At the 1932 Democratic National Convention, the live band at one point burst into “Happy Days are Here Again”, FDR’s favorite, drawing raucous cheers from convention delegates.  It went on to become the Democratic Party’s unofficial theme song for years to come.  The song is also associated with the repeal of Prohibition shortly after FDR’s election, sporting signs saying “Happy Days are Beer Again”.  And after the new rules passed last month by the Securities and Exchange Commission on how “demo-days” may be promoted without violating the securities laws, many of us could be forgiven if we break out into “Demo Days are Here Again”!

Welcome to Part Two of my deeper dive series into the SEC’s recently promulgated exempt offering amendments.  The final rules release could be found here, my initial post on the release here and Part One of the series on the new higher exempt offering caps here.

Like many others in the innovation ecosystem, I get lots of invitations to attend so-called demo-days or pitch days at which startups are invited to present to an audience that ostensibly includes potential investors, with the aim of securing investment.  Promoters of demo-days broadly advertise these events over the internet and through email blasts.  Yet since the most commonly used offering exemption prohibits the use of general solicitation, I’m often left scratching my head, hopefully not over a bad case of pityriasis capitis, thinking how this is not a blatant securities law violation.

That’s because a general solicitation is defined in Rule 502(c) to include “any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”  Under previous SEC guidance, a demo day presenter would not be deemed to have engaged in general solicitation if the promoter limits attendance to individuals either with whom the startup or the promoter has a pre-existing substantive relationship or that have been contacted through an informal, personal network of experienced, financially sophisticated individuals, such as angel investors.  But for most demo day events, that doesn’t get enough people in the room.

New Rule 148

Under new Rule 148, a demo day communication will not be deemed to constitute general solicitation or general advertising if certain conditions are met with respect to the issuer, advertising content, the promoter and communications concerning an offering.  There are additional limitations on virtual events.

First, more than one issuer must participate in the event.  This is intended to prevent a promoter from holding an event that is essentially a sales pitch for one issuer’s offering while calling it a “demo day.”

Second, no sponsorship by brokers, dealers or investment advisers.  The idea here is to limit the exemption to events sponsored by organizations less likely to have a profit motive for their involvement in the event or whose sole or primary purpose is to attract investors to private issuers.

Third, if the demo day is organized by an angel group, the group must have “defined processes and procedures” (although not required to be in writing) for investment decisions.

Fourth, no referencing any specific offering of securities by an issuer in any event advertising.

Fifth, sponsors may not provide investment advice to attendees, help negotiate an investment, charge fees other than reasonable administrative fees, receive compensation for making introductions between attendees and issuers, or receive any event compensation that would trigger registration as a broker or dealer under the Securities Exchange Act or as an investment adviser under the Investment Advisers Act.  The rationale here is to limit the potential for a sponsor to profit from its involvement or to have a potential conflict of interest due to its relationship with either the issuer or investors attending the event.

Sixth, information that may be communicated regarding an offering of securities is limited to notification that the issuer is in the process of offering or planning to offer securities, type and amount of securities being offered, intended use of the proceeds and unsubscribed amount.

And lastly, online participation in the event is limited to individuals associated with the sponsor organization (e.g., members of an angel group or students, faculty and alumni of a university), individuals the sponsor reasonably believes are accredited investors and individuals invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event.  These participation restrictions address concerns about events otherwise making broad offering-related communications to non-accredited investors, particularly in light of the increasing prevalence of virtual “demo days” which are more accessible and widely attended by the general public.

Overall, new Rule 148 will allow startups greater flexibility at demo and pitch day events to say a few high-level things about their offerings without the uncertainty as to whether they’re blowing their offering exemption in the process. Demo days are here again!

Last month, the Securities and Exchange Commission passed sweeping reforms of the rules governing exempt offerings (the “2020 Reforms”) to make it easier for issuers to move from one exemption to another, to bring clarity and consistency to the rules governing offering communications, to increase offering and investment limits and to harmonize certain disclosure requirements and bad actor disqualification provisions.  I blogged about the SEC’s rules release here.  I also said at the time I would blog separately about some of the particular reforms contained in the new rules.  Here, then, is the first installment of a multi-part series on the new reforms, this one on the new offering and investment caps for Regulation A, Regulation Crowdfunding and Rule 504.

The SEC has estimated that approximately $2.7 trillion of new capital was raised through exempt offerings in 2019, of which only 0.05% was raised under Regulation A, Regulation Crowdfunding and Rule 504 combined.  These three exemptions contain a variety of requirements and investor protections, including limits on the amount of securities that may be offered and sold under the exemptions. Regulation A and Regulation Crowdfunding also include limits on how much an individual may invest.   One of the primary reasons cited for the underutilization of these exemptions is that the dollar limits have been set too low to make them useful.

Higher Caps for Tier 2 of Regulation A

SEC rules promulgated in 2015 under the JOBS Act of 2012 established two tiers of offerings under Regulation A: Tier 1 for offerings up to $20 million in a 12-month period, and Tier 2 for offerings that do not exceed $50 million in a 12-month period.

The 2020 Reforms increase the maximum offering amount under Tier 2 of Regulation A from $50 million to $75 million, and the maximum offering amount for secondary sales by existing affiliate stockholders from $15 million to $22.5 million.

Despite the increase in the offering cap to $50 million in 2015, Regulation A financing levels remained modest relative to traditional IPOs and Regulation D.  A 2020 report by the SEC’s Division of Corporation Finance found that from June 2015 to December 2019, $2.4 billion was raised by 183 issuers in Regulation A offerings, $230 million in Tier 1 and $2.2 billion in Tier 2.  The 2020 report noted that the weak Regulation A deal levels are likely related to a combination of factors, including the pool of issuers and investors drawn to the market under existing conditions, availability to issuers of attractive private placement alternatives without an offering limit, availability to investors of attractive investment alternatives outside of Regulation A with a more diversified pool of issuers, limited intermediary participation and a lack of traditional underwriting and a lack of secondary market liquidity.

The new $75 million cap will likely attract a more seasoned pool of investors as well as institutional investors, and improve the economics for issuers and broker dealers to participate in the Regulation A market.

Not everyone was in favor of raising the Tier 2 cap.  Some opponents believe that issuers raising such large amounts of capital should be subject to the full disclosure regime of a Securities Act registration. Others worry about the negative effects of increasing the use of Regulation A for unsophisticated non-accredited retail investors given the increased risks of investor losses.  The counter view, however, is that the enhanced issuer eligibility, content and filing requirements for issuers in Tier 2 offerings continue to provide appropriate protections for investors at the higher offering limit.

Higher Caps for Regulation Crowdfunding

The JOBS Act provided that the aggregate amount raised in Regulation Crowdfunding offerings during any 12-month period may not exceed $1 million, but also required the SEC to adjust the aggregate cap not less frequently than once every five years to reflect changes in the Consumer Price Index for All Urban Consumers.  In 2017, the SEC raised the maximum offering limit to $1.07 million.

Regulation Crowdfunding also limits the amount individual investors are allowed to invest across all Regulation Crowdfunding offerings over the course of a 12-month period. The amount of the individual limit depends on his or her net worth and annual income, with an overall cap currently set at $107,000.  The current (pre-amendment) individual investor limitations are set at:

  • The greater of $2,200 or 5% of the lesser of his or her annual income or net worth, if either annual income or net worth is less than $107,000; or
  • 10% of the lesser of his or her annual income or net worth, if both annual income and net worth are equal to or greater than $107,000.

The 2020 Reforms raise the Regulation Crowdfunding aggregate offering limit from $1.07 million to $5 million.  The 2020 Reforms also amend the investor limit in two important ways.  First, by not applying any investment limits to accredited investors; and second, by allowing non-accredited investors to rely on the greater of their annual income or net worth when calculating the limit on how much they may invest.

A 2019 SEC study found that the number of offerings and the total dollar amount of funding raised under Regulation Crowdfunding were relatively modest, with issuers raising only $108 million from May 16, 2016 through December 31, 2018. The study also found that the typical offering during the reviewed period raised less than the 12-month offering limit.

Approximately 2,000 offerings were initiated under Regulation Crowdfunding in the three and a half years from the time the exemption first became available through the end of 2019, but market participants had expressed concern that the vitality of the market and the number of offerings was being constrained by the $1.07 million offering limit.

Currently, companies seeking to raise more than $1.07 million need to spend time and expense pursuing other exempt offerings to supplement amounts raised under Regulation Crowdfunding and meet their funding needs, as the existing offering limits in Regulation Crowdfunding are insufficient to meet those needs. Permitting larger offerings under Regulation Crowdfunding should encourage more issuers to use the exemption and will lower the offering costs per dollar raised, which will make the exemption a more efficient capital raising option for smaller issuers.

The higher cap should also make Regulation Crowdfunding a more viable option for issuers looking to raise more than $1.07 million, but for which Regulation A may be cost prohibitive and for which Regulation D is too limiting in terms of the investor pool. Crowdfunding offerings permit greater participation of retail investors, in contrast to Rule 506(b) offerings under which technically up to 35 non-accredited investors may participate but as a practical matter hardly any offerings include them because of the built-in disclosure bias in favor of Rule 506(b) offerings made only to accredited investors.

As for accredited investors, the elimination of investment limits will make the treatment of accredited investors consistent across offering exemptions.  Accredited investors are not subject to investment limits in Regulation D offerings. Allowing accredited investors to invest without limit in a Regulation Crowdfunding offering will obviously help issuers to meet their capital raising goals.

Higher Caps for Rule 504

In 2016, the SEC amended Rule 504 to raise the aggregate dollar amount of securities an issuer may offer and sell in any 12-month period from $1 million to $5 million.  Nevertheless, Rule 504 continues to be a neglected capital raising pathway. From 2009 through 2019, only only two percent of the capital raised in sub-$5 million Regulation D offerings by issuers other than pooled investment funds was offered under Rule 504 (and under Rule 505, prior to its repeal), while 98 percent of the capital raised was offered under Rule 506.

The 2020 Reforms raise the maximum offering amount under Rule 504 of Regulation D from $5 million to $10 million.

The Rule 504 exemption has largely remained unused by issuers for several reasons, including the low $5 million offering cap. Increasing the offering amount will enable more issuers to gain access to this alternative pathway and provide more investment opportunities to investors.

But another reason for the underutilization of Rule 504 is the lack of state preemption. Securities issued in a Rule 504 offering are not deemed “covered securities”, as is the case under Rule 506(b) and (c), and as a consequence issuers in Rule 504 offerings must go through merit reviews under state blue sky laws in each state in which the offering is made.  Categorizing Rule 504 securities as “covered securities” would greatly simplify the compliance requirements for issuers relying on Regulation D, and further promote access to Rule 504 for issuers that previously ignored this exemption because of the onerous requirement to comply with state blue sky laws.  For the time being, the SEC has chosen not to take that step.

The foregoing offering cap changes will generally become effective 60 days after publication in the Federal Register, likely to occur sometime in February 2021.

On November 2, 2020, the SEC adopted significant rule amendments to simplify, harmonize and improve the exempt offering framework to facilitate capital formation and investment opportunities in startups and emerging companies. The rule amendments were initially proposed in March 2020, and first conceived in a concept release in June 2019.  The reforms simplify the integration doctrine, revise the offering and individual investment limits for certain exemptions, clarify communication rules regarding “testing-the-waters” and demo days and harmonizes disclosure and eligibility requirements and bad actor disqualification provisions. The amendments will generally become effective 60 days after publication in the Federal Register, likely to occur sometime in February 2021.

Each of the foregoing reforms is significant, and deserves its own blog post, so over the next several weeks I’ll aim to write more extensively about each one.  In the meantime, this post provides a brief summary of the amended rules, and for those who would like to go to the 388-page source, here’s a link to the SEC release containing the final rule amendments.


The amount of capital raised in exempt offerings in the United States is at least twice the amount raised in SEC-registered offerings. Emerging companies rely on multiple rounds of exempt offerings as to enable them to scale, and the trend has been for such companies to defer initial public offerings in favor of late stage private funding or other liquidity events.  The exempt offering framework has developed over time through legislative changes and SEC rules, including Regulation D and SEC rulemaking under the JOBS Act of 2012.  The current exempt offering framework is widely regarded as extremely complex and made up of differing, exemption-specific requirements and conditions.

On June 18, 2019, the SEC issued a concept release that solicited public comment on possible ways to simplify, harmonize and improve the exempt offering framework to promote capital formation and expand investment opportunities while maintaining appropriate investor protections.  After processing the comments received in response to the concept release, the SEC proposed a set of amendments in March 2020 that would generally retain the current exempt offering structure but reduce potential friction points, address gaps and complexities and help provide viable alternatives to dominant capital raising tools.

On November 2, 2020, the SEC issued a final rule release adopted the amendments substantially as proposed.

Integration Framework Reforms

The integration doctrine seeks to prevent an issuer from improperly separating a single offering into two or more separate offerings in an effort to fit the “separate” offerings within registration exemptions that would not be available for the combined offering. The Securities Act integration framework consists of a mixture of rules and SEC guidance for determining whether ostensibly separate securities transactions should be considered part of the same offering.

The amendments establish a new integration framework with a general principle that looks to the particular facts and circumstances of two or more offerings, and focuses the analysis on whether the issuer can establish that each offering either complies with the registration requirements of the Securities Act, or that an exemption from registration is available for the particular offering.

The new integration framework appears in the form of an amendment to Rule 152 under the Securities Act.  New Rule 152 will provide that offers and sales will not be integrated if, based on the particular facts and circumstances of the offerings, the issuer can establish that each offering either complies with the registration requirements of the Securities Act, or is eligible for an exemption from registration.

The amendments also provide the following four non-exclusive safe harbors from integration:

  • Any offering made more than 30 days before the commencement of any other offering, or more than 30 days after the termination or completion of any other offering, provided certain conditions are met.
  • Offers and sales made in compliance with Rule 701, pursuant to an employee benefit plan or in compliance with Regulation S will not be integrated with other offerings
  • an offering for which a registration statement has been filed will not be integrated if it is made subsequent to (i) a terminated or completed offering for which general solicitation is not permitted, (ii) a terminated or completed offering for which general solicitation is permitted that was made only to qualified institutional buyers and institutional accredited investors, or (iii) an offering for which general solicitation is permitted that terminated or was completed more than 30 calendar days prior to the commencement of the registered offering; and
  • offers and sales made in reliance on an exemption for which general solicitation is permitted if made subsequent to any terminated or completed offering.

Offering and Investment Limit Reforms

The new reforms will increase the offering and individual investment limits for certain exempt offerings, as follows:

Regulation AThe maximum offering amount under Tier 2 of Regulation A will increase from $50 million to $75 million, and for secondary sales from $15 million to $22.5 million.

Regulation CrowdfundingFor Regulation Crowdfunding, the amendments (i) raise the offering limit from $1.07 million to $5 million, and amend investment limits for investors by not applying any investment limits to accredited investors and allowing non-accredited investors to rely on the greater of their annual income or net worth when calculating the limit on how much they can invest.

Rule 504 of Regulation DThe maximum offering amount under Rule 504 of Regulation D will increase from $5 million to $10 million.

“Test-the-Waters” and “Demo Day” Communications

The rule amendments include several changes relating to offering communications, including:

  • permitting an issuer to use generic solicitation of interest materials to “test-the-waters” for an exempt offering of securities prior to determining which exemption it will use for the sale of the securities;
  • permitting Regulation Crowdfunding issuers to “test-the-waters” prior to filing an offering document with the SEC in a manner similar to current Regulation A; and
  • providing that certain “demo day” communications will not be deemed general solicitation or general advertising.

Special Purpose Vehicles for Regulation Crowdfunding

The amendments will allow sponsors to use Regulation Crowdfunding to raise capital into a special purpose vehicle whose purpose is to invest in an operating company.  Previously, special purpose vehicles were excluded from Regulation Crowdfunding.

Other Reforms to Specific Exemptions

The amendments also:

  • change the financial information that must be provided to non-accredited investors in Rule 506(b) private placements to align with the financial information that issuers must provide to investors in Regulation A offerings;
  • add a new item to the non-exclusive list of verification methods in Rule 506(c);
  • simplify certain requirements for Regulation A offerings and establish greater consistency between Regulation A and registered offerings; and
  • harmonize the bad actor disqualification provisions in Regulation D, Regulation A and Regulation Crowdfunding.

Stay tuned to my next blog post on the new integration rules, my first deeper dive installment on the new reforms.


On October 21, 2020, the United States District Court for the Southern District of New York entered a final judgment on consent against Kik Interactive Inc. to resolve the Securities and Exchange Commission’s charges that Kik’s unregistered public sale of digital tokens in 2017 violated the federal securities laws.  The final judgment requires Kik to pay a $5 million penalty, obligates Kik for the next three years to provide notice to the SEC before engaging in certain offers or sales of digital assets and permanently enjoins Kik from violating the registration provisions of the Securities Act of 1933.  Kik sold its digital tokens to the public prior to achieving functionality, which under prevailing legal standards meant that the tokens were deemed to be securities and their sale without registration or exemption violated the securities laws. But despite some unfortunate factors relied on by the court, the case leaves open the possibility for the unregistered public sale of fully functional digital tokens whose development is completely funded through an earlier exempt offering round.

Factual Background

Kik Interactive Inc. is a Canadian corporation formed in 2009 to develop a mobile messaging application called Kik Messenger. Despite the application’s initial success and Kik’s raise of over $100 million in venture funding, the company was losing Kik Messenger users by 2017 and was expected to run out of cash by the end of that year.  After an unsuccessful effort through an investment bank to get acquired, Kik pivoted and adopted a plan to fund its operations through a two-stage initial coin offering of “Kin” digital tokens for in-app purchases on its blockchain network: initially through simple agreements for future tokens or “SAFT”s, followed by a public sale of Kin into which the SAFT rights would convert at a 30% discount.

From May to September 2017, Kik offered and sold SAFTs to accredited investors, raising approximately $49 million. Under the SAFTs, Kik was obligated to deliver half the Kin tokens into which the SAFT was convertible at the time that Kik delivered tokens to the general public and the other half on the one-year anniversary of the first delivery.  Kik filed a Form D with the SEC after the conclusion of the SAFT offering, claiming an exemption under Rule 506(c).

The terms of the SAFT included an aggressive deadline of September 30 for the public token sale (which would trigger the issuance of the first half of the conversion Kin) with a draconian forfeiture feature: if the September 30 deadline was not met, Kik would be required to return 70% of the cash invested in the SAFT round ($35 million of the $49 million raised) to the SAFT investors.

Kik began offering Kin to the general public during the same period of May through September 2017 in which it was conducting the offer and sale of the SAFTs. With the September 30 deadline looming, Kik proceeded with closing the public token sale one day after the SAFT offering was completed.  Kik raised an additional $50 million in the public sale, with proceeds paid in Ether currency.

Legal Background

Two months before bringing the lawsuit against Kik in June of 2019, the SEC published a framework for analyzing the circumstances under which a digital token would be deemed an investment contract and thus a security.  It was intended to assist compliance with the U.S. federal securities laws by startups seeking to be funded by an initial coin offering by providing a toolkit for applying the Supreme Court’s Howey test to determine whether digital tokens are deemed to be “investment contracts” and therefor securities.  Under Howey, a financial arrangement is an investment contract when there is an investment of money, in a common enterprise, with a reasonable expectation of earning a profit through the efforts of others.

Under the framework, the inquiry into whether a purchaser is relying on the efforts of others generally focuses on whether, at the time the digital tokens are sold, the sponsor of the tokens is responsible for the development, improvement, operation or promotion of the network, and whether there are essential tasks or responsibilities to be performed by a sponsor, rather than an unaffiliated, dispersed community of network users commonly referred to as a “decentralized” network.  Other areas of focus are whether the sponsor creates or supports a market or price for the digital asset, and whether the sponsor has a continuing managerial role concerning the network or the characteristics or rights the digital asset represents.

Basically, where the network or the digital token is still in development and not fully functional at the time of the offer or sale, purchasers would reasonably expect a sponsor to further develop the functionality of the network or digital asset.  Under such circumstances, purchasers would be determined to have a reasonable expectation of earning a profit through the efforts of others and the digital token would be deemed to be an investment contract and thus a security (assuming the other prongs of the Howey test are also satisfied).

The SEC’s Lawsuit Against Kik

The SEC sued Kik in June of 2019, alleging that Kik’s offering of Kin digital tokens violated Section 5 of the Securities Act.

The SEC devoted most of its complaint to asserting facts to establish that Kik failed the last two prongs of Howey, namely that purchasers of Kin had a reasonable expectation of earning a profit from Kin and that such profit would necessarily flow from the efforts of others, namely the managers of Kik. The focus of the SEC’s complaint was on three overarching factors: the manner in which Kik marketed Kin to investors, the lack of functionality of the Kin token and ecosystem and Kik’s motivation for selling Kin to the public prior to achieving functionality.

Kik was shown to have marketed Kin in a manner that emphasized Kik’s primary role in developing it and the potential for Kin to increase in value, rather than the underlying ecosystem and functionality of the token.  Kik promised prospective investors that it would create demand for Kin by building new products, services and systems for the Kin ecosystem, by modifying Kik Messenger, by implementing new technology to allow for scalable, fast and cost-effective transactions, and by building a “rewards engine”.  Kik also emphasized its experience and ability, and maintained that Kik itself intended to profit from Kin’s appreciation in value.

The complaint next asserted that Kik pursued the public sale without first achieving a decentralized economy for Kin, and without even ensuring that investors would be able to buy goods and services with the tokens upon their receipt. Instead, Kik pursued a “superficial Minimum Viable Product” in the form of digital cartoon “stickers”, intended as an added benefit to Kik Messenger users who purchased Kin. The stickers would appear inside Kik Messenger and would be available only to Kin buyers who also had a Kik Messenger account. The more Kin owned by a Kik Messenger user, the higher the user’s “status” level and the more stickers the user could access.  According to the SEC, Kik developed the stickers in an effort to create a hypothetical “use” for the tokens, which Kik believed was relevant to whether its public sales of Kin were securities transactions under the securities laws.

So why didn’t Kik just defer the public sale until the Kin token and ecosystem were functional? Apparently, the $49 million of proceeds would not give Kik enough runway to complete the development of the Kin ecosystem and it needed to raise additional funds in the public sale.  Moreover, Kik was racing against the SAFT’s aggressive deadline for completing the public sale and effecting the issuance of the first tranche of Kin to the SAFT investors; failure to meet the deadline would mean forfeiture of $35 million of the $49 million raised.

On the third anniversary of that deadline, Judge Alvin Hellerstein ruled that Kik had offered and sold securities without registration or exemption in violation of Section 5 of the Securities Act, granting the SEC’s motion for summary judgment and instructing the parties to submit a joint proposed judgment for injunctive and monetary relief.

Judge Hellerstein’s opinion consists of two basic findings: First, that the sale of Kin to the public was a sale of a security requiring either registration or exemption; and second, that although the pre-sale of SAFTs, if viewed in a vacuum, appeared to have qualified for an exemption under Rule 506(b), it was actually part of an integrated offering with the public sale, thus blowing the exemption.

As to whether Kin was a security, Judge Hellerstein applied the Howey test and focused largely on the last two prongs: whether there was (i) an expectation of profit, (ii) through the efforts of others.  In its marketing campaign, Kik stressed the profit making potential of Kin, saying it would be tradable on secondary markets.  Although Kik also characterized Kin as a medium for consumptive use for digital services such as chat, social media and payments, any such consumptive use was unavailable at the time of Kin’s public distribution and would only materialize if the enterprise became successful.  Kik conveyed the notion that growth in value would rely heavily on Kik’s managerial and entrepreneurial efforts, saying that it would “provide startup resources, technology and a covenant to integrate with the Kin cryptocurrency and brand”. The judge also stressed that Kik’s insistence that market forces would drive the value of Kin “ignored the essential role of Kik in establishing the market”.

Even assuming Kik had met the requirements for an exemption under Rule 506(c) (primarily, use of reasonable methods to verify that all purchasers were accredited investors), the exemption would be blown if the SAFT presale would be found to be integrated with the public sale.  That’s because the reasonable verification requirement was clearly not be met as to all the purchasers in the public sale.  In determining whether two ostensibly separate offerings should be integrated, a court considers whether the offerings (i) are part of a single plan of financing, (ii) involve issuance of the same class of securities, (iii) have been made at or about the same time, (iv) involve the same type of consideration, and (v) are made for the same general purpose.  Not all factors have to exist, and courts generally give the most weight to the first and fifth factor.

As to the first and fifth factor, the court found that the SAFT round and the public sale were part of a single plan of financing, effected for the same general purpose. Proceeds from both sales went toward funding Kik’s operations and building the Kin ecosystem.  The two offerings were intertwined in ways that went beyond the use of funds, and the court used as an example that under the SAFTs, investors could not receive their Kin unless there was a successful launch through the public sale.  The court also found that Kik offered and sold the same class of securities in the two offerings, namely fungible Kin that were equal in value.  Although investors in the two offerings received the tokens via different instruments with different rights, the court determined the ultimate result was distribution of identical assets.  Finally, the sales took place at about the same time.  The only factor weighing against a finding of integration is that Kik received different forms of consideration from the two sales (dollars in the SAFTs, Ether in the public sale).

On October 21, the court entered final judgment on consent requiring Kik to pay a $5 million penalty, obligating Kik for the next three years to provide notice to the SEC before engaging in certain offers or sales of digital assets and permanently enjoining Kik from violating the registration provisions of the Securities Act.


There are a few valuable takeaways from this case.

First, the facts and circumstances were such that made it extremely easy for the court to conclude that the Kin digital tokens were securities.  Because of the draconian forfeiture feature in the SAFT, Kik chose to speed up the public release of the tokens before reaching anything close to full functionality in order to avoid forfeiting $35 million.  Kik’s marketing materials overwhelmingly emphasized the investment potential of the Kin tokens, rather than their utility.  Not all future blockchain startups seeking to fund development through ICOs, however, will be under the kind of financial stress experienced by Kik, and should be able to resist the type of forfeiture feature the SAFT investors imposed on Kik.  More importantly, given the SEC’s and the courts’ emphasis on token functionality, it should be evident that the amount raised in a SAFT should ideally provide sufficient runway to complete the development of the digital token and the underlying network to achieve full functionality.

Second, the court’s integration analysis suggests a very high bar to avoid integration and a blown exemption.  Here again, the facts easily pointed to a conclusion that the presale and public sale should be integrated.  The Kin public sale closed the day after the SAFT round, and both had the same general purpose.  But the court also relied on two factors that could create unfair integration challenges to issuers in the future.  One of those factors was that SAFT investors could not receive their Kin tokens unless there was a successful launch through the public sale.  But that would be true of every SAFT, and the reliance on this point as a factor could throw into question the viability of SAFT based ICOs.  The court also maintained that both the SAFT and the public Kin sale involved the issuance of the same security despite the fact that, as the court acknowledged, the respective investors received their securities through different instruments with different rights.  This too is a universal feature in SAFTs and thus presents additional uncertainty to ICOs involving them.  Hopefully, the courts will have an opportunity soon to clear up this uncertainty.

Finders play a vital role in introducing startups to potential investors.  Yet the general requirement that persons soliciting investors must register with the Securities and Exchange Commission as broker-dealers and be subject to the SEC’s broker-dealer regulatory regime has been a source of much uncertainty for finders and companies alike and has posed a serious impediment to raising capital.  On October 7, a divided SEC voted to propose a limited, conditional exemption from broker-dealer registration for individual finders who engage in limited activities on behalf of issuers.  The proposal will undergo a 30-day comment period.  Its ultimate fate is uncertain, at least in the announced form, given the split vote and election uncertainties that could impact the SEC’s composition after November.


Section 3(a)(4) of the Securities Exchange Act generally defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”  Section 15(a)(1) of the Exchange Act generally makes it unlawful for any broker to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker is registered with the SEC. Consequently, absent an available exemption, a person engaged in the business of effecting transactions in securities for the account of others is a broker and required to register as such under the Exchange Act.

The question of whether a “finder” – a capital raising matchmaker with no involvement in negotiating price or other terms – is a “broker” within the meaning of the Exchange Act turns on the relevant facts and circumstances of each case.  Over the years, courts and the SEC have focused on whether a person participates on a regular basis in securities transactions at key points in the chain of distribution, including actively soliciting or recruiting investors, participating in negotiations, providing investment advice, handling funds or securities and, perhaps most notably, receiving transaction-based compensation.

The SEC has not previously recognized a “finders” exemption.  Instead, deal makers have sought guidance from SEC staff no-action letters addressing circumstances under which persons may act as “finders” without registering as broker-dealers.

Folks my age and older may remember pop singer Paul Anka for hits like Put Your Head on My Shoulder and “(You’re) Having My Baby,  but securities lawyers associate the name with an SEC no-action letter relating to acting as a finder without registration.  In 1991, Mr. Anka entered into an agreement with The Ottawa Senators Hockey Club Limited Partnership (the “Senators L.P.”) to provide it names of potential investors in exchange for a transaction-based success fee.  In its related no-action letter, the SEC staff stated it would not recommend enforcement against Mr. Anka if, without registering as a broker-dealer (and presumably without giving the staff a private performance of “Having My Baby”), he provided the Senators L.P. a list of potential investors he had a pre-existing relationship with and reasonably believed to be accredited, but with whom he would have no further contact concerning the Senators L.P.  The staff noted its no-action decision was also conditioned on Mr. Anka not engaging in the following activities: soliciting the prospective investors, participating in any general solicitation, assisting in the preparation of sales materials, performing independent analysis, engaging in “due diligence”, assisting or providing financing, providing valuation or investment advice and handling any funds or securities.

The Paul Anka no-action letter only has relevance, however, to one-off arrangements and does not give much comfort to finders seeking to introduce investors to issuers for a living.  The staff’s response noted that Mr. Anka had not previously engaged in any offering of securities (other than buying and selling securities for his own account), had not acted as a broker or finder for other private placements of securities and did not intend to participate in any distribution of  securities after the completion of the proposed private placement.  Accordingly, finders in the business of intermediating private capital-raising transactions have not been able to rely on the Paul Anka letter, and consequently have had to choose between registering with the SEC as broker-dealers and assuming the risk of not doing so including the possibility of an SEC enforcement action.  This has dissuaded otherwise well-connected individuals from acting as finders, thus denying many early stage companies and other issuers an important capital raising tool.

The Finder Exemption Proposal

The proposed finder exemption would provide a non-exclusive safe harbor from broker registration for two types of finders based on the activities in which they are permitted to engage and with conditions tailored to the scope of their activities. Tier I Finders would be limited to just providing names and contact information of prospective investors to issuers. Tier II Finders would be permitted to engage in limited solicitation efforts.

General Conditions

Both Tiers would be subject to the following general conditions:

  • Only for deals with issuers not required to be SEC reporting companies.
  • Only exempt offerings (i.e., no registered offerings).
  • Finder may not engage in general solicitation.
  • Potential investor must be an accredited investor, or finder has reasonable belief potential investor is an accredited investor.
  • Written agreement between finder and issuer describes services and fees.
  • Finder not an associated person of a broker-dealer.
  • Finder not subject to statutory disqualification.

Finders seeking to rely on the exemption would not be permitted to participate in transaction structuring, negotiating offering terms, handling funds, preparing of sales materials, providing independent analysis or due diligence, investment financing, providing valuation or investment advice and secondary offerings.

A few observations about the general conditions. An issuer’s failure to comply with the conditions of an offering exemption would not, in itself, make the broker-dealer exemption unavailable to the finder provided the finder can establish that he did not know and, in the exercise of reasonable care, could not have known, that the issuer had failed to comply.  But a finder who causes the issuer’s blown offering exemption would not be able to rely on the broker-dealer exemption.  Presumably, the condition that the finder not engage in general solicitation does not limit the exemption to only offerings that prohibit general solicitation; for example, the exemption could be available in offerings under 506(c), so long as the finder himself does not engage in any general solicitation act. Although not explicit, the prohibition on general solicitation implies that finders may only approach investors with whom they’ve had a pre-existing relationship.  The requirement that the potential investor be accredited suggests that the exemption would be unavailable if one of the finder’s potential investors was not accredited, even if all purchasers in the offering were.  Finally, if the proposal is approved, the written agreement requirement would make it prudent for finders to engage counsel to assist them with crafting appropriate engagement letters that conform to the ultimate rule, including provisions such as indemnification that are not mandated by the proposal but would provide additional protection.

Tier I Finders

Tier I Finders would be allowed to provide names and contact information of potential investors in connection with a single capital raising transaction by a single issuer in a 12-month period, but would not be allowed to have any contact with any potential investors about the issuer.  Basically, the exemption as to Tier I Finders is essentially a codification of the Paul Anka letter with a few additional requirements (non-reporting issuer, associated person and statutory disqualification), inasmuch as it prohibits solicitation activities and severely limits the frequency of transactions.

Tier II Finders

Tier II Finders would be allowed to solicit investors on behalf of an issuer and would not be subject to any transaction frequency limitation, provided the solicitation-related activities are limited to:

  • Identifying, screening, and contacting potential investors;
  • Distributing issuer offering materials to investors;
  • Discussing issuer information included in any offering materials, provided no valuation or investment advice is provided; and
  • Arranging or participating in meetings with the issuer and investor.

In exchange for being allowed to solicit investors and have the potential to engage in more offerings with issuers and investors, Tier II Finders would need to provide potential investors, prior to or at the time of the solicitation, certain disclosures that include:

  • Tier II Finder’s name;
  • Issuer’s name;
  • Description of relationship between Tier II Finder and issuer, including any affiliation;
  • Statement that Tier II Finder will be compensated by the issuer for their solicitation activities and description of terms of such compensation arrangement;
  • Any material conflicts of interest resulting from the arrangement or relationship between Tier II Finder and issuer; and
  • Affirmative statement that Tier II Finder is:
    • acting as an agent of the issuer;
    • not acting as an associated person of a broker-dealer; and
    • not undertaking a role to act in the investor’s best interest.

The foregoing disclosures may be made orally, provided they are subsequently made in writing (including electronically) prior to or at the closing.  To help ensure the investor receives the required disclosures, a Tier II Finder would also need to obtain from the investor, prior to or at the time of any investment in the issuer’s securities, a dated written acknowledgment of receipt of the Tier II Finder’s required disclosures, which can also be satisfied electronically.

Seeking Comments

The SEC is seeking comments with respect to 45 questions relating to the proposed finders exemption.

As to whether the exemption should be limited to natural persons, I think the answer is no.  Most finders operate through an entity for limited liability purposes.  Restricting the exemption to natural persons would deny those individuals the protection of limited liability otherwise afforded them by doing business through an entity.

As to the question of whether the finder should be prohibited from engaging in general solicitation, it strikes me that the accredited investor requirement mitigates the investor protection concern.  I would analogize the circumstances here to Rule 506(c) offerings, where the allowance for general solicitation is mitigated by the requirement that all purchasers be accredited investors.  Shouldn’t the same principle apply here?

On the question of whether the agreement between Tier II Finders and the issuer should subject the issuer, without affecting the finder’s obligations, to liability to investors for the finder’s misstatements, I would say maybe. Although the issuer cannot always control the finder, the issuer can protect itself by negotiating in engagement letters for reciprocal indemnification by the finder of the issuer for losses suffered as a result of third party claims over finder misstatements.

On the question of whether finders should be prohibited in certain circumstances from receiving transaction-based compensation, and instead be required to receive compensation that is not tied to the success of the transaction (i.e., a fixed fee or other arrangement), I would say no.  In the real world, finders and issuers will not work together if the finder may not be paid a transaction based fee.

The Securities and Exchange Commission expanded the definition of “accredited investor” by adding new categories of investors that have sufficient investment knowledge and expertise to participate in private investment opportunities.  The amendments mark a shift away from wealth as the sole focus of eligibility.  The new rule is effective 60 days after publication in the Federal Register.


All sales of securities in the U.S. must either be registered with the SEC (expensive, time consuming and triggers ongoing public reporting) or qualify for an exemption.  The most common exemption is under Rule 506(b) of Regulation D, which allows an unlimited number of accredited investors and up to 35 non-accredited investors.  If all purchasers in a Rule 506(b) offering are accredited investors, however, the issuer need not satisfy the specific, mandated disclosure obligations of Regulation D, which explains why the vast majority of Rule 506 offerings are sold only to accredited investors.[1]

Until now, the rules for determining accredited investor status used wealth as a proxy for financial sophistication.  Specifically, individuals needed to satisfy either an income test ($200,000 in each of the last two years or $300,000 jointly with a spouse) or a net worth test ($1 million without including a primary residence). In its rule release, the Commission stated that it doesn’t believe wealth should be the sole means of establishing financial sophistication of an individual for qualification purposes.  Rather, it can be demonstrated by the ability to assess an investment opportunity, i.e., the ability to analyze risks and rewards, capacity to allocate investments so as to mitigate or avoid risks of loss or the ability to gain access to information about an issuer or about an investment opportunity.

Amended Accredited Investor Definition

The new definition creates new categories of individuals and entities that qualify as accredited investors irrespective of their wealth, on the basis that such investors have demonstrated the requisite ability to assess an investment opportunity.

The amended definition adds the following natural persons:

  • natural persons holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the Commission has designated as qualifying an individual for accredited investor status; and
  • natural persons who are “knowledgeable employees” of a private-fund issuer of securities being offered.

In a separate related order, the SEC designated the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative (Series 65) as the initial certifications, designations or credentials referred to in the first new category above.

For entities, the amended definition adds the following categories:

  • SEC- and state-registered investment advisers and rural business investment companies;
  • limited liability companies with total assets in excess of $5 million;
  • entities not formed for the specific purpose of acquiring the securities offered and owning investments in excess of $5,000,000;
  • family offices (i) with assets under management in excess of $5 million, (ii) that are not formed for the specific purpose of acquiring the securities offered, and (iii) whose prospective investment is directed by a person who has such knowledge and experience in financial and business matters that it is capable of evaluating the merits and risks of the prospective investment; and
  • family clients of a family office meeting certain requirements.

In a sign of the times, the amendment allows natural persons to include joint income from “spousal equivalents” when calculating joint income, and defines spousal equivalent as a cohabitant occupying a relationship generally equivalent to that of a spouse.

Interestingly, some commenters during the comment period expressed support for geography-specific financial thresholds that scale for geography and would lower the thresholds in states or regions with lower cost of living, noting that income and cost of living tends to be higher in coastal cities.  In its rule release, the SEC did acknowledge that geographical income and wealth disparities may lead to concentrations of accredited investors in large coastal cities, but determined not to add geography-specific financial thresholds because of the complexities they would create for issuers and investors.  Nevertheless, the SEC believes the new accredited investor criteria would help mitigate the disparate geographic effects of the current wealth-based criteria by including non-wealth-based alternative criteria for natural persons to qualify.

Predicted Outcome

Although the expanded accredited investor definition will certainly increase the number of qualifying individuals, it’s tough to estimate how many people who hold relevant certifications or designations already qualify under the existing income or net worth tests.  Consequently, it’s difficult to predict how many newly eligible accredited investors the amended rule will actually create.  The SEC itself stated that it expects the number of newly eligible accredited investors to be insignificant relative to the existing number, and that the amount of capital to be invested by newly eligible accredited investors to have only “minimal effects” on the private offering market.  Finally, perhaps the shift away from wealth as the sole focus of eligibility will in fact result in a de-concentration of accredited investors away from coastal cities and the major startup hubs of Silicon Valley, New York City and Boston.


1  Rule 506(c) offerings, an alternative to Rule 506(b), require all purchasers to be accredited investors (because the exemption allows the issuer to use means of general solicitation to find investors) and the issuer must use reasonable methods of verification to determine accredited investor status.

This past June, autonomous vehicle technology startup Zoox agreed to be acquired by Amazon for a whopping $1.3 billion.  Time for the common stockholders to pop the champagne, right?  Not exactly, according to a complaint filed in the Delaware Court of Chancery by two common stockholders.  Although many details have been redacted from the public version of the complaint, it alleges that the common stockholders’ share of the $1.3 billion purchase price is dwarfed by the cash and stock bonuses payable to Zoox executives, let alone the liquidation preferences payable to the venture capital investors. The complaint also alleges that Zoox’s valuation was nearly $2 billion higher in 2018, and that a recent competing bid ignored by Zoox was more favorable to the common holders than the Amazon deal.  The fact pattern of the Zoox case illustrates the friction that often exists between preferred and common stockholders of venture backed companies in the context of proposed acquisitions, as well as efforts made by such companies and their VC investors to neutralize common stockholder and management opposition.

Motivations to Resist

There are several factors that may motivate management and common stockholders of a venture backed company to resist a proposed acquisition, even one with a seemingly attractive purchase price.

First, some background on exits.  VCs need to exit a portfolio company within a few years of making the investment in order to return proceeds to their limited partners before the expiration of the VC fund, which is typically ten years after fund formation.  Unlike investors in public companies who can generally exit by selling their shares into a public market with ready buyers, VCs have no secondary market into which they can sell shares in most if not all of their portfolio companies and can only exit in an initial public offering, acquisition or liquidation of the company.

Of the three exit scenarios, IPOs are on balance the most favored by executives.  They provides the greatest likelihood of job security and typically result in less oversight and scrutiny of management because the company is transitioning from being privately held by VC investors exercising contractual control rights to a more diffuse ownership.  Also, in an IPO, preferred holders almost always are forced to convert into common under the terms negotiated in the certificate of incorporation; that usually guarantees the IPO terms to be favorable to the common holders because otherwise the preferred would not support proceeding with the offering.

By contrast, an acquisition has a tendency to present less job security to management than an IPO, particularly if the acquirer is a strategic buyer that has its own management team in place.  Even if the management team survives the acquisition, it will likely face greater operational oversight than in an IPO because it will have only one owner – the acquirer – rather than diffuse ownership in an IPO.

As for the common stockholders, including founders, executives and employees who own restricted stock or options, an acquisition may not yield any return on their common shares if there have been large amounts of VC investment in the company and the aggregate dollar amount of liquidation preference exceeds the purchase price in the acquisition.  In such a scenario, the preferred holders would be entitled to receive all of the acquisition proceeds and the common holders would receive nothing, leaving the common stock worthless.  Such holders would also be forfeiting future upside in their equity, and may believe that the company is on an upward trajectory and could be sold down the road for a much higher price that would clear the liquidation preference stack and produce greater returns for the common.

Means to Resist

Management and common stockholders have several arrows in their respective acquisition resistance quivers.  Management cooperation is critical to an acquisition process, and executives could choose not to cooperate.  They may even exploit their position as gatekeepers by not informing the board or the VCs of acquisition inquiries.  Many acquisitions, particularly by financial buyers, depend on executives continuing to manage the business post-closing and management could sabotage a deal by refusing to commit to stay on.

Common stockholders also have several means to resist an acquisition they disfavor.  First, although few venture backed company boards are controlled by the common stockholders, the common often maintain significant influence on the board nonetheless.  Under most voting agreements, the common are entitled to one or more board seats with at least one seat going to independent directors.  Common stockholders could pressure their board designees to reject a proposal and to seek to influence independent directors to do so as well.  Directors owe fiduciary obligations to all stockholders, and independent directors may be more reluctant to support a proposed acquisition opposed by the common holders.  Further, many boards seek unanimity with respect to a vote on a significant transaction such as an acquisition because of the threat of litigation.  Second, mergers and acquisitions almost always require some level of stockholder approval and common stockholder opposition could matter if the relevant state statute or the terms of the deal require a supermajority vote, in which case a minority group could block a deal if it constitutes a large enough percentage so as to prevent the company from securing the requisite vote threshold.  Certain states such as California require that acquisitions be approved by each class of voting securities, giving the common a class veto irrespective of the percentage the common represents of the outstanding voting shares.  Acquirers sometimes condition a deal on 90% or some other level of supermajority approval, thereby creating a veto opportunity for the common. Finally, common stockholders could threaten litigation, although this tactic does involve reputational risk associated with opposing a deal favored by the investors; founders and executives following an exit often recycle themselves in another startup, in which case they could likely find themselves seeking either VC funding or employment from a VC backed company.

Carve-out Plans to Overcome Resistance

Companies and VCs could try to overcome management and common stockholder resistance through a carve-out plan.  Executives could be offered bonuses under a carve-out plan linked to completion of an acquisition.  Whether or not such a bonus would be economically dilutive to VCs depends on whether and to what extent the acquisition proceeds exceed the liquidation preference stack.  If it does, aggregate bonuses within such excess would not come out of the VCs’ pocket.  By way of example, if the acquisition price is $100 million, the liquidation preference stack is $95 million and the aggregate bonuses are $4 million, the company will pay out (i) $4 million to the executives in bonuses, $95 million to the VCs and $1 to the common stockholders.  Such bonuses would not cost the VCs anything but rather would come out of the common stockholder payout.  It appears the foregoing scenario is what happened in the Zoox deal, causing the common holders to assert that the payout to them is dwarfed by the bonuses payable to executives.

A management carve-out plan typically designates either a percentage of acquisition proceeds or a fixed amount to be paid to plan participants.  The typical size pool is around 10% of acquisition consideration, but may vary with the number of participants in the plan or shift on a sliding scale depending on the amount of consideration.  For example, the pool could be 8% if the consideration exceeds $80 million, 10% if it exceeds $100 million and 12% if it exceeds $120 million.  “Consideration” for the purpose of calculating the pool typically assumes no carve-out plan and excludes transaction expenses.  The portion of a pool attributable to an earn-out or escrow would be payable to participants only if and when it’s paid to stockholders.  Participation could be broad-based, although it’s typically limited to senior executives whose retention is crucial to the acquisition process.  Allocation of value within the pool could be extremely flexible and could be linked to factors such as rank, tenure and base pay.  Rights in the plan typically don’t vest until the acquisition closes so that anyone who leaves beforehand would forfeit his or her benefit.  Adoption of a plan often necessitates a charter amendment to designate the preference of the carve-out plan over the capital stock.

Similarly, to overcome common stockholder opposition, a carve-out plan could be adopted so that some agreed upon amount is carved out of the preferred holders’ liquidation preference and paid to the common.  Obviously, the preferred holders would need to agree.  Common stock carve-outs are more likely to occur when the VCs don’t control the board (and need to sway one or more independent or common stockholder designee directors), when the common stockholders get a class vote and/or when the common would otherwise get wiped out.  Occasionally, carve-outs are conditioned upon common stockholders signing liability waivers and/or upon representative directors voting in favor of the acquisition.

Board Duties and Liability

When a board is asked to approve a management carve-out plan, it must consider its fiduciary obligations to maximize value for all stockholders.  On a very basic level, a management carve-out reduces the amount that would otherwise go to the stockholders.  As mentioned above, whether the proceeds of the plan get carved out of the preferred’s share or the common’s share depends on whether the acquisition proceeds exceed the aggregate liquidation preference amount.  Accordingly, in considering the adoption of a carve-out plan, the board risks being the target of litigation for breach of fiduciary duty or corporate waste if the plan is not carefully structured so that it fairly allocates financial burden between the common and preferred.

Because of the inherent conflicts that result from the presence on the board of preferred stockholder designees, director conduct may not receive the benefit of the deferential standard of the business judgment rule, and instead may be judged by the stricter standard of entire fairness under which both price and process must be proved to be fair to avoid liability.  Risk could be mitigated by having the process run by a special committee of disinterested directors, and further mitigated through stockholder approval (which would be generally required if the plan is carved out from the preferred holders’ liquidation preference).

The controlling case here is the 2013 Delaware case of In Re Trados, where the acquisition of a VC-backed company resulted in senior management receiving payments under a carve-out plan, and the common stockholders receiving nothing and sued the directors for breach of fiduciary duties.  In applying the entire fairness standard, the court held that although the directors failed to execute a fair process there was no liability because the common stock was worthless even without the carve-out plan.  In other words, the aggregate liquidation preference exceeded the acquisition consideration which meant the plan proceeds were carved out of the preferred holders’ payout.

It’s no shocker that the Coronavirus pandemic has slowed down venture capital investment dramatically, with 2020 now on pace to be well below the high levels of the past couple of years.  According to Pitchbook, VC deal flow through June 28 fell to just 4,675 funding rounds as compared with 6,357 in the first half of last year.  But a drop in dealmaking volume may not be the pandemic’s only impact on the VC market.  In the immediate aftermath of the dot com meltdown in 2001 and the financial crisis in 2008, VCs were able to negotiate for more favorable terms to protect their investment as a result of lower investment supply and the leverage that comes with it.  It stands to reason that we will see the same phenomenon now, with the pendulum swinging back in favor of VCs.  Consequently, companies and their founders need to understand these pro-investor terms so that they could at least try to minimize their severity and make good dealmaking decisions overall.  This blog post will review several of the deal terms most likely to be targeted by VCs in reaction to new market realities.

Liquidation Preference

Investors may seek to enhance their liquidation preference rights in two ways: preference multiple and participation.

In a normal, reasonably competitive market, such as existed the last several years, liquidation preference multiples have settled at one.  On a sale of the company, the VC would first get its money back.  Simple and fair.  It’s also consistent with what liquidation preference is intended to be, namely downside protection.  In a disappointing ultimate strategic outcome for the company, the investor arguably should get the amount of its investment back, plus accrued and unpaid dividends, before the common holders receive anything.

Investors are likely now to negotiate for some multiple of their investment, i.e., 1.5x, 2x, 3x, etc., on the theory that the deterioration of the risk/reward profile means that the investor should receive a higher reward upon exit to compensate for the greater risk.

Investors are now also likely to negotiate for participating preferred, i.e., the right to participate, after receiving their liquidation preference, in remaining proceeds with the common shareholders on a pro rata, as converted basis.  Participating preferred is often referred to pejoratively as a form of double-dipping, and in fact VCs rarely received it in recent years.  Without it, upon a sale of the company, investors would just compare the amount of the preference against the amount they’d receive on conversion and take the higher amount.  With participating preferred, they get both.

My view is that companies have the better argument here in that participating preferred goes way beyond liquidating preference’s intended purpose of providing downside protection.

Redemption Rights

A right exercisable by the investor that the investor be bought out after a certain number of years could be extremely risky to a company.  Most companies will not have the cash on hand or access to debt or equity financing needed to satisfy the redemption obligation.  The practical result of the redemption period expiring is a shift in leverage in favor of the investor to force either a sale of the company or a renegotiation of existing investment terms.  Over the last several years, VC deals have not included redemption rights.  The perceived longer path to liquidity, however, will now likely cause investors to seek redemption rights, particularly in later stage deals.  They may also seek shorter periods before redemption rights become exercisable, e.g., three years rather than five or seven.  One way for a company to mitigate the effect of redemption is to negotiate for deferred payment of the redemption price.  Investors may also require a company to create a sinking fund to ensure adequate capital for the redemption.


Investors will almost always get protection against economic dilution in the form of anti-dilution provisions which adjust the conversion rate of the preferred into common resulting in a larger number of common shares upon conversion in the event of a down round.  The method of calculating the conversion price adjustment is often the subject of negotiation.  In normal market conditions, most anti-dilution provisions are based on a weighted average formula which takes into account the number of shares issued in the down round relative to the number of shares outstanding, i.e., the actual dilutive effect of the round.  But there are different ways of calculating shares outstanding to arrive at the weighted average adjustment.  “Broad-based” anti-dilution is more founder-friendly than a “narrow-based” anti-dilution formula because it is more inclusive in terms of what is deemed outstanding resulting in less dilution than a narrow-based formula.  A broad-based weighted average formula would typically include within outstanding shares not just common shares actually outstanding, but also all shares issuable on exercise of options and on conversion of convertible securities such as preferred stock.  In contrast, a narrower formula might include in the calculation of outstanding shares only those shares of common that are actually outstanding (i.e., excluding shares of common issuable on conversion of options, warrants and, potentially, even the preferred stock itself).  While narrow-based anti-dilution formulas are more investor-friendly, the most investor-friendly category of anti-dilution protection is “full ratchet” anti-dilution which adjusts the conversion price all the way down to the lower down round price irrespective of the actual number of additional shares issued in the down round, i.e., regardless of its dilutive effect.

With additional leverage moving their way, VCs could be expected to negotiate for greater anti-dilution protection.  In most cases, I expect investors will only seek a more narrow-based version of weighted average anti-dilution protection by including fewer categories of options and convertible securities in the calculation of fully-diluted outstanding shares.  In more extreme cases, they may push for a full ratchet anti-dilution feature.

Preemptive Rights

VCs typically receive preemptive or pro-rata rights, i.e., the right to participate in a future round in proportion to ownership.  Normally, these rights don’t generate much friction in a negotiation, with any negotiation here being typically limited to which categories of issuances would be excluded and thus outside the reach of the right.  As a practical matter, preemptive rights are usually waived by investors in connection with subsequent rounds.

In the current environment, it could be expected that VCs will negotiate for the right to invest in subsequent rounds above their pro-rata ownership, perhaps 1.5x – 2x their ownership interest. This enhanced right could be valuable because it would allow investors to “load up” on successful portfolio companies in subsequent financings.

Cram Downs

A significant portion of those rounds that will successfully close in this climate will likely be down rounds, which typically result in harmful consequences and thus a serious morale problem for founders and employee holders.  Earlier preferred stock investors are protected with antidilution rights which get triggered in a downround resulting in a more favorable conversion rate and ultimately more common shares on conversion.  But that comes at the expense of greater dilution to the common holders.  Another consequence of a down round is that it often results in employee stock options being underwater.  These events could result in a serious hit to company morale.

To combat the foregoing morale issues, VCs may seek to force earlier investors to bear the brunt of the down round by either waiving their anti-dilution rights, which would minimize the dilutive hit to the common holders, or converting their preferred shares outright into common which would remove much of the preferred stock liquidation preference stack above the common holders.  Convincing previous investors to waive antidilution rights or convert is no easy task but, if successful, could greatly benefit employee holders and the new investors by reducing the amount of liquidation preference outstanding and giving the remaining preferred stockholders greater control over the company.

The impact of the Coronavirus and COVID-19 on venture capital investment will likely be similar to what we saw in the aftermath of the 2008 recession and the 2001 dot-com meltdown. VC investors will redirect their attention away from sourcing new deals and toward managing their existing portfolios, trying to determine which should survive and which should be liquidated or shut down. Faced with a distressed investment market, many surviving companies without sufficient reserves will be forced to try to raise additional funds in “down rounds”, i.e., at pre-money valuations lower than the post-money valuation of their previous round. This blog post will address the resulting economic dilution and other consequences to previous investors and founders, as well as the protection against economic dilution that VCs always negotiate for.

Economic Dilution

The first consequence of a down round is economic dilution to founders and previous investors. Suppose a company raises $4 million in a Series A round at $1 per share at a pre-money valuation of $12 million ($16 million post-money). The investor would receive 4 million shares constituting 25% of the post-money capitalization. Now imagine the company is later forced to raise an additional $4 million but at a pre-money valuation of only $10 million. The company would issue the new investor 6,400,000 shares at $0.625 per share ($10,000,000/16,000,000 shares). As a result, the previous investor’s shares would now be worth only $2.5 million (4 million shares x $0.625), a $1.5 million writedown from its original $4 million value representing economic dilution of 37.5%.

Enhanced Rights

Just as down round investors negotiate aggressively on valuation, they also tend to push for more favorable features in other non-price terms. If the lower valuation and lower price reflect the new investors’ perception of higher risk, down round investors are likely to want to protect against such greater risk with enhanced rights such as multiple, senior and participating liquidation preferences, milestone based staggered funding, cumulative dividends, redemption, board control, senior tag-along and drag-along rights, more robust vetoes and other enhanced rights. Faced with no alternatives, companies may have no choice but to accommodate these demands.

Underwater Shares

The aggressive terms sought by down round investors would typically leave existing shareholders worse off. But because the approval and/or cooperation of these shareholders may be needed to complete the down round and beyond, the company may be forced to sweeten the deal for these shareholders. For example, if the down round investors demand a multiple liquidation preference, the shares held by junior preferred and common shareholders could be worthless. In the hypothetical $4 million down round above, if the down round investors negotiate for and receive a 4x liquidation preference, they would receive $16 million off the top from the proceeds of any sale of the company and the other shareholders and optionee employees would get nothing unless the company were sold for more than that.

One source of leverage earlier preferred investors often have at their disposal is that they typically have a series-based veto over future funding rounds, i.e., a funding round requires the consent of some vote threshold of that series of preferred. Similarly, founders and other key employees may have leverage to the extent they’re considered indispensable to the future operations and ultimate success of the company. This in turn may result in the down round investors being forced to relax their position, or the company agreeing to more favorable voting rights for the preexisting investors and founders or other protections to ensure against any transaction that doesn’t result in any portion of proceeds paid to them.

Anti-(Economic)Dilution Protection

An earlier round investor can protect itself against percentage dilution from a subsequent round by exercising its preemptive rights to buy its pro rata share of the next round, thus preserving pre-round percentage ownership. But the preemptive right holder may not have the means to participate in the next round. One way to protect against economic dilution from a subsequent down round is through exercising a veto right over future issuances. But a veto right will only give an investor the ability to block a transaction; if the investor waives the veto or otherwise elects not to exercise, the veto won’t protect the investor from the negative economic impact. For that kind of protection, the investor will need to negotiate in advance for anti-dilution protection in the form of price adjustments. Preferred stock is almost always convertible into common based on a conversion formula that typically starts out at a 1:1 ratio, i.e., one common share on conversion for every preferred share owned. If there’s a down round, the anti-dilution provisions kick in and automatically adjustment downward the conversion price of the holder’s preferred shares resulting in a larger number of common shares being issued to the investor upon conversion.

The magnitude of the conversion price adjustment, and thus in the number of additional shares issuable upon conversion, depends on which of the three basic formulas are used: broad-based weighted average, narrow-based weighted average and full ratchet. In either type of weighted average anti-dilution formula, the adjustment amount will depend on the relative size of the down round and measured by comparing the number of shares issued in the down round against the number of shares outstanding on a fully-diluted basis, with the difference being how broadly or narrowly “fully-diluted” is defined.

Under a broad-based weighted average formula, we look at the number of common shares outstanding on a fully-diluted basis after giving effect to the exercise or conversion of all outstanding warrants, options, convertible securities or other equity derivative securities. This formula dampens the magnitude of the conversion price adjustment the most by spreading the dilutive effect over the most possible securities.

The narrow-based weighted average formula, on the other hand, only takes into account currently outstanding common and preferred stock, or in a more granular version only outstanding common stock and issuances of common stock equivalents at a conversion or exercise price lower than the then applicable conversion price (e.g., in-the-money stock options). A more extreme version of this formula only includes the protected security and the dilutive issuance itself (together with outstanding common). In any event, this type of formula provides an intermediate adjustment by arriving at a blended conversion price higher than the down round price.

The most extreme version of anti-dilution and the most protective for the preferred shareholder is called full ratchet because the conversion price would simply ratchet all the way down to the down round price irrespective of how few or how many shares were issued in the down round. This results in the largest downward adjustment in the conversion price and greatest upward adjustment of shares on conversion to the protected holder and the most dilution to junior security holders.

One overlooked impact of anti-dilution rights is that they also increase the voting power of the rights holder, but whereas the economic impact of the additional shares resulting from a lower conversion price is only experienced upon a liquidity event such as a sale of the company, the shift in voting power happens right away because voting on general matters at the common stock level is based upon shares owned on a fully-diluted basis.

As mentioned above, anti-dilution adjustments cause junior investors and common stockholders who have no anti-dilution protection to suffer disproportionate dilution from the down round. The value of their securities shrinks as a proportion of the pre-money capitalization of the down round. Consequently, approval for the down round (if required) may be difficult to secure from these stockholders without an upward adjustment to the conversion price of the protected holder’s shares (i.e., higher than if the anti-dilution adjustments were strictly followed) and, even where junior security holder approval is not needed, it may be necessary to sweeten the deal for founders and key employees by offering them additional stock options or bonuses in order to retain and incentivize them.

Title III crowdfunding may be an attractive capital raising alternative during the current Coronavirus pandemic because it allows companies to use the internet to solicit potential investors and not be restricted to accredited investors. But some of the requirements under Regulation Crowdfunding may diminish its utility for issuers with urgent capital needs as a result of COVID-19. Recognizing this, the Securities and Exchange Commission on May 4 stepped up and issued temporary final rules relaxing certain timing and financial information requirements for offerings initiated under Regulation Crowdfunding between May 4 and August 31. The temporary rules allow issuers that meet certain eligibility criteria to assess interest in a Regulation CF offering before having to prepare full offering materials, and then once launched, to close the offering and have access to funds sooner than would be possible without the temporary relief. The temporary rules also provide an exemption from certain financial statement review requirements for issuers targeting $250,000 or less within a 12-month period in reliance on Regulation CF.


To be eligible for the relaxed temporary rules, an issuer must have been organized and have had operations for no less than six months prior to the commencement of the offering. The SEC believes this eligibility requirement is appropriate because the temporary relief is intended primarily to assist existing companies that require additional funds because of adverse effects caused by the closures and safety measures designed to slow the spread of COVID-19, not newly formed companies. In addition, a company would be ineligible if it previously conducted a Regulation CF offering but failed to comply with its requirements.

Omission of Financial Statements from Initial Form C Filing

An issuer seeking to conduct a Regulation CF offering to address urgent funding needs triggered by COVID-19 may not have current financial statements available, or may have difficulty securing reviewed or audited financials due to the crisis. Therefore, under existing Regulation CF rules that require reviewed or audited financials, such an issuer may find it difficult to launch a timely offering. The issuer may also be more reluctant to incur the cost of reviewed or audited financials during the pandemic without some indication the offering has a chance of succeeding.

The temporary relief will allow issuers to go live with offering information on a funding portal prior to posting financial statements. Specifically, the temporary rules allow eligible issuers to omit required financials in the initial Form C filed with the SEC, to the extent such financials are not otherwise available, and commence its offering on the funding platform. The financials must then be included in an amendment to the Form C and provided to investors and the portal before the portal accepts any investment commitments. This will allow issuers to test the waters and gauge investor interest in an offering before going through the effort and expense of preparing financials.

Increase in Dollar Threshold Triggering Reviewed Financials

Under existing rules, an issuer targeting more than $107,000 but not more than $250,000 in a 12-month period must provide financial statements that are reviewed by an independent public accountant. The SEC recognizes that obtaining reviewed financial statements could pose serious challenges to an issuer with immediate capital needs due to COVID-19. By allowing issuers to gain more timely access to capital, the temporary rules are expected to benefit eligible issuers affected by COVID-19 that may be facing unexpected delays in securing financing due to a temporary inability to retain an independent accountant.

Accordingly, the temporary rule allows eligible issuers in offerings of up to $250,000 (rather than $107,000) to provide financial statements that are only certified by the principal executive officer, assuming reviewed or audited financials are not otherwise then available.

Suspension of 21-Day Requirement

Current rules provide that information in an offering statement must be publicly available for at least 21 days before securities may be sold, although the funding portal may accept investment commitments during that time. In light of the need for expedited access to capital among small business issuers affected by COVID-19, the temporary rules replace the 21-day rule with a requirement that the intermediary make the mandated issuer information publicly available on its funding platform before securities are sold in the offering. Accordingly, an issuer may close a raise during the temporary rule offering period as soon as it’s raised the target offering amount, even if the offering hasn’t been live for 21 days, as long as the closing occurs at least 48 hours after the last investment commitment and the funding portal notifies investors of the early closing.

Relaxation of Cancellation Process

Regulation CF investors normally have an unconditional right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the offering materials. If an issuer reaches its target offering amount before the stated deadline, it may close the offering only if: (i) the offering remains open for a minimum of 21 days; (ii) the intermediary provides notice about the new offering deadline at least five business days before the new deadline; (iii) investors are given the opportunity to cancel their commitment until 48 hours prior to the new deadline; and (iv) at the time of the new deadline, the issuer continues to meet or exceed the target offering amount.  Although these rules are intended for investor protection, the SEC acknowledges they may also diminish the utility of Regulation CF for issuers with urgent capital needs as a result of COVID-19.

To provide relief to issuers with urgent funding needs, the temporary rules provide that any investor seeking to cancel a commitment must do so within 48 hours of making the commitment, unless there’s a material change to the terms of the offering or to the information provided by the issuer. In addition, once an issuer has received binding commitments (i.e., commitments for which the 48-hour general cancellation period has run) that equal the target offering amount, the issuer may close the offering on a date earlier than the deadline identified in its offering materials. In order to do so, the issuer must comply with additional disclosure requirements and the intermediary must provide notice that the target offering amount has been met, but is not required to provide the five business days’ notice of the earlier closing deadline, as would normally be required.

As mentioned above, the temporary relaxed rules apply only to offerings initiated under Regulation CF between May 4 and August 31, 2020.