Startup Financing Is Not A DIY Project

There are projects that are easy enough for a smart startup founder to take on, and then there are projects that are simply too complex, and which require the help of an experienced lawyer. Financings, such as a seed round or convertible note financing, are definitely not DIY projects.

Several years ago, I bought a townhouse in Berkeley. There was no disposal in the kitchen, so I decided to install one. I went to Home Depot, and picked the one that had “Easiest To Install” printed on the box. It was about $65, so the price was right. Well, I learned that “easiest to install” does NOT mean “easy to install.” First, I couldn’t detach the drainpipe from the sink drain, and not being an experienced plumber, I didn’t know how much brute force I could apply without destroying the sink. So I called a plumber, and he took care of that, and installed the disposal under the sink. Then he pointed out that there was no electrical outlet for plugging in the disposal. I called an electrician to install a new outlet, and finally, two professionals and $300 later, my disposal worked. What I thought was an easy DIY project, because of what the box said, turned out to be not so easy or cheap after all. The problem was, I didn’t know what I didn’t know.

When it come to securities and corporate finance, the overwhelming majority of startup founders don’t know what they don’t know. Today I had a discussion with a very smart acquaintance about “friends and family” rounds. I pointed out that there’s no special exemption under securities laws for friends and family, and that when a startup raises money from them, generally the startup is violating the securities laws. Not only might the startup have to return all the investors money, but there could be civil and criminal penalties, as well as problems with later financing rounds. This was all news to him, and I bet it’s news to most startup founders.

Convertible note rounds aren’t simple, either. If you don’t understand all the moving parts, it is really easy to screw up. Do the startup founders read the reps and warranties in the note purchase agreement? Do they know why those reps and warranties are there, or what may happen if a rep turns out to be false? If the convertible note has a valuation cap, do you know about the liquidation preference overhang problem? Do you know how to fix it? Are you willing to pay me a few hundred dollars to save yourself a few hundred thousand dollars? How many startup founders know that they have to file a Form D with the SEC, as well as with the states where the startup and its investors are located, when doing a convertible note round? I imagine very few. There are even some startup lawyers I know of who routinely do not file a Form D after a seed round for their clients.

The bottom line is, when you are facing something where you might incur civil or criminal penalties, and which, if done wrong, can screw up your later attempts to get investment, you should invest in a good lawyer, and let him or her do it the right way. Because some projects, like investment rounds, are simply not DIY.

New Exemption for Sales of Restricted Stock

President Obama signed legislation this month that creates a new, explicit exemption for private resales of restricted and control securities. The legislation, contained in Fixing America’s Surface Transportation Act (the FAST Act), will make it easier for the holders of restricted stock to cash out their holdings, provided they sell only to accredited investors.

Here is an overview of the new exemption’s requirements:

  • The seller can’t be the issuer of the stock or a direct or indirect subsidiary of the issuer
  • Each purchaser must be an “accredited investor”
  • There cannot be any general solicitation or advertising
  • The stock must be part of a class of stock that has been authorized and outstanding for at least 90 days prior to the sale date
  • The stock cannot be part of an unsold allotment to, or subscription or participation by, a broker or dealer as an underwriter or a redistribution
  • The seller is subject to the “bad actor” disqualification
  • If the issuer is a non-reporting issuer (not subject to the reporting requirements of Sections 13 or 15(d) of the Exchange Act), there are additional information requirements. The issuer must provide the seller and prospective purchaser, upon request, with reasonably current information about the issuer’s management team, financials, etc.

This new exemption, which is found in Section 4(a)(7) of the Securities Act, should provide a useful alternative to the Rule 144 safe harbor, which requires that the securities have been outstanding for at least 6 months if the issuer is a reporting company, or 1 year in all other cases. Rule 144 also places limits on the amount of stock that can be sold, a limitation that is not present in the Section 4(a)(7) exemption.

The new exemption also will provide a simplified alternative to the “Section 4(a)(1 ½) exemption,” which has been developed over a period of several years, but which has never been officially codified into law.

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EQUITY CROWDFUNDING 2.0

On October 30, the SEC took another shot at legalizing equity crowdfunding, by passing final regulations that are much more streamlined and simpler than the original regulations. The new regulations will take effect sometime next spring or summer, at the earliest.

Under the new regulations, a company can raise a maximum aggregate of $1 million through crowdfunding during a 12-month period. The company must use an SEC-registered intermediary – either a broker-dealer or a funding portal. While the company still must file certain information with the SEC and provide it to investors, the new regulations are more relaxed about the required financial statements. If the offering is between $500,000 and $1 million, the financial statements must be “reviewed” by a public accountant, but they need not be audited (unless audited financials are available). This removes a significant cost barrier that had existed in the previous set of regulations. During any 12-month period, the aggregate amount of securities a company can sell to an investor through all crowdfunding offerings cannot exceed $100,000.

On the investor side, the investment limits for individual investors over a 12-month period, across all crowdfunding offerings, are:

  • If either the investor’s annual income or net worth is less than $100,000, he can invest the greater of (a) $2,000 or (b) 5% of the lesser of annual income or net worth
  • If both the investor’s annual income and net worth are equal to or greater than $100,000, she can invest up to 10% of the lesser of her annual income or net worth.

So let’s look at Joe Investor, who earns $75,000 per year and has a net worth of $35,000. Since Joe’s net worth is less than his annual income, he can invest the greater of $2000 or 5% of his net worth, which comes to $1750. So in this scenario, Joe can invest $2000 over a 12-month period.

Now let’s look at Melinda Investor, Joe’s much more successful younger sister. Melinda earns $200,000/year, and has a net worth of $350,000. Since her income is less than her net worth, Melinda can invest up to 10% of her $200,000 income, or $20,000.

Securities purchased through a crowdfunding offering generally cannot be resold for one year after purchase.

While the new regulations greatly simplify the process for doing equity crowdfunding, they don’t really address the main problem that faces any startup that wants to use this. How does the company deal with potentially thousands of new stockholders, many of whom may have invested only a few hundred dollars (if that much)? I call these people the Great Unwashed, because beyond a few handfuls of cash, none of these are value-added investors. None will be bringing their expertise and experience to the company, the way a good angel or venture capital investor does. And yet the startup must prepare an annual report that it has to provide to all these stockholders. It also has to hold an annual meeting, notify all these stockholders of the meeting, hold the meeting at a location where these stockholders can attend (if they want), and allow them to vote on various corporate matters, such as the board of directors. Now the company will need to use some of those new funds to hire an investor relations manager, or use an outside service, and will have to devote time to keeping the Great Unwashed happy.

 

 

The Friends & Family Round

Prior to doing a seed round or a full venture capital financing, startups frequently need to do a “friends and family” round of financing. This money is often essential to carry startups through to the point where an angel investor would be interested, especially in the regions where angels will require more than just an idea or even an MVP before investing. A poorly-handled friends and family round, however, can get a startup in a lot of trouble. It could result in penalties and fines for violating federal and state securities laws, and it could also jeopardize getting angel financing. This piece should give some guidance as to how to do a friends and family round the right way.

Before getting into the details, we need to cover some basic securities laws. I promise to keep it non-technical. The federal securities laws require that before a company can sell any securities, those securities either have to be registered with the SEC, or exempt from registration. The registration process is quite expensive, with public filings and extensive disclosures. Think publicly-traded companies, like Apple, or Google. To avoid the prohibitive expense of registering securities, startups and other private companies look to one of several exemptions. This is how seed rounds and venture capital financings are handled.

These exemptions allow companies to offer and sell to either accredited investors, non-accredited investors, or both. Without going into extensive detail, accredited investors are rich people who can afford to lose their entire investment, or people who are sophisticated enough so that they can understand the risks of investing in an unproven startup. Or both. The preferred route is to offer and sell securities only to accredited investors. This greatly reduces the paperwork and disclosures that would otherwise be required when selling to non-accredited investors, or the Great Unwashed, as I like to call them.

The problem with the friends and family round is twofold. First, there’s no “friends and family” exemption from the registration requirement. So the securities laws apply, and the friends and family round has to fit into one of the other exemptions. Meaning either the investors are accredited, or non-accredited. That leads to the second part of the problem. Most friends and family are non-accredited. It would be great if all our friends and family were wealthy, or highly sophisticated investors, but for most of us that simply isn’t the case. So how can we get financing from friends and family without getting in trouble?

OPTION 1 – Accredited Investors Only

This is the preferred route. Only offer the investment opportunity to accredited investors. You could use a convertible note, much as you would with your angel investors, or you could use the SAFE structure. SAFE is relatively new, and it means Simple Agreement for Future Equity. You can find a discussion of SAFE here. The general idea is to use fairly standardized documents that won’t require a great deal of customization. This will keep your legal costs down (but that doesn’t mean you should try this without a lawyer).

Some key deal points in this option, whether you use a convertible note or SAFE:

  • Don’t include a valuation cap – trying to value the company at such an early stage just doesn’t make sense, and will most likely cause problems with later financing rounds.
  • Do include a discount, to reward your investors for the risk they are incurring by investing at such an early stage. A 20% discount is fairly standard.
  • Do include a “most-favored nation,” or MFN, provision. This allows the terms to be amended to be equivalent to the terms for the next financing round (typically the angel round).
  • You might also consider having your MFN provide a discount to the valuation cap that the angel investors get in a seed round. After all, these early investors are taking on a higher risk than the angels, so they should be rewarded.

OPTION 2 – Non-Accredited Investors

So what about the situation where you need money, you have friends and family that want to invest, but none of them are accredited investors? First of all, if you allow them to invest, you are going to get into trouble with the securities laws, because in all likelihood, you won’t be able to comply with the disclosure requirements. So instead of letting them invest in your company, you should structure this as a loan.

This loan will be a straight loan, not a loan that converts into equity. You will need to make it clear to these people that if they get repaid at all, it will be their principal and interest. If your company gets bought by Google or has an IPO, they won’t become millionaires. Because this is a risky loan, the interest rate should be correspondingly high. The maturity date, which is when the loan becomes due, should be tied to a future funding event, rather than a date on the calendar. Also, set the threshold for this funding event high enough that it is not an angel investment; angels are putting money into your company to help it grow, not to pay back your early lenders. So the loan should mature at a funding event of several million dollars, which will likely be your Series A round. Finally, the loan should be subordinated to any future debt issued to angel investors. That means that the angel investors will get paid back before the friends & family.

Is this option a great deal for the friends & family? No, it isn’t, and there are a lot of risks for them, without much upside other than the satisfaction of helping you succeed. Remember, however, this option is your last resort. You turn to this when there are no accredited investors out there, and you need this money to stay afloat.

A final word about your legal expenses. It’s tempting to think that because the documents are fairly standardized, or because you are dealing with friends and family, you don’t need to use a lawyer. Of course you don’t want your legal expenses to be a significant percentage of the capital you are raising. Resist the temptation to think you can hack this, because you can’t. Somewhere along the line, you’ll make a mistake that will cost you a lot more later. A mistake could mean no angel round, or it could mean serious penalties imposed by the SEC. Even if you find the documents online – and the SAFE documents are – you still want an experienced lawyer to walk you through them, so you know what the terms are and how they affect you. Standardized does not equal simple. You’ll want to make sure you’ve covered all the bases, and the best way to ensure that is to use a professional.*

*The powers-that-be require me to say that this is an attorney advertisement, so just in case you weren’t sure already, this is an attorney advertisement.

SAFE – A New Financing Tool for Startups

If you follow startups, you’ve probably heard of convertible notes and Series A financings, but the newest item is the SAFE – the Simple Agreement for Future Equity. SAFE is a seed-stage financing tool that provides a lower-cost, speedier alternative to convertible debt financings. SAFE was devised by Y-Combinator partner Carolynn Levy, who is also an attorney. The SAFE documents are designed to be short (about 5 pages, which is short for legal documents), and fairly standardized.

Y Combinator describes SAFE as “essentially convertible debt without the debt.” A convertible note is a loan that converts into equity in a company when certain events occur. When an investor uses SAFE, he is buying the right to obtain preferred stock when an equity-financing round occurs. It’s more like a warrant than debt. And unlike a convertible note, you don’t need to specify a term or an interest rate. When a convertible note reaches its maturity date without another financing round in sight, the startup needs to negotiate with the investor to extend them term. No such problem with SAFE. You also don’t necessarily need a valuation cap with SAFE, which can make the financing faster and less expensive. The SAFE document specifies that when an equity financing round occurs, the holder of the SAFE has the right to get preferred stock, based on his investment and the discount rate. If there is an acquisition or an IPO, the SAFE holder can either get his money back, or convert the SAFE to common stock.

Y Combinator has provided 4 variations of SAFE:

  1. SAFE Cap, No Discount
  2. SAFE Discount, No Cap
  3. SAFE CAP and Discount
  4. SAFE MFN, No Cap, No Discount

Cap refers to the valuation cap, as you probably already figured. Discount refers to the discount rate, which enables the SAFE investor to obtain a more favorable price for equity to compensate for the greater risk of investing early. For example, let’s say there’s a discount rate of 20%. When the next equity financing round occurs, if the new investors are buying in at $1/share, the SAFE investor gets to buy in at $0.80 per share. So the new investor gets 100,000 shares for $100,000, while the SAFE investor gets 125,000 shares for $100,000.

MFN means “most favored nation.” Let’s say a startup issues a SAFE MFN, with no cap or valuation discount, and then later issues a SAFE upon better terms to the later investors (for example, the later SAFE has a discount or a valuation cap). The SAFE MFN will be amended to include the more favorable terms from the later SAFE.

There are two important things to keep in mind with the SAFE. First, they are still securities, and therefore covered by the securities laws. While the documents are relatively straightforward, as legal documents go, it’s still worth talking with your lawyer before doing a SAFE financing. Second, the SAFE does go on your cap table, just like a warrant or option.