Archives for 2010

Can a California company have unpaid interns?

April 15, 2010 By Yokum 10 Comments

(The following is from a WSGR client alert.)

On April 7, 2010, the California Division of Labor Standards Enforcement (DLSE) issued an opinion letter addressing the requirements employers must meet in order to have unpaid interns in compliance with California law. Although widely published news reports, including a recent New York Times article analyzing the DLSE’s April 7th opinion letter, have raised hopes that California is relaxing its position with respect to the permissibility of unpaid internships, such optimism appears to be misplaced and employers must continue to exercise caution in this area.

The DLSE’s guidance is timely, as thousands of college graduates and students prepare to hit the job market in search of employment opportunities. Many employers offer internships for a variety of reasons, including providing useful “real world” experience to students seeking to learn more about a particular industry or profession, and trying to help the children of customers, business colleagues, or friends. However altruistic their reasons, employers must be aware that California and federal law severely limit the circumstances under which such internships can be unpaid.

In response to a letter from an attorney representing Year Up, Inc., (a program aimed at developing fundamental job and technical skills in information technology for 18- to 24-year-olds) about the classification of internships in California, the DLSE concluded that the interns enrolled in the internship program were not employees under California law, and therefore were exempt from coverage under California’s minimum wage law. In reaching its conclusion, the DLSE followed the federal Department of Labor’s (DOL’s) criteria for determining whether the interns were exempt from minimum wage coverage and examined the “totality of the circumstances” surrounding their activities. Ultimately, the DLSE’s opinion letter reiterated its longstanding position that California follows the same stringent federal factors in analyzing the classification of interns, and thus serves as a reminder to employers that improper classification of employees as unpaid interns can be costly.

The DOL has articulated six criteria to determine whether an “intern” or “trainee” is exempt from the Fair Labor Standard Act’s minimum wage coverage. In order to qualify as an unpaid internship, all six factors must be satisfied under state and federal law. The six criteria are as follows:

1. The training, even though it includes actual operation of the employer’s facilities, is similar to that which would be given in a vocational school.

2. The training is for the benefit of the trainees or students.

3. The trainees or students do not displace regular employees, but work under their close observation.

4. The employer derives no immediate advantage from the activities of the trainees or students, and, on occasion, the employer’s operations actually may be impeded.

5. The trainees or students are not necessarily entitled to a job at the conclusion of the training period.

6. The employer and the trainees or students understand that the latter are not entitled to wages for the time spent in training.

The DLSE’s new opinion letter concluded that all six criteria also must be satisfied in California. However, the agency now appears to take a more relaxed approach as to when an employer will meet certain aspects of the six factors. For example, in determining whether regular employees are displaced (i.e., the “non-displacement” criterion), the DLSE now takes the position that occasional or incidental work by an intern should not defeat the exemption provided such work does not intrude into activities that could be performed by regular workers and effectively displace them. As the stringent six criteria must still be satisfied, it will be difficult for companies, particularly for-profit companies, to have properly classified unpaid interns. The recent New York Times article regarding internships quoted Nancy J. Leppink, the acting director of the federal Labor Department’s Wage and Hour Division, as stating, “There aren’t going to be many circumstances [where for-profit companies can have unpaid internships and] still be in compliance with the law.”

Many companies have relied upon unpaid interns as a way to minimize costs and provide opportunities to eager workers who are willing to work for free in hopes of ultimately securing a paid position. Such an approach is risky, and employers must understand that the consequences of utilizing unpaid internships that do not comply with applicable law are potentially grave. As with misclassification of an employee as an independent contractor, employers with misclassified unpaid interns face potential liability for unpaid wages and violations relating to failure to pay minimum wage, which could be significant for a full-time intern. In addition to the wages due to unpaid interns, the employer could face potential liability for overtime and missed meal or rest periods. Moreover, the employer could be liable for various penalties under California’s Labor Code (including waiting-time penalties for failing to pay wages on a timely basis), as well as unpaid employment-related taxes owed to governmental agencies.

For more information about legal issues regarding interns, please contact Fred Alvarez, Kristen Dumont, Laura Merritt, Ulrico Rosales, Marina Tsatalis, Alicia Farquhar, or another member of the firm’s employment law practice.

How do the sample Series Seed financing documents differ from typical Series A financing documents?

March 14, 2010 By Yokum 13 Comments

After the recent announcement of the Series Seed Financing documents by Marc Andreesen, Brad Feld points out that there are now four sets of “open source” equity seed financing documents:

TechStars Model Seed Funding Documents (by Cooley)
Y Combinator Series AA Equity Financing Documents (by WSGR)
Founders Institute Plain Preferred Term Sheet (by WSGR – disclaimer, I represent the Founders Institute and was involved in drafting this document)
Series Seed Financing Documents(by Fenwick & West)

My general opinion is that anything that makes the financing process faster and easier or otherwise educates entrepreneurs is a good thing. (A reminder that anything I write on this site is only my personal opinion and does not represent the views of WSGR or anyone else from WSGR.) In addition, I think that a “peace treaty” between early-stage investors and startup companies on standard terms (at least at a term sheet level) is a step in the right direction.

I previously wrote a post titled “How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?” Much of the commentary on the Y Combinator documents is also applicable to the Series Seed documents. (In fact, I recyled part of that post in writing this post. I also reviewed the TechStars documents last year and they are similar in concept to the Y Combinator documents as the chart below indicates.)

This post assumes that you have a basic understanding of Series A financing terms. If you don’t, please educate yourself on this site, Venture Hacks and the term sheet seriesby Brad Feld/Jason Mendelson, among other places. If you really want to understand the nuances in venture capital financing documents, please review the NVCA model venture capital financing documents.

What situations should the Series Seed documents be used in?

The Series Seed documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. under $500K).

I was actually somewhat surprised that the following investors have agreed to use the Series Seed documents in certain of the their deals: Baseline, Charles River Ventures, SV Angel (Ron Conway), First Round Capital, Harrison Metal Capital, Mike Maples, Polaris Venture Partners, SoftTech VC and True Ventures. In contrast, Fred Wilson says while he is “hugely supportive of his intent here, I can’t and won’t get behind the Series Seed forms because they leave out some critical stuff that we simply won’t do a deal without.”

I think that there are certain situations where the Series Seed and other stripped down equity financing documents might be appropriate, but I know that there are lots of situations where early-stage investors probably wouldn’t agree to the Series Seed terms.

Recently, I have seen a lot of seed stage financings being structured as convertible debt with a price cap, which is an alternative to the equity financing contemplated by the Series Seed documents. Certain angel investors refuse to do convertible debt deals, but will be okay if there is a price cap. In fact, I have seen convertible debt used to raise up to $1.0 million, but it seems like the sweet spot is around $500K. Convertible debt documents are generally much more simpler to draft and read than equity financing documents, so I typically recommend convertible debt for companies raising below around $750K.

In my experience, if a company is raising, say $1.0 million, the investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors. Therefore, the Series Seed documents may not be acceptable in these situations. I think that the Series Seed documents are probably most appropriate in a friends and family equity seed financing, as opposed to a round led by a professional investor.

Why is it called Series Seed?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights. There is no real rule to what a particular series of preferred stock is called.

What rights does the Series Seed have?

Ted Wang explains most of the highlights of the documents. The primary rights in these documents, ranked in order of importance in my opinion are:

Non-participating preferred liquidation preference. The investor receives their money back and the remainder goes to the common.

Limited protective provisions. Among other things, the company can’t be sold without consent of a majority of the Series Seed.

Future rights. If new investors get better rights in a future equity financings (such as registration rights, price-based anti-dilution, redemption rights, etc.), then the holders of the Series Seed get these better rights.

Right of first offer on future financings. Self-explanatory.

Board seat. The Certificate of Incorporation gives the Series Seed a board seat, while the common get two board seats.

Information rights. The investor receives unaudited annual and quarterly financial statements.

Drag along. The Series Seed documents include a fairly harmless drag-along provision, which requires the investors and the key common stockholders to vote in favor of a “deemed liquidation event” (which basically means sale of company transaction) if a majority of the holders of common stock, a majority of the holders of the Series Seed and the board approve the transaction. Given the general theme of the documents to eliminate unnecessary provisions, it strikes me as somewhat odd that there would be a drag-along. If I represent investors in a later Series A financing, I would probably use the existence of the drag-along as an excuse to implement a more aggressive drag-along provision — which does not require the approval of the holders of common stock to trigger.

Legal fees. The company is obligated to pay $10K for investors counsel. I suspect that this seems reasonable if there is basically no due diligence due to the early stage of the companies. (By the way, the TechStars documents and the Y Combinator documents do not have a provision to reimburse counsel for the investors, probably on the theory that the situation where the documents are used don’t require counsel to review the documents on behalf of the investors.)

What are the primary rights that are missing from the these documents that would be in a typical Series A financing?

In the Series Seed documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet.

Dividend preference. Almost all startup companies don’t declare dividends, so deletion of a dividend preference is irrelevant to an investor. The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.

Registration rights. As a practical matter, I don’t think that investors should really care about registration rights.

Anti-dilution protection. Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series Seed is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series Seed is unlikely.

Comprehensive protective provisions. The Series Seed documents are fairly light on protective provisions compared to a typical Series A financing.

Co-sale rights. These rights are missing, which is probably okay since I have never heard of a co-sale right being used before.

Voting agreement. In a typical venture financing, there is a voting agreement that governs how specific board seats will be filled. In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.

Comprehensive representations and warranties. The Series Seed Stock Purchase Agreement has fairly limited reps and warranties. As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues. In an early stage company, extensive reps and warranties are probably unnecessary.

Legal opinion. A company counsel legal opinion is missing in these documents. A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.

Why will or why won’t people adopt the Series Seed documents?

Investor pressure. The only way that the Series Seed documents will be widely used is if investors demand use of the documents.

Investors want additional protections. I suspect that things like lack of anti-dilution protection, a desire to have participating preferred stock and weak protective provisions will make it difficult for some investors to agree to use the documents without modification. Once you start making substantial changes to the forms, then I think some of the value of standardization goes away.

Law firm resistence. As a reference point, WSGR generally does not use the NVCA documents in a Series A financing when it represents the company unless the investor specifically demands that the NVCA documents be used. This represents approximately 20% of all venture financings in the U.S. I’ve read the WSGR form Series A documents hundreds of times (and probably have most of the provisions memorized). I think I’ve only come across the NVCA forms a couple of times, and both times were on deals with Boston-based company counsel, where use of the NVCA documents is more widespread. In addition, WSGR’s Series A documents can be created using the document automation software behind the WSGR term sheet generator. Therefore, using WSGR form documents when I represent a company is much more efficient than using the NVCA documents.

Drafting issues in later rounds. One thing that I don’t like about stripped down documents is that adding provisions in the future is painful — especially if the documents are not written in a modular fashion. For example, adding in the anti-dilution provisions into the Series Seed documents requires the insertion of a couple of pages of text into the Certificate of Incorporation. It’s somewhat painful to ensure that all of the section references (including Microsoft Word auto-reference codes) and defined terms work properly. Therefore, in my opinion, it’s actually more difficult to add the modular sections than it would be to start from a new robust template and tweak it to fit the term sheet. I’d encourage the Series Seed project to have redlines of at least the Series Seed Ceritificate of Incorporaiton against the form of Series A Certificate of Incorporation that it was based on in order to show that the documents can easily be modified in a Series A financing to include anti-dilution and other provisions. (It seems like the Series Seed Certificate of Incorporation is mostly based on the NVCA form of Certificate of Incorporation with various formatting and simplification-related changes.)

Use of different forms for later Series A financing. As a practical matter, in a typical Series B financing, the Series A documents will generally be tweaked slightly for the Series B, and company counsel will send redlines to investor counsel to show changes from the Series A (which are typically minimal). When a company does a Series A financing and the Series Seed documents are in place, the Series Seed Stock Purchase Agreement and Investors Rights Agreement will probably not be re-used. As discussed above, the Certificate of Incorporation will need to be amended and restated and various provisions will need to be plugged in. (By the way, restated means that the entire document is redone in its entirely, as opposed to just an amendment, which might refer to discrete sections like: “Article IV shall be amended such that the number of shares of Common Stock shall be 15,000,000.”) The Series Seed Stock Purchase Agreement has no lingering obligations, so Series A investors will want a more traditional stock purchase agreement with closing conditions and closing certificates — and it is much easier to use a typical Series A Stock Purchase Agreement than modify the Series Seed Stock Purchase Agreement. In addition, there will be so many new provisions added to the Investor Rights Agreement (such as registration rights) that starting from a more robust form is easier than adding provisions to the Series Seed Investor Rights Agreement.

What’s the difference between the Series Seed documents, the TechStars documents, the Y Combinator documents and TheFunded Plain Preferred term sheet?

The Y Combinator documents were released in August 2008. The TechStars documents were released in February 2009. TheFunded released their “Plain Preferred” term sheet in August 2009. The Series Seed documents were released in March 2010. Below are some of the material differences between the Series Seed, Y Combinator and TechStars documents. (I won’t bother outlining the differences in TheFunded term sheet, as it was more intended for a typical Series A institutional venture capital financing, as opposed to the seed stage contemplated by the other documents.)

	Series Seed	Y Combinator	TechStars
Name of security	Series Seed	Series AA	Series AA
Principal documents	COI, SPA, IRA	COI, SPA, IRA	COI, Subscription Agt.
Dividend preference	Pro rata with common	Silent	Pro rata with common
Liquidation preference	1x non-participating	1x non-participating	1x non-participating
Redemption rights	None	None	None
Anti-dilution	None	None	Broad-based weighted average
Board composition	2 common; 1 preferred	2 common, 1 preferred	2 common, 1 preferred (if Series AA is at least 5% of fully-diluted)
Protective provisions	Typical list for company-friendly VC financing	Changes in preferred and merger/sale of assets only	Changes in preferred only
Information rights	Unaudited annual and quarterly	Unaudited annual and quarterly	Unaudited annual
Registration rights	None	None	None
Right of first offer on new financings	Yes	Yes	Yes
Right of first refusal and co-sale agreement	Assignment of company right of first refusal to investors	Silent	Silent
Drag-along	Yes for Series Seed holders and founders. Triggered upon (i) majority of common, (ii) majority of Series Sees, and (iii) board approval.	No	No
Future rights	Yes	No	Yes
Legal opinion	None	None	None
Legal fees	$10K to investor counsel	None	None

What would you change about the documents?

I’m still pondering and will update this post later after I speak to some early-stage investors.

What is an employee retention or M&A carveout plan?

February 21, 2010 By Yokum Leave a Comment

I was speaking at an event last month to a group of CEOs and was surprised by the number of CEOs that were worried about the value of their common stock in a M&A transaction. Due to aggregate liquidation preferences that may exceed the acquisition price in an M&A deal, common stock may be rendered worthless. For example, if a company has raised $20M in venture financings by issuing non-participating preferred stock, the holders of common stock will not receive any proceeds from an M&A transaction unless the transaction value exceeds $20M. If you can’t figure this out yourself, you should probably build a liquidation preference spreadsheet to model how liquidation preferences work depending on M&A transaction value.

In response to the problem of worthless common stock, some companies have implemented employee retention plans, which are also referred to as M&A carveout plans. This was particularly common from 2001 to 2003, after the dot-com crash when companies had raised a large amount of venture financing at high valuations.

Below are some common structures for employee retention plans and issues related to each alternative. I have intentionally not covered all of the corporate law implications of designing and implementing a retention plan or provided a comprehensive analysis of any particular tax or accounting issues, as they are fairly complex and depend on specific facts. A company’s board of directors will need guidance from counsel on meeting their fiduciary duties when implementing a retention plan.

1. Change of Control Bonus Plans

Under a change of control bonus plan, eligible employees are entitled to certain benefits upon change of control transactions as specifically defined in the plan documents. This can be simple as an agreement with an individual employee that says “if you are still employed when the company is sold, you will receive $X.”

More complex plans set aside a pool of money for employees and a mechanism for dividing the pool. In addition, the plan could pay a fixed amount under the plan to the individuals, regardless of the value of the triggering event. Alternatively, the plan could pay a percentage of the proceeds from the triggering event (e.g. 10% of the size of the deal). In some cases, the payout may be a sliding scale (e.g. 10% of the first $5M in proceeds, 15% of the next $5M in proceeds, and 20% of the amount over $10M). In plans where the size of the payout is dependent on the size of the transaction, the definition of the transaction value needs to account for situations such as assumption of debt by the acquiror, earnouts, escrows, and illiquid stock as acquisition consideration, among other things. In addition, given that the plan is intended to solve for situations where common stock is worthless, they should terminate above certain transaction values, or payouts should take into consideration the value of the common stock.

2. Straight Retention Plans

Under straight retention plans, eligible employees are entitled to certain benefits or payments that are not contingent upon any triggering event, such as a change of control. These bonus payments may be paid as long as the employee is employed on a certain date (i.e. 50% of base salary if still employed 6 months later).

The following issues relate to both change of control bonus plans and straight retention plans:

• Currency. The company must determine the currency with which to pay the eligible employees. Typically, employees receive stock, cash or a combination thereof. A retention plan that pays employees in acquiror stock is less common than a cash payment plan as payment in acquiror stock will be ordinary income to the employee, and receiving illiquid acquiror stock in a taxable transaction is not desirable in most situations.

• Participation. The company must determine which employees are eligible to participate in the program. Executive management is typically the key participant, however, participation may be determined by time of service or benefits can be given to all employees.

• Allocation. Once the company has determined who is eligible, they must further determine how to allocate the units or stock to be issued to the employees. Alternatives include position, time of service, current equity holdings or other metrics as determined by the company’s board of directors. The board can set aside some of the “retention pool” for future issuances. However, it must determine when establishing the plan what will happen to the pool upon certain triggering events.

• Vesting. The company must determine whether the stock or cash distributed will be fully vested at the time of grant or will vest over time. The company must further determine which, if any triggers, will accelerate vesting and to what degree.

• Last Man Standing. Related to vesting issues, the company must also determine whether benefits will be forfeited if employees are terminated within a certain period of time of the change of control and whether the forfeited benefits will be redistributed to remaining employees. If the employee needs to be employed at the time of the change of control transaction, this may lead to a perverse incentive for company management to terminate employees, especially if the forfeited benefits are redistributed to remaining company management.

3. Junior Preferred Stock

Some companies have implemented junior preferred stock, which often receives a certain percentage liquidation preference on the sale of the company. The junior preferred can be created as an option plan or sold directly, with or without vesting. The junior preferred is often junior to existing preferred stock, but senior to common stock, in order to provide liquidation preference for certain classes of employees, senior to common stock. Participation, allocation and vesting issues are similar to those described above.

What is a convertible bridge note with a price cap?

January 11, 2010 By Yokum 20 Comments

I seem to be doing a lot of pre-Series A convertible bridge note financings these days. As I have written previously, I think that convertible notes with even large conversion price discounts (e.g. 50%) or warrant coverage are typically more company-favorable than a Series A financing where a valuation is set. After completing a lot of convertible debt deals over the last year on behalf of both companies and investors, I have refined some of my thoughts about pre-Series A convertible debt terms.

Observation 1 — Convertible debt is a bad deal for angel investors

I think many sophisticated angel investors realize that convertible bridge notes do not adequately compensate angel investors for the risk that they take in funding early-stage companies. For example, typical provisions in a company-friendly pre-Series A convertible bridge note financing may include a 20% conversion discount from the Series A price and a 2x return on a sale of company.

Assume the angel investor invests $500K. If the company eventually raises $50M in a Series A financing at a $100M valuation, a 20% discount from that price is not particularly attractive compensation for that investment risk, as the investor would only own about 0.4% of the company after the financing (assuming that the shares issued upon conversion of the bridge were not included in the pre-money fully-diluted share number). Similarly, if the company is sold for $100M, the investor would only receive 2x their investment back (plus interest), or a total of $1M, which would only be 1% of the sale price.

If the investor had invested $500K in a Series A Preferred Stock at a $4.5M premoney valuation, then the investor would own 10% of the company. If the company raises $50M in a Series B financing at a $100M valuation, the investor would own 6.67% of the company post-Series B financing.

Similarly, if the company was sold for $100M before another round of financing, the investor would receive 10%, or $10M.

Observation 2 – Angel investors realize convertible debt is a bad deal so they demand price protection provisions (i.e. a price cap)

Due to the economic results described above, many sophisticated angel investors refuse to do convertible note bridge financings unless the conversion price on the debt is capped. In other words, an investor may request that the conversion price is the lower of (i) a 20% discount from the Series A price, or (ii) the price per share determined if the valuation was $[X]M. Typically, the valuation might be some reasonable projection of the valuation range in the eventual Series A financing. The valuation is typically higher than what would be set if the investor and the company negotiated a valuation at the time of the convertible debt financing, but lower that the expected Series A valuation if the company achieved their objectives.

Similarly, in the event of a sale of company before a Series A financing, a sophisticated angel investor may request that they receive the better of (i) 2x their investment back (plus interest), or (ii) the return if they had invested their money at an $[X]M valuation.

In any event, I think that convertible debt financings are still easier to complete than a Series A financing, so a convertible note with a cap achieves the investor’s objective without the complexity of a Series A financing.