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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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.

Anatomy of a Term Sheet – Piggyback and S-3 Registration

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth.

Last time we began a discussion of registration rights, and focused on demand registration rights. Today we are going to focus on two other kinds of registration rights — piggyback rights and S-3 registration rights — as well as expenses and lockup terms.

Piggyback Registration Rights

Here is the piggyback registration rights term from our Model Term Sheet:

The holders of Registrable Securities will be entitled to “piggyback” registration rights on all registration statements of the Company, subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered to a minimum of [2030]% on a pro rata basis and to complete reduction on an IPO at the underwriter’s discretion.  In all events, the shares to be registered by holders of Registrable Securities will be reduced only after all other stockholders’ shares are reduced. 

This is a fairly straightforward and noncontroversial term. Basically, if the company is going to be registering its securities with the SEC for a public offering, the investors want to be able to register the securities they hold at the same time. This will enable the investors to cash out without complying with Rule 144’s requirements.

There are a couple of interesting aspects to note. In the case of an IPO, the underwriter has the discretion to override the piggyback rights of the investor. In the case of subsequent public offerings, the underwriter can cut back the percentage of the investors’ shares that will be permitted to piggyback on the registration.

Founders and management should also negotiate to have piggyback registration rights, for the same reason the investors want them. The founders will want to participate in an IPO or other public offering, so they can cash out shares without complying with the requirements of Rule 144.

S-3 Registration Rights

The S-3 registration rights term is as follows:

The holders of [10-30]% of the Registrable Securities will have the right to require the Company to register on Form S-3, if available for use by the Company, Registrable Securities for an aggregate offering price of at least $[1-5 million].  There will be no limit on the aggregate number of such Form S-3 registrations, provided that there are no more than [two] per year.

A Form S-3 registration is shorter and less burdensome than the Form S-1 registration used in an IPO. It can be used by the company one year after an IPO, and allows the company to reference certain items contained in other SEC filings. Consequently, while the S-3 registration rights are demand rights, they aren’t as burdensome as the primary demand registration rights.

The company will want to limit the number of S-3 registrations to 1 or 2 a year, because of the costs and time involved. The company also will want to set a minimum dollar amount for S-3 registrations (somewhere between $1 million and $5 million), again because of the cost and time involved.

Expenses and IPO Lockup

There are two other items related to registration rights worth covering while we are on the subject. The first is expenses. Typically the company will pay the expenses of an SEC registration. Our model term sheet also contains a provision for the company to pay for one special counsel to represent all participating stockholders, subject to a negotiable cap on fees.

The second item is the IPO lockup. The lockup term prevents investors, directors, officers, and major shareholders (1-5%) of the company from selling their shares until 180 days after an IPO, if the underwriter requests. This allows the market to adjust and absorb the additional sales.

Thank you for reading. You can follow me on Twitter @PaulHSpitz

Anatomy of a Term Sheet – Registration Rights

Welcome back to Anatomy of a Term Sheet, a multi-part series in which we take the model Series A term sheet from the NVCA, and analyzing the various terms in depth. 

We have finished with the charter terms and the Stock Purchase Agreement section of the model Term Sheet. Today we start working on the Investor Rights Agreement section, and we will begin with registration rights.

The ultimate goal of any venture capital investment is to make money. Most VC investments either fail, or just barely return the investors’ money. Consequently, VC’s have to hit a grand slam now and then, to pay for all the mediocre and poor investments, and allow the VC’s to cash out with a good return on their investment.

Cashing out is not an easy or simple process for the VC. Until the company goes public, all the investments in the startup, whether it is the seed investment or the Series A (and B, and C, etc.), have been private transactions. The company’s securities – common stock, convertible notes, and preferred stock – have all been sold without registering them with the SEC, and therefore the securities are “restricted.” Rule 144 of the Securities Act of 1933 imposes certain restrictions on the sale of unregistered securities, including that you must hold them for at least one year before you can sell. Also, certain public information about the company must be available, and there are limits on the volume of shares that can be sold, unless the seller holds the securities for at least two years and is not an affiliate of the company. Registration of the stock allows the VC investor to sell the stock without complying with Rule 144, but it is an expensive, time-consuming process involving lawyers, accountants, and investment bankers.

There are two kinds of registration rights: demand rights and piggyback rights. Here’s an example of the demand rights term from our model term sheet:

Upon earliest of (i) [three-five] years after the Closing; or (ii) [six] months following an initial public offering (“IPO”), persons holding [__]% of the Registrable Securities may request [one][two] (consummated) registrations by the Company of their shares.  The aggregate offering price for such registration may not be less than $[5-15] million.  A registration will count for this purpose only if (i) all Registrable Securities requested to be registered are registered, and (ii) it is closed, or withdrawn at the request of the Investors (other than as a result of a material adverse change to the Company). 

“Registrable securities” are defined as all shares of common stock that will be issued upon conversion of the Series A preferred stock. The idea behind demand registration rights is that at some point in time, the VC investors want to be able to compel the company to register their shares with the SEC, so that they can cash out. The registration process takes up an enormous amount of management time and attention, and as a practical matter, it is extremely unlikely that investors are going to invoke demand registration, forcing a company to go through registration of their securities without management’s full buy-in. Nevertheless, there are points to negotiate. For example, the company will want to limit the number of demand registrations to one, while the investors will want the right to demand two or more. Another negotiable point is the minimum dollar size needed to trigger the demand rights. The company will want to set a reasonably high minimum dollar size for the offering, given the expense of a registration. The company also will want to ensure that a significant percentage of the investors support the registration demand, and that a single investor cannot cause a registration.

In the next installment, we will look at piggyback rights. Thanks for reading!

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Anatomy of a Term Sheet – Conditions to Closing

Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth. 

We’ve gone through the charter terms that involve changes to the startup’s certificate of incorporation, and now we are working on the Stock Purchase Agreement section of the model Term Sheet. In a Series A investment transaction, the startup is issuing preferred stock to the investors. As part of the transaction, the startup and the investors sign a contract called a stock purchase agreement, which contains a variety of terms application to the transaction. In the last installment, we looked at the reps and warranties that each side makes to the other. Today we look at conditions to closing and counsel/expenses. 

Conditions to Closing

This is what the closing conditions term looks like in the model term sheet:

Standard conditions to Closing, which shall include, among other things, satisfactory completion of financial and legal due diligence, qualification of the shares under applicable Blue Sky laws, the filing of a Certificate of Incorporation establishing the rights and preferences of the Series A Preferred, and an opinion of counsel to the Company. 

The financial and legal due diligence can be a time-consuming process, as the investors will want to thoroughly investigate the company’s business. In addition, if the company has been sloppy in its corporate housekeeping, time must be spent cleaning up the corporate records.

Qualification of the shares under Blue Sky Laws means ensuring that there is an applicable exemption from registration under federal and state securities laws. Rule 506(c) of Regulation D under the federal Securities Act provides an exemption for private placements, so long as the startup business offers the securities only to accredited investors. There is no limit on the size of the investment, and the prohibitions against general solicitation and advertisement do not apply. In addition, Rule 506(c) largely preempts state securities laws; the company only has to do a notice filing on Form D, consent to service of process, and pay a filing fee.

The company will have to file an amended Certificate of Incorporation, containing the new class of preferred stock and outlining the rights and preferences of the holders of the preferred stock. If the company had been set up as an LLC, it will have to convert to a C corporation, which can delay the closing and raise the legal costs. This is why startups that are thinking about raising venture capital money should incorporate as a C corporation from the outset.

Finally, the investor may require the startup’s lawyer to provide an opinion letter stating that (a) the company is validly existing, in good standing, and authorized to do business where located; (b) the company has the authority to enter into the various agreements involved in the transaction, and that they are enforceable against the company; (c) the performance by the company of the transaction, including the issuance of the preferred stock, will not violate state of federal law; (d) the capital structure of the company is as described; (e) all shares are validly issued; and (f) there is no litigation threatening the transaction. Since the startup’s lawyer is incurring potential liability in issuing the opinion letter, the lawyer will have to conduct some due diligence on the company before signing off. There can be problems when the investors try to push their own due diligence obligations onto the startup’s counsel, to save money.

Counsel & Expenses

Venture capital financings are unusual, in that the startup company pays not just its own attorney fees, but also the investors’ legal fees:

Company to pay all legal and administrative costs of the financing [at Closing], including reasonable fees (not to exceed $[_____])and expenses of Investor counsel[, unless the transaction is not completed because the Investors withdraw their commitment without cause].

One reason for this is the capital structure of venture capital firms. If the VC firm paid its own attorney fees directly, the money would come out of the VC firm’s management fee, reducing the income to the VC partners. Another reason is to create an incentive for the startup company not to negotiate too vigorously over terms that the investor will not remove or change. If there are multiple investors, it also saves them from having to argue about how to split the legal bill among them.

In any case, it has become an industry standard for the startup company to pay the investor’s legal fees out of the financing proceeds. Rather than trying to change this, the best option for the startup is to try to cap the amount of investor legal fees it will pay. Since you are paying the investor’s lawyers to negotiate against you, putting a cap on their fees gives them an incentive to be more reasonable, rather than argue until they are blue in the face. It is typical to set the cap between $10,000 and $20,000.

In some deals, the startup company is also responsible for drafting all the documents. This is another odd duck term, because in typical transactions (leases, acquisitions, mergers, etc.), the party with greater leverage drafts the documents. Usually, the first draft is going to be more favorable to the party that prepared the draft. While having the startup’s lawyers draft the documents will raise the startup’s attorney fees, keep in mind that nobody is drafting these documents from scratch. There are numerous model documents that provide a starting point, including the NVCA documents we have been using in this series.

That is it for the Stock Purchase Agreement terms. Next time we will dive into the Investor Rights Agreement terms, including registration rights, among other important terms. Thanks for reading!

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