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.
Monday, February 21, 2011
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.
Saturday, January 29, 2011
Interns, Early Employees and Other Unpaid People
Any business, especially a pre-funded start-up, has an incentive to pay its agents as little as possible. Two issues here.
First, founders rarely think twice about working without pay, the idea being that everyone's compensation is represented by theoretical post-IPO pay out. However, all states, including California, have state minimum wage laws, which means problems might arise if, among other things, someone leaves the company prior to that pay-out (and the issue of his compensation is not contemporaneously resolved and documented).
Second, a start-up might be in a position to hire college students to work their little hearts out for free. This sounds convenient, but, like the decision to roll through a stop sign, requires some caution and forethought.
The legality of unpaid internships is a matter of both federal and state labor laws, which provide narrow exemptions for interns from minimum wage and overtime laws (state laws tend to pretty closely follow the Department of Labor (the "DoL") federal standard). The most recently promulgated federal standard (in the form of an April 2010 fact sheet on maintaining a compliant internship program) sets forth a six factor test for the exemption, which essentially requires:
1. The internship must provide some level of vocational or education-like training (think of an apprenticeship model) similar to the training given in a vocational school or academic institution.
2. The employer cannot derive "immediate advantage” from the intern’s activities. (This has been subject to a few different interpretations and the most reasonable standard of judgment (to the extent regulators' past practice and a 2002 decision by the Department of Labor’s Wage and Hour Division are indicative) seems to be whether the internship is, at the very least, mutually advantageous to both parties.)
3. The intern cannot be doing the same work as a regular employee (the "non-displacement" criterion). He should be doing intern stuff.FN1
As it turns out, this test may be almost impossible to satisfy. The acting director of the federal Labor Department’s Wage and Hour Division has stated, “There aren’t going to be many circumstances [where for-profit companies can have unpaid internships and] still be in compliance with the law.” That's a curiosity because unpaid internship programs are thriving and ubiquitous, at the highest level of business. So, on one hand, internship programs are unethical and illegal, and surely the cause of your ruin, FN 2 and on the other, you're a nit-wit if don't have one.
There are two alternative conclusions in light of this. The standard legal counsel is: pay the minimum wage. Don't roll through that stop sign! It's not invalid advice since a) the fact the DoL promulgated the fact sheet and 6 factor standard has people wondering if the DoL plans to more aggressively regulate; b) it might increase quality of your interns; and c) arguably, any company that can't benefit from a bright eager college kid at a minimum wage salary has problems.
As a matter of practice, however, based on the historical level and type of enforcement by the Department of Labor and their state regulator counterparts (as well as some of their published findings and commentary), the legal exposure from a well managed and properly instituted unpaid internship program is probably limited (depending on the circumstances) so long as you a) document the program and program processes FN3; b) limit interns to part-time work (to respect the DoL's non-displacement criterion) and c) most importantly, employ common sense and a generous spirit, which means the following:
-Hire carefully. FN4
-Be nice to your intern (free lunches, etc.).
-Don't treat him/her like just another employee.
-Don't make him/her hand sponge the bathrooms.
-Accept the fact that by giving your intern(s) meaningful assignments (to respect the DoL's "training" criterion), it's going to require a certain level of management effort, time and hassle.
FN1. The additional requirements include that the internship benefits from the training, you can't promise the intern a job after completion of the internship and he/she must appreciate no wages will be paid to him/her.
FN2. The liability for employers with misclassified unpaid interns includes unpaid wages, overtime and missed meal or rest periods, and certain waiting-time penalties as well as unpaid employment-related taxes owed to governmental agencies.
FN3. First and foremost, you should design and document a rudimentary "curriculum" (put together something) that the company plans to teach the intern. Additionally, you'll need to investigate whether there any state specific requirements (such as ensuring the intern receives academic credit from his school). More generally, you'll need to develop a wariness with respect to any written material (emails/agendas/plans) discussing tasks for which the intern(s) are responsible. Ideally, these materials should include language that reflects the tasks have some educational purpose.
FN4. Probabilistically, the trouble a company encounters in connection with an unpaid internship won't be caused by a random state or federal investigation. It will be caused by a disgruntled intern.
First, founders rarely think twice about working without pay, the idea being that everyone's compensation is represented by theoretical post-IPO pay out. However, all states, including California, have state minimum wage laws, which means problems might arise if, among other things, someone leaves the company prior to that pay-out (and the issue of his compensation is not contemporaneously resolved and documented).
Second, a start-up might be in a position to hire college students to work their little hearts out for free. This sounds convenient, but, like the decision to roll through a stop sign, requires some caution and forethought.
The legality of unpaid internships is a matter of both federal and state labor laws, which provide narrow exemptions for interns from minimum wage and overtime laws (state laws tend to pretty closely follow the Department of Labor (the "DoL") federal standard). The most recently promulgated federal standard (in the form of an April 2010 fact sheet on maintaining a compliant internship program) sets forth a six factor test for the exemption, which essentially requires:
1. The internship must provide some level of vocational or education-like training (think of an apprenticeship model) similar to the training given in a vocational school or academic institution.
2. The employer cannot derive "immediate advantage” from the intern’s activities. (This has been subject to a few different interpretations and the most reasonable standard of judgment (to the extent regulators' past practice and a 2002 decision by the Department of Labor’s Wage and Hour Division are indicative) seems to be whether the internship is, at the very least, mutually advantageous to both parties.)
3. The intern cannot be doing the same work as a regular employee (the "non-displacement" criterion). He should be doing intern stuff.FN1
As it turns out, this test may be almost impossible to satisfy. The acting director of the federal Labor Department’s Wage and Hour Division has stated, “There aren’t going to be many circumstances [where for-profit companies can have unpaid internships and] still be in compliance with the law.” That's a curiosity because unpaid internship programs are thriving and ubiquitous, at the highest level of business. So, on one hand, internship programs are unethical and illegal, and surely the cause of your ruin, FN 2 and on the other, you're a nit-wit if don't have one.
There are two alternative conclusions in light of this. The standard legal counsel is: pay the minimum wage. Don't roll through that stop sign! It's not invalid advice since a) the fact the DoL promulgated the fact sheet and 6 factor standard has people wondering if the DoL plans to more aggressively regulate; b) it might increase quality of your interns; and c) arguably, any company that can't benefit from a bright eager college kid at a minimum wage salary has problems.
As a matter of practice, however, based on the historical level and type of enforcement by the Department of Labor and their state regulator counterparts (as well as some of their published findings and commentary), the legal exposure from a well managed and properly instituted unpaid internship program is probably limited (depending on the circumstances) so long as you a) document the program and program processes FN3; b) limit interns to part-time work (to respect the DoL's non-displacement criterion) and c) most importantly, employ common sense and a generous spirit, which means the following:
-Hire carefully. FN4
-Be nice to your intern (free lunches, etc.).
-Don't treat him/her like just another employee.
-Don't make him/her hand sponge the bathrooms.
-Accept the fact that by giving your intern(s) meaningful assignments (to respect the DoL's "training" criterion), it's going to require a certain level of management effort, time and hassle.
FN1. The additional requirements include that the internship benefits from the training, you can't promise the intern a job after completion of the internship and he/she must appreciate no wages will be paid to him/her.
FN2. The liability for employers with misclassified unpaid interns includes unpaid wages, overtime and missed meal or rest periods, and certain waiting-time penalties as well as unpaid employment-related taxes owed to governmental agencies.
FN3. First and foremost, you should design and document a rudimentary "curriculum" (put together something) that the company plans to teach the intern. Additionally, you'll need to investigate whether there any state specific requirements (such as ensuring the intern receives academic credit from his school). More generally, you'll need to develop a wariness with respect to any written material (emails/agendas/plans) discussing tasks for which the intern(s) are responsible. Ideally, these materials should include language that reflects the tasks have some educational purpose.
FN4. Probabilistically, the trouble a company encounters in connection with an unpaid internship won't be caused by a random state or federal investigation. It will be caused by a disgruntled intern.
Friday, January 28, 2011
Raising Capital and Securities Laws - An Introduction
A subset of the requirements for seed and VC financing is compliance with federal and state securities laws (the latter tend to track the requirements of the former). As a general matter these laws are designed to protect investors by demanding that sellers of securities (like stock) make proper disclosures to investors (about the value of the business) usually by making information about the company and the sale publicly available. Within the context of start-up financing, however, there are exemptions from these statutory demands (which are very expensive to comply with) so long as the start-up follows certain rules.
The chief exemption at issue here is Regulation D, promulgated under the Securities Act of 1933, which provides, through Rules 504-506 of Reg D, the framework typically used by start-ups when selling stock.FN1 These rules principally turn on the i) amount of capital being raised, ii) type of investor and iii) method of conducting the sale but in specific application can get highly technical (mostly due to "if, then" contingencies between state requirements and federal requirements) so take the summary below as an overview subject to caveat.
As a threshold matter there are capital restrictions. Rule 504 is restricted to "offerings" of up to $1 million, Rule 505 to offerings of up to $5 million and Rule 506 to any higher amount.FN2 Note that it's the "offering" amount, not the "sale" amount, that determines the classification.
Second, there are the investor type and investment method limitations and they operate as follows:
-Rule 504 is the most liberal, placing no restrictions on the number of persons purchasing securities or on what the purchaser may do with the purchased securities (so long in the latter case as the investors are "accredited"). There are no disclosure requirements (with respect to the documents provided to investors) under Rule 504 as long as statements in any "offering materials" (including marketing documents such as a power point or business plan or memorandum) do not violate the Security Act's antifraud prohibitions (by being misleading), HOWEVER, it does not allow (absent state registration of the securities) "general solicitations" or advertisements (there's a slew of technical rules on what constitutes a general solicitation but basically it's marketing to investors with whom there wasn't a pre-existing relationship).
NOTE, however, the state securities laws may qualify Rule 504 (California, for instance, limits (via Section 25102(f)) all such non-registered offerings to no more than 35 "unaccredited" investors).
-Rule 505 like the California rule requires that all but 35 of the investor(s) be "accredited" (i.e., i) a company or investment group with over $5 million in assets, ii) founder(s) of the company, iii) or wealthy people (based on a net worth/income test)).FN3 In addition, to the extent an offering is made to any unaccredited investors (here is the huge difference from Rule 504), disclosure documents must be provided that are generally the same as those used in registered offerings (an exercise costly enough that it effectively bars the inclusion of unaccredited investors). Finally, the securities sold must be "restricted" (i.e., resale in the public marketplace is prohibited absent some Securities Act exemption).
-Rule 506 - the most commonly relied upon exemption for Series A financings - is substantially similar to 505 except i) there is no $ cap, ii) the 35 unaccredited investors (if any) have to be "sophisticated", and iii) it preempts state securities laws, so the only form required to be filed with states (in which there is a sale) is a copy of a "Form D" (filed with the SEC).FN4
The upshot of the above is that companies that sell to friends and family use 504 and everyone else uses 506. In both cases, any information given to investors must be accurate and complete, which means that financial data, if any, should as a mater of best practice be audited and certified and the term sheet and purchase agreement be industry standard.
The final step to close the transaction is to file a Form D SEC notice of sale filing (that notifies the SEC that securities are being sold pursuant to Regulation D and provides basic information on the company and the offering).FN5 In addition, all proper materials must be filed with in each state in which there is sale (i.e, where a buyer is a resident) (in the case of a 506 offering, simply send a copy of the SEC Form D and the applicable state Form D "appendix"). In most states such forms do not need to be filed until the money has been received from the relevant investor(s). The typical grace period for filing these forms is 15 days after the transfer of funds.
FN1. Two caveats here. First, start-ups will also need to seek a separate exemption (Rule 701) for the creation of a stock option pool. Second, other sections of the Securities Act (e.g., Sections 4(2) and 4(6)) also provide exceptions to registration that would be applicable to start-ups raising capital, however, these sections are either less straight-forward (due to judicial interpretation) or niche enough that Rules 504-506 have over time become the "best practices" exemptions applicable to most capital raising scenarios.
FN2. Note that these monetary limitations are calculated on a rolling basis within a 12 month period - the "integration rule." The integration rule is one more incentive to use a Rule 506 exemption (which has no monetary limit).
FN3. Specifically, a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase or ith income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
FN4. 506 but not 504 and 505 preempts state laws because the latter were adopted under Section 3(b) of the Securities Act rather than 4(2).
FN5. None of Rules 504-506 require a filing of a Form D - the benefit of doing so is primarily in that if it's a Rule 506 offering then state securities laws are preempted.
The chief exemption at issue here is Regulation D, promulgated under the Securities Act of 1933, which provides, through Rules 504-506 of Reg D, the framework typically used by start-ups when selling stock.FN1 These rules principally turn on the i) amount of capital being raised, ii) type of investor and iii) method of conducting the sale but in specific application can get highly technical (mostly due to "if, then" contingencies between state requirements and federal requirements) so take the summary below as an overview subject to caveat.
As a threshold matter there are capital restrictions. Rule 504 is restricted to "offerings" of up to $1 million, Rule 505 to offerings of up to $5 million and Rule 506 to any higher amount.FN2 Note that it's the "offering" amount, not the "sale" amount, that determines the classification.
Second, there are the investor type and investment method limitations and they operate as follows:
-Rule 504 is the most liberal, placing no restrictions on the number of persons purchasing securities or on what the purchaser may do with the purchased securities (so long in the latter case as the investors are "accredited"). There are no disclosure requirements (with respect to the documents provided to investors) under Rule 504 as long as statements in any "offering materials" (including marketing documents such as a power point or business plan or memorandum) do not violate the Security Act's antifraud prohibitions (by being misleading), HOWEVER, it does not allow (absent state registration of the securities) "general solicitations" or advertisements (there's a slew of technical rules on what constitutes a general solicitation but basically it's marketing to investors with whom there wasn't a pre-existing relationship).
NOTE, however, the state securities laws may qualify Rule 504 (California, for instance, limits (via Section 25102(f)) all such non-registered offerings to no more than 35 "unaccredited" investors).
-Rule 505 like the California rule requires that all but 35 of the investor(s) be "accredited" (i.e., i) a company or investment group with over $5 million in assets, ii) founder(s) of the company, iii) or wealthy people (based on a net worth/income test)).FN3 In addition, to the extent an offering is made to any unaccredited investors (here is the huge difference from Rule 504), disclosure documents must be provided that are generally the same as those used in registered offerings (an exercise costly enough that it effectively bars the inclusion of unaccredited investors). Finally, the securities sold must be "restricted" (i.e., resale in the public marketplace is prohibited absent some Securities Act exemption).
-Rule 506 - the most commonly relied upon exemption for Series A financings - is substantially similar to 505 except i) there is no $ cap, ii) the 35 unaccredited investors (if any) have to be "sophisticated", and iii) it preempts state securities laws, so the only form required to be filed with states (in which there is a sale) is a copy of a "Form D" (filed with the SEC).FN4
The upshot of the above is that companies that sell to friends and family use 504 and everyone else uses 506. In both cases, any information given to investors must be accurate and complete, which means that financial data, if any, should as a mater of best practice be audited and certified and the term sheet and purchase agreement be industry standard.
The final step to close the transaction is to file a Form D SEC notice of sale filing (that notifies the SEC that securities are being sold pursuant to Regulation D and provides basic information on the company and the offering).FN5 In addition, all proper materials must be filed with in each state in which there is sale (i.e, where a buyer is a resident) (in the case of a 506 offering, simply send a copy of the SEC Form D and the applicable state Form D "appendix"). In most states such forms do not need to be filed until the money has been received from the relevant investor(s). The typical grace period for filing these forms is 15 days after the transfer of funds.
FN1. Two caveats here. First, start-ups will also need to seek a separate exemption (Rule 701) for the creation of a stock option pool. Second, other sections of the Securities Act (e.g., Sections 4(2) and 4(6)) also provide exceptions to registration that would be applicable to start-ups raising capital, however, these sections are either less straight-forward (due to judicial interpretation) or niche enough that Rules 504-506 have over time become the "best practices" exemptions applicable to most capital raising scenarios.
FN2. Note that these monetary limitations are calculated on a rolling basis within a 12 month period - the "integration rule." The integration rule is one more incentive to use a Rule 506 exemption (which has no monetary limit).
FN3. Specifically, a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase or ith income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
FN4. 506 but not 504 and 505 preempts state laws because the latter were adopted under Section 3(b) of the Securities Act rather than 4(2).
FN5. None of Rules 504-506 require a filing of a Form D - the benefit of doing so is primarily in that if it's a Rule 506 offering then state securities laws are preempted.
Thursday, January 20, 2011
Customer Data and Use/Distribution Disclosure
You care about your customer's privacy but you also want to get rich. This can be a dissonance.
The Federal Trade Commission Act and its state statutory analogues (which govern unfair or deceptive business practices) govern issues related to consumer privacy for commercial web sites (the FTC was given jurisdiction over online privacy and information security in 1999).FN1Federal regulators and state attorneys general are fairly active in investigating companies who misuse customer data. The take-away from such investigations is not that you can't capitalize on the value of such data; however, there are some points to consider:
1 - Doing What You Say. The scrutiny of an online privacy practice begins by identifying how the web site collects and uses customer data (including non-identifable data such as IP addresses). The reality is that unless the customers/users are uniquely protected (see FN1) there are few business limitations on what you can do with customer data once they knowingly give it to you. The most troublesome (to the company) violations of consumer privacy almost always occur in the following scenario: there is a discrepancy between how customers think a company will use/distribute their data and how that data is actually used and distributed.FN2
2 - (!!!) CONSPICUOUS (!!!) Display. The privacy policy, however finely articulated, can't be buried deep within the site. Best practice (as well as California statutory requirement) is to link to it from the home page.FN3
3 - What You Say. The privacy policy should identify a) what customer data is being collected (this includes ostensibly transactional data like IP address, user names, passwords, etc.), b) how it's being collected, c) how it's being used and why (for security purposes, diagnostics, improving the user experience, etc.), and d) whether it's being distributed to any third parties. Occasionally, you hear an argument that disclosure should be vague so as to avoid accusations of deception later, but that's 1) a bit nefarious and 2) you probably won't get away with it.
With respect to distribution, identify the third parties that will be given the data, and how those third parties will use it. Additionally, even if the data is not being distributed as part of business relationship, disclose that the data may be subject to (i) disclosure via a subpoena or some other governmental request (given enough process the government will always, always, be able to obtain the data (don't act like you're not impressed)) and (ii) an unlawful security breach.
4 - Retention. The policy should also address the issue of how long the company intends to retain the data, which should probably include whether the customer's data may be sold in event of a merger or bankruptcy (and thereby subject to the privacy practices of the acquiring third party).
5 - Appropriate Security Procedures. This is as much a business and technical issue as a legal issue but the history of FTC actions suggests that even well intentioned web sites may run afoul of FTC regulations if their security practices are not reasonable and appropriate to the nature of the data.
6 - Consumer Choice and Changes. Provide methods for users to correct inaccuracies or otherwise review and change personally identifiable information and describe how changes to the privacy policy will be communicated (California statutory requirements).
FN1. Until recently, no law made it a generalized requirement that a web sites have a privacy policy - it was primarily used as a business strategy (to appear trustworthy). The California Online Privacy Protection Act (enacted 2004), because it mandates privacy policies to any California consumer, changed that. In addition, if a web site operates in a) the financial services industry, b) the health care industry or c) can anticipate users under the age of 13, special and additional compliance measures must be heeded. The specific governing laws here are beyond the scope of this post but in brief they include the following: a) Gramm Bliley Leach Act (which requires that special disclosure and opt out provisions (in certain cases) be provided where the web site is collecting financial information), b) Child Online Privacy Protection Act - not to be confused with the Child Online Protection Act - (which applies to the online collection of personal information from children under 13), and c) Health Insurance Portability and Accountability Act (which establishes regulations for the use and disclosure of protected health information).
FN2. Recent studies indicate that there is a widespread disconnect between how privacy policies are articulated at the highest level of management and how privacy practices operate on the ground. In addition, from a business perspective, it might make sense to know the privacy policies of your competitors.
FN3. Google, for example, got heat for failing to put a privacy policy disclaimer on their famously sparse home page (they argued that it appeared on search pages and users could use the search box to find it). After some negotiation, they caved and placed it center bottom.
The Federal Trade Commission Act and its state statutory analogues (which govern unfair or deceptive business practices) govern issues related to consumer privacy for commercial web sites (the FTC was given jurisdiction over online privacy and information security in 1999).FN1Federal regulators and state attorneys general are fairly active in investigating companies who misuse customer data. The take-away from such investigations is not that you can't capitalize on the value of such data; however, there are some points to consider:
1 - Doing What You Say. The scrutiny of an online privacy practice begins by identifying how the web site collects and uses customer data (including non-identifable data such as IP addresses). The reality is that unless the customers/users are uniquely protected (see FN1) there are few business limitations on what you can do with customer data once they knowingly give it to you. The most troublesome (to the company) violations of consumer privacy almost always occur in the following scenario: there is a discrepancy between how customers think a company will use/distribute their data and how that data is actually used and distributed.FN2
2 - (!!!) CONSPICUOUS (!!!) Display. The privacy policy, however finely articulated, can't be buried deep within the site. Best practice (as well as California statutory requirement) is to link to it from the home page.FN3
3 - What You Say. The privacy policy should identify a) what customer data is being collected (this includes ostensibly transactional data like IP address, user names, passwords, etc.), b) how it's being collected, c) how it's being used and why (for security purposes, diagnostics, improving the user experience, etc.), and d) whether it's being distributed to any third parties. Occasionally, you hear an argument that disclosure should be vague so as to avoid accusations of deception later, but that's 1) a bit nefarious and 2) you probably won't get away with it.
With respect to distribution, identify the third parties that will be given the data, and how those third parties will use it. Additionally, even if the data is not being distributed as part of business relationship, disclose that the data may be subject to (i) disclosure via a subpoena or some other governmental request (given enough process the government will always, always, be able to obtain the data (don't act like you're not impressed)) and (ii) an unlawful security breach.
4 - Retention. The policy should also address the issue of how long the company intends to retain the data, which should probably include whether the customer's data may be sold in event of a merger or bankruptcy (and thereby subject to the privacy practices of the acquiring third party).
5 - Appropriate Security Procedures. This is as much a business and technical issue as a legal issue but the history of FTC actions suggests that even well intentioned web sites may run afoul of FTC regulations if their security practices are not reasonable and appropriate to the nature of the data.
6 - Consumer Choice and Changes. Provide methods for users to correct inaccuracies or otherwise review and change personally identifiable information and describe how changes to the privacy policy will be communicated (California statutory requirements).
FN1. Until recently, no law made it a generalized requirement that a web sites have a privacy policy - it was primarily used as a business strategy (to appear trustworthy). The California Online Privacy Protection Act (enacted 2004), because it mandates privacy policies to any California consumer, changed that. In addition, if a web site operates in a) the financial services industry, b) the health care industry or c) can anticipate users under the age of 13, special and additional compliance measures must be heeded. The specific governing laws here are beyond the scope of this post but in brief they include the following: a) Gramm Bliley Leach Act (which requires that special disclosure and opt out provisions (in certain cases) be provided where the web site is collecting financial information), b) Child Online Privacy Protection Act - not to be confused with the Child Online Protection Act - (which applies to the online collection of personal information from children under 13), and c) Health Insurance Portability and Accountability Act (which establishes regulations for the use and disclosure of protected health information).
FN2. Recent studies indicate that there is a widespread disconnect between how privacy policies are articulated at the highest level of management and how privacy practices operate on the ground. In addition, from a business perspective, it might make sense to know the privacy policies of your competitors.
FN3. Google, for example, got heat for failing to put a privacy policy disclaimer on their famously sparse home page (they argued that it appeared on search pages and users could use the search box to find it). After some negotiation, they caved and placed it center bottom.
Friday, January 14, 2011
Privacy Laws and the unBank
The obvious trouble with banking rules regarding consumer privacy (governed in relevant (to this posting) part by Title V of the Gramm Bliley Leach Act ("GBL")) is the compliance costs. FN1 Less obvious is the problem of being a bank and not knowing it.FN2
The advent of the Internet is recent enough that the law with respect to online financial services is still a little unsure of itself. This creates opportunity and legal exposure for early movers.
The definition of a bank according to the GBL (in final promulgation) includes any companies that are "significantly engaged" in providing financial products/services (like loans, financial or investment advice, or insurance). FN3 Thus, certain companies not traditionally thought of as "banks," like certain institutions of higher learning (if they offer loans and at least with respect to "security" of consumer data FN4), auto dealers (if they finance), tax preparers, providers of real estate settlement services, and debt collectors are deemed banks for the purposes of the rule.
Further, because the "significant engagement" definition requires a fact-based determination in an rapidly evolving industry, there remains uncertainty regarding the level of financial activity that is required for a company to become subject to GLB. Do, for example, certain payment service providers (e.g., Paypal FN5) qualify (probably - although it may turn on whether the PSP "holds" onto funds)? Peer-to-peer lending companies (such as Prosper, Lending Club, and Zopa) (quite likely)? Gift card applications (like the mobile ones offered by Starbucks or Target)? Mobile ticketing platforms (e.g., BART)? Nonprofits issuing charitable gift annuities? Providing long-term payment plans subject to interest (for any product)?
A useful short-hand (and oblique low-brow cultural reference) is this: if you're in the business of linking a customer to a bank account, you might be a financial institution.FN6
FN1. The business of providing banking services (online or otherwise) demands careful observance of federal and state rules with respect to the protection of consumer's non-public financial information. The rules are niche and multitudinous (turning in part on whether the bank has an on-going (like a personal loan service) or one-off transactional (like with a check cashing service)) relationship with the customer (only the former are entitled to receive a financial institution's privacy notice automatically; the latter must receive a privacy notice only if such consumer's information is being shared with non-affiliated third parties (with some exceptions)) but, in brief, they require the following: a) disclosure of information collected and distributed to affiliated and non affiliated third parties, b) opt-out procedures, c) annual notices and d) the implementation of an information security program. You can go here for a more detailed run down on the application of these requirements.
FN2. Among the penalties for non-compliance with GLB is up to five years in prison.
FN3. Definition at 16 CFR 313.3(k)(1).
FN4. The GLB governs acts beyond the disclosure of privacy practices, including the requirements for safeguarding the security of private data and the prevention of scams to get customer data ("pretexting").
FN5. Many commentators have found it noteworthy that Paypal distributed an annual, GLB-compliant, privacy disclosure to its users.
FN6. We can probably go further and say that if you receive or transmit bank account information from your customers (even if you don't hold any of the customer's funds, even for a moment) you should seriously consider whether your subject to the GLB.
The advent of the Internet is recent enough that the law with respect to online financial services is still a little unsure of itself. This creates opportunity and legal exposure for early movers.
The definition of a bank according to the GBL (in final promulgation) includes any companies that are "significantly engaged" in providing financial products/services (like loans, financial or investment advice, or insurance). FN3 Thus, certain companies not traditionally thought of as "banks," like certain institutions of higher learning (if they offer loans and at least with respect to "security" of consumer data FN4), auto dealers (if they finance), tax preparers, providers of real estate settlement services, and debt collectors are deemed banks for the purposes of the rule.
Further, because the "significant engagement" definition requires a fact-based determination in an rapidly evolving industry, there remains uncertainty regarding the level of financial activity that is required for a company to become subject to GLB. Do, for example, certain payment service providers (e.g., Paypal FN5) qualify (probably - although it may turn on whether the PSP "holds" onto funds)? Peer-to-peer lending companies (such as Prosper, Lending Club, and Zopa) (quite likely)? Gift card applications (like the mobile ones offered by Starbucks or Target)? Mobile ticketing platforms (e.g., BART)? Nonprofits issuing charitable gift annuities? Providing long-term payment plans subject to interest (for any product)?
A useful short-hand (and oblique low-brow cultural reference) is this: if you're in the business of linking a customer to a bank account, you might be a financial institution.FN6
FN1. The business of providing banking services (online or otherwise) demands careful observance of federal and state rules with respect to the protection of consumer's non-public financial information. The rules are niche and multitudinous (turning in part on whether the bank has an on-going (like a personal loan service) or one-off transactional (like with a check cashing service)) relationship with the customer (only the former are entitled to receive a financial institution's privacy notice automatically; the latter must receive a privacy notice only if such consumer's information is being shared with non-affiliated third parties (with some exceptions)) but, in brief, they require the following: a) disclosure of information collected and distributed to affiliated and non affiliated third parties, b) opt-out procedures, c) annual notices and d) the implementation of an information security program. You can go here for a more detailed run down on the application of these requirements.
FN2. Among the penalties for non-compliance with GLB is up to five years in prison.
FN3. Definition at 16 CFR 313.3(k)(1).
FN4. The GLB governs acts beyond the disclosure of privacy practices, including the requirements for safeguarding the security of private data and the prevention of scams to get customer data ("pretexting").
FN5. Many commentators have found it noteworthy that Paypal distributed an annual, GLB-compliant, privacy disclosure to its users.
FN6. We can probably go further and say that if you receive or transmit bank account information from your customers (even if you don't hold any of the customer's funds, even for a moment) you should seriously consider whether your subject to the GLB.
Subscribe to:
Posts (Atom)