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.

COVID-19 induced declines in private and public company valuations have left many employee stock options “underwater” or “out-of-the-money”, i.e., exercise prices exceeding fair market value. This is a problem for employees and companies alike. Underwater options no longer serve their retention and incentivization objective, but nevertheless use up finite authorized shares and count against authorized capital and option plan caps. Consequently, companies should seriously consider restoring financial incentives by either repricing or exchanging the underwater options. This post will review stock option repricings and exchanges, and will address relevant corporate governance, securities law, accounting and investor relations considerations relating to each technique.

Option Repricing

In a true repricing, the company unilaterally reduces the exercise price of the underwater option, either by amending the existing option grant/option agreement or by cancelling the option and replacing it with a lower priced option.

The primary advantage of the repricing technique is its simplicity. Another advantage applicable to public companies is that repricing does not generally trigger the federal securities laws’ tender offer rules.

There are a few disadvantages. First, stockholders generally view repricings unfavorably as a windfall to employees not shared by existing stockholders. Second, NYSE and Nasdaq listed companies must secure stockholder approval unless the plan under which the options were granted explicitly allows repricings without such approval. In soliciting stockholder approval, a public company must disclose in a proxy statement all material information necessary for stockholders to make an informed decision, including the reason for the repricing, historical price variations, the employees eligible to participate in the offer and what happens to shares underlying repriced options. Proxy advisory firms (e.g., ISS, Glass Lewis) generally oppose repricings unless the vesting schedule is adjusted, the exercise price is reset at or above fair market value and the repricing proposal excludes officers and directors. ISS has indicated that repricing underwater stock options after a recent precipitous drop in a company’s stock price demonstrates “poor timing and warrants additional scrutiny.” Further, ISS has indicated that the options being repriced should have been granted “far enough back (two to three years) so as not to suggest that repricings are being done to take advantage of short-term downward price movements.” As a result, repricings as a practical matter are typically limited to underwater options where the exercise price of the surrendered option is above the stock’s 52-week high, where officers and directors are either excluded or included on less favorable terms and where the new stock option has a longer vesting period than what remains under the cancelled stock option.

On April 8, 2020, ISS issued COVID-19 specific guidance, which stated that, during the pandemic crisis, ISS will generally recommend opposing any repricing that occurs within one year following a steep drop in a company’s stock price and will examine specific repricing factors, such as whether surrendered options are added back to the plan reserve, whether replacement awards vest immediately and whether executive officers and directors are able to participate.

Even if a company’s option plan explicitly allows repricing (meaning that stockholder approval is not required), ISS has indicated that a repricing without stockholder approval will likely result in an adverse recommendation for the company’s say-on-pay proposal and, in certain circumstances, for the election of the members of the company’s compensation committee.

For private companies, both the underwater stock option and the repriced stock option will count towards the “hard cap” and “soft cap” limits under Rule 701 of the Securities Act of 1933, the safe harbor for compensatory offerings. The hard cap is a limit on the number of equity awards that a company may grant in reliance on Rule 701 in any 12-month period; in certain situations, a repricing will blow the cap, making the exemption unavailable. Under the soft cap, a company that exceeds $10 million in equity awards in any 12-month period must provide sensitive disclosure (including financial and risk disclosure) to its equity award holders.  See previous blog post on Rule 701 here.

Finally, repricings may result in an accounting charge to the extent the value of the new options exceeds the value of the repriced options.

Option Exchange

The alternative to option repricing is exchanging the underwater options for fewer lower exercise priced options, i.e., at a ratio of less than one-for-one, so that the value of the new options is no higher than the underwater options.

The primary advantage here is that it reduces the overhang of (useless) equity inasmuch as it results in fewer options being outstanding. Further, there should be no accounting charge as a result of the exchange because the value of the new options is no higher than the exchanged options.

Companies effecting an options exchange must comply with federal securities law tender offer rules which are generally triggered when stockholders are asked to make an investment decision about selling or exchanging one security for another or modified one. The tender offer rules require that the company file a Tender Offer Statement (Schedule TO) with the SEC, attach a detailed Offer to Exchange (which makes the offer to the optionholders) and deliver it to the optionees. The company must keep the tender offer open for at least 20 business days.

As is the case with repricings, option exchanges effected by listed companies must be approved by the stockholders under NYSE and Nasdaq rules (unless the underlying plan provides otherwise). See above regarding the process of seeking stockholder approval. Proxy statement disclosure is somewhat more complicated in an exchange as compared with a repricing because the company must explain how it determined the value of the exchanged options.

Under current accounting rules, an option exchange is considered a modification of the old option. If there is an increase in value when comparing the new option with the old, then an accounting charge is taken. But if there is a true value-for-value exchange (underwater option is exchanged for option subject to a fewer number of shares), then the exchange is a neutral event with no accounting charge.

One quick tax point that relates to both repricings and exchanges. In either case, it’s critically important to make sure the exercise price of the new options is at or above fair market value at the time of the repricing or exchange. If it isn’t, the new discounted option may be immediately taxable and subject to a 20% penalty and interest under dreaded Section 409A.

Among the many challenges companies are facing during the COVID-19 pandemic is how to conduct their shareholder meetings. Current social distancing requirements are effectively forcing companies to choose between postponing meetings and conducting them virtually. This requires careful attention to state executive orders, the relevant corporate statute, the company’s certificate of incorporation and by-laws, as well as SEC rules and recent guidance in the case of public companies. Several states, including New York and Delaware, have issued executive orders designed to facilitate virtual meetings, and the SEC has issued virtual meeting proxy guidance, including for companies that mailed proxy materials to shareholders but wish to change to virtual meetings because of social distancing concerns.

State Corporate Law

State corporate statutes dictate how shareholder meetings are to be conducted, including whether and to what extent such meetings may be held virtually.

For corporations incorporated in New York, the Business Corporation Law (the “BCL”) requires that shareholder meetings be held at such place fixed by the company’s by-laws. Although the BCL allows remote shareholders to participate electronically (provided reasonable procedures are in place to enable participation and voting), the statute does not explicitly authorize virtual-only meetings and has generally been understood to require a physical location. On March 20, 2020, however, Governor Cuomo issued Executive Order No. 202.8, which among other COVID-19 emergency measures temporarily suspends the BCL’s meeting requirements “to the extent they require meetings of shareholders to be noticed and held at a physical location” through April 19, 2020, subsequently extended by further executive order to May 7, 2020. Essentially, the order temporarily permits New York corporations to hold annual and special shareholder meetings solely by means of remote communication.

For Delaware corporations, if the organizational documents do not require a physical location, the annual meeting may be held virtually (i.e., telephonically or online). However, Delaware law requires reasonable measures to ensure stockholders may meaningfully participate in the virtual meeting through a secure and verifiable process, which focuses on access to the meeting, voting and access to the stockholder list.

SEC Guidance and Delaware Clarification

On March 13, 2020 (updated as of April 7), the SEC’s Division of Corporation Finance issued guidance on holding virtual shareholders meetings, including guidance on transitioning from a previously noticed in-person meeting to a virtual or hybrid (i.e., in-person meeting that permits electronic shareholder participation) annual meeting format. The guidance requires companies planning to conduct a virtual or hybrid meeting to take the following steps:

  • Notify shareholders of such in a timely manner with information on the logistical details of the virtual or hybrid meeting, including how shareholders can remotely access, participate in and vote at the meeting.
  • Companies that haven’t yet filed definitive proxy materials should include the above disclosures in the definitive proxy statement and other soliciting materials.
  • Companies that have already filed and mailed proxy materials and seek to change to a virtual or hybrid meeting should issue a press release announcing the change, file the press release as definitive additional soliciting material on EDGAR and take all reasonable steps necessary to inform other intermediaries in the proxy process (e.g., proxy service providers) and other relevant market participants (e.g., the relevant national securities exchanges) of the change.

The guidance unintentionally gave rise to concern among Delaware corporations that a press release meeting the above SEC guidance would not necessarily qualify as effective notice under Delaware law. Consequently, Delaware Governor John Carney clarified the ambiguity by issuing an executive order on April 6 that a press release announcing a change from an in-person to a virtual or hybrid meeting due to COVID-19 issues and otherwise in compliance with the SEC’s guidance will constitute effective notice under Delaware law, provided it is promptly posted on the company’s website. The order also provides that if alternatively the meeting is adjourned, the company would not be required to call the meeting to order in order to adjourn, but would permit such adjournment to be announced solely by means of the SEC filing and press release.

Practical Considerations

There are some best practices emerging for conducting a virtual or hybrid annual meeting, including the following:

  • Engaging a remote communication service provider (such as Broadridge or Computershare) to host the virtual or hybrid meeting.
  • Ensuring the remote communication method allows shareholders to vote, make comments, ask questions, hear answers and otherwise exercise all of the rights shareholders have under state law for participation in shareholder meetings.
  • Ensuring the technology platform used to conduct the virtual meeting will accommodate all of the shareholders, board members, members of management, and other persons participating in the meeting.
  • Making shareholders aware of the procedures necessary to access and participate in the virtual meeting.

Venture-backed companies did not receive the relief they had hoped for this past Friday, April 3rd, when the Small Business Administration (“SBA”) issued affiliation rule guidance on the Paycheck Protection Program (“PPP”) created under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The guidance largely affirms existing SBA regulations as they previously applied to SBA 7(a) loans and includes no affiliation rule waiver other than the limited waivers in the CARES Act. The absence of an applicable waiver means most venture-backed companies will need to include employees of other portfolio companies of their VC investors in determining whether they fall below the 500 employee limit for PPP eligibility. Without any further relief, PPP loans will not be extended to venture-backed companies, many of which are vital in the fight against the Coronavirus pandemic.


The CARES Act temporarily adds a new Paycheck Protection Program to the SBA’s 7(a) loan program providing guarantees for forgivable loans of up to $10 million (capped at $349 billion in the aggregate). The PPP is intended to provide economic relief to small businesses adversely impacted by COVID-19. An entity is generally eligible for the PPP if it, combined with its “affiliates”, has 500 or fewer employees whose principal place of residence is in the United States or is a business that operates in a certain industry and meets applicable SBA employee-based size standards for that industry. If two or more companies are deemed affiliates of each other, all employees of each of the affiliated entities are aggregated for the purpose of calculating the 500 employee threshold.

Without a waiver of the SBA affiliation rules, venture backed companies would be deemed affiliates of all other companies in their VC investor’s portfolio and would be required to aggregate employee numbers with those of the other portfolio companies.  Moreover, many venture backed companies have multiple VC investors.  Some receive investment from corporate VCs, where the related corporate entity single-handedly employs more than 500 persons.

On April 3, the SBA issued guidance on application of the SBA’s affiliation rules to the PPP in the form of an interim final rule and a summary of the applicable affiliation tests (together, the “PPP Affiliation Guidance”).  The day before the release of the PPP Affiliation Guidance, House minority leader Kevin McCarthy told the Axios Pro Rata Podcast the waiver would happen: “I just got off the phone with Treasury Secretary Mnuchin and this is going to be solved.” Speaker Nancy Pelosi also pushed for relief.  Nevertheless, the PPP Affiliation Guidance gave venture backed companies no satisfaction.

Determining Affiliate Status

Under the PPP Affiliation Guidance, any of the circumstances described below would be sufficient to establish affiliation for applicants for the Paycheck Protection Program.

  • Affiliation based on ownership. An entity is an affiliate of another entity that owns or has the power to control more than 50 percent of the first entity’s voting equity. If no individual or entity is found to control, the SBA will deem the board of directors or president or chief executive officer (or other officers, managing members, or partners who control the management of the entity) to be in control of the entity. The SBA will deem a minority shareholder to be in control, if that individual or entity has the ability, under the concern’s charter, by-laws or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.
  • Affiliation arising under stock options and convertible securities. In determining size, the SBA considers stock options, convertible securities and agreements to merge (including agreements in principle), to have a present effect on the power to control an entity. The SBA treats such options, convertible securities and agreements as though the rights granted have been exercised. An individual or other entity that controls one or more other entities cannot use options, convertible securities or agreements to appear to terminate such control before actually doing so.  The SBA will not give present effect to an individual’s or entity’s ability to divest all or part of its ownership interest in order to avoid a finding of affiliation.
  • Affiliation based on management. Affiliation arises where the CEO or president (or other officers, managing members or partners who control management) also controls the management of one or more other concerns. Affiliation also arises where a single individual or entity that controls the board or management of one entity also controls the board or management of one of more other entities. It also arises where a single individual or entity controls the management of the applicant entity through a management agreement.
  • Affiliation based on “totality of the circumstances”.       The SBA may consider all connections between the borrower and a possible affiliate and, if no single factor is sufficient to constitute affiliation, the SBA may determine on a case-by-case basis that affiliation exists when there is “clear and convincing evidence” based on the totality of the circumstances.

Who’s in Control?

VC funds typically own less than 50% of the voting securities of their portfolio companies, primarily to preserve proper management incentives, and compensate for its minority position by negotiating for certain control rights. In the VC context, affiliation typically comes down to an analysis of those control rights. Because SBA affiliation rules do not specify the exact control rights that will or will not trigger affiliate status, determinations must be made on a case-by-case analysis of relevant administrative case law guidance to determine loan eligibility.

Based on a review of SBA Office of Hearings and Appeals (the “OHA”) case law, the National Venture Capital Association put together a handy list of block rights which would constitute the type of control sufficient to trigger affiliate status.

In Control

The existence of a block right by a VC fund, exercisable either by the fund itself at the stockholder level or by its designee(s) at the board level, over any of the following actions would likely constitute the type of control that triggers affiliate status for PPP eligibility purposes:

  • Making, declaring, or paying distributions or dividends other than tax distributions.
  • Establishing a quorum at a meeting of stockholders (and likely, by extension, at a meeting of the board).
  • Approving or making changes to the company’s budget or approving capital expenditures outside the budget.
  • Determining employee compensation.
  • Hiring and firing officers and executives.
  • Changes in the company’s strategic direction.
  • Establishing or amending an incentive or employee stock ownership plan.
  • Incurring or guaranteeing debts or obligations.
  • Initiating or defending a lawsuit.
  • Entering into contracts or joint ventures.
  • Amending or terminating leases.

Out of Control

By contrast, the NVCA’s review of OHA case law shows that VC funds may have block rights over the following extraordinary decisions without triggering affiliate status:

  • Selling all or substantially all of the company’s assets.
  • Placing an encumbrance or lien on all or substantially all of the company’s assets.
  • Engaging in any action that could result in a change in the amount or character of a company’s capital contributions.
  • Changing the company’s line of business.
  • Engaging in a merger transaction.
  • Issuing additional stock/equity.
  • Amending the organizational documents of a company.
  • Filing for bankruptcy.
  • Amending the governing documents to materially alter the rights of the existing owners.
  • Dissolving the company.
  • Increasing, decreasing, or reclassifying the authorized capital of the company.
  • Increasing or decreasing the size of the board.
  • Entering into a confession of judgment.
  • Disposing of the goodwill of the company.
  • Committing to take any action that would make it impossible for the company to carry on its ordinary course of business.


As of now, many of the companies that would be excluded from PPP loan eligibility by a strict read of the SBA’s affiliation rules are precisely the innovative emerging companies vital to the fight against the new Coronavirus, namely biotechs developing vaccines and therapies, technology companies developing testing solutions, medical device companies and PPE companies. For that reason, it is expected that there will be continuing pressure for a regulatory or legislative fix for the affiliation rule problem as it would impact venture-backed companies. Whether the fix arrives in time is anyone’s guess. The PPP will be open only until the earlier of either June 30, 2020 or when the $349 billion cap in funding is exhausted.

Public companies stressing over how to meet filing deadlines during the COVID-19 crisis and what to say about the pandemic’s impact just received a filing reprieve and disclosure guidance from the SEC. The Securities and Exchange Commission issued an order on March 25, 2020 conditionally extending the deadlines for certain public company filings under the federal securities laws. On the same day, the staff of the SEC’s Division of Corporation Finance issued guidance on disclosure considerations and other securities law matters related to COVID-19.

Filing Extensions

Subject to certain conditions summarized below, SEC filers will have a 45-day extension to file certain disclosure reports that would otherwise have been due between March 1 and July 1, 2020. For example, a smaller reporting company with a normal filing deadline of March 30, 2020 for its Annual Report on Form 10-K will now have an extended deadline of May 14, 2020.

To qualify for the filing extension under the order, a filer must (i) be unable to meet a filing deadline due to circumstances related to COVID-19 and (ii) file a Current Report on Form 8-K (or Form 6-K) for each delayed filing by the later of March 16, 2020 or the original filing deadline of the report stating:

  • that it is relying on the order;
  • a brief description of the reasons why it could not file the report, schedule or form on a timely basis;
  • the estimated date by which the report, schedule, or form is expected to be filed; and
  • company-specific risk factors explaining the impact, if material, of COVID-19 on its business, which may be subject to the protections of the statutory safe harbor for forward-looking statements.

If the reason the report cannot be filed timely relates to the inability of any person, other than the company, to furnish any required opinion, report or certification, the Form 8-K (or Form 6-K) must attach as an exhibit a statement signed by that person stating the specific reasons why that person is unable to furnish the required opinion, report or certification on or before the date the report must be filed.

A registrant relying on the order would not need to file a Form 12b-25 so long as the report, schedule or form is filed within the time period prescribed by the order. The SEC order does not apply to Schedule 13D filings or amendments to a previously-filed Schedule 13D. Finally, the SEC order also does not apply to Section 16 beneficial ownership reports on Forms 3, 4 and 5.

COVID-19 Disclosure Guidance

Also on March 25, 2020, the staff of the SEC’s Division of Corporation Finance provided guidance on disclosure and other securities law obligations relating to COVID-19. The guidance provides a series of factors for companies to consider when drafting COVID-19 disclosure, including the following:

  • COVID-19’s impact on financial condition and results of operations, future operating results and near-and-long-term financial condition.
  • COVID-19’s impact on capital and financial resources, including overall liquidity position and outlook, cost of or access to capital and funding sources.
  • Material uncertainty about ongoing ability to meet credit agreements covenants because of the impact.
  • Course of action taken or proposed to be taken to remedy any material liquidity deficiency.
  • COVID-19’s effect on the company’s balance sheet and the company’s ability to account timely for those assets.
  • Anticipation for any material impairments (e.g., with respect to goodwill, intangible assets, long-lived assets, right of use assets, investment securities), increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments that have had or are reasonably likely to have a material impact on the financial statements.
  • Adverse impact of any COVID-19-related circumstances such as remote work arrangements on the company’s ability to maintain operations, including financial reporting systems, internal control over financial reporting and disclosure controls and procedures.
  • Any expectation that COVID-19 will materially affect the demand for the company’s products or services.
  • Whether the company anticipates a material adverse impact of COVID-19 on supply chain or methods used to distribute products or services.
  • Whether operations will be materially impacted by any constraints or other impacts on human capital resources and productivity.
  • Whether travel restrictions and border closures are expected to have a material impact on ability to operate and achieve business goals.

The guidance also confirmed the need for companies and insiders to refrain from trading in the company’s securities prior to dissemination of material non-public information. For example, where COVID-19 has affected a company in a way that would be material to investors or where a company has become aware of a risk related to COVID-19 that would be material to investors, the company, its directors and officers, and other corporate insiders who are aware of these matters should refrain from trading in the company’s securities until such information is disclosed to the public.