Legal Aspects of Corporate Financing Structures
Carol: Hi. Good morning. This is our first APAS meeting for this new season. We’re glad to have you all here. I think it’s easier to do the commercials up front when people are still, before they’re sneaking out the door. Next month should be a really interesting presentation. As most of you are aware, SAS70 is going away and it’s replaced by SSAE16.
So we’re going to have a speaker from BPM, I believe, that formerly did SAS70 reviews. And now, we move into this new type of review. We will talk about the changes and also make us as auditors aware of what we need to look at it and be aware of on the new reports. So I think that will be a really good topic so that will be the second Wednesday of the month in here, 8 o’clock in the morning. So watch for that, Wednesday.
I also need to make you aware of is CalCPA has changed the way they advertise their events. Instead of, you used to get like an email for just this event, for the APAS meeting. And now, they feel like people were getting too many emails so now they send out an upcoming events email. And so, it will have like our event plus maybe the tax groups event. And so, you kind of have to watch for those and get used to the new system because we want to make sure everybody knows about our events.
So anyway, if you have any questions, you can always contact me. I’m Carol Wagner. I’m an audit partner here at ASL.
We are very fortunate this morning to have Roger Royse speaking to us about the legal structures involved in equity, instruments and corporations. Roger has his own firm, Royse Law Group and he is on Peninsula as well as many locations. He started out locally with Berliner Cohen and GCA Law Partners and the New York City office of Milbank, Tweed, Hadley and McCloy.
Roger is an active member of the American Bar Association and Business Law Section. He has his law degrees from the University of North Dakota and New York School of Law. So we really appreciate Roger speaking to us and we look forward to what he has to say. Thanks for coming.
Roger: Thank you Carol. I also would like to thank Abbott, Stringham & Lynch for hosting us here today. The materials that we’re going to cover today are some fairly basic corporate, and maybe not so basic, corporate aspects of equity transactions. You have a set of PowerPoint slides. You have a printed version. Take really good notes because I’m going to say a lot that is not on those slides.
And I do have fairly extensive detailed outlines and materials that are going to be available on the website Royse University. It’s not up yet because I’m still fighting with my art people over the logo. When it is, you will be able to go there and download pretty much everything I’m going to tell you plus a lot more. And if you take a card, and you toss it right here, I’ll send you a copy of that outline so I make sure that you’ve got it.
A couple of years ago, I was involved in a preferred stock financing. I didn’t know a whole lot about the investor other than that their money was green. And sometime after the transaction, I got a call from the accountant for the investor. He said, “Oh, we’ve got a big problem.” He says, “We’ve got a UBTI problem here because the preferred stock is voting stock and not non-voting.
And at that time, I thought, “Well, that’s odd,” because I’ve been doing this for more years than I’m going to tell you but I’ve done maybe hundreds of financings and I don’t think I’ve seen non-voting preferred very often. And it occurred to me that we, as tax people, have to be good corporate people as well as good tax people. And you, as accountants, probably also must have some basic understanding of the corporate law aspects of these transactions. I think this is really instructive not only for you as accountants but also us tax lawyers must be good corporate people.
And that’s what we’re going to cover here today – the basic corporate aspects of equity and financings. I’m not going to talk too much about tax – just corporate – although I probably won’t be able to help myself at some point.
So, stepping back and taking a bigger chunk the first question we’re going to ask when a company goes out to do a financing is what is it they need? What type of security? And a question that you may get even before company counsel gets is how should we capitalize? Should we do debt? Should we do straight debt or bank debt? Can we even get bank debt? Should it be convertible debt or preferred stock?
I’m going to focus mainly on preferred stock but I want to say a few words about debt. That is a whole other discussion, but some of you may be familiar with the concept of venture debt, which is out there and the distinguishing factor is that is usually bears a relatively high interest rate. It always comes with warrant coverage, sometimes a lot of warrant coverage and it is always secured.
Venture debt will typically be used in a company that has valuable technology and that can actually serve as security. And you understand risk reward analysis.
The idea behind venture debt is that the risk is relatively high; it’s higher than bank debt but there is enough security so it’s a little less risk than equity risk. The returns are less than equity. It’s a negotiated process and the warrants will usually reflect the risk.
Convertible debt is what we are doing a lot more these days than in the past. And just to step back a minute, let me give you a sense of what the market looks like in my neighborhood, Palo Alto, most of the time. Because of web 2.0 every financing we do doesn’t have to be 5 or 10 million dollars. I have companies that get to revenue on a couple hundred thousand dollars. They are much smaller. It doesn’t take that much money to launch an internet company these days.
In fact, I have one client who I saw him 2-3 years ago; it’s a game company and he needed a million dollars to buy a software tool. It has been 3 years and the software tool is now tens of thousands of dollars and he doesn’t need 10 million dollars to launch his game. I saw him last weekend and he needs a couple hundred thousand dollars. That is all it now takes.
So there is that sort of thing going on in the market. Financings are much smaller. As the size of the financing comes down the transaction costs ideally would come down too. The clients don’t want to pay lots and lots of money on due diligence figuring out valuations after only putting a hundred thousand dollars in a company. So the system that has evolved is this idea of convertible debt and the idea was that “Gee, we don’t have to value the company now. We’ll loan you the money and you will either repay us back or we’ll convert this debt to equity when we finally do an equity financing, when the big boys come in and we have an institutional professional investor valuing you. We’re going to feel pretty comfortable about that value.
And to reward us for getting in early the debt will convert at a discount. These days it’s a little less than 20% because the market is a little frothy but usually its about 20% discount. Ten to thirty is the range depending on where the market is. That is the model.
Over the last couple of years there has been an addition to that model and that is a cap on valuation. Investors have found that when they do these deals they work against themselves because they’re money is working to increase the value of the company and what does that mean? That means when the debt converts they get a smaller percentage because the value has gotten higher. Do you see the disconnect?
So finally people wised up and said the value when we convert is going to be no more than X dollars. That is the convertible debt model and it is by far the most commonly used these days in the angel world, but also with VC’s who have also lowered their expectations.
By the way, I’m talking to VCs these days who five years ago had to invest millions of dollars or they weren’t interested. Now they will do a smaller convertible debt round.
Roger: Preferred stock which is what we’re going to spend the most of our time today talking about. The first practice point is that preferred stock for tax purposes has a different meaning than it does for corporate purposes. When you see the words preferred stock in the tax code, you look carefully. Oftentimes, they mean limited. The Code might not mean “preferred” it might mean stock that is limited in terms of how much it can participate in corporate growth.
Well, that is hardly ever what we mean in the Silicon Valley by preferred. We mean it gets a preference and it oftentimes participates as well. That is what we call it participating preferred. So there’s a little bit of a disconnect and I want to show you where that is important. I was going to go through this because a lot of times people will freak out because “oh no, it’s preferred and there are these 305 or OID issues with preferred.” You have to think about it and look at it carefully and say, “Well, yeah, it’s preferred but it’s not the kind of preferred that the tax code is really concerned about.” When the tax code uses the term, it is oftentimes saying that it looks a lot like debt.
Just a heads up on some of the things we’ll talk about. I guess, the last point I’ll make from a big chunk perspective, relates to the type of investors. In my mind, there is a progression with a typical startup company. First, the founders may put in a little bit of money to get things rolling, probably in exchange for equity. If it’s a lot of money, they might try to make it debt. Good luck with that. If you’re lucky, they will have documented the contribution. Most of the time, they won’t so you can fight that battle later.
Friends and fools come along. They will do equity a lot of times but hopefully not, because that’s going to create securities issues most of the time because they don’t have a lot of money for securities compliance. Friends and family are often not accredited investors. Their money may go in as debt, and since they don’t have a way of valuing the company, it will be convertible debt.
Then, individual angels are next. That’s really the affinity investors. You won’t call them friends and family. They’re putting in bigger chunks of money. They just love your idea. They like your game or they believe in the social media site or whatever.
The next level are the angel groups, and that is more of a formal process. These are institutions or groups. They have their committees and they set up their organizations and maybe you go and pitch to them. That again is probably going to be convertible debt, but not always. And if you can get past them, then you’re on to VCs, and that’s a whole different discussion. We’re going to get into that. It’s a much higher level of sophistication when you’re going the VC route.
There are also private equity groups. Their terms tend to be a little more flexible or let’s just say it’s a different market. Sometimes, they’re more tax sensitive than VCs.
I want to make an overriding comment about financial investors. Angel groups tend to be a little more tax sensitive. If you’re dealing with angels, you might actually find people that are thinking about after tax returns and also aren’t subject to all the restrictions that some of these institutional funds are. So you might end up financing an LLC, in which case everything I’m telling you has to translate into LLC language.
Once you get to the VC level, however, those funds will almost always want to invest in a C corporation. And that’s more than just a historical accident. It’s because the fund documents, the organizing documents (and we do a lot of fund formation work) will usually prohibit the VC fund from investing in a pass through entity. Or if they do, they must invest through blockers or corporations or something like that. And the reason why is because they likely have investors who are pension plans so they want to avoid UBTI, Unrelated Business Taxable Income. And secondly, they may have investors who are foreigners and want to avoid all the nasty withholding tax issues that you have. So almost always, we’re in a C corporation environment when we’re moving up the chain to institutional investment.
Roger: A lot of this is going to be very basic for some of you but bear with me. I want to make sure we’re all on the same page. So after we’ve answered that question, what type of security are we going to issue and we’ve gotten together with our appropriate finance guys and decided that it’s going to be preferred stock, the next question is capitalization and value.
I want to pause on pre-money and post-money because sometimes there is some confusion about this even among knowledgeable people. Let’s suppose my company is worth $2 million and I want to sell 1/3 of the company. How much am I going to sell that 1/3 of the company for? Anybody? Well, the answer is $1 million. Okay. And the reason is because I’ve got 2 million now. I get another million. Now, it’s worth 3 million and the investor has the 1/3. One million for 1/3.
It seems sort of obvious, does it? But every once in a while, you have to stop and explain that “no, it’s not $667,000 because you must add in the investor’s money.” I know it seems obvious to this group but just to understand it’s not obvious to all the business people out there. So you may have to stop and educate them on this. That’s pre-money and post-money and that’s the way companies are valued in this environment. We back into it. You take the post-money and you back into the pre-money.
Let me say a little bit about capitalization because when we figure out the true price per share and the value divided by the number of shares, it’s almost always done on a fully diluted basis. By fully diluted, we mean we take all the common, we take all the preferred stock and the common that the preferred converts into. We have warrants on preferred. We take that into account. We have options and really good cap tables will value the company on a price per share basis as if all the options that are granted have been exercised and will also show you that number as if all the options that are reserved are outstanding as shares.
Fully diluted usually includes all the options that are in reserve. There’s just no magic to reserved shares. We just pull the number out of the air. “We hereby reserve 1 million shares for issuance under the option pool.” What it means is that we don’t have to go back to the shareholders to get additional authority for the board of directors to grant options. There is some significance to that because when a company is valued, they’re going to assume all the shares in that option pool have been issued when we figure out price per share.
The investors often times will say, “We want you to establish an option pool on a pre-money basis,” in other words “before we put our money in.” What that means is that the pre-money, common shareholders are going to get diluted but not the preferred shareholders. Does everybody understand that? How that works? Okay.
Again, it’s sort of a little trick and it may be obvious to this group but keep in mind that it’s not obvious to your clients. And if they run off and sign term sheets without talking to us, you’ll see that that they won’t get it and they won’t understand it. When price per share is based on fully diluted shares, the bigger that option pool, even though those options are not granted and shares are not issued, it still will decrease their price per share.
The other thing where there is oftentimes a little confusion is this concept of authorized, issued and outstanding shares. And I know you folks know this because you do financials. But typically, we authorize a number of shares in the articles of incorporation or certificate of incorporation in Delaware and that’s maximum number of the shares that can be issued without going back to the secretary of state and increasing the number.
I’ve got a talk I do called Top 10 Legal Mistakes. I’ve actually got a book that I’m writing. I’m going to finish it this summer if it kills me. It’s called Dead on Arrival. And in that book I go through 10 common legal mistakes that startups make. And of those mistakes, I put them in 3 categories. Some are dead on arrival mistakes. You just can’t fix them. Others, you can fix them but it’s going to create a valuation discount and otherwise are not going to be a big deal and we can fix them. One of the big mistakes I often see people make is ownership of shares that are not authorized. They’ll blow through the authorized number.
In that case the certificate that somebody has, in my mind, is a receipt for shares, right? So the shares that somebody thinks that they have, they don’t have. They don’t exist. It’s legally impossible. Why is that a problem? Because why don’t we just go and increase the authorized shares? Well, maybe you do that but suppose they’re our common stockholders, suppose they’re our founder so the share value has gone up between then and now when we find the problem. That means that they’re getting the shares later at a higher price.
I think you might have a compensation issue. So it is a problem plus you must get everybody to come back and agree because it didn’t happen. And there’s a little bit of a difference of opinion as to whether you can ratify the earlier issuance. I don’t think you can. I think it just didn’t happen. I think it can only happen now when the shares exist. So pay very close attention to the authorized shares.
Not only that but the authorized number has to be big enough to cover all the convertibles, right? Now, sometimes, you will see documents because you know that in Delaware you pay tax and one formula is in part based on the number of authorized shares. So sometimes, you will see documents that say, “Well, we’re not going to authorize 10 million shares now because that will increase our Delaware fees. So what we’ll do is we’ll promise to authorize enough later to cover all the convertibles when they convert, right?
If you’ve got a warrant for a bunch of shares, you might not have the shares authorized now. You will have it when the warrant converts. I suppose that works but what happens if the company just doesn’t do it because that warrant is pretty much worthless until the company does it. Yes, you can go sue the company and force them to do it. But who wants to buy a lawsuit? So almost always, the number of authorized shares will cover all the convertibles, all the preferred, all the options, everything like that. It’s something we all need to pay attention to. And then, of course again, a lot of what I’m telling you folks is probably obvious to you but there was a time… In fact, I just had this come up yesterday when someone said, “Okay, we’re doing preferred stock and we’re doing options and we’re going to value the options at 1/10 of the preferred because that’s the way we did it 10 years ago.” Ten years ago, the world was different. These days, the VCs will insist on a professional valuation for 49A purposes. You folks know that.
The other thing that’s significant is I don’t know if you’ve ever seen 10 to 1 but not anymore. And I don’t think it even worked 10 years ago because there are different kinds of preferred. I don’t see how you can value all types of preferred with the same metric. But all those issues are gone. It’s a valuation process and that’s just something I want to point out.
There’s one more thing here that’s popping up more and more now and that’s the idea of a Carve-out plan. Because of this valuation process, because the days of playing games with option prices are pretty much gone, a lot of times it’s not all that attractive especially if you have companies that just can’t quite get around to granting their options because they’re too busy doing other things. And by the time they do it, the option price is unattractive.
So one of the things you’ll see in cap tables now is a Carve-out plan. This is a compensatory bonus. “When we exit, we’re going to pay you X% of the proceeds of the exit.” There’s all sorts of complicated formulae that go into that but there was a time and, again, I was doing those 10 years ago in the company context and people used to scratch their heads and wonder what I was talking about, why are you doing this. It’s weird. It’s strange. Now, I see it in almost every company because it’s just a nice, simple, direct way of getting to the point and avoiding these valuation issues. You’re going to see that more and more. The sort of subtle thing is that it does affect the value. Sometimes, it’s not there.
I guess the final thing I’ll say about this is in technology companies, in the startup world, especially here in the Valley, we typically do not take into account and add to the value of the company the option exercise price, right? So we’re figuring out our valuation or price per share on a fully diluted basis. We’re assuming all options that are authorized are issued, are granted and exercised. We’re assuming all those shares are outstanding. Shouldn’t we also assume that the people paid the company an exercise price and that increased the value? Logically, we should. And there are some companies that used what is called the treasury method. There are some companies that actually do that in terms of figuring out valuation and price per share.
I think I’ve only seen it once in the last 10 years and that’s only because the company had so many shares subject to option. They had so many options out that it made a material difference. Otherwise, that’s usually the subtlety that we just don’t bother with. And I know that probably that might bother some people but just be aware that that’s how you’re going to see that.
So let’s talk a little bit about preferred stock and I’m going in no particular order here. I’m just going to take a few of these points. So I’m almost halfway done and I’m only on slide 4. So, first of all, again, backing up a little bit, preferred stock is going to be authorized in Certificate of Incorporation in Delaware and Articles of Incorporation in California. The usual way is to have all the rights and privileges of the preferred set forth in the certificate or articles.
Part number 1, just as a matter of process, the board of directors has to approve that. To amend articles requires consent of the shareholders in both California and Delaware. There is this concept called blank check preferred where the articles basically say the board of directors is authorized to create all the rights and preferences of various series of preferred. You will see that sometimes and the reason that’s there is so you don’t have to go back to the shareholders every time you issue preferred. The board is given the authority to do that.
Otherwise, you have to go to the certificate to figure out what the terms of the preferred are. This is going to be important to do because small differences in those terms can make pretty big results both economically and even as a tax matter. Starting with the conversion price, the only thing I want to pause on is that in my world, preferred always converts to common. It will convert right before a qualified IPO or it will convert at the election of the majority of the preferred or some other percentage or it will automatically convert sometimes on certain other events but usually, it’s IPO.
You have to figure out at what price it converts. Typically, not always, we start out each share of preferred converting to one share of common just to keep the numbers simple, but we don’t usually say it that way. We usually say it has a conversion price. The conversion price is typically going to be the issue price of the preferred divided by the conversion price. And what is conversion price? Conversion price starts out as issued price. So if I sell you preferred stock for a dollar a share and then the next day we do an IPO it’s going to convert at the conversion price. The conversion price is going to be 1 dollar a share. So it all works out at 1 on 1.
Why do we phrase it that way? Because the conversion price is going to be adjusted by different anti-dilution terms. If I sell you preferred stock for a dollar a share and a day later, I do a big common stock split so now I have twice as many common shares, well, that’s not very fair, is it? The conversion price will adjust by that so the number of common shares when the preferred converts is going to increase proportionately. Okay. That’s why you’ll see it phrased kind of funny that way but that’s the concept – is to take into account anti-dilution.
Conversion triggers, IPO or consent of the majority and anti-dilution. I’ve given you the basic one where these additional stock dividends or stock splits. That always has an anti-dilution adjustment. You can see how unfair it would be if it didn’t. I’m going to talk about other anti-dilution adjustments a little later.
I’m going to set this here so I don’t have to turn my back on everybody. Participating versus non-participating. Do you remember about what I said about not talking about tax? Well, here is another tax point. A lot of times, people will hang their hat on this participation feature and say because of that this is not preferred stock for purposes of some of the punitive provisions of the tax code.
For example, as you know, there are rules in Code section 305 that imply a sort of OID concept on redeemable preferred. I’m going to talk about that later.
I’m going to step back and say remember non-qualified preferred? In other words, non-qualified preferred stock is not treated as preferred stock. It’s treated as debt. So you may have tax issues when you didn’t think so. For example, you might not have a 351 transaction and you thought you didn’t because non-qualified preferred stock is treated as debt. Well, that’s not qualified preferred? It’s capped and limited as to growth, right? And it’s redeemable basically. That’s kind of the big picture which you want to look at those rules whenever you see preferred stock and you’re being asked about the tax aspects if it’s redeemable. That’s the thing to look for. And again, I’m going to talk more about that when we get into redemption.
One of the first things I do when I see articles or certificate or a term sheet is I see if the stock is redeemable. If it’s not redeemable, I don’t think about it. If it’s redeemable, then we have to do the analysis.
Okay. So participation, just so we’re all on the same page. What that means, nonparticipating preferred means that the preferred stock it gets, a certain return and that’s it, right? So I buy it for a dollar a share, it means I’m going to get a dollar back on liquidation of the company or sale of the company. Or maybe I get $2 back. Or maybe I get some multiple. But whatever it is, that’s it. I don’t participate in growth any further than whatever my multiple is. And that is not really dependent on growth. That’s non-participating.
Participating means that the preferred gets a preference and/or also gets a percentage as if converted to common. That’s participating. So remember what I was saying about conversion. A preferred stockholder would not likely convert participating preferred stock to common because they’re already participating. They don’t need to convert, right? If it’s non-participating, then they might.
There are more variations of participation than we can talk about it. It’s always negotiated and the market can be relatively efficient and say what’s standard these days. But I have seen more variations than you can imagine because it’s not only the preferred versus the common. It’s preferred versus other series of preferred.
Who gets paid first? Is it pari passu? Is it the series A first and then the series B? Or is it the B first and then the A? And then, what’s the multiple? Does the preferred stock get one time their investment back or do they get 2 or 3 or 4? So what you’ll typically see is if a class of stock is entitled to a multiple of their investment, in other words, I invest in the company and I say, “I want 5 times my money back before the common gets anything.” There will be a cap on it. It will often be, in other words, X times up to a cap.
If it’s participating stock, I get one time my money back plus my percentage as if I converted based on my percentage interest in the company or it might even be I get one time or my percentage as if I converted. It’s whatever is negotiated and it’s the kind of thing that somebody has to look pretty carefully at. There are very sophisticated software programs that model this. This is one of those provisions that every once in a while it slips by. I’ve seen a lot of companies where the founders are working for the investors and they don’t know it. They’re just never going to clear those preferences.
Liquidation events, sale or merger of the company, liquidation of course, sale of all of the assets of the company, that’s all pretty standard stuff. Sometimes, we have a big negotiation over whether an exclusive license is a liquidation event. Every once in a while, that is not a liquidation event. And sometimes, a liquidation event is all of those things unless the preferred stockholder decides that it’s not. So the parties pretty much agree on what the liquidation event is.
I don’t have it on the screen but there’s also a question as to value. And how do we value the consideration? If I’ve got my preferred stock and I’m entitled to a dollar a share before the company gets anything and we do a type C reorg, we do an asset for stock transaction, and the company sells all of its assets to a company and gets back stock. The stock is then distributed in liquidation. How do we value the stock? There are often provisions in the agreements regarding how we value that. Typically, the board of directors in good faith. Typically, that’s it.
Startup companies don’t usually pay dividends. Nevertheless, since we like to negotiate, we also have provisions about dividends in the certificate and articles. The first thing is that there’s a concept of a cumulative and a non-cumulative dividend. Again, out here on the West Coast, almost always we see non-cumulative dividends – not always, but almost always – it’s “when as and if” declared. Meaning that it never gets declared paying, and it does not add to the liquidation profits.
Cumulative dividends, on the other hand, even if not declared, will continue to accumulate and will add to the liquidation preference but preferred stockholders get it on the backend – that’s the basic difference.
Typically, in negotiated provision, you’ll see accumulated dividends in East Coast deals more than you’ll see them on the West Coast. The tax issue, of course, is the treatment. There’s very good authority and a lot of people take the position that the payment of the cumulative dividend on liquidation is subject to capital gains treatment and not treated as a dividend, just like any other proceeds from the sale of stock. That position is not certain, by far, but it is the position that most people will take.
Separately, similar to dividends is payment in kind. Preferred stock that pays in kind probably results in capital gain, not interest – but with debt, PIK interest is interest. With a conversion of debt you’re going to have interest income but a lot of people take the position that you won’t have that result with preferred stock.
The one time that you do is if you have redeemable preferred, because then, it will be treated under our 305 rules on redemption premium, and I haven’t gotten to that slide yet.
Typically, it’s one share, one vote. And typically, you’ll find preferred stock voting on an as-converted basis. So the preferred stock has as many votes as the common into which it converts.
Class voting – California requires class voting. What I mean by that is on certain decisions, in California, each class has to have the right to approve it – majority of the common, majority of the preferred. For example, a merger or sale of a company.
Delaware doesn’t have that rule. In Delaware, you can just lump all the shares together and every share can have one vote – the common and preferred voting together. It’s not the only reason but it’s probably the single biggest reason that most VC backed companies are Delaware companies. 80% of the corporations I form are Delaware corporations.
Why is that? Because the VC’s and investors don’t want to be held up when a good deal comes along they want to take. They don’t want a founder that’s more interested in protecting their job than getting liquidity for its investors to stop the deal through this class voting idea. So most of the time you’ll see Delaware corporations and this is the biggest reason why it’s a class voting.
Even in Delaware it has to say that your organizing documents. The documents also must state that voting is on an as converted basis.
Typically, there’ll be negotiated protective provisions and the most heavily negotiated one will be the selection of directors, which we’ll talk about later, but other protective provisions will typically provide preferred stock with a right to approve or block sometimes, a merger or acquisition, bankruptcy, liquidation, a right to increase the number of shares. By the way, in both California and Delaware, it takes a shareholder vote to increase the number of authorized shares.
The protective provisions may include a special vote of preferred to issue additional shares of any equity that’s senior to the existing preferred. It sort of makes sense – you may be able to stop them from diluting you.
Those are typical protective provisions, sometimes there’ll be a protective provision relating to increasing the option pool; there will be protective provisions relating to sales and licensing and incurrence of debt. As you might expect, there’s a long list that gets negotiated. It will go in the articles so it binds the company as a matter of internal governance, but it’s a matter of agreement.
You know, this is a good place to mention the concept of a venture capital operating company. Remember what I said about VCs often having qualified plans as their investors. If that happens, they’re subject to a whole set of rules, and one of which is they have to be a venture capital operating company. In other words, they can’t have more than 25% of the stock of the company and they can’t have more than 50% of their assets in companies that they don’t retain management rights. The first place that comes up is in the protective provisions. You’ll see language sometimes that will give the investor management rights. If you violate these rules, then they’ve got a problem under ERISA. It’s a prohibited transaction.
The biggest one is the selection of directors because that is a management right. In other words, the fund has to have the right to take part in management to a substantial extent. And one of the ways you do that is by having a member on the board.
We’ll talk about this later but you can have a management rights letter that accomplishes and gives the VC management rights by virtue of having advisers and observers. But the most common way is just put a member on the board – probably the best way.
Dilution. So I’ve listed three kinds and what I mean by this is suppose that the company issues preferred stock at $1 per share. Things don’t go so well. A year later, they do a down round. That never happens, right? Okay. So they do a down round and all they have to do is issue stock at 50 cents a share. Full ratchet dilution, which we hardly ever see, I mean, somebody has to have extremely good negotiating power to get what they call “full ratchet” or it has to be a troubled company.
Full ratchet means it’s a proportionate change. So in other words, it’s as if your early investor got in at a later, lower price. So you issued stock to me for a dollar a share and a year later, you issued those shares to somebody else for 50 cents, I want my shares for 50 cents. That’s full ratchet, anti-dilution.
We don’t go back and change the old documents. What happens is, remember that conversion price I talked about? We changed the conversion price, right? So now our conversion price, remember if it is a dollar a share, we started out with a conversion price of a dollar. A year later, they issue the shares for 50 cents. Our conversion price under full ratchet is now 50 cents. You usually get twice as many shares on conversion. That’s the mechanism. Okay. Hardly ever do you see a full ratchet. It’s quite harsh on a company. And by the way, do the math, it comes out on the founder’s hides. Nobody else’s. That’s the way it works out because the later investor is going to value as if everything has been converted.
What we see most often is a very watered down and rather weak anti-dilution provision called broad-based weighted average. And I won’t torture you with the formula for coming up with that. But I will tell you that the distinguishing factor of broad-based weighted average anti-dilution is it treats all of the common stock at the time of the diluted event, it treats all of the common stock as having been issued at the conversion price. Okay. And if you go through the formula, if you treat all of the common stock as having been issued at the conversion price, you have an average. And you average the existing share price and its weighted and then you arrive at the new conversion price.
So in my example, 50 cents per share, you’re not going to end up with a conversion price of 50 cents per share. You may end up with a much higher one because you’ve taken an average of a new price and the old price. And assuming that all the common has been issued at the converted price which of course it hasn’t.
When you work through the formula, you’ll find relatively modest adjustments for anti-dilution under a broad-based weighted average. And by the way, that’s weighted average. The reason we call it broad-based is because we include all the options issued or reserved under the plans in this calculation. So you can see it really waters the formula down. Like I say, I have the materials, I can give you the formula if you want it. You can work through it.
One thing, almost everybody has a temptation. The first time they see this, they want to go in and kind of monkey with the formula, reword it, rewrite it. Don’t. Resist that temptation. This is a formula. Everybody uses it. Everybody accepts it. Resist the temptation to fight with it. That’s my advice on that.
Narrow-based weighted average applies the same concept but we exclude convertibles and then we exclude options and warrants and debt from that calculation.
There are a couple of other types of anti-dilution. There’s one called the market price, I don’t know if you’ve ever seen it, where basically the conversion price is the market price. So then, there’s one called book value. The conversion price just gets a book value. They use the book value. I hardly ever see those. I almost always see broad-based, once in a while narrow and every once in a while if it’s a troubled company, full ratchet.
Because it’s such a hassle to go through the calculation and it’s hardly worth the trouble, oftentimes, we would just ask people to waive it. And the documents will often say, almost always would say that a majority of the preferred stock can waive an anti-dilutional protection. Not only for them but for everybody else in the preferred stock class just so we can avoid having to go through this calculation. But nevertheless, we will have pages and pages and pages of the calculation in the organizing documents.
You probably heard of this concept of pay to play. I mentioned this idea of a down round and the last several years, I’ve seen lots of down rounds. We hear about people getting squashed in a down round. What do we mean by that? Well in a pay to play provision, all this fancy anti-dilution protection you got, that’s great! You get that protection. So if you do a down round, you get that many more shares when you convert but only if you participate in the next round of financing. So you got to pay to play. You’ve got to put more money into the next round and then you get your anti-dilution protection. If you don’t put more money into the next round, what happens is your preferred shares, they convert to a shadow preferred or derivative preferred. Sometimes, it even converts to common stock and you lose all that anti-dilution protection and you just get squashed.
Ten or fifteen years ago, I personally invested in one of my internet company clients and we did a down round of pay to play. I said, “What, are you nuts? You guys are going broke. Forget it.” And our percentage went way down. I want you to know that the company went public. But what was my interest worth? Not even what I paid for it because it’s pay to play and if you convert to common, it can be really, really dilutive. I’m still mad about that.
Redemption rights. Sometimes, you’ll see redemption rights in corporate financing documents. There are two kinds. There’s automatic redemption and there’s elective. There’s this idea of stock callable by the company so the company can force redemption or the investor can force redemption. What we’re concerned about usually in the documents is where the investor can force redemption by majority vote on preferred stock.
Where to begin? Why does an investor want this? I guess that’s the first question. Redemption rights usually are a way for the investor to force a liquidity event to the company because, let’s be honest, the company is not going to be able to redeem our stock. Maybe they will. Maybe it can go up. Theoretically, we always say, “You can go out and you could do a financing.” But the fact of the matter is that’s just not going to happen. If the company is 4 years out and they haven’t had a liquidity event, they’re not going to be able to take out the investors.
Redemption rights are usually a way to force the company to put itself on the market. That’s why you oftentimes see it. Theoretically, it’s a way to give the investors their money back plus a return. So, one of the things we should keep in mind is that in California, redemption rights are still subject to section 500 of the Corporations Code. And section 500 limits the amount of distributions and redemptions a corporation can make by a formula of either retained earnings or its net assets. It is subject to that. It’s a corporate law matter.
Aside from that, the other issue that I look at before we get into the guts of it is the tax issue. If it’s mandatory redeemable, we may have this 305 issue. In other words, if there’s unreasonable redemption premium, which is pretty narrowly defined these days, the preferred stockholder may have to take into income a a portion of the redemption premium over the life of the preferred under OID concepts. But keep in mind it treats it as a dividend so we must look at the E&P of the company. Many companies don’t have E&P and if so it’s really a non-issue. You do a lot of work, a lot of analysis for nothing because it ends up being a nothing.
But once in a while, you have a company that does have earnings and profits. And it does have mandatory redeemable stock that either is callable and is redeemable by the investor and is more likely than not to be redeemed, or it’s redeemable by the company. We have to engage in an analysis. Every once in a while that happens with redemption. There are other legal and tax issues in terms of how these things are structured.
First question is, what’s the redemption price? What return is this investor insisting that he be guaranteed? They’re usually harsher in the East Coast than on the West Coast on this. They’re going to want a return for their fund. What amounts? In other words, is it 25% a year for every year starting on the fourth year because that’s usually how it works? And then, there are windows. When is it redeemable? And is it cumulative? These are heavily negotiated provisions.
In other words, if 25% of the stock is redeemable in the fourth year and if I don’t redeem, is that cumulative? I mean, can I force you to redeem it in the second year? That kind of thing. You’ll find all that stuff to be negotiable.
The last thing I will say is typically, the majority of the preferred, even when you have redemption rights, will waive that.
Registration Rights – So backing up a little bit, we have rule 144, which typically requires a holder of securities to hold that stock for a year before they sell. And oftentimes, you will see companies, investors or shareholders of the companies say, “I want to transfer stock.” The company will say, “Well, I need an opinion from your lawyer that says that you’ve satisfied rule 144 and have owned it for a year,” Sometimes, it’s 2 years if public information is not available.
There are securities restrictions. Typically, a preferred stockholder will want to negotiate some of their liquidity. They want to negotiate the ability to force liquidity of the shares and force the company to go public and file the registration statement. This really happens in 3 ways.
Number 1 is demand registration. I don’t do public company work. I know some of you do. It’s a very expensive, distracting process when you have to do a public registration so companies don’t like to do it. By the way, as a practical matter, I hardly spent any time at all negotiating these things. I have never seen a demand registration in all the 25 years I’ve been doing this. It just doesn’t happen.
It’s really kind of up to the underwriters. You’re either ready to go or you’re not. If you are, everybody knows it and you go. I’ve never seen anybody exercising demand registration. We’ve all spent lots of money over the years negotiating demand registration rights but it’s not the kind of thing I really worry a whole lot about in a financing.
Demand registration is exactly what it says. The investor can demand that their shares, can force the company to go public. The questions are, when can they do that? You usually want to give them like a 3-year window before they can exercise demand registration. How many shares? The company will want blackouts. They will want to be able to not to have to do it if they’re on the verge or doing an M&A deal or something like that. They will negotiate all of that but the basic idea is that the investor can demand that some portion of their shares be registered so they can sell them off in the open market.
Piggyback registration means that the company has already decided to go public and register their shares and the investor has a right to include some percentage of their shares in that registration so they get liquidity. By the way, in demand registration, it’s always negotiated and limited as to how many times they can demand, right? Usually, you will want to demand once or twice after 3 years.
Piggyback negotiation is where percentage of their shares can be included in an existing company registration.
S3 is a secondary offer. The company is already public. They’ve already filed all the information and taken the pain and gone through all the trouble. S3 rights means that the investor can demand a follow-on registration for shares of an existing public company.
Board Representation – Board size is always negotiated. The preferred will want representation on the board and you will find that in the organizing documents, the articles or the certificate. Where I usually see, what I try for is a 3-member board on a close of Series A and 5-member in Series B. I don’t always get it but the bigger the board, the harder it is to get things done. That’s my experience. So I try to keep the board small. Like I said, we don’t always get it. Sometimes, we have 5 members on a close of Series A.
Typically, what I see is that the investor will not have the majority. They will have an odd number. The investor will have one of a 3-member board. The founders and common stockholders will have one. And then, the third one will be the chosen independent industry luminary, the type of person that we hope that can resolve these sorts of dead locks.
Board size should always be an odd number for obvious reasons. It is typically negotiated and oftentimes named. So they’ll say, “Gee, of our 5-member board, one of the board members, the common gets 2 but one of them has to be the CEO and the other one could be whoever the common selected.”
Sometimes it can be rather complex, the procedures we go through. We have complicated voting agreements that make sure we have the right board. The board size is set by agreement and in the articles, and who gets to designate board members.
The other thing, because we don’t want the board to be too big, almost always, the VCs will we want to bring their observers along to sit in on the board meetings. And even though they’re not voting, they can participate. They can offer their input. They have quite a bit of input actually. Observer rights are more important than you might think. Also we use observers for investors that have relatively low percentages. They don’t want the board seat but they have money in it so they should have a say, a non-voting say. Those are the observers. You will find all 3 of those things in the company’s organizational documents.
A co-sale right is a right that allows the investor to participate in any sale that a founder might make of their shares. The founder goes out and sells some shares. They must take the investor’s shares along with them. A tag along, drag along, that’s the flipside. If the investor finds someone who wants to buy all their shares, the founders agree that they’re going to sell their shares to that third party as well. That’s a drag along. We can drag them along in our sale.
In a co-sale, we can participate in the sale. I don’t think I’ve ever seen a drag along used because you can imagine how difficult it is to get an uncooperative seller especially a founder who probably has to stick around and make the transition.
Strategic investors. A strategic investor that means somebody that’s in the business that’s investing in the company not only for the return but also to ensure a source of supply or the position for a later acquisition. They almost always ask for rights of refusal. In other words, they will almost always say, “Look, your company, if you decide you’re going to go on the market and you’re going to be sold, you’ve got to give us the first right of refusal. You must tell us first and let us match any offer you get.”
Rights of first refusal typically make a company much less marketable because what buyer wants to go through all the diligence of evaluating a company and valuing it if there’s just going to be somebody else who’s going to swoop in and buy it out from under them? Therefore, the company negotiates hard against that. And where we oftentimes end up is maybe a right of notification. We will let you know before we go out and solicit any offers. And then, there are time periods like how long this is going to be and how quickly they have to act. All relatively heavily negotiated when you have a strategic investor because keep in mind they’re not after return on the stock. They want the company.
Lock up. Everybody in the company should, in a well-advised company, will sign a lock up. What that means is they’ll agree not to trade in their shares usually within 180 days after the company goes public provided everybody else in management signs the same lock up. And you can see why because it will disrupt the offering process if they are able to go out and trade freely while everybody is locked up while trying to stabilize the market. That’s another transfer strategy.
Information rights. Investors want to see financials. These days, periodically, they want to see narratives or what the company is doing. More and more, I see them ask for budgets. I see them ask for business plans. The important thing is its almost always audited for equity structure.
Expenses of doing the financing. Don’t freak out when you see the company agree to pay an investor’s fees. That’s pretty standard. The best you can do is get a cap on those reasonable expenses the company pays.
Insurance and indemnity. Investors who serve on the board, they want to be insured. They want D&O insurance. They want to be indemnified by the company. Pretty standard for the company to indemnify. Now, the typical one page articles of incorporation that some of the online corporate services provide, they don’t have much about indemnity and we almost always have to amend those to give the company the authority to provide indemnity to the maximum extent required by law to its directors. And that’s always the first thing I always do when I get into a company that somebody has done it yourself and incorporated because they always mess that up. So just keep in mind indemnity is really important.
And even if it’s in the articles, your director doesn’t feel that safe about it because someone might go and amend the articles and take it away. So there’s almost always an indemnification agreement on top of the indemnity that is baked into the organizational documents.
Indemnity is very important. Every once in a while, you’ll see indemnity not only of directors but the company and investor will negotiate for indemnity of the investor as odd as that sounds. And if you think about it, you can see what problems that sometimes creates. So it’s just a matter of bargaining, positioning and negotiation power.
Because just imagine, everybody gets sued because of a minority unfairness claim because of something the majority shareholder did. Well then, the company has to indemnify the majority of shareholder. They really basically often cause all the problems. It really does prevent anybody from suing the company. That’s why people try to slip it in there. And I’ve gotten that sometimes on the investor’s side. I fought it really hard on the company’s side. So it’s just an ounce of prevention.
And that’s the end of our hour so I hope that this kind of gives you an overview of some of the typical corporate and preferred stock structures you see in the Valley and technology companies. I know this is very heavily weighted for corporate issues but I think its good for all of us to have kind of the basic understanding of how these things are put together. If you have no questions I’d be happy to take them.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.