“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  Along with this spate of SPAC liquidations, 143 SPAC IPOs have withdrawn this year and 46 de-SPAC transactions (acquisitions of operating companies by SPACs) were terminated.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.


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

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

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

So what are those legal, contractual and market impediments?

Securities Laws

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

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

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

Contractual Restrictions

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

Market Factors

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

Small Business Capital Formation Advisory Committee

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

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

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

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

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

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

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

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

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

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

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

Poison Pill Exemption

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

Material Adverse Effect

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

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

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

Reverse Breakup Fee

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

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

Ordinary Course Covenant

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment Activity

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

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

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

Fundraising Activity

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

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

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

Exit Activity

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

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

Predictions for 2022

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

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

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

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