A law firm as creative as you are.
image001
You have the ambition. We can help you get there.

Massachusetts Appellate Court Rules On General Release Provisions As They Relate To Severance Agreements And Promises Of Equity

Posted on Jan 17th, 2018

Ryan S. Carroll

The Massachusetts Appeals Court recently affirmed the practice that a general release, including one provided in the context of an employment separation, extinguishes the signing party’s rights to all claims predating that release.  However, that general statement does not come without some caveats.

Alan MacDonald (MacDonald), had two separate terms of employment with Jenzabar, first as a CFO and later as a “Mergers and Acquisitions Researcher”.  During his first term of employment, MacDonald executed an employment agreement which provided for: (i) the issuance of a number of shares of preferred stock and (ii) an option to acquire 1,516,000 shares of common stock.  MacDonald and Jenzabar would enter into two additional agreements relating to his equity.  MacDonald then left Jenzabar and had not received his preferred shares nor exercised any of his vested interests.  At a later date, MacDonald joined Jenzabar for the second time and left shortly thereafter.  After his second departure, MacDonald and Jenzabar executed a severance agreement which provided for Jenzabar to continue to pay MacDonald’s salary and other benefits for six months in exchange for a general release of all claims, an affirmation and extension of a confidentiality obligation and an agreement that the severance agreement terminated and supersedes all other oral and written agreements or arrangements between MacDonald and Jenzabar.  After he signed the severance agreement, MacDonald attempted to exercise his option and Jenzabar denied the request, citing the release.  Litigation then ensued as to MacDonald’s rights to the equity and the enforceability of the severance agreement.

In MacDonald vs. Jenzabar, the court ruled that the general release provision and a merger and integration clause in the severance agreement extinguished MacDonald’s rights to the equity.

The general release language (“from any and all claims, liabilities, obligations, promises, agreements, damages, causes of action, suits, demands, losses, debts, and expenses . . . of any nature whatsoever, known or unknown, suspected or unsuspected, arising on or before the date of this Agreement.“) was held to be both clear and broad and that MacDonald released all rights to the preferred stock and option.  Further, the court cited that, “a general release disposes all claims and demands arising out of any transactions between the parties” and that “any intended exception should have been expressly stated.

Lastly, the court ruled the merger and integration clause contained in the severance agreement clearly extinguished all rights to the promised preferred shares and the option.

This case is an overall win for employers with respect to their separation arrangements. The case also illustrates the significance of any single word or phrase (or lack thereof) in a tightly-worded document, such as a release, when under the microscope of a court’s review.  Any ambiguity in this context creates risk for each party, and conversely creates negotiating leverage in terms of pre-litigation negotiations, leading to unnecessary cost and other negative impact for both parties.


Some Thoughts on Convertible Notes vs. Straight Equity

Posted on Mar 15th, 2013

In today’s early stage fundraising market, most seed investments come in several flavors: common stock, convertible notes (or “converts” as they are sometimes called) and a simple preferred stock investment. There are a lot of interesting posts on this topic on Quora and elsewhere so we thought that we would provide our take.

Common Stock

If you are looking for a simple and inexpensive process and you are raising a small amount of money ($250,000 or less), common stock may be a good choice. The documentation can be very simple – a short subscription agreement (with an investor questionnaire), shareholder agreement, stock certificates and you may be done. Typical terms include basic information rights, rights of first refusal and co-sale (or tag along) rights and a pro-rata right to participate in the next round of financing of the Company. From the company’s standpoint, it is generally a good idea to keep these deals as simple as possible, both to keep costs down and to avoid a complicated structure that could impact future investment rounds. If the company is an S-corporation, a common stock round (assuming all investors are eligible S-corp shareholders) also helps the company to keep its S-corp status, which can create tax benefits for active investors and founder shareholders.

The downside of an early common stock round is that it can lock the company into a fixed valuation that has not been really tested by the market. If the valuation is set too high, it will be difficult for the company to issue cheap stock and options. Since this is often a key attraction in joining a company at an early stage before they raise a larger capital round, an excessively high valuation could prejudice the company in attracting key talent at this formative stage. Another downside to a fixed price is that follow-on investors may challenge the valuation that was reached and try to impose a lower valuation—a down round—later. This potentially puts the company in the awkward position of mediating between the original investors and the new money. The original investors, of course, put their money in at a higher risk and may insist on their negotiated deal. The new money may want to pay less and thereby substantially dilute the original seed investors. Unlike a preferred stock or convertible note structure, common stock usually does not offer a simple price protection (like a weighted average broad based anti-dilution adjustment).

If the common stock value is too low, it may be unfair to the founders and key employees. This issue may take awhile to germinate, but by the first or second venture round, there may be pressure from management and the new investors to try to “reshuffle the deck” to get the key players more of a stake in the Company’s long term outcome.

Convertible Notes

There a lot of variations on this deal structure. Over the last several years, the most prevalent terms include an unsecured note carrying a 24-36 month term, interest ranging from 5-10%, and a conversion price based on the next “Qualifying Financing” of the Company (usually $1-2MM of new money). The conversion price is now often subject to two outside conditions that help reduce some of the uncertainty of the valuation of the Qualified Financing by subjecting it to a cap and a discount of the price in that round. The cap can range from $1-2MM on low end (considered low) to $7-8MM on the higher end (this range is usually seen where the Company already has some traction or where the founders are known players and therefore able to command better terms). The discount ranges from zero to 30%, usually being in the realm of 10-20%. Similar to common stock terms, investors usually get basic information rights and pro-rata participation rights for the company’s next financing round.

The documentation for these deals also tends to be pretty light, and while a bit more than the common stock offering, a lot less than a preferred stock investment. Typical documents involve a subscription or purchase agreement and some form of convertible note. Deals can also include warrants, although this seems a bit less common in today’s market. Similar to a common stock round, these deals can be closed quickly and cost-efficiently.

Like the common stock deals, a downside of convertible notes for the company can arise at the time of the next round, if the new investors see the terms as being too rich and do not want the old investors converting into the same security as them, and at a lower price. This issue has caused many sophisticated investors to opt for more set terms on valuation, resulting in the recent popularity of preferred seed rounds, discussed below.

Series Seed or Series A-1 Lite Preferred Stock

Because preferred stock investments are significantly more complicated to close than the other deal formats, a number of national law firms and investor syndicates have tried to develop a simple set of deal documents to make this structure more attractive. (See Fenwick & West Series Seed Docs for example.) While we commend these authors for trying to establish an open-source library to streamline this process and reduce expenses, these documents are basically a watered down version of other more comprehensive VC form documents, such as the NVCA Model Documents, and leave a lot of details out that could be material. For a small amount of investment — $500,000 or less — it would seem hard to justify this structure. Also, if the Company is an S-corp, it will automatically blow the Company’s S-corp election, something that may be better delayed until the investment amount is substantial and merits losing the single-tax structure. The creators behind the Series Seed argue that those documents can be just as fast and cost-effective as convertible notes, with the added benefits of giving “investors more clear definition around rights, more stability and less potential squabbling in the next round.”

The bottom line is that no structure is perfect and there are tradeoffs for all of the parties involved. While there are lots of free (and freemium) resources available to help educate entrepreneurs on these issues, experienced counsel should be sought to help document any transaction and ensure that it is done properly. All of these structures are designed to be cost efficient, to reduce the inevitable temptation for clients to do it themselves, and to allow folks with little or no money to establish the right foundation for their investment that will facilitate their growth and future investment potential.

If you have any questions about this topic, please email us.