actual number of such accounts, and the actual number of false or spam accounts could be higher than … estimated”.  Musk’s suggestion that the percentage of spambots may be significantly higher is an indirect allegation that Twitter has breached its SEC filing representation in the merger agreement.  In any event, a condition to Musk’s obligation to consummate the transaction is that all of Twitter’s representations be materially true as of the closing.  Hence, the information requested by Musk is arguably “related to the consummation” of the merger because it enables Musk to determine whether Twitter has breached one its representations, and consequently whether Musk may terminate the agreement.

The other provision of the merger agreement that Musk’s lawyers assert obligates Twitter to provide the requested fake account analysis information is Section 6.11, Financing Cooperation.  That section of the agreement generally obligates Twitter to “provide any reasonable cooperation reasonably requested by [Musk] in writing in connection with [his] … debt financing”.[1]

The Skadden letter ends ominously by stating that Musk reserves his rights resulting from Twitter’s alleged information covenant breach, including his right to terminate the merger agreement and not proceed with the acquisition.  Musk has the right to terminate the agreement if Twitter breaches any of its obligations in the agreement (including the covenant to provide information) and the breach is not cured within thirty days following notice.  The Skadden letter could be deemed to be such notice, which means Musk, assuming he prevails in his allegations of breach, may be able to terminate the agreement on or about July 6.

Or maybe not.  Built into the information and cooperation covenants are a bunch of carveouts which Twitter may be able to rely on as a defense.  Most relevant is that Twitter has no obligation to provide the information required under Section 6.4 if doing so would cause significant competitive harm to Twitter if the acquisition doesn’t close.  In the past, Twitter CEO Parag Agrawal has said he “doesn’t believe that the … [bot] estimation can be performed externally, given the critical need to use both public and private information (which we can’t share).”  Similarly, the financing cooperation covenant in Section 6.11 provides that Twitter is not required to disclose any material, non-public information except under agreed upon confidentiality arrangements.  The Skadden letter, for its part, makes a point of saying that anyone reviewing the data would be bound by a non-disclosure agreement, and that Musk would not use any competitively sensitive information if the acquisition doesn’t close.

Ironically, it’s possible Musk may have breached the merger agreement by prematurely alleging a violation by Twitter of the financing cooperation covenant.  Section 6.11 states that Twitter will be deemed to be in compliance with the covenant unless Musk’s failure to obtain the debt financing was due solely to a material breach by Twitter of its obligations under that section.  It also states that Musk may not even allege that Twitter is not in compliance with Section 6.11 unless the same condition applies, i.e., that Musk’s failure to obtain the debt financing was due solely to a material breach by Twitter of its obligations under the section, which implies that he can’t even make the allegation unless the debt financing has fallen through, which it hasn’t.

[1] The Skadden demand letter states the contractual obligation to provide cooperation in connection with the debt financing includes “providing information ‘reasonably requested’ by Mr. Musk”, but I don’t see that specific requirement in Section 6.11 of the merger agreement.

In what seems like one of the speediest transaction processes ever for a deal of its size, Twitter agreed on April 25, 2022 to be acquired by Elon Musk for $54.20 per share or about $44 billion.  It all started with Musk disclosing on April 4 that he had taken a 9.2% stake in Twitter, followed by Twitter announcing the next day that it will appoint Musk to the board, Musk declining the appointment around April 11 and offering on April 13 to buy the company for $54.20 per share, Twitter adopting a poison pill on April 15, Musk announcing on April 21 he had secured $46.5 billion in funding commitments and finally the announcement on April 25 that the parties had signed a merger agreement (the “Merger Agreement”).  Only 12 days elapsed between offer and signing, and only four days between the funding announcement and signing.  That’s about as speedy a transaction as a SpaceX rocket.

Elon Musk’s acquisition of Twitter (the “Acquisition”) is structured as a reverse triangular merger, meaning that a shell subsidiary of the acquirer (or of an entity controlled by the acquirer) merges into the target with the target surviving as a wholly-owned subsidiary of the acquiring entity.  Musk formed two entities to effectuate the merger, X Holdings I, Inc. (“Parent”) and its wholly-owned subsidiary, X Holdings II, Inc., which will merge into Twitter at the closing with Twitter surviving as a wholly-owned subsidiary of Parent.  Parent is wholly owned by Musk.

Poison Pill Exemption

Before signing the Merger Agreement, Twitter first had to exempt Musk from the poison pill the company adopted in the form of a preferred stock rights agreement.  Under the rights agreement, if anyone crossed a 15% ownership threshold, all stockholders other than the 15% holder would have had the right to buy new shares at a 50% discount, resulting in massive dilution to the acquirer. The purpose of the poison pill/rights agreement was for the Twitter board to buy time and build leverage by effectively forcing Musk to negotiate with the board rather than launch a tender offer directly to the stockholders.   A useful feature of the rights agreement is that the board retained the right to amend the agreement without the consent of the rights holders. To avoid having the Acquisition trigger the pill, Twitter amended the rights agreement on April 25 to provide that neither the execution of the Merger Agreement nor the Acquisition itself will trigger the pill.

Material Adverse Effect

From the outset, Elon Musk’s offer for Twitter generated a great deal of skepticism.  He didn’t have either the cash or (initially) the funding, and his own credibility was called into question, not least because of his infamous 2018 tweet that he was “considering taking Tesla private … funding secured”, for which he was sued by the SEC for securities fraud.  So the Merger Agreement contains several features that are intended to protect Twitter and its stockholders from Musk walking away.

Most acquisition agreements allow the buyer to walk away if the target has suffered a material adverse effect (“MAE”) between the signing of the agreement and the closing.  The devil in this detail is what exactly constitutes a MAE.  The current trend with MAE clauses, particularly when the seller has some amount of leverage, is to include a long list of specific circumstances that are expressly stated to not constitute a MAE.

The Merger Agreement contains nine such MAE carveouts: (i) changes to the industry, (ii) changes to any law or to GAAP, (iii) general economic, regulatory or political conditions, or in the financial, credit or securities markets, in the U.S. or anywhere in the world, (iv) any act of God, force majeure, terrorism, cyberattack, war, etc., (v) any epidemic pandemic (including COVID-19), any measures in reaction thereto, or any political or civil unrest, (vi) the negotiation, execution, announcement or consummation of the Merger Agreement, including the identity of Elon Musk or his financing sources, (vii) any action taken pursuant to the Merger Agreement or will the consent of Musk or his affiliates, (viii) changes in Twitter’s stock price or trading volume, failure to meet analyst estimates or credit rating changes (unless thing giving rise to the foregoing is itself a MAE not otherwise excluded), and (ix) anything previously disclosed in an SEC filing.

Reverse Breakup Fee

Buyers often seek to protect themselves against the target terminating the deal and agreeing to be acquired by a third party bidder making a superior offer.  The standard protection for buyers in this regard is a breakup fee that the seller would be required to pay to the buyer if the seller accepts such a third party offer.  Sellers, on the other hand, also have an interest in protecting themselves against a buyer walking away other than for failure of the target to satisfy a condition to closing.  The remedy to the seller is referred to as a reverse breakup fee, payable by the buyer.

The Merger Agreement requires Musk-owned Parent to pay Twitter a reverse breakup fee equal to $1 billion if the conditions to Parent’s obligations to close are satisfied and Parent nevertheless fails to close, or if Parent breaches any of its representations, warranties or covenants in a manner that would cause a closing condition to not be satisfied.  Importantly, Elon Musk agreed to provide a limited guarantee in favor of Twitter to back up Parent’s obligation to pay the reverse breakup fee.  The Merger Agreement also requires Twitter to pay a breakup fee to Musk if Twitter enters into a definitive agreement with a third party bidder for a “superior proposal”, defined as a proposal to acquire at least 90% of Twitter or of its assets that the Twitter board determines in good faith is more favorable to Twitter’s stockholders than the Musk offer.

Ordinary Course Covenant

Buyers also typically seek protection against a target making significant changes to its business or its assets between signing and closing, such as terminating employees, customers or suppliers.  The applicable protection here is in the form of a covenant to operate the target in the ordinary course in between signing and closing, coupled with a right to terminate if this covenant is breached.

The Merger Agreement’s ordinary course covenant, however, has two important features that protect Twitter against Elon Musk using ordinary course as an excuse to walk away.  First, Twitter’s obligation with regard to operating in the ordinary course is qualified by “commercially reasonable efforts”, i.e., it must use “its commercially reasonable efforts to conduct the business of [Twitter] in the ordinary course of business”.  Many practitioners believe that “best efforts”, “reasonable efforts” and “commercially reasonable efforts” represent a hierarchy of standards to determine the level of effort that must be employed by the target to satisfy its ordinary course obligation, with “best efforts” demanding the greatest effort and “commercially reasonable efforts” the least.

The second pro-seller feature here is a carveout for COVID-19 measures.  The covenant states that Twitter must use commercially reasonable efforts to conduct its business in the ordinary course between signing and closing “except with respect to actions or omissions that constitute COVID-19 Measures”.  “COVID-19 Measures” are defined broadly to include every conceivable response to COVID-19 and any variants, mutations or associated epidemics, pandemics or disease outbreaks, including quarantine, “shelter in place,” “stay at home,” workforce reduction, shut down and closure, whether recommended or promulgated by any governmental authority, or other reasonable actions taken in response to the foregoing.


But not everyone is ready to concede that the Twitter board did its job of adequately protecting the stockholders (at least not when there’s potential money to be made).  One plaintiff’s firm has already reared its inevitable head, announcing it is investigating Twitter for possible breaches of fiduciary duty and other violations of law in connection with the Acquisition, and inviting stockholders to “join the action”.  The firm’s press release alleges the Merger Agreement unreasonably limits competing bids by prohibiting solicitation of further bids and imposing a significant penalty if Twitter accepts a superior bid.  That’s a reference to the Merger Agreement’s “no-shop” restriction and the aforementioned $1 billion breakup fee.  The no-shop provision prohibits Twitter from soliciting any offer from, or engaging in negotiations with, or furnishing any material non-public information to any third party relating to a possible competing acquisition proposal.  The Merger Agreement does provide Twitter with a fiduciary out, however, allowing Twitter to speak to third parties if the board determines in good faith that such discussions could result in a superior proposal.

Elon Musk’s contentious relationship with the Securities and Exchange Commission is likely to become even more complicated as a result of Mr. Musk’s filings with the Commission to report his recent purchases of shares in Twitter, Inc.

On April 4, 2022, Elon Musk filed a Schedule 13G  with the SEC to report his ownership of 73,486,938 shares or 9.2% of Twitter, Inc.  Schedule 13G is a short form beneficial ownership filing used by passive investors.  The next morning, Twitter filed a Current Report on Form 8-K to announce that it had agreed to appoint Mr. Musk to the board of directors with a term expiring in 2024 and that Musk’s ownership in Twitter may not exceed 14.9% for the duration of his tenure and for 90 days thereafter.  Later that day on April 5, Musk filed a long-form Schedule 13D as to the same shares he previously reported on his 13G, along with other detailed information required in a 13D.

What seems crystal clear is that Elon Musk missed the applicable 10-day filing deadline under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934 to report 5% ownership in a public company. The chronology of Musk’s Twitter stock purchases as listed on Schedule I of his 13D indicates that by March 14, 2022, his ownership of Twitter stock exceeded 40,032,058 shares, which is 5% of the 800,641,166 shares outstanding as per Twitter’s 10-K.  Crossing the 5% threshold on March 14 means that the deadline for filing either a 13G or 13D would have been March 24, yet Mr. Musk didn’t file until April 4.  That gave him an extra 10 days in which to buy additional shares (he increased his ownership during that time by an extra 4.1%) before the per share price spike that occurred when he finally announced his holdings on April 4.  On the day of Musk’s initial announcement, Twitter closed at $49.97 per share, an increase of 27% over the previous day’s close.

Failing to file on time may not have been the only possible securities law infraction here.  The particular form Musk used initially to report his holdings also raises questions.  Schedule 13G and Schedule 13D are alternative forms used to disclose ownership of more than 5% of a class of equity security in a company.  Passive investors may use the short-form Schedule 13G in lieu of the more onerous Schedule 13D.  Among the categories of information required in a Schedule 13D but not in Schedule 13G are a list of the investor’s transactions in the company’s stock during the last 60 days, source and amount of funds used, method of acquisition, purpose of the acquisition, and plans or proposals that would result in a material change in the company, such as corporate transactions, changes in board composition, by-law changes and material changes in the issuer’s business.  A Schedule 13D must also include as exhibits copies of all written agreements related to the acquisition and holdings.

The key issue then is: what does it mean to be a passive investor (and thus eligible for the less burdensome 13G), and was Elon Musk a passive investor when he filed his Schedule 13G with respect to his 5% ownership in Twitter?  Rule 13d-1(c) provides that a 5% owner could file a short-form 13G instead of the more detailed 13D if the person “has not acquired the securities with any purpose, or with the effect, of changing or influencing the control of the issuer, or in connection with or as a participant in any transaction having that purpose or effect”.

Several commentators have suggested that Elon Musk was not eligible to use Schedule 13G because of numerous tweets calling for changes in business policies at Twitter, such as implementation of an edit feature on its social media platform.  These commentators assert that the foregoing tweets and similar advocacy by Mr. Musk for changes in the Twitter platform indicate that he was not passive.  I’m not so sure.

The aforementioned Rule 13d-1(c) regarding Schedule 13G eligibility focuses on whether or not the shareholder is seeking to change or influence control of a company.  Control is a different concept from business practices.  In a Compliance and Disclosure Interpretation (“CDI”) dated July 14, 2016, the SEC offered guidance on this issue, sharply contrasting efforts to influence basic business decisions with seeking changes in control.  It stated that merely participating in the “formulation, determination, or direction of the basic business decisions” of a company would not render a shareholder ineligible to use Schedule 13G.  Instead, 13G eligibility hinges on whether the shareholder acquired or is holding equity securities “with the purpose or effect of changing or influencing control” of the company, a determination based upon all relevant facts and circumstances.  By way of example, the CDI states that engagement on corporate governance topics, such as removal of staggered boards, majority voting standards in director elections and elimination of poison pills, without more, generally would not disqualify an otherwise eligible shareholder from filing on Schedule 13G if the discussion is being undertaken by the shareholder as part of a broad effort to promote the investor’s view of good corporate governance practices for all of its portfolio companies, rather than to facilitate a specific change in control in a particular company.  By contrast, Schedule 13G would be unavailable if a shareholder engages with the issuer’s management on matters that specifically call for the sale of the issuer to another company, the sale of a significant amount of the issuer’s assets, the restructuring of the issuer or a contested election of directors.

Here, Elon Musk would argue that in advocating for an edit button and other similar policy changes, he was merely trying to influence basic business decisions of Twitter relating to the functionality of its social media platform, and that such advocacy did not in any way seek to bring about change in the control of the company.

But of course there are other facts and circumstances to consider.  Twitter announced the day after Mr. Musk’s 13G filing that the company would appoint Mr. Musk as a director.  The SEC has taken the position that a director cannot be deemed a passive investor for the purpose of 13G eligibility.  The letter agreement filed by Twitter as an exhibit to its 8-K, in which it agreed to appoint Musk as a director, was dated April 4, the day Musk filed his 13G.  Moreover, Twitter’s CEO Parag Agrawal tweeted on April 5 that “through conversations with Elon in recent weeks, it became clear to us that he would bring great value to our Board”, implying the company and Musk had for weeks been engaged in discussions about him joining the board.  So given the SEC’s position that a director cannot be a passive investor for 13G/13D purposes, the discussions referred to by Mr. Agrawal, and certainly the agreement to appoint Musk to the board, would seem to have disqualified Musk from using Schedule 13G and required him to report his ownership on the more detailed Schedule 13D.

Another noteworthy aspect to Mr. Musk’s Twitter ownership filings is his failure to provide a required certification in his original 13G.  Musk indicated on the facing page of his 13G that he was filing pursuant to Rule 13d-1(c), the rule that allows a passive investor to file the short-form 13G rather than the more detailed 13D.  But Item 10 of Schedule 13G requires the filer to include the following certification if the statement is filed pursuant to Rule 13d-1(c):

By signing below I certify that, to the best of my knowledge and belief, the securities referred to above were not acquired and are not held for the purpose of or with the effect of changing or influencing the control of the issuer of the securities and were not acquired and are not held in connection with or as a participant in any transaction having that purpose or effect, other than activities solely in connection with a nomination under § 240.14a-11.

Instead of certifying that his purchase of Twitter shares was not made for the purpose or with the effect of changing or influencing the control of Twitter, Mr. Musk just inserted “Not Applicable”.  Could Mr. Musk have been trying to have it both ways, filing the short form 13G while not certifying that his shares in Twitter were not acquired or held for the purpose or with the effect of changing or influencing the control of Twitter, Inc.?

Leaving aside the omission of the “no control” certification, an argument could be made that Mr. Musk should be deemed to have been passive at the time of his 13G filing because he was merely advocating for changes in Twitter’s business practices, and that his status as a passive investor only changed when Twitter announced the agreement to appoint him to the board.  Like Twitter, the SEC does not have an edit feature, so when the board appointment was formalized, Musk had no choice but to file a 13D.

Mr. Musk has shown himself to be defiant when it comes to the SEC, at times mocking.  After tweeting in 2018 that he had “funding secured” for his proposal to take Tesla private, the SEC alleged that Mr. Musk had never previously discussed such a deal and that his statement, which caused Tesla’s stock to skyrocket, constituted fraud. Musk and the SEC entered into a consent decree which, among other sanctions, required Musk to obtain company pre-approval of any written communications that contain information material to Tesla or its shareholders.  After the SEC asked for information on whether Tesla was satisfying its obligation to monitor his public messages, as per the consent decree, Musk tweeted an apparent reference to a sex act: “SEC, three letter acronym, middle word is Elon’s”.  Musk recently filed a motion seeking to terminate the consent decree.  And earlier this year, it was reported the SEC was investigating whether Mr. Musk and his brother violated insider-trading rules after his brother sold $108 million of Tesla shares one day before Elon Musk polled Twitter users on whether he should sell 10% of his stake in Tesla and pledging to abide by the vote’s results.

It remains to be seen to what extent the apparent issues surrounding Mr. Musk’s beneficial ownership filings regarding his shares in Twitter, Inc. will further complicate his existing battles with the SEC.

The Securities and Exchange Commission just proposed new rules to protect investors in private investment funds.  The proposed rules would require private fund advisers to disclose certain information and avoid certain practices.  But these retail-like protections for private fund investors seem inconsistent with the long-held belief that such investors can fend for themselves.  The proposed rules also raise legitimate questions about the continued denial to retail investors of access to investments in private funds.

The capital markets blogosphere has already offered worthy summaries of the proposed rules, and my aim here is not to add to those.  In brief, registered private fund advisers would need to provide investors with detailed quarterly information on fees, expenses and performance, obtain annual financial statement audits by a PCAOB-registered auditor and provide investors with an independent fairness opinion for any adviser-led secondary transaction.  All private fund advisers would be prohibited from engaging in certain sales practices, conflicts of interest and compensation arrangements, including charging certain types of fees and expenses to a private fund or portfolio investment, allocating certain fees and expenses in a non-pro rata manner and providing certain types of preferential treatment.

The SEC does have authority to regulate advisers to private funds.  Dodd-Frank requires that advisers to private funds register with the SEC, and that the SEC establish reporting and recordkeeping requirements for such advisers for investor protection and systemic risk purposes.

But why the need for retail-like protections?  Most securities offerings by private funds are conducted under Rule 506(b), which for all practical purposes limits offerings under the Rule to accredited investors.  And offerings conducted under Rule 506(c) by definition are limited solely to accredited investors.  The entire rationale for the special status afforded to accredited investors is that these are persons who can fend for themselves.  But being able to fend for themselves means they, alone or with the advice of lawyers and other advisers, know what questions to ask and what information to demand, and have the leverage to extract it from private fund managers.  Having the ability to fend for themselves means they don’t need the retail-like type of protections the SEC is proposing here. The historical rationale for carving out a special category of persons that may invest in non-registered offerings is that such persons have the leverage to extract material information from the issuer and/or have the financial wherewithal to bear the risk of loss.  But by imposing retail-like mandates on advisers to an asset class invested in only by accredited investors, the proposed rules would seem to contradict that rationale.  Further, if the SEC will impose a whole new retail-like disclosure and practice regime on private fund advisers, what would be the continuing justification for the retail vs. accredited investor distinction?  Shouldn’t the new retail-like mandates open the door to access to private fund investment by retail investors?

Commissioner Hester Peirce put it best in her statement on the SEC’s proposed private fund adviser rules:

“Today’s proposal represents a sea change. It embodies a belief that many sophisticated institutions and high net worth individuals are not competent or assertive enough to obtain and analyze the information they need to make good investment decisions or to structure appropriately their relationships with private funds. Therefore, the Commission judges it wise to divert resources from the protection of retail investors to safeguard these wealthy investors who are represented by sophisticated, experienced investment professionals. I disagree with both assessments; these well-heeled, well-represented investors are able to fend for themselves, and our resources are better spent on retail investor protection. Accordingly, I am voting no on today’s proposal.”

Commissioner Pierce makes a good point about diversion of scarce enforcement resources.  As she later points out, the SEC has historically prioritized the protection of retail investors over those deemed able to protect themselves, even after Dodd-Frank.  Adoption of these proposed rules will require a redeployment of resources away from retail investor protection in favor of protecting those with means and sophisticated counsel.

2021 was a spectacular year for the American venture capital ecosystem, with VC investments, fundraising and exits all setting new highs.  That according to the latest PitchBook-NVCA Venture Monitor, the self-described definitive review of the U.S. venture capital ecosystem.  Nevertheless, it is difficult to predict how 2022 will turn out for the VC industry, as it remains to be seen to what extent the tremendous amount of VC fund dry powder will be offset by the headwinds generated by outsized valuations, stock market volatility and inflation-induced interest rate hikes.  For now, let’s take a look at how well the VC industry did this past year.

Investment Activity

U.S. startups raised $329.9 billion in venture investments in 2021, nearly doubling the previous annual record of $166.6 billion set in 2020. Total VC deal count also increased significantly to an estimated 17,054 deals in 2021, up from 12,173 in 2020.

The Venture Monitor covers all equity investments into startup companies headquartered in the U.S. from an outside source, not just from institutional investors, and may include individual angel investors, angel groups, seed funds, VC funds, corporate venture, corporate investors and institutions.  Each subcategory of startup company – seed, angel, early-stage and late-stage[1] – set records in 2021 for total dollars invested and deal count.  There was a combined total of 6,649 seed and angel deals, the first time that number exceeded 5,800.  Early stage deals exceeded $80 billion, just about double the previous record, spread over an estimated 5,351 deals, a 57% increase over the previous year. Finally, over $220 billion was invested in late-stage startups across more than 5,000 deals, more than double 2020’s record in dollars raised and a 47% increase in deal count year-over-year.

Also noteworthy is that 4,000 startups raised their first venture round in 2021, a new record, collectively raising $23.8 billion, also a new record.  Previously, the record high for the number of first financings in a year was 3,704, and the record amount invested in these companies was just $15.3 billion.

Fundraising Activity

Venture capital has outperformed all other private capital asset classes in recent years, including private equity, secondaries, real estate, private debt and funds of funds.  Consequently, investors continued to allocate larger amounts of capital toward venture, which in turn enabled VCs to break fundraising records in 2021.

U.S. VC funds raised a record $128.3 billion across 730 funds in 2021, a 47.5% year-over-year increase as compared with the previous record of $86.9 billion set in 2020. Median and average fundraising value in 2021 jumped to $50 million and $188.1 million, respectively, a significant increase over 2020’s median and average of $42.1 million and $156.9 million.

Venture Monitor defines VC funds as pools of capital raised for the purpose of investing in the equity of startup companies. In addition to funds raised by traditional VC firms, PitchBook also includes funds raised by any institution with that primary intent. But funds identifying as growth-stage vehicles are classified as private equity funds and are not included in the report.

Exit Activity

Perhaps the biggest story of 2021 was the massive exit activity among venture backed companies during the year.  VC backed companies produced approximately $774.1 billion in exit value through public listings and acquisitions, a whopping 168% increase over 2020, with the lion’s share of that – $681.5 billion – being in the form of public listings.  Much of the increased public listing activity was attributed to SPACs, which emerged as a popular alternative to IPOs in 2020 and 2021.  Exit count also set a new record in 2021 with over 1,800 deals closed, which suggests the year’s exit performance was broad based, rather than relying heavily on massive deals.

The lion’s share of exit activity in 2021 went to public listings, producing $681.5 billion of the $774 billion in exits.  A total of 296 venture backed companies completed public listings in 2021, an extraordinary increase of 114.5% over 2020.  Interesting to note that the Venture Monitor changed this category from “IPO” to “public listings”, which includes IPOs, direct listings and reverse mergers via SPACs, to accommodate the different ways it tracks the transition of venture backed companies to public markets.

Predictions for 2022

Despite the phenomenal performance of venture capital in 2021, the prospects for the industry in 2022 will depend on how some tailwinds and developing headwinds play out against one another.  Chief among the tailwinds is the prodigious level of VC investor dry powder.  The venture ecosystem is flush with over $220 billion in untapped cash, according to the Venture Monitor, including nearly $130 billion raised last year and $13 billion already raised in the first week of January of this year.

But there are new challenges heading into 2022, the first of which are the highest levels of inflation in 40 years.  In an effort to mitigate against that, the Federal Reserve has announced it intends to raise interest rates, after more than a decade of near-zero rates, threatening one of the key factors in the recent multi-year bull market — cheap capital – and portending a drag on market stock prices.  This could in turn lead to lower late-stage private company valuations, which means a more difficult exit environment for venture backed companies.

But could lower valuations be a form of winning by losing for the venture industry?  Valuations went through steep escalations last year across all stages of development.  For example, seed pre-money valuations grew to a median of $9.5 million, an increase of 35.7% over the previous record high of $7.0 million in both 2019 and 2020.  Median late-stage pre-money valuations spiked last year to approximately 20 times revenue, nearly double the 10.9x multiple in 2020, according to PitchBook.  Some VCs are concerned about the risk of a bubble forming in the venture capital markets and are suggesting the industry would benefit from a valuation retrenchment.  But lower valuations of course are a double-edged sword for VCs; they want reduced valuations for the initial investment, but higher valuations in subsequent rounds (because the earlier purchased shares get marked up) and on exit.

[1] Venture Monitor considers a seed round to be a round below $500,000 and is the first round as reported by a government filing.  It would be deemed an angel round if there is no prior PE or VC investment in the company and it can’t be determined if any PE or VC firms are participating.  A round is generally classified as early stage if it involves the issuance of Series A or B, and late-stage if Series C or later.

Should a buyer be allowed to walk away from an acquisition if an extraordinary event occurs between signing and closing that forces the target company to take emergency remedial measures outside its ordinary course, even if consistent with industry practice under the circumstances?  This became a pressing issue during the early months of the COVID-19 pandemic as buyers were attempting to back out of deals.  In the first COVID-19 era Delaware court case on this topic, the Delaware Supreme Court on December 8, 2021 upheld the Chancery Court’s decision that the buyer was justified in terminating the purchase agreement because the target’s remedial responses to the pandemic departed from past practice and violated the agreement’s covenant to operate in the ordinary course, even though the measures were a reasonable response to plummeting demand and were widely implemented in the industry.

The dispute in AB Stable VIII LLC v. Maps Hotels and Resorts One LLC grew out of an agreement by MAPS Hotel and Resorts One LLC (the “Buyer”) to purchase fifteen hotel properties from AB Stable VIII LLC (the “Seller”) for $5.8 billion.  A closing delay pushed the transaction up against the COVID-19 outbreak and the damage it inflicted on the hospitality industry. In response to the pandemic, the Seller made drastic changes to its hotel operations after signing the purchase agreement, including closing hotels and laying off or furloughing thousands of employees.  Although the Seller asked for the Buyer’s consent, it then failed to respond to the Buyer’s reasonable request for relevant information. The Buyer then terminated the purchase agreement and walked away, citing a breach of the Seller’s ordinary course covenant.  The Seller then commenced a lawsuit seeking specific performance.

The purchase agreement in AB Stable contained a typical “covenant compliance” condition, under which the Buyer could walk if the Seller breached any of its pre-closing covenants.  The issue before the court was whether the Seller failed to satisfy the covenant to operate the business in the ordinary course between signing and closing.  The case turned on the specific language of the ordinary course covenant, which read as follows:

“…[B]etween the date of this Agreement and the Closing Date, unless the Buyer shall otherwise provide its prior written consent (which consent shall not be unreasonably withheld, conditioned or delayed), the business of the Company and its Subsidiaries shall be conducted only in the ordinary course of business consistent with past practice in all material respects, including using commercially reasonable efforts to maintain commercially reasonable levels of Supplies, F&B, Retail Inventory, Liquor Assets and FF&E consistent with past practice…”

The Seller argued that “ordinary course of business” during the pandemic should mean the prevailing industry standard under current circumstances, not its own past practice.  The court, however, interpreted the adverb “only” in conjunction with the phrase “consistent with past practice” to mean that the parties created a standard that looks exclusively to how the business operated in the past, and that industry responses to the pandemic were not relevant to the standard.  The court also rejected the Seller’s alternative argument that there was no breach of the ordinary course covenant because the “business” in question was the parent company’s asset management business, which does not involve the day-to-day operation of the hotels, and in which there were no changes to the parent’s role of deploying capital and overseeing the hotels’ managers.  The court rejected this argument inasmuch as the plain language of the covenant requires that the “business of the Company and its subsidiaries be operated in the ordinary course”, meaning that the covenant extended to the operation of the hotels themselves. The court’s reading was also informed by other parts of the same covenant which required the Seller to maintain commercially reasonable levels of assets such as food, furniture, toiletries and other items required in hotel operations.  Finally, the court noted the absence of a reasonableness qualifier with respect to the relevant part of the covenant, which supported the proposition that the parties intended the seller’s obligation to be absolute.

The court’s decision at this point would seem to impose on sellers an awful dilemma. Take reasonable measures that preserve the business but which violate the ordinary course covenant, and the buyer gets to walk.  Or refrain from taking remedial measures and risk running the business into the ground, which would likely be a material adverse event resulting in the buyer terminating here as well and the seller ending up with a failed business.  But by imposing a consent requirement, the purchase agreement anticipated this dilemma by involving the Buyer in the Seller’s response to disruptive events.  The Buyer might have wanted to respond to the pandemic in different ways to ensure the long-term profitability of the business or to prioritize certain operations.   As the court pointed out, the Seller was not hamstrung by the ordinary course covenant.  It was simply required to seek consent before taking action, and if consent was “unreasonably” denied, the Seller could have challenged the Buyer’s unreasonable denial.  Here, the Seller did ask for the Buyer’s consent, but then failed to respond to the Buyer’s reasonable request for relevant information in response.  Having departed from past practice without securing the Buyer’s consent, the Seller breached the ordinary course covenant, which excused the Buyer’s obligation to close.

The clear lesson of AB Stable is that parties to an acquisition agreement should draft ordinary course covenants very carefully so as not to leave the interpretation of “ordinary course” to chance.

  • First, sellers should seek to include, and buyers should seek to exclude, “commercially reasonable efforts” from the covenant. In AB Stable, the covenant to operate in the ordinary course was not qualified by the term “commercially reasonable efforts”, and the court ruled that the Seller had an absolute “flat” obligation to operate in the ordinary course.
  • Second, sellers should avoid use of the adverb “only” in conjunction with the phrase “consistent with past practice”. The court interpreted that combination to mean that the parties created a standard that looks exclusively to how the business operated in the past, and that industry responses to the pandemic were not relevant to this standard.
  • Third, sellers that operate through subsidiaries should resist, while buyers should negotiate for, the insertion of “and its subsidiaries” in reference to the business that is required to be operated in the ordinary course. The Seller in AB Stable had argued creatively that it had not violated the ordinary course covenant because it had not made any changes to its asset management business, which was the business of deploying capital and overseeing the hotels’ managers, but lost on that argument because the covenant had an explicit reference to the business of the Seller’s subsidiaries.

Ever since the SPAC market exploded in late 2020 and early 2021, the SEC has sounded alarm bells through investor alerts, staff statements and public comments.  In March of 2021, it warned investors not to invest in SPACs just because of celebrity endorsements. In April, an SEC staff announcement said SPACs needed to account for warrants as liabilities, not equity, which led to many SPACs slamming on the IPO brakes and to post-combination companies restating their financials.  And when Gary Gensler took over as SEC Chairman in April, he promised further scrutiny of SPACs.

Greater scrutiny has arrived in the form of the SEC review process as reflected in comment letters over the last few months relating to SPACs.  The SEC selectively reviews filings made under the Securities Act of 1933 and the Securities Exchange Act of 1934 to monitor compliance with applicable disclosure and accounting requirements. After reviewing a filing, the SEC will send a comment letter to the issuer with detailed comments regarding critical disclosures that appear to conflict with SEC rules or accounting standards, as well as disclosure that appears to be deficient in explanation or clarity. The SEC doesn’t evaluate a transaction’s merits from an investment perspective.

Companies generally respond to each comment in a response letter back to the SEC and, where appropriate, in amendments to its filings.  Comment and response letters are kept confidential until the SEC has completed its review, at which point they become publicly accessible on the SEC’s EDGAR system.

The SEC could issue comment letters at two different junctures in a SPAC life cycle.  First, in connection with the S-1 filed to cover the shares to be issued in the IPO, and then, assuming the SPAC identifies a target, in connection with the S-4 registration statement relating to the business combination or “de-SPAC” transaction.  Because the SPAC is by definition a shell company at the time of its IPO, the far more interesting comment letters are the ones relating to the business combination S-4.

Recent comment letters sent to SPAC sponsors relating to proposed business combinations reveal the SEC’s enhanced focus on conflicts of interest inherent in most de-SPAC transactions.  For examples, see here, here and here.  The following are three conflict of interest comments that have appeared in several SPAC comment letters, followed by the ways in which sponsors have been responding.

Please revise to quantify to the extent known the interest of the SPAC officers and directors in the business combination. For instance, we note the reimbursement of out of pocket expenses, working capital loans, and the continuation of [SPAC director] as a director of the post-combination company.

In response to this comment, sponsors have added more detail into the right of SPAC board members to be reimbursed for out of pocket expenses in connection with identifying, investigating and consummating a business combination; conversion of working capital loans made by the sponsor and SPAC officers and directors to the SPAC; and the expected dollar amount of board compensation that will be paid to SPAC directors who continue as directors of the post-combination company.

We note your risk factor that the sponsor, certain members of the Board, and officers of [the SPAC] will benefit from the completion of a business combination. Please revise to highlight that these parties may be incentivized to complete an acquisition of a less favorable target company or on terms less favorable to shareholders rather than liquidate.

In response to this comment, sponsors are disclosing in tabular format the public shareholders’ and the SPAC’s initial shareholders’ (including the sponsor’s) investment per share and how these compare to the implied value of a share of post-combination company common stock upon completion of the business combination.  Often, the implied value of the post-combination company common stock represents a decrease from the initial public offering price of $10.00 per public share, but a significant increase in value for the sponsor and other insiders relative to the price they paid for their founder shares.

Sponsors are also adding language to the valuation information above to the effect that in light of the foregoing per share value analysis, the sponsor and insiders holding holding founder shares may be economically incentivized to complete an initial business combination with a riskier, weaker-performing or less-established target business, or on terms less favorable to the public shareholders, rather than liquidating the SPAC.

We note that your charter waived the corporate opportunities doctrine. Please address this potential conflict of interest and whether it impacted your search for an acquisition target.

Every SPAC following its IPO engages in the business of identifying and combining with one or more targets.  But the SPAC’s sponsor and officers and directors are typically affiliated with other entities (operating companies or investment vehicles) engaged in a similar business, including other SPACs.  Those officers and directors may become aware of business opportunities that may be appropriate for presentation to both the SPAC and the other entities to which they owe fiduciary or contractual duties.  It’s fairly common for a SPAC’s certificate of incorporation to renounce the SPAC’s interest in any corporate opportunity offered to any director or officer unless the opportunity is expressly offered to the individual solely in his or her capacity as a director or officer of the SPAC and the opportunity is one the SPAC is legally and contractually allowed to pursue and it would otherwise be reasonable for it to pursue, assuming the director or officer is permitted to refer that opportunity to the SPAC without violating any legal obligation.

The common rationale for the “corporate opportunity” waiver is that in the absence of the waiver, certain candidates would not be able to serve as an officer or director, and the inclusion of the waiver provides greater flexibility to attract and retain the best officers and directors.

In response to the comment, however, sponsors have been adding to the foregoing disclosure that the personal and financial interests of the directors and officers may influence their motivation in timely identifying and selecting a target business and completing a business combination. Further, the different timelines of competing business combinations could cause directors and officers to prioritize a different business combination over finding a suitable acquisition target for the SPAC. Consequently, directors’ and officers’ discretion in identifying and selecting a suitable target business may result in a conflict of interest when determining whether the terms, conditions and timing of a particular business combination are appropriate and in the public shareholders’ best interest, which could negatively impact the timing for a business combination. Sponsors then state whether they believe any such conflicts of interest impacted the SPAC’s search for an acquisition target.

Background: Crypto Catch 22

Followers of the SEC’s efforts to regulate digital tokens will recall former SEC Corp Fin Director William Hinman’s speech at the June 14, 2018 Yahoo Finance Conference in which he introduced the now generally accepted proposition that a digital asset could originally be deemed a security while its network is being developed but then evolve into a non-security where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, i.e., where the network is decentralized or functional.  See my blog post on this here.

Under the Howey test, digital tokens offered and sold before the underlying network is decentralized or functional would likely be deemed to be securities so long as purchasers reasonably expect the network’s developers to carry out the essential managerial or entrepreneurial efforts necessary to build value in the tokens.  But for a network to mature into a decentralized or functional network not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts, the tokens must be distributed to and freely tradeable by potential users, programmers and participants in the network. The problem with this crypto Catch 22 is that the application of the federal securities laws to the pre-“network maturity” distribution of tokens thwarts the network’s ability to achieve maturity and prevents tokens initially sold as a security from evolving into non-securities on the network.

Crypto Mom’s Safe Harbor

To address this problem, in March 2020 SEC Commissioner Hester Peirce (aka “Crypto Mom”) introduced a proposal (which I blogged about here), revised in April 2021 as Safe Harbor 2.0, to create a three-year safe harbor during which developers would be allowed to distribute tokens to facilitate participation in and development of a functional or decentralized network, exempt from the registration requirements of the federal securities laws, so long as certain disclosure and other conditions are met, including filing a notice of reliance on the safe harbor. Safe Harbor 2.0 proposed three changes to the original.  First, a requirement for semi-annual updates to the plan of development disclosure. Second, a mandatory exit report at the end of the three-year grace period containing either an analysis by outside counsel explaining why the network is decentralized or functional, or an announcement that the tokens will be registered under the Securities Exchange Act of 1934.  And third, guidance for outside counsel’s decentralization analysis in the form of facts and circumstances guideposts rather than a bright-line test.

The Clarity for Digital Tokens Act of 2021

Crypto Mom’s Safe Harbor 2.0 has not been adopted by the SEC, but it now has a powerful sponsor in Congress.  On October 5, 2021, Cong. Patrick McHenry, ranking member on the Financial Services Committee and leading capital markets reform advocate, introduced a bill called the Clarity for Digital Tokens Act of 2021 which would effectively codify Commissioner Peirce’s Safe Harbor 2.0 proposal.

The Clarity for Digital Tokens Act would create an exemption from registration under a new Section 4B to the Securities Act of 1933 (to be called “Token Safe Harbor”) for the offer and sale of a token if (i) the initial development team intends for the network on which the token functions to reach network maturity within three years after the first token sale, (ii) the token is offered and sold for the purpose of facilitating access to, participation on or the development of the network and (iii) the initial development team complies with certain disclosure and filing requirements.

Disclosure Requirements

The Act’s disclosure provisions would require developers to disclose on a freely accessible public website the source code; the steps necessary to independently access, search and verify the network’s transaction history; a description of the purpose of the network; the current state and timeline for the development of the network to show how and when the initial development team intends to achieve network maturity, with semi-annual updates; prior token sales; identities of the initial development team and certain token holders; trading platforms on which the token trades; related person transactions; and a warning that the purchase of tokens involves a high degree of risk and potential loss of money.

Filing Requirements

As is the case with Safe Harbor 2.0, the Act’s filing requirements would consist of a notice of reliance on the safe harbor and an exit report.  The notice of reliance on the safe harbor would need to be filed with the SEC prior to the date of the first token sold in reliance on the safe harbor.  If a development team has sold tokens prior to the effectiveness of the Act but wants to avail itself of the safe harbor, it may do so by filing the notice of reliance as soon as practicable.

The exit report would generally need to be filed on or before the expiration of the three year anniversary of the first token sale, the contents of which would depend on the development team’s determination at that point as to whether network maturity has been achieved, and if so whether for a decentralized or functional network.

If the dev team determines that network maturity has been reached for a decentralized network, the exit report would need to include a legal analysis that consists of a description of the extent to which decentralization has been reached as to voting power, development efforts and network participation, as well as an explanation of how the dev team’s pre-network maturity activities are distinguishable from the team’s ongoing involvement with the network.

If the dev team determines that network maturity has been reached for a functional network, the legal analysis would need to include a description of the holders’ use of tokens and an explanation of how the dev team’s pre-network maturity marketing efforts and the team’s ongoing efforts will continue to be focused on the token’s consumptive use, and not on token price appreciation.

If alternatively the initial dev team determines that network maturity has not been reached, the exit report would need to include a description of the status of the network and the next steps the dev team intends to take, and a statement acknowledging that the team will register the tokens as a class of securities under Section 12(g) of the Securities Exchange Act of 1934 within 120 days after filing the report.

Network Maturity

The Act defines “network maturity” as the status of a decentralized or functional network that is achieved by meeting the standard of either control or functionality.  Under the control standard, network maturity exists when the network is not economically or operationally controlled and not reasonably likely to be economically or operationally controlled or unilaterally changed by any single person, entity or group of persons or entities under common control.  Any network of which the initial development team owns more than 20% of the tokens or more than 20% of the means of determining network consensus would be not qualify for network maturity. A network would be determined to be “functional” if the tokens are used by token holders for transmission and storage of value on the network, for participation in an application running on the network, or otherwise in a manner consistent with the utility of the network.

Final Thoughts

The proposed Clarity for Digital Tokens Act of 2021 gives Congress an opportunity to bring greater clarity in a responsible manner to crypto developers seeking ways to finance the development of their network and achieve network maturity without unreasonable regulatory impediments.  As to the overarching determination of whether or not network maturity has been achieved, the Act takes a facts and circumstances approach rather than a bright line test, which is probably the sensible approach.  It remains to be seen whether the Act will gain traction on the Hill.