The Annual Shareholder Meeting

There can be a short-term economic incentive for early start-ups to issue restricted stock - rather than stock options - as incentive equity to employees/advisors, in no small part due to an IRS (409A of the code) requirement that a formal (i.e., costly) valuation be conducted prior to issuing  stock options (so as to set the exercise (FMV) price of the stock option). The externality is that restricted stock (absent some special story) carries all the voting and dividend rights of regular stock. This can play out myriad ways but, as illustration of the potential for unforeseen consequences, consider the following issue:

Delaware (where most start ups are incorporated) law requires that a corporation hold an annual meeting of the shareholders to elect directors.FN1 (Industry standard bylaws track this requirement). While the law allows shareholders to act by written consent in lieu of an actual (sending out notices, arranging a time and place, etc.) annual meeting, such paper consent is sufficient only IF it's unanimous (i.e., ALL the company's stockholders sign the consent (as opposed to a voting majority of the stockholders)).FN2 There is only one exception to this: where all the directorships are vacant (because the director resigned or died, etc.)

Note the implication: a start-up that proceeds by paper consent in lieu of an actual meeting must find each shareholder, communicate the consent process and retrieve a signature. In the event that myriad restricted stockholders (employees/advisors) are spread over a diverse geographical area (e.g., engineers based overseas), this presents no small logistical annoyance, exacerbated by the reality that the outcome of the director elections is almost always a foregone conclusion (i.e., the advisors/employees own a materially insignificant percentage of the voting stock), and, more importantly from a fairness perspective, is almost never a contested issue (generally start-ups do not alter the Board until a financing event).

Such inefficiencies may and probably do motivate many start-ups to ignore the unanimity requirement. But the case law is crystal clear that this is a statutory violation.FN3 In 1996, presiding over Hoschett v. TSI International Software (in which a minority shareholder sued a privately-held Delaware corporation for electing directors through a non-unanimous shareholder written consent in lieu of a meeting), the Delaware Court of Chancery reached this conclusion: "an argument predicated on alleged efficiency and practicality [is] unpersuasive ... absent unanimous consent that the mandatory language of Section 211(b) places on TSI [there is a] legal obligation to convene a meeting of shareholders to elect directors pursuant to the constitutional documents of the firm".FN4

In light of Hoschett, private companies seeking a consent in lieu of an annual meeting have three basic options: 1) solicit signatures from each and every stockholder, 2) ignore the law (by not holding a meeting or not electing directors at the meeting), or 3) precede the consent with the removal or resignation of the sitting directors (as noted Section 211 allows for non-unanimous actions where directorships are vacant at the time of the action). The first is a hassle, the second is illegal, and the third is technically compliant but such a contrivance it's unclear how it would stand up in court.

It is hardly sound legal counsel to advocate the nonobservance of the law but it's also difficult to argue against a line of action that is almost surely supported/acceptable by and fair to all affected parties and the prevailing norm. And that's all the New Media Lawyer is going to say about that.


FN1. Section 211 of the Delaware General Corporation Law says in pertinent part, "an annual meeting of stockholders shall be held for the election of directors."

FN2. Ibid to FN1, saying, "Stockholders may, unless the certificate of incorporation otherwise provides, act by written consent to elect directors; provided, however, that, if such consent is less than unanimous, such action by written consent may be in lieu of holding an annual meeting only if all of the directorships to which directors could be elected at an annual meeting held at the effective time of such action are vacant and are filled by such action."

FN3. Interestingly, although the tradition of an annual shareholders meeting for the election of directors goes way, way back, there's little case law on the issue. The 1996 Delaware Chancery Court opinion in Hoschett may be the only U.S. authority directly on point.

FN4. Note that the scope of the Court's holding explicitly covered a shareholder action that re-elected current directors: "[T]he mandatory requirement that an annual meeting of shareholders be held is not satisfied by shareholder action pursuant to Section 228 purporting to elect a new board or to re-elect an old one."

Director Governance and Insider Transactions

There's a moment in the emergence of the start-up, after some critical mass of investors and employee-owners have bought in, when the founder's interests start to materially separate from the start-up's.FN1

While corporate conflicts of interests are relatively routine, start-ups are somewhat unique in that the persons who hold a large if not majority stake in the company - the founders - typically also comprise the centralized authority - the Board of Directors. Thus, the conventional guard against conflicts of interests - investing decision-making authority in "disinterested" directors - is infeasible. There are no or not enough disinterested directors to vote.

As a consequence, decisions by the start-up's Board often lack the benefit of the business judgment rule (which requires plaintiffs who subsequently sue to prove the Board acted in bad faith - proving negligence or unfair terms is insufficient).FN2 Instead, courts will apply a generalized fairness doctrine as the standard of review of Board actions, a doctrine which presumes that the conflicted directors acted unfairly and places the burden of proof on directors to show fair dealing (and in the case of valuation of the company, fair value).

Many transactions before a start-up Board's consideration raise theoretical conflict of interest issues, so the risk is widely applicable; however, as a matter of practice, the most salient risks occur during a dilutive financing. The "insider led" (i.e., director or major/controlling investor led) down round is particularly risky because such investors have the ability to set the investment terms (so are any financing events which provide some liquidation return for investors (where, for example, insiders might have more information regarding a potential liquidity event than the other shareholders)).FN3

The recommended precautions to guard against subsequent claims of conflict of interest (i.e., suits by disgruntled stockholders) can get pretty technical and each set of facts requires individualized scrutiny, etc., however, two action items will generally reduce the lion's share of exposure:

First, secure approval from all stockholders with full disclosure of terms (with particular detail on the benefits of the financing terms to the controlling investors (i.e., the Board members) and factors that would adversely affect or impact non-participating shareholders) even if such approval is not technically required under previous financing agreements.

Second, specifically in the context of financings, allow for equal participation in, or a rights offering that accompanies, the financing, even if, again, the previous financing documents do not demand it. Shareholders (and sometimes, to a lesser extent, employees with vested options) should be permitted the right to participate in the financing on or participate on substantially the same terms as the inside investors.

FN1.
 The manifestation of this separation takes myriad forms, but can include, just by way of illustration, both small events (the use of start up assets for both personal and business purposes or transactions with third parties (leasing of software, rental space, etc.) in which the founder has some business stake) and large (authorizing or not authorizing an acquisition in order to keep one's job).

FN2.
California and Delaware statutory laws protect a board of directors so long as the relevant transaction was either (i) approved by a vote of disinterested directors or special committee, (ii) approved by a vote of the disinterested stockholders, or (iii) even in the absence of approvals, the transaction was fair and reasonable at time it was authorized by the Board. The benefit of the approvals, note, is that the transaction doesn't have to be fair and reasonable, so long as the proper approvals were secured. Note further, however, that under respective state laws, failure to secure approvals coupled with a finding the transactions was not fair and reasonable leads to PERSONAL liability (which is a serious matter given that most private start ups do not carry D&O insurance).

FN3.
The disclosure issue is a relatively transparent issue of insider trading but the self dealing issue is slightly opaque. Another way to see it is to consider how readily an insider led "down round" can be used as a pretext to dilute other stockholders. Directors and majority stakeholders would always profit from a down-round in which they but no one else participated, because in the absence of any true arms length negotiation they could price the round at a very low price, invest a small amount of capital and come out with a huge portion of the equity.

The Application of Rule 144 to Start-ups

SEC Rule 10b-5 (fraud) and Regulation D (disclosure requirements) are the federal securities laws people generally pay attention to, principally because when things go wrong (e.g., a start-up fails/never gets market traction), investors look at them for cause to sue.

Rule 144 by comparison is less commonly leveraged as a litigation tool and accordingly, a bit boring. However, because Rule 144 is structurally embedded in the narrative of any venture financing it's useful to understand how it works.

In essence, Rule 144 articulates the statutory requirements for reselling stock received from a company. The relevant context is this: when an investor/founder/employee receives equity in a start-up, it's almost always pursuant to SEC exemption Regulation D (and the attendant state statute); such exemption making it unnecessary for the issuing company to provide otherwise obligatory (and burdensome) disclosures and reports to the investor/founder/employee. The exemption is allowed because such transaction involves a "private" (not generally available to the public) sale to an investor/founder/employee who presumably has enough information and sophistication not to be swindled.

However, once the issuer/founder/employee receives the equity, the SEC has a new worry: that he's not an investor but a bag man. An underwriter. A stooge. The conduit through which the company sells securities to the public absent registration. Hence, Rule 144.

Rule 144 generally applies to "restricted securities" - definitionally interpreted to mean securities that have been issued pursuant to a private and unregistered transaction (such as start up stock).FN1 Rule 144 is a non-exclusive "safe harbor": it sets forth the circumstances by which these restricted securities (often referred to as legend stock (because the certificate received by investor will bear a legend indicating the stock is subject to restrictions), restricted securities or 144 stock) may be sold in the public market without risk of violating federal securities laws.

Historically, law suits in connection with the re-sale of stock in VC or angel funded companies have been uncommon events. Moreover, under the terms of most equity issuances to investors/founders/employees, usually manifested in an Investor Rights Agreement, investor/founder/employee is prohibited from reselling CONTRACTUALLY.FN2 Usually, the terms prohibit resale absent company's permission and subject to the presentation of a legal opinion or SEC "no-action" letter (or equivalent) that the sale is exempt from securities laws.

As a consequence, even though as a technical matter of federal securities laws an investor/employee/founder could (at least in some cases) legally sell his restricted stock pursuant to Reg D (or some equally applicable exemption from federal securities laws), his contractual agreements with the issuing company would probably prohibit it, which means, for all practical purposes, the investor/founder/employee is stuck with the stock until the company reaches some liquidation event - namely an IPO or merger with a public company.FN3

In the event of such an IPO or merger, Rule 144 comes into issue. In both an IPO and a merger, trading of stock acquired before the IPO or merger remains restricted (save some exceptions for shares issued pursuant to Rule 701 (pursuant to a stock option plan)).

Rule 144 has two main requirements in the event of resale after an IPO or merger: that the reseller have held the stock for a certain period prior to the resale and that the reseller only sell a certain amount of stock (known as a selling volume limit).FN4 The former imposes a 6 month (previously 12 month) holding period (that begins when the subject shares are fully paid for) and the latter sets the selling volume limits at greater of 1% of outstanding shares or average reported weekely volume of trading during preceding four weeks (meaning, once the company's stock post IPO or merger is being traded on a public exchange, then the seller's sales of stock can only comprise a small percentage of the trading of the company's stock). Once these requirements are satisfied, the reseller may request the company remove the restrictive legends on his stock certificates, sell to the open market and start living the dream.FN5

FN1.  Rule 144(a)(3) identifies what sales produce "restricted securities." Typical examples are VC investments, employee stock option plans, and compensation for professional services. It should be mentioned that Rule 144 also governs "control securities" - defined as those held by someone (such as a director or large SH) in a relationship of control with the issuer (the difference here is one of rationale: the restriction is based on the seller's status (in fact the underlying stock he owns in fact could be registered); for example, if he can or does control the company issuing the stock.

FN2. The company imposes the contractual limitation because the SEC will hold the company responsible for violating the 1933 Act if the holder transfers when he should not.

FN3. The other reasonably foreseeable scenario is a resale to a large bank or bank-like fund via Rule 144A. Rule 144A permits resales of the restricted securities to a "qualified institutional buyer", provided that such QIB be provided certain financial and other information about the issuer. QIB includes any institution that owns and invests on a discretionary basis at least $100 million in securities of nonaffiliated institutions, except that a bank or savings and loan must also have an audited net worth of at least $25 million, along with certain mutual funds and registered dealers. 

FN4.  In addition to the holding period and volume limitation, there are three other basic requirements: 1) Information about the company must be publicly available for at least 90 days before resales  (this generally means the issuer has complied with the periodic reporting requirements of the Securities Exchange Act of 1934), 2) the stock must be sold through brokers or directly to a market-maker (such as an investment banker), and 3) a Form 144 must be filed with the SEC at the time of any sale, with an exception for sales of fewer than 500 shares for less than $10,000.

FN5. It should be noted that contractually (via the purchase agreement and related agreements), most investors/employees/founders are prohibited from selling off their shares immediately after an IPO or merger anyway, via a mechanism called a "lock-up", which varies but usually lasts for about 6 months.

The Problem of Anonymized Data

Over the past three or so years both OK Cupid and Facebook have published a great deal of aggregated, anonymized data for, let's say, the enlightenment and mirth of society at large. Facebook shared information on how "happy" users seemed on certain days and OK Cupid shared (as it has been doing) some interesting information about dating preferences of certain groups. 

The LA Times blog has been one of the few voices to point out the privacy implications of these data shares, saying, "Despite its silly name, the Gross National Happiness indicator is creepy. We're in there."

Several events - most notably the promotional (and seemingly innocuous) publication by Netflix of data regarding movie preferences of its customers - have revealed fundamental security problems with so-called anonymized data (Netflix was sued in 2009 in connection with this and settled out of court). By some accounts, the widely used concept of "personally identifiable information" on web site privacy policies - which by implication suggests the existence of information about you that is somehow not "personally identifiable" - is misleading. There's been a spate of studies finding that people with PHDs have the capacity to "re-identify" or disambiguate so-called anonymized data. The underlying principle is that ostensibly random data points (such as a birth date and a zip code) can be tied to a specific person if coupled with some other set of information (publicly available or readily mined, etc.) It's not clear that data anonymized in accordance with best practices is easy (cheap) to re-identify but it is clear that it can be done.

Thus, a quandry for businesses that want to sell or otherwise profit from anonymized data. U.S. laws and state laws with respect to consumer data privacy don't forbid it. In fact there are hardly any restrictions whatsoever on properly de-identified data, even if the data is being sourced from financial or health-related data or data concerning children (laws are more restrictive with respect to these categories of data). Further, as most privacy policies on web sites inform users that "anonymized" data may be shared with third parties, in most circumstances users have a reasonable expectation (due to a privacy policy or otherwise - provided they had proper notice and consent of the privacy policy) that their data might be released in such a form and hence would not have contractual cause to sue in the event it ever was. Relatedly, one would not expect the FTC (or analogous state agency) to prosecute a company for sharing anonymized data (on grounds of misleading consumers about data collection and sharing practices) so long it took precautions to ensure the data couldn't be easily re-identified.

But this is uncertain. The lack of case law at this point makes it difficult to clearly define what constitutes a) proper precautions (if any) for anonymizing data and b) reasonable consumer expectations as to the same . By way of example, The California Supreme Court recently held, for the first time, that a ZIP code - standing alone- qualifies as "personally identifiable information." See Pineda v. Williams-Sonoma Stores Inc., No. S178241 slip op. (Calif. Feb. 10, 2011).

Share Calculation on a "Fully-Diluted Basis"

Most seed or series financings calculate the preferred stock share price paid by the investor on a "fully-diluted basis."FN1 This sounds like math but really it's basic, macro-level accounting.

The underlying principle is this: the determination of how many shares the investor receives for the money he's investing is a proxy for something more crucial: the investor's percentage ownership of the company.

The investors have an incentive to capture as much percentage ownership as possible and thus have an incentive to capture as many shares as possible. "Fully diluted basis" means that the investor's proposed percentage ownership of a company be calculated against the absolute TOTAL number of shares outstanding in the company - the "basis".

The reason this matters, and why the terminology is often embedded in legal documents, is that often at the time of a seed or series financing there is outstanding stock that gets overlooked. This stock has been effectively but not technically issued - in the form of unexercised stock options, warrants, convertible debt and the like. The calculation of what's included in the basis determines who will assume the future diluting effect of any stock that is not exercised at the time of the financing (but almost surely will be at a later date).

If the basis calculation includes unexercised stock, then at the time of the financing the existing common stock holders (i.e., founders) - but not the investors - are, in effect, diluted. If the calculation doesn't, then when the stock is eventually exercised, all the existing stock holders, including investors, share pro rata in the dilution effect. For example:

Pre-financing Company has issued 5 shares of common stock but also has unexercised debt and stock options convertible into a total of 3 shares of common stock. Investor wants 50% ownership. If basis does not include the unexercised securities, investor gets 5 shares. If basis does so include, then investor gets 8 shares (for the same amount of money invested).

So, that's the concept. Mechanically, the calculation works on the level of the share: the larger the basis the less the investors will have to pay per share of the preferred stock. This is a function of the oft-cited formula: per share price = pre-money valuation / total outstanding shares.

FN1. “Fully-diluted” capitalization typically means (i) all issued (outstanding)  common stock, (ii) all issued (outstanding) preferred stock, (iii) any issued (outstanding) warrants, (iv) all issued (outstanding) options, (v) options reserved for future grant, and (vi) any other convertible securities. In essence, the only category of stock that is not counted in this fully-diluted capitalization number is the stock that is "authorized" in the Articles of Incorporation but as yet not issued.

The Crowd-Funding Problem

Crowd-funding - raising capital through a large network of individuals each providing a small investment that collectively adds up to a large sum - seems a natural evolution of the start-up financing model. The problem is that it's illegal. FN1

Securities laws generally require the "registration" of the sale of any securities, such as the common or preferred stock offered in seed or Series A financings, requiring technical compliance with a number of registration rules, including, among other things, the disclosure of vast quantities of information to purchasers and the preparation of audited financials. All of this is super expensive. The economics of crowd-funding don't allow it.

Of course, there are a number of exceptions to the registration rules, the most notable being the "private placement" exemption, originally curated under Section 4(2) of the Securities Act and later broadened under Regulation D. Most seed and series financings are conducted pursuant to Section 506 of Reg D, which permits sales of securities to "accredited" (i.e., wealthy) investors without costly disclosure documentation.

The whole idea of crowdfunding of course is that you shouldn't have to own a polo pony and a Porsche to make investments in start-ups, which moves us to Section 504 of Reg D, which does not impose an "accredited" investor requirement.FN2 The big problem here is that Section 504 still prohibits a "general solicitation" or advertisement of the offering to the public at large. 504 requires a pre-existing, substantive relationship between an issuer (or its broker-dealer) and the investor(s), and this is why 504 is relied on almost exclusively for investments from close family and friends (and not say, from half-known acquaintances you're connected to on linkedin).FN3

Accordingly, absent some special story, neither 504 nor any other federal exemption provides safe harbor for the crowd-funding structure. The only legal way (for now) to raise capital through crowd-funding would be to go through the full registration process at both the federal and state levels, which isn't economically tenable.FN4

FN1. This blog post presumes a conventional financing by a corporation and not a creative alternative (such as a revenue sharing plan, giving investors a flat payment or investors being involved in the day to day running of the business). Although be aware that Section 30(b) of the Exchange Act may prohibit transactions which are designed to evade the Exchange Act.

FN2. Note than 504 expresses a federal securities laws exemption. State securities laws impose their own requirements and exemptions. Although state securities laws tend to track federal requirements, in some cases, state laws are more restrictive.

FN3. Relatedly, for any entrepreneur interested in building a crowd-funding platform/web site, there is the broker-dealer problem. Section 15 of the Securities Exchange Act requires that anyone acting as a "broker-dealer" - which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others" - must go through its own expensive and lengthy registration process. Whether a crowd-funding platform constitutes a "broker-dealer" is a technical question and the relevance of past precedent (comprised of almost exclusively of SEC no-action letters, etc.) is hardly clear. However, it's probably safe to say that the more any such platform/web site is promoting sales of securities (telling an investor about some company, trying to encourage investment) and the more the incentive the platform/web site has to make such sales happen (receiving a commission), the more the broker-dealer requirement is implicated. 

FN4. If history is any indication so long as there is significant market interest in a particular kind of transaction and no one is being taken advantage of, the SEC will make adjustments to the law to allow a market in such transactions to develop. Being a first mover in such a market involves without question legal risk but it would seem anyone who waits until the SEC makes compliance issues crystal clear will lose out. Such is the dilemma.

409A Constraints on Stock Option Grants

Hot tax code insight of the week!FN1 Section 409A of the Internal Revenue Code requires that companies issue stock options at a strike price that reasonable approximates FMV.FN2 This has one of two practical consequences:

              i) start-ups issue restricted stock instead (or an analogous exemption (any property (such as stock appreciation rights) subject to Section 83 is okay)), thereby bypassing 409A; or
              ii) start-ups go through the (somewhat expensive) process of establishing a FMV (in compliance with 409A) prior to issuing in stock options.FN3

Here's the background: under the previous regulatory framework (governing things during the early '00s), stock options could be issued fast and loose, often according to some vague formula (like 1/10 of the value of the last financing's share price). This allowed rich guys to defer huge portions of their rich guy salaries into the future.

So the IRS enacted 409A, which governs all deferred compensation plans and agreements entered into, or vesting after, January 1, 2005, and requires that i) stock options are issued at FMV and ii) the FMV must be determined using “reasonable application of a reasonable valuation method.” The IRS has provided guidance that the determination of reasonableness (an inherently circumstantial standard) will presumptively be satisfied by either of the two following approaches:

1) Independent Appraisal. An independent valuation by qualified experts using standard methods recognized under the IRS Code.

2) Illiquid Start-up Appraisal. Certain private companies (in existence less than 10 years and not anticipating an IPO in the next 6 months nor a merger in next 90 days (among other things)) can rely on valuation by a person (including an employee) with significant knowledge or training in performing such valuations. (Go here for a detailed discussion of the requirements).

The presumption of reasonableness is rebuttable only upon evidence that the method or the application of such method was "grossly unreasonable" (there's no official guidance on what this means).

Such valuations last for 12 months absent any intervening events that would materially and reasonable affect FMV. Failure to comply has a number of consequences, the most salient being that employees will be subject to taxation at each vesting milestone plus a 20 percent penalty, and potential interest.

Most companies engage in precisely the kind of appraisal required by 409A at each financing event but if such financing was more than a year in the past and the company is short on cash it is probably better off issuing restricted stock rather than stock options as incentive equity.

FN1. A character in David Foster Wallace's novel Pale King (set in an IRS office in the Midwest) describes tax compliance as "boredom beyond any boredom he’d ever felt."

FN2. More generally, 409A applies to any legally binding right to deferred compensation (any agreement, plan or arrangement that provides for a deferral of compensation, even if such compensation is subject to restrictions (such as vesting)).

FN3. The cost for valuation appraisal varies, but will probably come in between $5k and $25K.