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Should a company allow option exercises with promissory notes?

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I typically discourage companies from allowing option exercises by means of a promissory note. Promissory notes can provide employees a means of exercising options and starting their capital gains holding periods without coming up with cash. However, the promissory notes must be substantially full recourse to start the capital gains holding period, which creates a real obligation for the employee even if the stock eventually becomes worthless. A bankruptcy trustee might attempt to collect on a full recourse note in the event the company goes bankrupt. Full recourse means that the note is a general obligation of the employee, as opposed to recourse being limited to the stock purchased in the event of default.

If the promissory note isn’t substantially full recourse, then the option isn’t deemed to be exercised for tax purposes. If the note is repaid (or forgiven) in the future and there is a difference between the purchase price and fair market value at that time, then the employee may have a taxable event. In addition, if the note is forgiven, it will create debt forgiveness income to the employee.

Promissory notes can create accounting problems for the company as well, and they create administrative complexities. Finally, loans to executive officers have received intense public scrutiny over the past several years, and public companies are now barred from making loans to (or materially modifying existing loans to) executive officers.

Should founders pay for their stock in cash or contribute intellectual property?

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If a founder owns intellectual property that he or she plans on contributing to a company, the founder may want to pay for founder stock by assigning the intellectual property rather than paying cash.  Even though founders typically purchase stock for $0.01 or $0.001 per share, the aggregate purchase price can often be in the thousands of dollars.  (Or course, the par value can be set extremely low, such as $0.00001 per share in order to allow founder stock purchases at extremely low prices.)  Sometimes, a founder will choose to assign a business plan to the company for this purpose.  Nevertheless, there are number of risks associated with purchasing founder stock by means of assigning intellectual property, including:

  • difficulty in adequately defining the scope of what is being assigned or what the company needs in this regard now or in the future;
  • difficulty in making sure the assignment is properly perfected;
  • difficulty in accurately valuing the assets assigned, which could affect the company’s stock option pricing if the company’s auditors determine that the value of the intellectual property (and, by correlation, the fair market value of the common stock purchased) was significantly higher than stated; and
  • potential tax ramifications (the contribution must to reviewed to make sure that the transaction complies with Section 351 of the Internal Revenue Code in order to be tax free).

In order for an exchange of property for stock to be tax free under Section 351, there are two requirements.  First, the property generally must to transferred solely in exchange for stock of the company.  This is easily met because the founder typically does not receive any cash in the exchange.  Second, immediately after the transfer, the founder(s), including those transferring cash, must own (i) stock possessing at least 80% of the combined voting power of all classes of stock entitled to vote, and (ii) at least 80% of the total number of shares of each other class of stock.  If there is more than one founder, the contributions do not need to be simultaneous, but need to be at or around the same time as the other founders so that it is part of the same transaction in order for the transfers to be aggregated to meet the 80% test.

If a founder chooses to purchase stock by means of assigning intellectual property, the founder needs to execute a proper assignment so that title to the intellectual property is clearly transferred to the company.  In addition, the founder should generally always include at least some cash consideration in order to ensure that the par value per share is paid in cash.

Should a company allow early exercise of stock options?

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Some companies allow employees to exercise their unvested stock options, or “early exercise.”  Once purchased, the unvested stock is subject to a right of repurchase by the company upon termination of services.  The repurchase price is the exercise price of the option.  Please note that a stock option is typically not early exercisable unless the board of directors of the company approves an option grant as early exercisable and the company issues the stock option pursuant to an option agreement that permits early exercise.

Allowing early exercise of unvested shares can provide employees with a potential tax advantage by allowing the employee to start their long-term capital gains holding period with respect to all of their shares and minimize the potential for alternative minimum tax (AMT) liability.  If an employee knows that he/she will early exercise a stock option immediately upon the grant of an option (when there is no difference between the exercise price and the fair market value of the common stock), the employee typically should want an NSO as opposed to an ISO, because long-term capital gain treatment for stock issued upon exercise of an NSO occurs after one year.  In contrast, shares issued upon exercise of an ISO must be held for more than one year after the date of exercise and more than two years after the date of grant, in order to qualify for favorable tax treatment.

There are several disadvantages to allowing early exercise, however, including:

  • Risk to employee.  By exercising a stock purchase right or immediately exercisable option the employee is taking the risk that the value of the stock may decrease. In other words, the exercising employee places his or her own capital (the money used to purchase the stock) at risk. Even if a promissory note is used to purchase the stock (future post to come), the note must be full recourse for the IRS to respect the purchase. In addition, if the employee purchases the shares with a promissory note, the note will continue to accrue interest until it is repaid, and a market rate of interest must be paid in order to satisfy accounting requirements. Depending on the number of shares purchased, the expected tax benefit from early exercise may not justify these increased risks to the stockholder.
  • Tax upon spread. If there is a “spread” at the time of exercise, the employee will trigger ordinary income (in the case of an NSO exercise equal to the difference between the exercise price and fair market value of the common stock on the date of exercise) and may trigger AMT liability (in the case of an ISO exercise, with the difference between the exercise price and fair market value of the common stock on the date of exercise being an AMT preference item). Any taxes paid will not be refunded if unvested shares are later repurchased at cost. (Please see the post “What’s the difference between an ISO and an NSO?” for a summary of the tax implications of exercising an ISO or an NSO.)
  • “Back door” public company.  Allowing employees to early exercise may increase the number of stockholders.  If the company ever reaches 500 stockholders, Section12(g) of the Securities Exchange Act of 1934 will require the company to register as a publicly reporting company.
  • Securities law issues upon a sale.  If the company has more than 35 unaccredited stockholders at a time when it has agreed to be acquired in a stock for stock transaction, the acquisition will likely be more complex and take longer to complete.
  • Administrative hassles.  A significant increase in the number of stockholders can place a tremendous administrative burden on the company. This is especially true when employees purchase shares subject to repurchase and when they purchase shares with promissory notes. The forms that the employee must complete and sign are much longer and more complicated. 83(b) elections must be filed with the IRS within 30 days of the purchase. Stock certificates for unvested shares must be kept by the company so that they can be easily repurchased if the employee leaves the company, which increases the risk that the stock certificates are lost or misplaced. Interest on promissory notes must be tracked.
  • Stockholder rights. Optionees have no rights as stockholders until they exercise their stock options.  If optionees exercise stock options, whether vested or unvested, they have the same voting rights as any other stockholder. Certain actions, such as amendment of the certificate of incorporation, which typically occurs in connection with every venture financing, require stockholder approval.  This requires certain information to be provided to the stockholder in order to make an informed decision.  Stockholders also have more statutory rights than optionees, including inspection rights. Stockholder information requirements may also be triggered under Rule 701.

What do you need to do before you quit your job to form a startup company?

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There are various things a potential founder of a new startup company needs to do before quitting their job.

1. Review all agreements with your current employer.  Most employees may have signed an offer letter and a confidential information and invention assignment agreement, as well as other documents such as a stock option agreement.  Depending on the company and the employee, other relevant documents might include a employment agreement, employee handbook, conflict of interest policy or severance/separation agreement. These documents should be reviewed carefully for provisions that may inhibit the future startup company.  Enforceability of some provisions in these documents, such as non-compete clauses, generally depends on the state where the employee is located.

Reviewing the documents for the following provisions is important.

  • Confidentiality.  All technology companies require employees to sign a confidentiality agreement that prevents the employee from using or disclosing employer confidential information except for the benefit of the employer.  These confidentiality provisions are typically for an indefinite period of time, as opposed to a finite period like five years.  In any event, most states prohibit the misappropriation of trade secrets as a matter of law, regardless of whether the employee signed a confidentiality agreement or not.  Thus, a potential startup company founder needs to ensure that he/she does not use former employer confidential information in connection with the new company.
  • Invention assignment.  In addition, all technology companies require employees to assign inventions created during employment to the employer.

A typical invention assignment clause provides:

I agree that I will promptly make full written disclosure to the Company, will hold in trust for the sole right and benefit of the Company, and agree to assign and hereby do irrevocably assign to the Company, or its designee, all my right, title, and interest in and to any and all inventions, original works of authorship, developments, concepts, improvements, designs, discoveries, ideas, trademarks, or trade secrets, whether or not patentable or registrable under patent, copyright, or similar laws, which I may solely or jointly conceive or develop or reduce to practice, or cause to be conceived or developed or reduced to practice, during the period of time I am in the employ of the Company (including during my off-duty hours), or with the use of Company’s equipment, supplies, facilities, or Company Confidential Information, except as provided in Section 3.F below (collectively referred to as “Inventions”).

In California, there is an exception to this requirement to assign inventions if the employee has made the invention on his/her own time not using company equipment and the invention does not relate to the business of the company or did not result from work for the company.  California Labor Code Section 2870 provides:

(a) Any provision in an employment agreement which provides that an employee shall assign, or offer to assign, any of his or her rights in an invention to his or her employer shall not apply to an invention that the employee developed entirely on his or her own time without using the employer’s equipment, supplies, facilities, or trade secret information except for those inventions that either:

(1) Relate at the time of conception or reduction to practice of the invention to the employer’s business, or actual or demonstrably anticipated research or development of the employer; or

(2) Result from any work performed by the employee for the employer.

(b) To the extent a provision in an employment agreement purports to require an employee to assign an invention otherwise excluded from being required to be assigned under subdivision (a), the provision is against the public policy of this state and is unenforceable.

However, an employee may still need to notify the company of an non-assigned invention under the terms of the invention assignment provision.  Occasionally, I have seen invention assignment clauses that require the employee to assign inventions created for a certain period of time after termination of employment, from six months to a year.  These clauses may be enforceable depending on the state and the facts and circumstances of the situation.

  • Invention disclosure.  Even if an employer does not require post-termination invention assignment, some employers include provisions in standard documents that require the employee to disclose inventions created (or patents filed) for a certain period of time after termination of employment.  This is less common and may be enforceable if it is reasonably necessary to protect the company’s business interests.
  • Non-compete.  In many states, non-competes are enforceable if they are reasonable in scope and duration.  However, non-competes are generally not enforceable in California except for limited exceptions, including in connection with the sale of a business.  Therefore, most startup companies located in California do not have non-compete provisions in their standard employee documents.  A typical non-compete clause provides:

A. During the term of my employment with the Company and period of twenty-four (24) months immediately following the termination of my employment relationship with the Company for any reason or any other amount of time as determined by the Company in accordance with the terms of my Employment Agreement thereafter (the “Noncompete Period”), I will not, directly or indirectly, for myself or any third party other than on behalf of the Company, without the prior written consent of the Company:

(1) engage in the “Geographic Area” (as defined below) as an employee, agent, consultant, advisor, independent contractor, proprietor, partner, officer, director, or otherwise of a Competing Business (as defined below);
(2) have any ownership interest (except for passive ownership of one percent (1%) or less in any entity whose securities have been registered under the Securities Act of 1933 or Section 12 of the Securities Exchange Act of 1934 or the securities laws of any other jurisdiction of the United States) in a Competing Business; or
(3) participate in the financing, operation, management, or control of a Competing Business.

B. “Competing Business” shall mean any firm, partnership, corporation, entity, or business that [___________].

C. The “Geographic Area” shall mean anywhere in the world where Company conducts business.

A potential startup company founder needs to review carefully the scope of the definition of Competing Business and the time period of the non-compete.

  • Non-solicit of customers and vendors.  Some employment documents also include a prohibition on soliciting customers and vendors of the employer.  In states like California where non-competes are generally not enforceable, provisions on non-solicitation of customers and vendors are likely to be considered a restraint on trade and not enforceable.  A typical non-solicit clause provides:

I also agree that for a period of twelve (12) months immediately following the termination of my employment relationship with the Company for any reason, I will not directly or indirectly solicit, divert or accept business from, or otherwise take away or interfere with, any customer or vendor of the Company, including any person or entity who was a customer or whose business was being pursued by the Company on or prior to the date upon which my employment relationship with the Company terminated.

  • Non-solicit of employees.  Most technology companies require employees to refrain from soliciting employees for a specified term, such as one year after termination of employment.  Thus, startup companies where founders intend to hire their former co-workers need to carefully navigate the bounds of permissible action under these clauses.  Please also keep in mind that key employees of company may be subject to fiduciary duties to the company and may be subject to claims of breach of fiduciary duty, fraud and intentional interference with contract for soliciting co-workers even in the absence of written agreements.  A typical non-solicit of employees clause provides:

I agree that for a period of twelve (12) months immediately following the termination of my relationship with the Company for any reason, whether voluntary or involuntary, with or without cause, I shall not either directly or indirectly solicit any of the Company’s employees to leave their employment, or attempt to solicit employees of the Company, either for myself or for any other person or entity. I agree that nothing in this Section 8 shall affect my continuing obligations under this Agreement during and after this twelve (12) month period, including, without limitation, my obligations under Section 2A.

  • No moonlighting.  Some employment documents contain explicit provisions that prevent employees from working on business activities unrelated to their employer, even if it is after hours.  This may limit pre-resignation activities.  A typical clause might provide as follows:

I agree that during the term of my employment with the Company, I will not engage in or undertake any other employment, occupation, consulting relationship, or commitment that is directly related to the business in which the Company is now involved or becomes involved or has plans to become involved, nor will I engage in any other activities that conflict with my obligations to the Company.

Some companies may have provisions that limit outside activities, whether related or unrelated to the employer’s business.

  • No conflicting stock ownership or directorships.  Some company conflict of interest policies prevent an employee from investing or holding outside directorships in other companies.  This may limit pre-resignation incorporation of a new company.  A typical conflict of interest policy provides:

The following are potentially compromising situations that must be avoided:

Investing or holding outside directorship in suppliers, customers, or competing companies, including financial speculations, where such investment or directorship might influence in any manner a decision or course of action of the Company.

2.  Return confidential information.  Most employment-related agreements require employees to return all company property to the employer.  A typical clause provides:

Upon separation from employment with the Company or on demand by the Company during my employment, I will immediately deliver to the Company, and will not keep in my possession, recreate, or deliver to anyone else, any and all Company property, including, but not limited to, Company Confidential Information, Associated Third Party Confidential Information, as well as all devices and equipment belonging to the Company (including computers, handheld electronic devices, telephone equipment, and other electronic devices), Company credit cards, records, data, notes, notebooks, reports, files, proposals, lists, correspondence, specifications, drawings, blueprints, sketches, materials, photographs, charts, any other documents and property, and reproductions of any and all of the aforementioned items that were developed by me pursuant to my employment with the Company, obtained by me in connection with my employment with the Company, or otherwise belonging to the Company, its successors, or assigns, including, without limitation, those records maintained pursuant to Section 3.C. I also consent to an exit interview to confirm my compliance with this Section 5.

Employees should carefully search all electronic and paper files for any employer material, including temporary internet files, emails sent to personal addresses, email contacts, and other types of information.  The inadvertent retention of these materials can be used by the employer in future litigation.

3.  Limit pre-resignation activities.  Creating intellectual property related to the current employer’s business, or otherwise using the current employer’s time or resources can be problematic due to typical invention assignment clauses in employee documents.  Employees must avoid using equipment (including employer-provided laptops), time, know-how, or other resources of their employer in connection with their new startup company.  In addition, no customers should be solicited for the new company, and no co-workers should be invited to quit and join the new company before resignation.

However, some pre-resignation planning is permissible to some extent. In general, describing general concepts for a new company that fall short of intellectual property creation and meeting with potential investors is permissible subject to the potential contractual limitations described above.  Investor presentations should be carefully drafted to avoid any inference that IP has already been created. Incorporating a company before resigning is probably also permissible subject to the same potential contractual limitations, keeping in mind that certain facts may seem bad in later litigation.

Keep in mind that key employees, such as officers, directors and managers) may owe a duty of loyalty to the company, regardless of whether there is a written agreement.  This duty would prohibit an employee from doing anything to harm the employer, such as competing with the employer or usurping and business opportunities of the employer.

4.  Prepare for the exit interview.  Many employee documents require employees to submit to an exit interview.  Prospective founders of a startup company should not lie in an exit interview if they are asked about their plans.  While there is no particular obligation to tell the truth, even a slight misrepresentation may be used against the founder in future litigation to show dishonesty.  Departing employees should prepare a high level, but truthful response to any direct inquiries by an employer regarding future plans. If the potential founder is going to form a competing company, the former employer will learn about it anyway if it is successful.

Departing employees must also be prepared to make written representations to their prior employers that they have returned all company information and material, and will continue to comply with confidentiality obligations.  A typical representation is as follows:

This is to certify that I do not have in my possession, nor have I failed to return, any devices, records, data, notes, reports, proposals, lists, correspondence, specifications, drawings, blueprints, sketches, materials, equipment, any other documents or property, or reproductions of any and all aforementioned items belonging to the Company.

5.  Stay on good terms.  Sometimes litigation arises simply because the former boss of a departing employee has a vendetta against the employee.  Keeping on good terms with your former employer may also be helpful if the employer might be a potential investor, customer or supplier for the new startup company.

6.  Don’t forget about stock options and benefits.  Most stock options expire within 90 days of the last day of employment. In some cases, the time period is shorter than 90 days.  If you want to exercise a stock option from your current company, you need to make sure that you do it within that time period.  Of course, exercising a stock option will require the employee to pay the exercise price for the options, and in some cases, the aggregate exercise price may be significant.  In addition, employees should make sure they understand COBRA insurance and how to transfer their 401(k) plans, along with other benefits issues.

7.  Consult with an attorney.  (I will write a post on “How do I find and hire a lawyer” in the near future.)  Many of issues described above are fairly tricky and the advice of a competent attorney is recommended.  In addition, if there are any potential issues regarding intellectual property ownership with former employers, consulting with an attorney is extremely important.  In fact, a general corporate attorney (like me) is probably not the right person to deal with a situation where there may be an IP dispute.  I typically get one of my IP litigation colleagues involved if there is any likelihood of a problem.  IP issues will come up in due diligence in a future venture financing or a sale of company, so it is extremely important to make sure things are done correctly from the very beginning.

How do you set the exercise price of stock options to avoid Section 409A issues?

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The following mini-FAQ is somewhat based on a WSGR client alert (note: PDF is slow loading).

Do the 409A regulations provide guidance on the valuation of stock subject to “stock rights”?

Yes. The regulations provide guidance regarding acceptable methods for determining the fair market value of: (a) readily tradable (public company) stock, and (b) stock not readily tradable (private company stock).

These regulations represent a significant change in the process for determining the fair market value of private company stock. In order to comply with Section 409A and thus avoid early optionee income recognition and, potentially, a 20 percent additional tax, prior to option exercise, most private companies will need to significantly revamp their fair market value determination process.

What are the acceptable methods for determining fair market value of public company stock?

The fair market value of public company stock may be based upon:

  • the last sale before or the first sale after the grant;
  • the closing price on the trading day before or the trading day of the grant;
  • any other reasonable basis using actual transactions in such stock as reported by such market and consistently applied; or
  • the average selling price during a specified period that is within 30 days before or 30 days after the grant if the valuation is consistently applied for similar stock grants.

What are the acceptable methods for determining fair market value of private company stock?

The fair market value of private company stock must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.

The factors to be considered under a reasonable valuation method include, as applicable:

  • the value of tangible and intangible assets;
  • the present value of future cash-flows;
  • the readily determinable market value of similar entities engaged in a substantially similar business; and
  • other relevant factors such as control premiums or discounts for lack of marketability.

How often do private companies need to perform fair market valuations?

The continued use of a previously calculated fair market value is not reasonable if:

  • the initial valuation fails to reflect information available after the initial date of the valuation that materially affects the value of a private company (for example, resolving material litigation or receiving a material patent); or
  • the value was calculated as of a date that is more than 12 months earlier than the date for which the valuation is being used.

As a practical matter, most venture backed private companies obtain a new valuation report every time they complete a preferred stock financing.

Is there a presumption of reasonableness?

Yes. The regulations provide a presumption that the fair market value determination will be considered reasonable in certain circumstances, including: (a) if the valuation is determined by an independent appraisal as of a date no more than 12 months before the transaction date, or (b) if the valuation is of “illiquid stock of a start-up corporation” and is made reasonably, in good faith, evidenced by a written report, and takes into account the relevant valuation factors described above.

This presumption of reasonableness is rebuttable only upon a showing by the IRS that either the valuation method, or the application of such method, was “grossly unreasonable.”

What is an “illiquid start-up corporation”?

Stock will be considered to be issued by an “illiquid start-up corporation” if:

  • the company has not conducted (directly or indirectly through a predecessor) a trade or business for a period of 10 years or more;
  • the company has no class of securities that are traded on an established securities market;
  • the stock is not subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or other “lapse restriction” such as the right to purchase unvested stock at its original cost);
  • the company is not reasonably expected to undergo a change in control or public offering within 12 months of the date the valuation is used; and
  • the valuation is performed by a person or persons “with significant knowledge and experience or training in performing similar valuations.”

This may result in additional expense and burden for smaller companies (for example, having to hire an appraisal firm). Also, this could be problematic for companies issuing stock options or SARs within a year prior to a change in control or an initial public offering.

Are the typical, historical fair market value determinations made by private company boards of directors permissible under Section 409A?

Generally, no. The regulations have significantly changed the method by which a private company determines the fair market value of its stock. For example, valuation of private company stock solely by reference to a ratio related to the value of preferred stock (the old 10 to 1 ratio) generally will not be reasonable.  Specifically, to comply with the proposed regulations, the valuation of “illiquid start-up corporation stock” must be:

  • evidenced by a written report which takes into account the relevant valuation factors discussed above; and
  • performed by a person or persons with significant knowledge and experience or training in performing such valuations.

Consequently, unless a private company board includes a director, or directors, who would satisfy the “significant knowledge and experience” requirement or a company employee satisfies this requirement, the determination of fair market value most likely will need to be made by an independent appraisal. However, if one of the private company directors is a representative of a venture capital investor, or if the company employs individuals with financial expertise who would satisfy the “significant knowledge and experience” requirements, it may be permissible for the written valuation report to be prepared by such individuals.

Are most companies getting independent appraisals done?

Any company that has completed a preferred stock financing with an institutional venture capital firm typically will get a 409A valuation report from an independent appraisal firm.  Most pre-VC financed companies that are not issuing large option grants will not incur the expense of a valuation report.

How much does a valuation report cost?

I have had early stage companies get valuation reports done for as cheaply at $5K.  However, these valuation reports may be rejected by the company’s auditors, resulting in the need to have them redone by another firm.  Valuation reports done by more reputable firms may cost $10K to $25K, and even higher for later stage companies.

What is the typical fair market value of the common stock in relation to the preferred stock price for an early stage company?

The CEO of a boutique valuation company told me recently that the fair market value of the common stock of a typical early stage technology company is at least around 25% to 30% of the last round preferred stock price.  The old rule of thumb that the option exercise price could be 10% of the preferred stock price is not valid.

Should board members representing inside investors vote on the board resolutions authorizing the insider-led down round?

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As a theoretical matter, entrusting disinterested directors to approve a down round or dilutive financing is an excellent way to protect the insider-affiliated directors against claims from stockholders.  In this situation, the board may establish a special committee comprised only of disinterested directors to negotiate and approve the financing.  In a perfect world, the insider-affiliated directors would not participate in any of the board discussions to approve the transaction.

However, establishing an independent committee of disinterested directors to approve the terms of an insider-led down round financing is often impractical.  Oftentimes, there aren’t any disinterested directors to approve the transaction. All of the directors affiliated with investors participating in the financing will not be disinterested.  In addition, directors that are also employees may not be considered disinterested because they have a vested interest in completing a financing in order to keep their jobs.

In many scenarios, the inside directors will have to vote in order to have a valid board action.  However, the board will not have the benefit of the business judgment rule unless a majority of the disinterested directors or disinterested shareholders approve the transaction.  In this situation, courts will apply the entire fairness doctrine as the standard of review of director actions, which presumes that the directors acted unfairly and places the burden of proof on the directors to show fair dealing and fair value for the company.

Why do preferred stockholders have odd economic incentives upon a sale of company when they have non-participating preferred stock or particpating preferred stock with a cap?

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Even savvy investors often don’t understand the subtle nuances on economic incentives that result from non-participating preferred stock or participating preferred stock with a cap in the event of a sale of company.

Assume a simple cap table of:

10,000,000 shares of common stock

10,000,000 shares of Series A preferred stock

Also assume that the Series A preferred stock has a $1.00/share liquidation preference and is non-participating.

If the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

If the company is sold for $10M to $20M, the holders of Series A would still receive $1.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $15M, then the Series A would receive $1.00/share and the common would receive $0.50/share.  Thus, the holders of Series A are indifferent between sale prices from $10M to $20M, which may lead to odd economic incentives.  Hypothetically, a venture capital fund holder of Series A might not want a company to argue hard over merger valuation with an acquiror if there is no marginal benefit to the fund and there is a risk that the deal may fall apart.

If the company is sold for over $20M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $30M, then the common would receive $1.50/share (assuming all Series A converted).  Of course, if some holders of Series A did not act in their optimal economic interest and convert, then the merger proceeds available to the common would increase and the common would receive greater than $1.50/share.

Similarly, if the Series A is participating with a cap, there will be a range of merger consideration values where the holders of Series A will be indifferent because the cap has been met, but it still does not make economic sense for the Series A to convert.

In the same example, assume that the Series A has a $1.00/share liquidation preference and is participating with a 3X cap.

Like the non-participating preferred, if the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

For merger consideration greater than $10M but less than $50M, the Series A participates with the common on the amount over $10M.  For example, if the merger consideration is $20M, the holders of Series A would receive $1.50/share, or an aggregate of $15M (which represents the $10M liquidation preference and $5M of participation with the common), and the holders of common would receive $0.50/share, or an aggregate of $5M.

If merger consideration is $50M, the holders of Series A would receive $3.00/share, or an aggregate of $30M (which represents the $10M liquidation preference and $20M of participation with the common), and the holders of common would receive $2.00/share, or an aggregate of $20M.  At $50M, the Series A hits the 3x cap on participation by receiving $3.00/share.

If the company is sold for $50M to $60M, the holders of Series A would still receive $3.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $55M, then the Series A would receive $3.00/share and the common would receive $2.50/share.  Thus, the holders of Series A are indifferent between sale prices from $50M to $60M, which may lead to the same odd economic incentives as the non-participating preferred stock, albeit at higher transaction values.

If the company is sold for over $60M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $60M, then the common would receive $3.00/share (assuming all Series A converted).

Please see the liquidation preference spreadsheet and program some examples if you want to proof this yourself.

If a down round financing is led by a new outside investor, does the board need to be concerned about the business judgment rule?

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Having a new lead outside investor substantially improves the legal risk in a down round financing.  In most cases, the outside investor acting as lead will agree to invest the largest amount of money in the round, will perform the diligence necessary to set the valuation and pricing, and will dictate the terms of the transaction, including the amount of additional investment required or permitted of the inside investors.  In these circumstances, even where the new financing is at a reduced valuation, the conflict of interest issues are normally eliminated.  A rights offering is typically not considered necessary, although the company may still conduct one in order to solicit additional investor investor interest.  Disinterested board and disinterested stockholder approval procedures are typically not necessary, although following them will also decrease risk.

What are securities laws?

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The SEC publishes a guide titled: Q&A: Small Business and the SEC that provides a simple answer.

In the chaotic securities markets of the 1920s, companies often sold stocks and bonds on the basis of glittering promises of fantastic profits – without disclosing any meaningful information to investors. These conditions contributed to the disastrous Stock Market Crash of 1929. In response, the U.S. Congress enacted the federal securities laws and created the Securities and Exchange Commission (SEC) to administer them.

Companies selling common stock, preferred stock or issuing options or warrants are issuing “securities.”  The Securities Act of 1933 generally requires companies selling securities to give investors full disclosure of all material facts that investors would find important in making an investment decision. The Act also requires companies to file a registration statement (i.e. see the Google IPO registration statement) with the SEC that includes information for investors, unless the security or the type of transaction is exempt from registration.

However, registering a securities offering with the SEC is a very expensive (typically costing over $1,000,000) and time-consuming process.  Therefore, sales of securities by companies to private investors or venture capitalists are usually structured to be exempt from the registration requirements of the Act.  These exemptions (post to come) are fairly technical and companies need advice from competent securities attorneys to ensure compliance.

Even if a securities offering is exempt from federal registration requirements, the company must also comply with securities laws in each state where securities are offered.  States may impose their own registration or qualification requirements that must be complied with unless an exemption is available.

Failure to comply with securities laws allows a purchaser to rescind or undo the purchase of securities and get his or her money back or recover damages.  These rescission rights create potential exposure to the company if its stockholders demand their money back.

Generally, the federal statute of limitations for noncompliance with the requirement to register securities under the Securities Act is one year from the date of the violation upon which the action to enforce liability is based.  State remedies and statutes of limitations vary and depend upon the state in which the shares were purchased.  For example, the California statute of limitations for noncompliance with the requirement to register or qualify securities under the California Corporate Securities Law is the earlier of two years after the noncompliance occurred, or one year after discovery of the facts constituting such noncompliance.

In extreme cases, a company may make a rescission offer (i.e. offer to repurchase the securities plus interest) to stockholders that were sold securities in noncompliance with securities laws in an attempt to eliminate the exposure from rescission rights.  The rescission offer itself must comply with all relevant securities laws.  For example, Google’s noncompliance with securities laws in connection with option grants required it to file a registration statement with the SEC to make the rescission offer at the time of its IPO and resulted in a cease and desist order by the SEC.

How can a board decrease litigation risk in an insider-led down round or dilutive financing?

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The role of the participating inside investors in an insider-led down round financing, who have the ability both to set the investment terms and make the investment, creates tension between management and minority stockholders on one hand, and the participating inside investors on the other. In addition, former founders or early investors not participating in the financing may perceive that the participating inside investors are attempting to secure control of the company by diluting their equity position.

Furthermore, the directors affiliated with the participating inside investors are often regarded as having a conflict of interest with regard to their approval of the down round financing.  This conflict of interest creates a difficult legal environment surrounding the actions of the board members and the company.

The actions of the board of directors are governed under state law by the business judgment rule.  This rule creates a presumption that business decisions made by a board of directors will be given deference by the courts if the board’s judgment is exercised diligently and in good faith.  Where the board’s decision may be influenced by conflicting financial interests of the directors (a so-called interested transaction), as in a down round financing, the favorable presumption of the business judgment rule falls away.  In these situations, the transaction is voidable by the shareholders or the company. Under corporate statutes in both Delaware and California, the board may successfully avoid an attempt to void the transaction by showing that the transaction was approved by a vote of the disinterested board members or a special committee, or by a vote of the disinterested stockholders or by proving that the transaction was intrinsically fair and reasonable at the time it was authorized by the board.

If the members of the board were to be found to have breached their duties, state law provides that they may be personally liable for their actions.  Since most private companies don’t carry directors’ and officers’ liability insurance and may not have the cash resources to engage in sustained litigation, the threat of personal liability can be serious.

Other theories of liability have been advanced based on the controlling influence that a venture fund or its general partners may have over the actions taken by a portfolio company.  These theories are based on facts which can demonstrate that a controlling stockholder has breached its fiduciary duty to minority stockholders, or that venture funds or their general partners have conspired with each other to aid and abet a breach of fiduciary duty owing to the stockholders.

There are a number of steps that a board of directors and the company can consider to reduce the risk of litigation from disenchanted stockholders when faced with a dilutive financing driven by inside investors.

  • A compelling board record. Board minutes reflecting the board’s thinking and analysis are important. Board members typically should meet in person or by conference telephone as opposed to taking action by written consent, and should devote more than a single meeting to decide to proceed with a down round financing. The minutes should reflect the board’s rationale for considering a down round financing and its efforts to recruit potential third-party investors.
  • Diligent assessment of alternatives. The board should attempt to demonstrate that it has considered all reasonable alternatives to the insider-led round. Although actual contacts and presentations with possible new investors are not legally required, if the company has not attempted to engage with new investors, there should be a plausible reason in the record for the board’s decision.
  • Approval by independent directors. Approval of the financing terms by the independent directors, or by a special independent committee of the board empowered to authorize the financing, may allow the board to take advantage of the business judgment rule.  Independent director approval may not be practical, however, in many circumstances.
  • Disinterested stockholder approval. Down round financing structures typically require stockholder approval. Securing the approval of the stockholders who are disinterested helps the company defend against an attempt to void the transaction by disenchanted stockholders.
  • Full disclosure of terms. Complete disclosure of financing terms is essential in a down round, with particular consideration of the benefits of the financing terms to the inside investors, the likelihood of replenishment of equity incentives to management and employees following completion of the financing, and factors that would adversely impact non-participating stockholders.
  • Rights offering. Perhaps one of most important steps in an insider-led down round financing is a rights offering that accompanies or follows the financing. All stockholders of the company, and frequently including employees with vested options and warrant holders with “in the money” rights, should be permitted the right to participate in the financing on substantially the same terms as the inside investors. The disclosure or information statement provided to all stockholders of the company can serve to summarize the financing terms while soliciting the interest of potential investors. The rights offering should be structured in a manner to comply with applicable state and federal securities laws and should allow sufficient time to allow potential investors to respond to the offer.

Unfortunately, there is no single step or combination of steps that can completely remove the risk of legal exposure in a down round financing. Board members may be faced with the difficult decision of proceeding with a financing that may result in litigation or shutting down the company.