A major theme of this Blog has always been ongoing legislative, regulatory and market initiatives to reform capital markets by targeting unreasonable or outdated impediments to capital formation to make it easier for early-stage companies to raise capital.  These impediments are not always obvious or direct.  One such indirect impediment has been the venture capital adviser exemption under the Investment Advisors Act of 1940, the eligibility requirements of which disincentivize VC investment in secondary transactions and in other VC funds, thereby unnecessarily hampering liquidity in the innovation ecosystem.  If a new piece of proposed legislation passed by the House Financial Services Committee becomes law, however, this impediment will be eliminated.

Continue Reading Proposed Reform of Venture Capital Fund Advisor Exemption Will Boost Startup Investment and Founder Liquidity

The collapse of Silicon Valley Bank will have enormous repercussions for startups and VCs in ways seen and unseen.  As for the unseen, SVB had deep relationships among the various players in the venture ecosystem.  Founders and investors established banking relationships with SVB in part because of the opportunities SVB provided to network within the space.  It will be difficult for other lenders who don’t have these deep relationships to replace SVB in this capacity and fill this valuable role.

Continue Reading Bumpy Ride Ahead for Startups After Silicon Valley Bank Crash

A new federal law goes into effect March 29, 2023 that conditionally exempts from broker-dealer registration persons who solely intermediate small, private company M&A deals.  Persons who intermediate larger private company M&A transactions will not be eligible for the new exemption and will need to continue to rely on the SEC’s 2014 no-action letter.  The new Federal legislation also does not preempt the states, so M&A intermediaries will need to continue to be mindful of state registration requirements.

Continue Reading Middle Market M&A Brokers Get Relief

Will employment non-competes soon be banned nationally?  Perhaps, if the Federal Trade Commission gets its way.  Last month, the FTC issued a Notice of Proposed Rulemaking (the “NPRM”) that would prohibit just about all employment non-competes. The proposal is now going through a 60-day comment period.  If ultimately adopted in anything close to its current form and survives inevitable legal challenges, the ban will significantly impede the ability of employers to safeguard proprietary information.

Continue Reading RIP Non-Competes?

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” Such was the lament of John Ray, the legendary restructuring executive tasked with the unenviable assignment of serving as the caretaker CEO of bankrupt FTX Trading Ltd.  As the criminal and civil cases by the DOJ, SEC and CFTC against FTX founder and former CEO Sam Bankman-Fried play out in the courts, what does the “complete failure of corporate controls” at FTX teach us about corporate governance, unchecked founder control and the importance of proper oversight?

Continue Reading FTX, Sam Bankman-Fried and the Risk of Unchecked Founder Control

Just last week, special purpose acquisition company The Music Acquisition Corporation (“TMAC”) called a special meeting of its stockholders.  It wasn’t the special meeting it originally envisioned.  TMAC was launched in February 2021 by long-time Geffen Records President Neil Jacobson to acquire a music business with the $230 million of SPAC IPO proceeds it raised.  The special meeting it envisioned at that time was one to approve an acquisition of a music company.  Instead, the special meeting to be held on November 30 is for the stockholders to approve an early liquidation of the SPAC and the return of remaining IPO proceeds to the stockholders.

TMAC is not alone in calling for early liquidation.  CNBC reports that 27 SPACs worth $12.8 billion have been liquidated so far this year through mid-October.  Along with this spate of SPAC liquidations, 143 SPAC IPOs have withdrawn this year and 46 de-SPAC transactions (acquisitions of operating companies by SPACs) were terminated.  This is an incredible turn of events from the SPAC hysteria we went through in 2020 and most of last year, when SPACs constituted more than half of the record number of IPOs.

One way that SPAC sponsors got lots of investors to invest in SPACs in the first place is by giving them redemption rights.  A SPAC investor may opt out of a proposed de-SPAC transaction and be entitled to his pro rata share of the IPO proceeds which are required to be held in trust.  Another investor protection is that a SPAC must liquidate and distribute those proceeds to the SPAC investors if it fails to complete a de-SPAC acquisition within a set timeline, typically two years. That two-year deadline has proven to be a ticking time bomb:  too many buyers chasing too few viable targets.

The increasing propensity of SPAC investors to seek redemption has created multiple problems for SPACs and their sponsors.  A standard condition to a target’s obligation to close a de-SPAC transaction is that there be a minimum amount of combined cash available from the trust account and from PIPE investments (private investments in public equity).  When aggregate redemptions get too big, the SPAC may fail to satisfy the cash condition, causing the de-SPAC transaction to crater.  Even if a de-SPAC transaction is able to close, excessive redemptions may threaten the financial viability of future operations of the post de-SPAC operating company because of the lack of available cash.  And more redemptions also mean a smaller stockholder base, which results in reduced liquidity in the surviving company’s stock.

The sponsor faces significant losses as well.  First, the transaction fees associated with effecting the IPO, sourcing, performing due diligence on, negotiating and documenting potential de-SPAC deals and getting them past the SEC regulatory process is an enormously expensive process and represents sunk costs to the sponsor; those expenses are not paid out of the trust account. These transaction fees have been estimated to average approximately $5-$10 million.  Second, the typical 20% promote to the sponsor in the form of shares in a de-SPAC’ed company is only worth something if an acquisition deal gets done.  If the SPAC fails to acquire an operating company and is forced to liquidate, the SPAC’s public shareholders at least get the IPO proceeds back with interest; the sponsor neither shares in the trust proceeds nor benefits from the 20% share allocation.  

But redemptions aren’t the sole cause for the recent string of SPAC liquidations. Another reason being cited by sponsors for liquidating now is the new excise tax under the Inflation Reduction Act, which imposes a 1% excise tax on any domestic corporation that repurchases its stock after December 31, 2022.  TMAC cited the excise tax as the primary reason it was seeking stockholder approval for a charter amendment to accelerate its liquidation.  Under its certificate of incorporation, TMAC could not otherwise liquidate until after the designated two-year deadline for completing a deal, or February 5, 2023.

A sponsor facing excessive redemptions has few options.  Sponsors will be loath to let a possible deal fall through and will thus have every incentive to negotiate with individual investors in an effort to change their minds regarding redemption.  This likely means some kind of concession from the sponsor, often in the form of a cut-back in the sponsor’s share allocation, typically 20%, in the company post-acquisition.  In fact, sponsors are getting squeezed on both ends as competition has been stiff among SPAC sponsors for targets.  This means sponsors are also under pressure to sweeten the pot for potential target companies by offering to decrease the 20% promote even further. Alternatively, the sponsor could seek supplemental funding to make up for the redemptions, either in the form of additional acquisition financing or as a line of credit post-closing to fund ongoing operations.

2022 was predicted by many to be the year of the red wave (turned out to be more of a red ripple).  It may be better remembered for another wave beginning with the letter “R”: a redemption wave.  Over the next few weeks, I expect to see those sponsors who are sitting on signed merger agreements trying to negotiate with SPAC shareholders to stem the tide of redemptions in an effort to satisfy cash closing conditions and close their de-SPAC transactions.  On the other hand, sponsors further away from consummating a de-SPAC transaction will have few good options and will be under enormous pressure to liquidate this year before the excise tax kicks in.

Elon Musk has lobbed in two additional termination letters since his original July 8 letter seeking to terminate his agreement to acquire Twitter for $44 billion.  Each termination letter cites alleged false representations and blown covenants by Twitter in the merger agreement, purportedly justifying termination.  Twitter’s response to each letter has been the equivalent of saying: “So what?”.

Musk’s first termination letter alleged that Twitter overstated the number of its monetizable users, understated the percentage of users that are fake accounts or bots and failed to provide information Musk needs to complete the transaction or to secure financing.

Musk’s second termination letter was sent after the Washington Post published a whistleblower report to Congress, the SEC, the FTC and the DOJ filed by Peiter “Mudge” Zatko, Twitter’s former chief security officer, on July 6, 2022.  The second letter asserts that the allegations in the whistleblower report, if true, would demonstrate Twitter violated several provisions of the merger agreement.  The allegations include that Twitter has been violating an FTC consent decree requiring the company to maintain a comprehensive information security plan (purported breach of the representation that Twitter is in compliance with applicable laws), that it failed to disclose in SEC documents the significant privacy, data protection, safety and cybersecurity risks Mr. Zatko alerted the board to (purported breach of the representation that Twitter’s SEC filings were truthful), that Twitter’s CEO presented false information to the board to cover up vulnerabilities in Twitter’s security and data protection infrastructure (purported breach of the representation regarding disclosure controls and procedures), that Twitter is facing multiple regulatory investigations relating to privacy and cybersecurity (purported breach of the representation that there are no threatened lawsuits that would constitute a material adverse effect), and that Twitter never acquired the rights to its core machine learning models (purported violation of the representation that Twitter was not infringing on anyone else’s intellectual property).

The third termination letter, dated September 9, 2022, asserts that Twitter’s $7.75 million severance payment to Mr. Zatko (the whistleblower) violated Twitter’s merger agreement covenant not to make any severance payments prior to closing other than in the ordinary course of business and consistent with past practice, in each case without Musk’s consent.

Normally, you don’t get to pile on to a previously delivered termination letter by sending subsequent letters with additional or alternative allegations.  Musk is maintaining in his second and third termination letters, however, that new facts have come to light since the previous termination letter(s) (i.e., the whistleblower allegations and severance payment) that provide additional and distinct bases to terminate the merger agreement.

Twitter’s responses to the second and third termination letters begin with a perfunctory denial of the allegations that it is in breach of the merger agreement.  But the thrust of its response to each of the letters is the same:  that the purported termination by Musk is invalid because (even if the allegations about Twitter are true) Musk himself has violated numerous obligations under the merger agreement, which serves to contractually prevent him from terminating the agreement.  Under Section 8.1(d) of the merger agreement, Musk’s right to terminate over a breach by Twitter of any representation or covenant is conditioned on one major requirement: that Musk himself not be in material breach of any of his representations, warranties or covenants in the agreement.

And what obligations does Twitter allege Musk breached?  First, his obligation to use reasonable best efforts to complete the merger.  Second, his “hell-or-high-water” covenant requiring him to do all things necessary to consummate and finalize the acquisition financing.  Third, to provide Twitter with information regarding the status of debt financing.  Fourth, to refrain from unreasonably withholding consent to operational decisions (e.g., by unreasonably withholding consent for employee retention programs).  Fifth, to seek Twitter’s consent for public comments about the deal.  Sixth, to refrain from disparaging Twitter or its representatives in tweets about the merger.  And finally, not to misuse Twitter’s confidential information.

It will be interesting to see how all this plays out in the trial, expected to begin October 17.  Although Chancellor McCormick denied Musk’s motion to delay the start date, she did allow him to add the whistleblower claims to his countersuit.  There will be a lot of arguing about whether any of the allegations by Musk constitute misrepresentations by Twitter and if so whether any such misrepresented matters would have a material adverse effect on the company.  His best shot would seem to be the $7.7 million severance payment to Mr. Zatko if Musk could prove it was not in the ordinary course of business or consistent with past practice.  That would be a covenant breach, and unlike representation breaches, he would not need to also prove material adverse effect.  In any event, Twitter will then invoke the unclean hands provision of Section 8.1(d) by seeking to establish that Musk himself is in violation of his own covenants, which seemingly would deny Musk the ability to terminate over any Twitter breach.

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.

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[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.