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SEC Proposes New Rules under JOBS Act to Facilitate Investment in Private Companies

Posted on Jan 16th, 2014

Pursuant to the Title IV of the JOBS Act, in December 2013  the SEC proposed new rules to facilitate start ups and smaller companies to raise capital.  Title IV of the JOBS Act created a new exemption under section 3(b)(2) of the Securities Act of 1933, as amended (Securities Act), for smaller offerings. As directed by section 3(b)(2), the proposed rules would amend  the existing Regulation A, an exemption for unregistered public offerings of securities up to $5 million.

These proposed rules could be significant. The amended Regulation A, commonly referred to as “Regulation A+,” is intended to facilitate capital formation for small companies by addressing certain issues in the current Regulation A that have deterred companies from using Regulation A to raise funds, including the low maximum offering amount and the high costs of state blue-sky compliance requirements.  The proposed rules would create two tiers of Regulation A offerings: Tier 1 for offerings of up to $5 million in a 12-month period and Tier 2 for offerings up to $50 million in a 12-month period.  Both tiers would be subject to certain basic eligibility, disclosure, and procedural requirements that are derived from the existing Reg A framework, with certain updates to conform to current practices for registered offerings. Tier 2 offerings would be subject to additional requirements, including the provision of audited financial statements, ongoing reporting obligations, and certain investment limitations.  Tier 2 offerings would provide federal law preemption and thus be exempt from having to comply with state blue-sky requirements.

The proposed rules are subject to a 60-day public comment period after publication in the Federal Register. If adopted, Regulation A+ has the potential to provide start-ups and private companies with a viable alternative for raising capital quickly and inexpensively, while improving the liquidity of their securities in secondary markets.  We will continue to monitor these developments and will post updates as they become available.

 


Massachusetts Supreme Judicial Court interprets Investor’s Right to Recover for Misstatements

Posted on Aug 12th, 2013

A recent SJC decision involving a personal investment by Jack Welch in a failed Massachusetts hedge fund. The full decision can be read here.  Welch sued the fund and its manager for their failure to disclose that the manager was involved in a civil litigation (a landlord-tenant dispute over a former residency of the manager in New York), claiming that if he had known about that matter, he never would have invested.

The SJC upheld the summary judgment entered against Welch, holding that omission ultimately was not material enough to find the fund liable.
This case is interesting for its confirmation of certain provisions under the Massachusetts law on the following issues:

  • The statutory standard of a misstatement or omission is material  under the Massachusetts Securities Act is whether there is a “substantial likelihood” that the omitted information would have “significantly altered the ‘total mix’ of information” available to the ordinary reasonable investor.
  • A “material” fact is oneA “material” fact is one to which a reasonable person would attribute importance for his or her choice of action in the transaction at issue. Zimmerman v. Kent, 31 Mass.App.Ct. 72, 78 (1991).
  • The court also held that if there is finding in this regard under the Uniform Securities Act, then there cannot be a finding that the actions were deceptive under Chapter 93A.
  • The decision also provides a helpful summary of Massachusetts common law on fraud and negligent misrepresentation:
    • Intentional misrepresentation (or “deceit”): (a) an intentional or reckless (b) misstatement (c) of an existing fact (d) of a material nature, (e) causing intended reasonable reliance and (f) financial harm to the plaintiff.
    • Negligent misrepresentation: (a) a provision, in the course of the defendant’s business, profession, employment, or in the course of a transaction of his pecuniary interest, (b) of false information for the guidance of others in their business transactions, (c) without the exercise of reasonable care or competence in the acquisition or communication of the information, (d) causing justifiable reliance by, and (e) resulting in pecuniary loss to, the plaintiff.

If you have any questions about this topic, please feel free to email me directly.   My email address is dimitry.herman@hermanlawllc.com.

 

 


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.