In connection with term sheets and the raising of capital, dividend preferences (a dividend is an annual distribution of profits to shareholders, generally paid in cash or stock) are rarely a meaningful negotiating point, for three main reasons.FN1 First, investor-backed start-ups rarely generate profits early on, so there's probably nothing to distribute and the issue is moot. Second, even if that doesn't prove the case, the founders understand any profits should be re-invested in the growth of the company. Third, unlike, say, private equity guys (who are investing big money (usually more than $50MM) with lowered expectations for return multiples on invested capital), VCs and angels are less focused on percentage annual yields than the long term multiple they'll get back from the investment. "The juice," as one commentator says here, "from the dividend is nice [for VCs], [but] it doesn't really move the meter in the success case".
What you get in 10% or so of financings,FN2 however, is investors asking for dividends that accrue and accumulate from one year to the next. Such dividends are called "cumulative' and are akin to roll-over minutes with a phone plan. To the extent a dividend is not declared (by the BoD) during a particular year, the dividend is carried forward to the next year. (Non-cumulatives (“when, as and if declared” dividends) do not carry-over).FN3
The argument from investors is that the cumulative dividend is necessary as reasonable down-side protection to guarantee a minimum annual rate of return on investment (often in the range of 5-10%).FN4
This wouldn't have an immediate impact on the company's cash position but if the investment remains outstanding for an extended period the effect could be large (and also generally doesn't reflect well (to future investors, potential lenders (i.e. creditors, etc.) on a balance sheet since the dividends are liabilities).
The move for the company is to concede to cumulative but establish conditions that ensure the cumulative dividends act as a protective device rather than a windfall. Allow unpaid accumulations to factor into the liquidation preference (or maybe even the redemption price) but not the conversion price (the rate at which the preferred stock converts into common stock).
The former scenario is not only the most common formulation - giving investors an increased share of the proceeds in the event of a sale - but the one that best serves to return investors some portion of their money back in the event the company needs to be sold on the cheap or liquidated due to insolvency.
The latter scenario, however, could have an enormous impact in the case of a successful company exit (e.g., an IPO) because it increases the investor's pro rata entitlement to proceeds and should be resisted for this reason (absent a cap to the investor's return or some other special story).
FN1. Language in term sheet in connection with dividends will read something like, "Dividends: The holders of the Preferred shall be entitled to receive [non-]cumulative dividends in preference to any dividend on the Common Stock at the rate of [x%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of the Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis.”
FN2. 10% number is from Fenwick and West, reporting in 2010.
FN3. If the non-cumulative is not declared by the BoD at year's end, it is extinguished and begins accruing anew the following year.
FN4. The logic of this can be deceptive. In a way it seems reasonable for the investors to receive some kind of interest return (in the form a dividend) for the time value of their investment. But note that investors have (almost always) an uncapped upside participation right. That's what they're buying: an equity instrument not a debt instrument.
Monday, April 18, 2011
Thursday, March 31, 2011
Stock Option versus Restricted Stock Awards
In most scenarios it benefits both the company and employees to give employees equity in the company. The employees are inspired by a sense of ownership and the company saves some cash. The trickier question is one of form: does the company offer stock options or restricted stock?
The mechanics of stock options are pretty basic: the company grants to the employee a call option to purchase - at a discount - X number of shares of the company's common stock. The discount is called the "exercise" (or "strike") price. Under this scenario, on the date the employee wants to sell and profit from his stock award, he purchases up to X number of shares and then turns around and sells the shares at a (presumably) much higher market value price and pockets the difference.FN1
Restricted stock, by contrast, is a straight gift of stock.FN2 The employee does not need to outlay any money. The "restricted" part is the caveat: the company retains the conditional right to purchase the stock back from you at some super cheap price - and usually this right expresses itself through a vesting requirement (i.e., although the stock is a straight gift it requires the employee to stick around the company for a certain period of time (market standard is 4 years to receive the full amount, with 1/4 of the total becoming available each year)).FN3
These structural differences implicate three main issues.
First, restricted stock gives the employee real as opposed to theoretical (in the case of options) value, and such real value is taxable to the employee upfront (stock options will not be taxed until the option is exercised (if ever)).FN4 So long as the initial value of the stock is low (such as in a start-up situation) this is probably to the advantage of the employee. The payment of that initial income tax aside, the employee won't pay any taxes until he sells the stock, at which point, so long as certain holding requirements are met, the tax will be capital gains rather than (historically higher) income tax.
By contrast, stock options will almost always result in ordinary income to the recipient when exercised (at least in the typical case where the underlying stock appreciates prior to exercise of the option).
Second, the grant of stock options require as a predicate the determination by the company of the "exercise" price. Because Section 409A of the Internal Revenue Code requires that the exercise price must be equal to (or greater than) the fair market value of the underlying stock as of the grant date, the company must coordinate (by the time of the grant) (i) an independent appraisal or (ii) if the company is an “illiquid start-up corporation,” a valuation of a person with “significant knowledge and experience or training in performing similar valuations” (who could be a company employee), which costs time and money.
Third, stock options give employees only the opportunity to benefit from the increase in the company’s value. If at a future date the market value of the shares drops beneath the exercise price per share (which is fixed to the time of the grant) then the stock options will be worthless.FN5
FN1. Two caveats here. First, in most cases, stock options are qualified/restricted by "vesting", which means that the right won't actually be triggered until a future date. Prevailing standards put the right to purchase 1/4 of the shares at the 1 year anniversary of the start date, 1/2 the shares become available to purchase at the 2 year anniversary, 3/4 on the third and all the shares on the 4th anniversary. In addition, most vesting provisions include acceleration clauses which accelerate vesting in the event of certain transactions (usually an IPO or acquisition). Second, more sophisticated service providers may exercise the option to purchase their stock before they intend to sell (because, essentially, the appreciation prior to exercise is taxed as income and the appreciation post exercise is taxed as capital gain).
FN2. Both stock options and restricted stock are sourced from the "incentive equity pool" of common stock reserved for employees. In most funded start-ups this pool will represent between 5-15% of the issued stock.
FN3. Restrictions can also be some sort of performance condition, such as the company reaching earnings per share goals or financial targets.
FN4. In most scenarios the employee will want to file here what is termed an "83(b) election" with the IRS so as to be taxed immediately upon the grant for the value (if any) of the restricted stock. If he doesn't make that filing within 30 days of the grant then he will be taxed incrementally over time as the restrictions to the stock disappear (i.e., the stock vests) - which can be prohibitively unaffordable if the stock appreciates significantly (yet remains illiquid).
FN5. Stock options have fallen out of favor during the last (markedly volatile) decade or so precisely due to this possibility.
The mechanics of stock options are pretty basic: the company grants to the employee a call option to purchase - at a discount - X number of shares of the company's common stock. The discount is called the "exercise" (or "strike") price. Under this scenario, on the date the employee wants to sell and profit from his stock award, he purchases up to X number of shares and then turns around and sells the shares at a (presumably) much higher market value price and pockets the difference.FN1
Restricted stock, by contrast, is a straight gift of stock.FN2 The employee does not need to outlay any money. The "restricted" part is the caveat: the company retains the conditional right to purchase the stock back from you at some super cheap price - and usually this right expresses itself through a vesting requirement (i.e., although the stock is a straight gift it requires the employee to stick around the company for a certain period of time (market standard is 4 years to receive the full amount, with 1/4 of the total becoming available each year)).FN3
These structural differences implicate three main issues.
First, restricted stock gives the employee real as opposed to theoretical (in the case of options) value, and such real value is taxable to the employee upfront (stock options will not be taxed until the option is exercised (if ever)).FN4 So long as the initial value of the stock is low (such as in a start-up situation) this is probably to the advantage of the employee. The payment of that initial income tax aside, the employee won't pay any taxes until he sells the stock, at which point, so long as certain holding requirements are met, the tax will be capital gains rather than (historically higher) income tax.
By contrast, stock options will almost always result in ordinary income to the recipient when exercised (at least in the typical case where the underlying stock appreciates prior to exercise of the option).
Second, the grant of stock options require as a predicate the determination by the company of the "exercise" price. Because Section 409A of the Internal Revenue Code requires that the exercise price must be equal to (or greater than) the fair market value of the underlying stock as of the grant date, the company must coordinate (by the time of the grant) (i) an independent appraisal or (ii) if the company is an “illiquid start-up corporation,” a valuation of a person with “significant knowledge and experience or training in performing similar valuations” (who could be a company employee), which costs time and money.
Third, stock options give employees only the opportunity to benefit from the increase in the company’s value. If at a future date the market value of the shares drops beneath the exercise price per share (which is fixed to the time of the grant) then the stock options will be worthless.FN5
FN1. Two caveats here. First, in most cases, stock options are qualified/restricted by "vesting", which means that the right won't actually be triggered until a future date. Prevailing standards put the right to purchase 1/4 of the shares at the 1 year anniversary of the start date, 1/2 the shares become available to purchase at the 2 year anniversary, 3/4 on the third and all the shares on the 4th anniversary. In addition, most vesting provisions include acceleration clauses which accelerate vesting in the event of certain transactions (usually an IPO or acquisition). Second, more sophisticated service providers may exercise the option to purchase their stock before they intend to sell (because, essentially, the appreciation prior to exercise is taxed as income and the appreciation post exercise is taxed as capital gain).
FN2. Both stock options and restricted stock are sourced from the "incentive equity pool" of common stock reserved for employees. In most funded start-ups this pool will represent between 5-15% of the issued stock.
FN3. Restrictions can also be some sort of performance condition, such as the company reaching earnings per share goals or financial targets.
FN4. In most scenarios the employee will want to file here what is termed an "83(b) election" with the IRS so as to be taxed immediately upon the grant for the value (if any) of the restricted stock. If he doesn't make that filing within 30 days of the grant then he will be taxed incrementally over time as the restrictions to the stock disappear (i.e., the stock vests) - which can be prohibitively unaffordable if the stock appreciates significantly (yet remains illiquid).
FN5. Stock options have fallen out of favor during the last (markedly volatile) decade or so precisely due to this possibility.
Monday, March 28, 2011
Contracts and Electronic Signatures
It's unnecessary to sign commercial contracts with a pen but the practice persists.FN1
The federal Electronic Signatures in Global and National Commerce Act, enacted in 2000 (note the federal law does not apply to intra-state transactions) and most states (due to the Uniform Electronic Transactions Act being adopted by most states) allow electronic signatures (or signature via an electronic record) for the valid execution of a contract. Neither law imposes a rigid format on the signature, so the fact that there isn't a “digital signature” - i.e., something like "/s/ Firstname Lastname" - doesn’t affect the fact that you can be deemed to have signed a contract by email correspondence.
Manual signature remains the custom in part because manual signature is a pretty effective authentication of the signator's willful and knowing acceptance of the terms of the contract (because a manual signature is personally identifiable in a (somewhat) unique way). Thus, reliance on an electronic signatures demands i) some proof of identity - something to verify that the putative signator's brother/aunt/stalker didn't send the electronic signature and ii) something to indicate that the signator knew what he was agreeing to (which is why when you go to amazon or bestbuy.com or wherever they require you to scroll down through terms and conditions or check some box (or an equivalent)) before you click through.
To the extent there is a mechanism in place that addresses these two issues statutory requirements will be satisfied. In most cases, verbal confirmation followed by an email from the signator enclosing the signature page with his electronic signature (first and last name) should suffice.
The effect of this, beware, cuts two ways. First, it means the process for executing a contract has been simplified. Second, however, it means e-mail correspondence may have unintended results. A vaguely worded or poorly thought through email can trigger all the responsibilities and obligations of an agreement. (Note that this could happen AFTER the agreement has been executed.FN2).
FN1. Note that certain contracts, such as trusts and certain real estate contracts, still require old school, manual signature and probably will for a good while longer.
FN2. E.g., in Stevens v. Publicis, S.A. (2008) the New York State Supreme Court held that a written agreement could be modified (i.e., amended) by e-mail correspondence.
The federal Electronic Signatures in Global and National Commerce Act, enacted in 2000 (note the federal law does not apply to intra-state transactions) and most states (due to the Uniform Electronic Transactions Act being adopted by most states) allow electronic signatures (or signature via an electronic record) for the valid execution of a contract. Neither law imposes a rigid format on the signature, so the fact that there isn't a “digital signature” - i.e., something like "/s/ Firstname Lastname" - doesn’t affect the fact that you can be deemed to have signed a contract by email correspondence.
Manual signature remains the custom in part because manual signature is a pretty effective authentication of the signator's willful and knowing acceptance of the terms of the contract (because a manual signature is personally identifiable in a (somewhat) unique way). Thus, reliance on an electronic signatures demands i) some proof of identity - something to verify that the putative signator's brother/aunt/stalker didn't send the electronic signature and ii) something to indicate that the signator knew what he was agreeing to (which is why when you go to amazon or bestbuy.com or wherever they require you to scroll down through terms and conditions or check some box (or an equivalent)) before you click through.
To the extent there is a mechanism in place that addresses these two issues statutory requirements will be satisfied. In most cases, verbal confirmation followed by an email from the signator enclosing the signature page with his electronic signature (first and last name) should suffice.
The effect of this, beware, cuts two ways. First, it means the process for executing a contract has been simplified. Second, however, it means e-mail correspondence may have unintended results. A vaguely worded or poorly thought through email can trigger all the responsibilities and obligations of an agreement. (Note that this could happen AFTER the agreement has been executed.FN2).
FN1. Note that certain contracts, such as trusts and certain real estate contracts, still require old school, manual signature and probably will for a good while longer.
FN2. E.g., in Stevens v. Publicis, S.A. (2008) the New York State Supreme Court held that a written agreement could be modified (i.e., amended) by e-mail correspondence.
Monday, March 7, 2011
A Primer on Copyleft and Related Open Source Issues
According to the conventional licensing model, holders of copyrighted software grant proprietary licenses to 3rd parties to use the software, usually in exchange for money. Such a license restricts how the software may be used (and modified or distributed) and if the licensee exceeds those restrictions the licensor may bring an action of infringement.
The so-called Copyleft model removes most of these restrictions but does so without making the software public domain (where users could modify then copyright such works, thereby undermining the effort).FN1 Copyleft maintains the licensing framework but aggressively enlarges the scope of the license on a very specific condition: use, modification and redistribution of the software (modified or not) is unlimited so long as this same allowance is given to all future licensees. The exact wording of the original license must be preserved each time the software is modified and distributed. Whatever rights inhere in the original license are there for perpetuity. This mechanism is variously referred to as a "Reciprocal Grant, "Viral License" or "License Inheritance."
As a necessary corollary to or function of the inherited license, all source code (read-only programs are insufficient) must be made accessible to future users (so it may be modified).
These requirements don't prohibit commercialization of the software. Copyleft does not necessarily mean "free." While you cannot charge for a proprietary license, you can charge for each copy or for warranty, support, services, etc. Because selling individual copies is rarely profitable (since the seller cannot by virtue of the sale control/limit what the buyer does with the source code thereafter - like give it away for free), the value of copylefted software to corporate enterprise typically inheres in the sale of products or services in which the copylefted software is embedded.FN2
FN1. In addition to copyleft there are so-called "academic" licenses which comprise with copyleft the two main groups of open source licenses.The Gnu Project's General Public License (the GPL) is probably the best-known and most widely used copyleft license.
FN2. The chief risk is this business model is the inadvertent surrendering of ownership to proprietary software. Determining what is a "derivative work" can be an uncertain inquiry (at least in part because of limited judicial interpretation with respect to the enforceability of copyleft licenses) and thus where the open source software is mingled/bundled with proprietary software, it's possible the proprietary license will be deemed to be a derivative of open source and therefore not protected by copyright.
The so-called Copyleft model removes most of these restrictions but does so without making the software public domain (where users could modify then copyright such works, thereby undermining the effort).FN1 Copyleft maintains the licensing framework but aggressively enlarges the scope of the license on a very specific condition: use, modification and redistribution of the software (modified or not) is unlimited so long as this same allowance is given to all future licensees. The exact wording of the original license must be preserved each time the software is modified and distributed. Whatever rights inhere in the original license are there for perpetuity. This mechanism is variously referred to as a "Reciprocal Grant, "Viral License" or "License Inheritance."
As a necessary corollary to or function of the inherited license, all source code (read-only programs are insufficient) must be made accessible to future users (so it may be modified).
These requirements don't prohibit commercialization of the software. Copyleft does not necessarily mean "free." While you cannot charge for a proprietary license, you can charge for each copy or for warranty, support, services, etc. Because selling individual copies is rarely profitable (since the seller cannot by virtue of the sale control/limit what the buyer does with the source code thereafter - like give it away for free), the value of copylefted software to corporate enterprise typically inheres in the sale of products or services in which the copylefted software is embedded.FN2
FN1. In addition to copyleft there are so-called "academic" licenses which comprise with copyleft the two main groups of open source licenses.The Gnu Project's General Public License (the GPL) is probably the best-known and most widely used copyleft license.
FN2. The chief risk is this business model is the inadvertent surrendering of ownership to proprietary software. Determining what is a "derivative work" can be an uncertain inquiry (at least in part because of limited judicial interpretation with respect to the enforceability of copyleft licenses) and thus where the open source software is mingled/bundled with proprietary software, it's possible the proprietary license will be deemed to be a derivative of open source and therefore not protected by copyright.
Monday, February 21, 2011
Anti-Dilution: Full Ratchet Versus Weighted Average
There are two principal approaches to anti-dilution provisions: the "Full Ratchet" and the "Weighted Average." These concepts tend to be explained by reference to computational formulas, which work off a variable called the "conversion price". Forget that. For two reasons. First, conversion price doesn't refer to currency but instead to an arbitrary ratio (usually 1 or .3 but it can be anything), so it's confusing. Second, the computation of the conversion price/ratio, while a necessary accounting tool, is a distraction from the operational result: the reallocation of stock from the founders to the angels.
Both approaches are based on the same predicate concern: what happens to the value of the angel's investment (in the form of preferred stock (that converts into common stock upon IPO/merger)) in the event that new stock is issued (sold) to someone else at a lower price (relative to that paid by the angel)?FN1
In most investment scenarios, like real estate, for example, if the post purchase market value is lower than the price paid, so it goes. That's the risk of real estate investment. The seller wouldn't retroactively kick in extra acreage or have a guest house built on the property to make the investor feel better.
Start-up financing does not operate like that. In the event the company's value goes down post purchase, anti-dilution provisions work to re-allocate shares from the existing common stock pool to the angel's preferred stock pool to make the angels feel better. The only question is, how many shares are re-allocated?
According to the Full Ratchet approach, the answer is: a lot. In fact, full ratchet does not even care about the number of the shares per se. It just cares about the bargain given to the new investors. How much are the new investors paying per share? That's deal the angel's now want.
An analogy would be you bought 10 pants at Banana Republic for $100 then someone else comes along and buys 10 pants for $10. Under FR, you get to say, 'Give me another 90 pairs of pants.'
It's called "Full Ratchet" because as a technical matter it demands that the ratio by which their preferred shares will be converted into common shares be retroactively decreased - "ratcheted down" - to the effective conversion ratio the new buyer is getting.FN2 The salient feature is that this occurs no matter how large or small the subsequent financing is (if - this is an extreme example - a company issues just 100 shares to subsequent investors at a $1.00 per share and the angels have 5,000 shares (for which they paid $10 per share), then under application of FR the angels gain (and the founders lose (the compensation has to come from somewhere)) an additional 45,000 shares.FN3
Weighted Average is a more measured approach. Although WA fixates on the deal the new buyers are getting, it takes into account the magnitude of the financing - how much new stock has been issued. The weight of the better deal price is balanced against the weight of the size of the purchase (similarly, the extent to which going 3 for 4 affects one's batting average depends on how late in the season the game is).FN4
There's a number of different formulas used for the calculation but as noted they aren't very intuitive so let's ignore them since the mathematical concept is straightforward. Take the post-money monetary value of the company under the old deal (just multiple the total number of company shares by the share price paid by the angel (in this case, $10 X the total number of shares (10,000 (assume 5,000 for angels, 5,000 for founders) = $100,000. This is our baseline company value under the old deal. Add to that the value being added by the new buyer - in this case $100 (100 shares at $1.00 per share). Divide (average out) that total value - $100,100 - by the total number of shares after the new buyer buys in: 10,100.
The number you get - $9.91 in this case - is going to be lower than the price paid by the angel - $10. It's an average between the old price and new price dependent on the aggregate number of shares being issued at the new price.FN2 How many shares does the angel's $50,000 investment get him now? Not 5,000 ($50,000/$10pershare) but 5,045 ($50,000/$9.91pershare).
FN1. "Original investor" and "new investor" are the two players here; "angels" is just shorthand for the former.
FN2. As noted, "conversion price" is misleading. The confusion becomes manifest in most examples you'll see - which will use $1 for the angel investment and then like fifty cents for the new investment and refer to these as conversion prices even though that is conflating two separate concepts. The conversion price is just the ratio by which preferred shares are converted into common shares, and often is 1:1 or .5:1. As a matter of fact, any investor will give a company a certain amount of money in exchange for a certain amount of preferred shares (which will have a certain price per share value that no one cares about) and THEN those shares will be deemed to convert to common shares according to a certain ratio.
FN3. Note that in these examples (and any such examples you'll see involving formulas) the calculation of the shares given to the new and old investors will be with respect to COMMON shares that the investors will eventually own. As indicated above no one really cares about how many preferred shares are being issued.
FN4. Under Weighted Average, the pants analogy works as such: There's 20 pairs of pants valued at $200 (you bought 10 for $100 and assume the founders also have 10). Add to the $200 valuation the $10 paid by the new buyers (for 10 pants). Divide $210 by the new total number of pants: 30, which equals $7. This becomes the retroactive price you paid. How many pants does $100 get you if it's $7 rather than $10 per pant? 14.28 instead of 10. Fashion for a fortnight.
Both approaches are based on the same predicate concern: what happens to the value of the angel's investment (in the form of preferred stock (that converts into common stock upon IPO/merger)) in the event that new stock is issued (sold) to someone else at a lower price (relative to that paid by the angel)?FN1
In most investment scenarios, like real estate, for example, if the post purchase market value is lower than the price paid, so it goes. That's the risk of real estate investment. The seller wouldn't retroactively kick in extra acreage or have a guest house built on the property to make the investor feel better.
Start-up financing does not operate like that. In the event the company's value goes down post purchase, anti-dilution provisions work to re-allocate shares from the existing common stock pool to the angel's preferred stock pool to make the angels feel better. The only question is, how many shares are re-allocated?
According to the Full Ratchet approach, the answer is: a lot. In fact, full ratchet does not even care about the number of the shares per se. It just cares about the bargain given to the new investors. How much are the new investors paying per share? That's deal the angel's now want.
An analogy would be you bought 10 pants at Banana Republic for $100 then someone else comes along and buys 10 pants for $10. Under FR, you get to say, 'Give me another 90 pairs of pants.'
It's called "Full Ratchet" because as a technical matter it demands that the ratio by which their preferred shares will be converted into common shares be retroactively decreased - "ratcheted down" - to the effective conversion ratio the new buyer is getting.FN2 The salient feature is that this occurs no matter how large or small the subsequent financing is (if - this is an extreme example - a company issues just 100 shares to subsequent investors at a $1.00 per share and the angels have 5,000 shares (for which they paid $10 per share), then under application of FR the angels gain (and the founders lose (the compensation has to come from somewhere)) an additional 45,000 shares.FN3
Weighted Average is a more measured approach. Although WA fixates on the deal the new buyers are getting, it takes into account the magnitude of the financing - how much new stock has been issued. The weight of the better deal price is balanced against the weight of the size of the purchase (similarly, the extent to which going 3 for 4 affects one's batting average depends on how late in the season the game is).FN4
There's a number of different formulas used for the calculation but as noted they aren't very intuitive so let's ignore them since the mathematical concept is straightforward. Take the post-money monetary value of the company under the old deal (just multiple the total number of company shares by the share price paid by the angel (in this case, $10 X the total number of shares (10,000 (assume 5,000 for angels, 5,000 for founders) = $100,000. This is our baseline company value under the old deal. Add to that the value being added by the new buyer - in this case $100 (100 shares at $1.00 per share). Divide (average out) that total value - $100,100 - by the total number of shares after the new buyer buys in: 10,100.
The number you get - $9.91 in this case - is going to be lower than the price paid by the angel - $10. It's an average between the old price and new price dependent on the aggregate number of shares being issued at the new price.FN2 How many shares does the angel's $50,000 investment get him now? Not 5,000 ($50,000/$10pershare) but 5,045 ($50,000/$9.91pershare).
FN1. "Original investor" and "new investor" are the two players here; "angels" is just shorthand for the former.
FN2. As noted, "conversion price" is misleading. The confusion becomes manifest in most examples you'll see - which will use $1 for the angel investment and then like fifty cents for the new investment and refer to these as conversion prices even though that is conflating two separate concepts. The conversion price is just the ratio by which preferred shares are converted into common shares, and often is 1:1 or .5:1. As a matter of fact, any investor will give a company a certain amount of money in exchange for a certain amount of preferred shares (which will have a certain price per share value that no one cares about) and THEN those shares will be deemed to convert to common shares according to a certain ratio.
FN3. Note that in these examples (and any such examples you'll see involving formulas) the calculation of the shares given to the new and old investors will be with respect to COMMON shares that the investors will eventually own. As indicated above no one really cares about how many preferred shares are being issued.
FN4. Under Weighted Average, the pants analogy works as such: There's 20 pairs of pants valued at $200 (you bought 10 for $100 and assume the founders also have 10). Add to the $200 valuation the $10 paid by the new buyers (for 10 pants). Divide $210 by the new total number of pants: 30, which equals $7. This becomes the retroactive price you paid. How many pants does $100 get you if it's $7 rather than $10 per pant? 14.28 instead of 10. Fashion for a fortnight.
Friday, February 18, 2011
Anti-Dilution Basics
Anti-dilution implicates two separate concepts, which tend to get muddled (like many words in the street glossary of financing, "dilution" has multiple meanings. Half of the expertise is being hip to the lingo).
First we have anti-dilution as the term is technically defined in term sheets, etc.: the proportional adjustment of stock ownership for a) internal recapitalizations (stock splits, stock dividends) or b) some exogenous transaction (i.e., a merger or, most significantly for this discussion, subsequent financing rounds). Within the context of the latter it means an angel's investment is protected from a future transaction in which the price-per-share is LOWER than the price-per-share they paid. It ONLY applies when the company's valuation GOES DOWN after the original investment. In VC parlance, it is "price-based protection" in the event of a "down-round."
Here's the relevant application: an angel investor has preferred stock (worth say $1.00 per share). The Company then creates and sells new stock (to say a VC) BUT at a price less than that (say $0.75 per share). Absent anti-dilution protection, there are now more shares in circulation and the average value of each share has gone down (to somewhere between 1 and .75 per share) so mathematically the angel's preferred stock has decreased in value.FN1
Anti-dilution mechanisms, however, work to give the angel FREE shares to compensate for the new stock being sold to the VC.FN2 The precise number of FREE shares depends on the anti-dilution mechanism (the most common being "full ratchet" and "weighted average" - the former is far more investor friendly) but the upshot is that the "value" of the original investor's investment will be maintained (or at least not lowered too much) despite the fact the market feels the company is performing more poorly than before (as evidenced by the lower valuation).
Note that the angel investor doesn't gain anything here. He just doesn't lose anything.FN3 Note also that this kind of anti-dilution is built (and usually only applies to "preferred" stock) into the charter documents.
Second, there are "pre-emptive rights" to participate in subsequent financing rounds - sometimes referred to as "right of first refusal" provisions - which effectively allow an angel investor to maintain his ownership PERCENTAGE by investing MORE money. In the parlance, this is the "right to maintain proportionate ownership”.
This right, as the parlance suggests, has a ceiling - typically "pro rata" to their existing ownership. Thus, if an investor has 10% ownership of a company and there is a new round of investment the investor has the right to invest enough money to maintain his 10% ownership but no more.
Pre-emptive rights are extraordinary rights which will not be inherent in a company's charter but rather provided (if at all) as part of a separate agreement (usually called an investor rights agreement) which accompanies the stock purchase (usually in connection with a Series A deal).
Note that if an angel lacks pre-emptive rights and the company valuation in a future round of financing increases, then anti-dilution does not apply. The angel's percentage ownership will necessarily be diluted due to the additional shares being put into circulation (i.e., a new claimant to the assets and/or income of a company reduces the percentage interests of the existing claimants), however, the overall value of his shares is going UP, due to the inflow of more capital, which naturally increases (at least for a time) the value of the company and any proportionate share in the company.
FN1. This presumes the net book/market value per share diminishes as a result of the financing. It's technically possible that the price per share paid by the VC investor for preferred was for some reason unaligned with the resulting book/market value of the common. This is unlikely but goes to show that the issue of dilution depends on what criteria are used to calculate the value.
FN2. The traditional mechanism by which this happens to angels is that the “Conversion Price” that determines the number of common shares the investor is entitled to receive upon conversion of the “preferred” stock is adjusted downward (by some pre-determined calculus), such that at the time of the future conversion, this investor will receive more shares in common stock (to compensate for the share value going down).
FN3. Somebody of course is losing - the founders and employees (or anyone else who owns the common stock). These parties are being diluted twice: once by the issuance of the shares to the new stockholders and a second time as a result of the adjustment to the conversion price of the preferred stock.
First we have anti-dilution as the term is technically defined in term sheets, etc.: the proportional adjustment of stock ownership for a) internal recapitalizations (stock splits, stock dividends) or b) some exogenous transaction (i.e., a merger or, most significantly for this discussion, subsequent financing rounds). Within the context of the latter it means an angel's investment is protected from a future transaction in which the price-per-share is LOWER than the price-per-share they paid. It ONLY applies when the company's valuation GOES DOWN after the original investment. In VC parlance, it is "price-based protection" in the event of a "down-round."
Here's the relevant application: an angel investor has preferred stock (worth say $1.00 per share). The Company then creates and sells new stock (to say a VC) BUT at a price less than that (say $0.75 per share). Absent anti-dilution protection, there are now more shares in circulation and the average value of each share has gone down (to somewhere between 1 and .75 per share) so mathematically the angel's preferred stock has decreased in value.FN1
Anti-dilution mechanisms, however, work to give the angel FREE shares to compensate for the new stock being sold to the VC.FN2 The precise number of FREE shares depends on the anti-dilution mechanism (the most common being "full ratchet" and "weighted average" - the former is far more investor friendly) but the upshot is that the "value" of the original investor's investment will be maintained (or at least not lowered too much) despite the fact the market feels the company is performing more poorly than before (as evidenced by the lower valuation).
Note that the angel investor doesn't gain anything here. He just doesn't lose anything.FN3 Note also that this kind of anti-dilution is built (and usually only applies to "preferred" stock) into the charter documents.
Second, there are "pre-emptive rights" to participate in subsequent financing rounds - sometimes referred to as "right of first refusal" provisions - which effectively allow an angel investor to maintain his ownership PERCENTAGE by investing MORE money. In the parlance, this is the "right to maintain proportionate ownership”.
This right, as the parlance suggests, has a ceiling - typically "pro rata" to their existing ownership. Thus, if an investor has 10% ownership of a company and there is a new round of investment the investor has the right to invest enough money to maintain his 10% ownership but no more.
Pre-emptive rights are extraordinary rights which will not be inherent in a company's charter but rather provided (if at all) as part of a separate agreement (usually called an investor rights agreement) which accompanies the stock purchase (usually in connection with a Series A deal).
Note that if an angel lacks pre-emptive rights and the company valuation in a future round of financing increases, then anti-dilution does not apply. The angel's percentage ownership will necessarily be diluted due to the additional shares being put into circulation (i.e., a new claimant to the assets and/or income of a company reduces the percentage interests of the existing claimants), however, the overall value of his shares is going UP, due to the inflow of more capital, which naturally increases (at least for a time) the value of the company and any proportionate share in the company.
FN1. This presumes the net book/market value per share diminishes as a result of the financing. It's technically possible that the price per share paid by the VC investor for preferred was for some reason unaligned with the resulting book/market value of the common. This is unlikely but goes to show that the issue of dilution depends on what criteria are used to calculate the value.
FN2. The traditional mechanism by which this happens to angels is that the “Conversion Price” that determines the number of common shares the investor is entitled to receive upon conversion of the “preferred” stock is adjusted downward (by some pre-determined calculus), such that at the time of the future conversion, this investor will receive more shares in common stock (to compensate for the share value going down).
FN3. Somebody of course is losing - the founders and employees (or anyone else who owns the common stock). These parties are being diluted twice: once by the issuance of the shares to the new stockholders and a second time as a result of the adjustment to the conversion price of the preferred stock.
Saturday, February 12, 2011
Annual Meeting of Shareholders (For Start-Ups)
Most state business statutes (e.g., Section 211 of the Delaware code) require that all corporations incorporated in that state hold an annual meeting of the shareholders. The principal purpose of the meeting is for the election of directors (but any other business properly brought before the meeting may be transacted). This requirement cannot be evaded by provisions in the bylaws.FN1
There are four important caveats here. First, the shareholders do not need to actually physically convene in one location. A meeting by video or phone conference will suffice. Second, there does not need to be any special notice (absent any mandate in the bylaws or certificate of incorporation) to the shareholders so long as shareholders waive notice and consent to the holding of the meeting (note that meetings of the shareholders are usually subject to somewhat technical notice requirements). Third, although not all shareholders need to participate, a quorum - usually defined in the bylaws as a majority of the shares permitted to vote (in no case can it be less than one-third of the shares permitted to vote under Delaware law) - is necessary for any meeting action to have force. Fourth, and most importantly, IF there is unanimous consent (this should be evidenced by executed document) as to the election of the Directors, there is no need to hold the annual meeting at all (i.e., unanimous consent functions "in lieu of an annual meeting" as the statute says).FN2
As already indicated, any other proper business may be transacted at the annual meeting.FN3
So why bother? Failure to hold the meeting does not result in dissolution of the corporation or invalidate subsequent corporate action. Instead, if the corporation fails to hold an annual meeting within 30 days after the designated date or if no date has been designated within 13 months of last annual meeting (or date of incorporation) any stockholder or director may apply to the DE Court of Chancery for an order requiring the meeting to be held.
More generally, however, especially with respect to start-ups and other emerging companies, an annual meeting is 1) evidence that the corporation is not just a shell for the personal interests of a handful of people and 2) a cost-effective guard against future claim(s) that certain corporate decisions did not properly reflect shareholder interests. It's an easy meeting to transact and document (most start-ups will just need 1) a waiver of notice and consent signed by all the shareholders and 2) Minutes of the Meeting which identify the directors who have been elected (signed by the "Chair of the Meeting" (an officer or whoever else the bylaws permits to chair the meeting)) and provides some level of protection in the event of a subsequent shareholder suit.
FN1. The location (it can be remote) and time of this annual meeting is built into the bylaws or chosen by the directors if the bylaws are silent (typically, though the timing is linked to either the date of the prior year's annual meeting or the end of the corporation's fiscal year and the applicable state statute will generally set the corporation's principal office as the default meeting location). Note, however, that nearly all statutory allowances given to directors (with respect to choice of location or any matter, really) are qualified (at least under Delaware law) by a generalized rule of equity whereby a court may subsequently find a board action inequitable even if it technically complies with statutory requirements if its implementation compromised a shareholder's ability to participate.
FN2. Caveat to the caveat: In the event that consent from the shareholders is less than unanimous, action by written consent (rather than an actual in person meeting) is still permissible if all of the directorships are vacant and need to be filled by such action.
FN3. Note also that "special" meetings of the stockholders may be called from time to time, customarily by the board of directors but also by any such person as is authorized to call a meeting in the certificate of incorporation or by the bylaws.
There are four important caveats here. First, the shareholders do not need to actually physically convene in one location. A meeting by video or phone conference will suffice. Second, there does not need to be any special notice (absent any mandate in the bylaws or certificate of incorporation) to the shareholders so long as shareholders waive notice and consent to the holding of the meeting (note that meetings of the shareholders are usually subject to somewhat technical notice requirements). Third, although not all shareholders need to participate, a quorum - usually defined in the bylaws as a majority of the shares permitted to vote (in no case can it be less than one-third of the shares permitted to vote under Delaware law) - is necessary for any meeting action to have force. Fourth, and most importantly, IF there is unanimous consent (this should be evidenced by executed document) as to the election of the Directors, there is no need to hold the annual meeting at all (i.e., unanimous consent functions "in lieu of an annual meeting" as the statute says).FN2
As already indicated, any other proper business may be transacted at the annual meeting.FN3
So why bother? Failure to hold the meeting does not result in dissolution of the corporation or invalidate subsequent corporate action. Instead, if the corporation fails to hold an annual meeting within 30 days after the designated date or if no date has been designated within 13 months of last annual meeting (or date of incorporation) any stockholder or director may apply to the DE Court of Chancery for an order requiring the meeting to be held.
More generally, however, especially with respect to start-ups and other emerging companies, an annual meeting is 1) evidence that the corporation is not just a shell for the personal interests of a handful of people and 2) a cost-effective guard against future claim(s) that certain corporate decisions did not properly reflect shareholder interests. It's an easy meeting to transact and document (most start-ups will just need 1) a waiver of notice and consent signed by all the shareholders and 2) Minutes of the Meeting which identify the directors who have been elected (signed by the "Chair of the Meeting" (an officer or whoever else the bylaws permits to chair the meeting)) and provides some level of protection in the event of a subsequent shareholder suit.
FN1. The location (it can be remote) and time of this annual meeting is built into the bylaws or chosen by the directors if the bylaws are silent (typically, though the timing is linked to either the date of the prior year's annual meeting or the end of the corporation's fiscal year and the applicable state statute will generally set the corporation's principal office as the default meeting location). Note, however, that nearly all statutory allowances given to directors (with respect to choice of location or any matter, really) are qualified (at least under Delaware law) by a generalized rule of equity whereby a court may subsequently find a board action inequitable even if it technically complies with statutory requirements if its implementation compromised a shareholder's ability to participate.
FN2. Caveat to the caveat: In the event that consent from the shareholders is less than unanimous, action by written consent (rather than an actual in person meeting) is still permissible if all of the directorships are vacant and need to be filled by such action.
FN3. Note also that "special" meetings of the stockholders may be called from time to time, customarily by the board of directors but also by any such person as is authorized to call a meeting in the certificate of incorporation or by the bylaws.
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