If your startup just got a term sheet from an investor saying that they want to invest in your company and want to receive participating preferred stock with all of these other rights, you may be a bit overwhelmed. First off, congratulations on the proposed investment. Next, I’ll explain what all of those terms on the term sheet mean in this post starting with the participation component of participating preferred shares. Read more
Category: Investors
JOBS Act Broker-Dealer Registration Exemption
The JOBS Act contained many provisions which were aimed at making the capital raising process easier, simpler and quicker from a host of angles. Many things promised in the JOBS Act will not come to fruition until the SEC promulgates the regulations on the specific topic. Some of these are equity crowdfunding, and the ability for issuers to use general solicitation in Rule 506 offerings.
One of the things contained in the JOBS Act which went into effect immediately, was an exemption for broker-dealer registration for persons or entities acting as brokers in certain 506 offerings. The SEC just confirmed this in a recent FAQ available here. I’ll give a quick overview below. Read more
FINRA “Know Your Client” and Suitability Rules
Last summer (2012) FINRA came out with new Know Your Client (“KYC”) and Suitability Rules, which replaced NYSE Rule 405 (the old KYC Rule) and NASD Rule 2310 (the old Suitability Rule) applicable to securities brokers/dealers and firms. The old rules were pretty unclear and the new rules help to clarify some points, but aren’t exactly as clear as they can be. FINRA will have some wiggle room in applying them.
Corporate Dual Class Share Structures
A dual class share structure is used in certain corporations where one or more classes are given all or a bulk of the voting rights and another class or class has the same economic interest in the company, but none of the voting rights. There can also be other rights that are given to one class instead of the other. This type of structure is used so that the existing Board of Directors and management of the corporation maintain their control of the company. It bcaeme common in news organizations (think the Economist Group, or the News Corporation a la Rupert Murdoch) so that the company could ostensibly keep its journalistic integrity and credibility or to stay true to its goals, without pesky shareholders muddying the waters.
A dual class share structure can serve desirable goals, such as shielding management and the board from short term views of dissident shareholders/analysts and hostile takeovers. This can be helpful, as the constant quarterly pressure to meet revenue expectations is a burden on many companies at the expense of long term sustainable growth. Management at companies with dual class structures argue that if shareholders aren’t happy with the structure, they are free to sell their shares and walk away. Not surprisingly, only companies that are rather a hot commodity in the market can really get away with using this structure.
New York’s Proposed Angel Investor Tax Credit
I’ve been following a bill proposed by New York Assembly member Kellner for a while now. It is an Angel Investor Tax Credit, available to investors in “qualifying businesses”. New York Bill No. A09958. Investors would receive a credit based on 25% of their investment, but the maximum investment you can obtain the credit for is capped at $250,000.
A qualifying business is one that:
- has gross revenue of less than $1M for the year before the investment;
- has no more than 20 full time employees (60% must reside in NY State);
- has operated in the State of NY for no more than seven consecutive years; and
- has received no more than $2M in investments (eligible for the credit from one or more angel investors)
To be eligible for the credit, the angel investor must be an accredited investor as defined in Rule 501 of Regulation D, except for those that either 1. control fifty percent or more of the company being invested in, or 2. any company whose normal business activities include venture capital investment.
First, the idea is noteworthy. A number of other states have passed similar credits to encourage angel investing. In Wisconsin, they passed such a credit and angel investments increase from $30M in 2005 to $180M in 2010. That’s staggering. I would prefer to see that the credit be available for seed/angel and venture capital companies, however. I think excluding them is a bad idea.
There are some critics of state angel investor tax credits. They are usually out of state VC funds and investors. They say that these types of credits would discourage interstate investing, such as Boston based VC’s investing in New York startups, and other such situations. I don’t know if those critiques are warranted, however, as out-of-state investors aren’t penalized in any way other than having more competition in New York State. As investors in-state are now sure they will at least recoup 25% of their investment in the year after they invest, as well as having the possibility for large returns (i.e. the home run) down the road.
The bill was referred to the ways and means committee in April and held for consideration there in June. There hasn’t been much action on it since then and won’t be until at least 2013. It is something to keep in mind however as any incentive that can be put on the table to get the economy moving, especially the startup community is a good idea. Access to capital is a big issue for many young companies.
To Register or Not to Register?: Broker-Dealers and Finders
If you are involved in a startup you undoubtedly have heard about the company’s need to raise money. If you’ve gone the regular route you may be funded by institutional investors, like an angel or VC fund. The company may also have raised money through a private placement by selling equity to investors directly or through brokers.
You may have heard of another type of person involved in the capital raising process called a “finder”. Everyone has heard of the term a “finder’s fee” which is known to be about 10% of the overall transaction. The concept is the same with startup financing or M&A activities, although who can qualify as a finder and how they can be compensated has been a big deal with the SEC in the last couple years. The real issue is when anyone can act as a finder, and if they really should be registered with the SEC as a broker-dealer. Read more
SEC proposed regulations would allow general solicitation and advertising in a Rule 506 financing
Last week the SEC issued its proposed regulations to allow for public advertising and general solicitation in Rule 506 offerings.
As way of background, at this point when companies are trying to raise funds in a private offering, they typically rely on Rule 506 of Regulation D of the Securities Act of 1933, which allows for an unlimited amount of funds to be raised and minimal disclosure requirements if the securities are sold to accredited investors. Offering undertaken pursuant to Rule 506 also preempt state securities laws, except those relating to fraud and notice filing (and notice filing fee) requirements. While all of the above makes Rule 506 the “go to” securities law exemption, the main reason it was originally allowed is because it has historically only been able to be used in private offerings, where the issuer (or the broker acting for the issuer) had a pre-existing relationship with the investor.
The JOBS Act, which I’ve discussed, contained a provision which would require the SEC to promulgate regulations to allow general solicitation and advertising in Rule 506 offerings, provided that all purchasers in such offering are accredited investors.
Using “Convertible Equity” instead of Convertible Debt
As I’ve discussed, an option for startups to raise money is to do a convertible debt financing. In this sort of a transaction, the investor gives the company a loan evidenced by a convertible promissory note. The note is convertible upon a later financing round into the same type of securities that the financing round’s investors receive, and the note holder gets a discount on the per share purchase price. The benefits of this are that it is generally much quicker and straightforward than a typical seed/angel round and the company and investor do not have to have the awkward and difficult conversation regarding valuation of the company. The detriment to this type of transaction is that the company’s balance sheet is saddled with debt, and if the company does not raise another round of investment before the term of the convertible promissory note comes due, then the investor can essentially bankrupt the company if the investor does not want to extend the due date. Also, there are a good amount of investors that do not like investing through a convertible note, as one of the important terms – how much of the company the investor will own – is up in the air.
Recently, TheFunded.com and the Founder Institute annouced the introduction of a new concept called “Convertible Equity”. The concept and draft documents, were put together by Yokum Taku or Wilson Sonsini and a top accounting firm. TechCrunch has a good write up on it.
The form documents are available for free download here.
From a quick review of the documents it seems to be a great compromise. There would be no more maturity date or interest due. The startup will not have any debt on its books, and the investors would have the opportunity to qualify for the exclusion available on gains for holding “qualified small business stock”. It will still leave open how much of the company the investor actually owns, however, but that can probably be resolved using a valuation cap or some similar mechanism that can be drafted into the convertible equity documents.
The documents appear to automatically convert into shares of the company stock upon a change in control or qualified investment. There doesn’t appear to be an option for the investors to decide to convert at will or in any other circumstance, although certain provisions can be added for different situations.
This would be great if it gets adopted in the startup community, but like anything, it may take awhile. I know I will be recommending it as an alternative to convertible debt.
Crowdfunding – Prepare your Company to Crowdfund
As I’ve discussed earlier, the SEC is now preparing regulations to allow for Crowdfunding pursuant to the recently passed JOBS Act. These should be done by 2013 (emphasis on should be done by then – we’ll see when they actually come out). As you may have heard, it will allow for true equity sales over the World Wide Web. Companies will soon be able to sell shares of their corporation (or LLC) through online portals to regular persons that are not accredited investors (i.e. not millionaires or otherwise sophisticated).
There are a couple of things to discuss, the first is whether this is something your company actually would want to do. The second item is, if it is something you want to do, then what can you do to prepare your company to do a Crowdfunding raise in 2013 (or whenever the SEC finishes the regulations).
How do I Value my Company?: Startup Valuation
One of the most important issues when raising money from investors is the valuation of the company. This will drive all of the other financial terms of the deal: how many shares will be sold, at what price per share, and how much equity the investor will own in the company after the transaction.
In essence, for early stage (pre-revenue) startups, the company’s valuation is whatever the market deems it to be. I’m not being glib, that’s actually how it works. For example, say that I have a flat screen TV that I want to sell, if someone offers me $800, and then someone else offers me $900. I’m selling it for the $900 and that’s the TV’s market value. If an investor values you at $1M, then that’s your market value. Now he could be undervaluing you, but probably not by a large amount, and if the investment goes forward at that valuation then it’s the de facto market price. Now that doesn’t mean that there is no room to negotiate. That’s why it’s always said that early stage company valuation is an art and not a science.