Writing his usual daily roundup in Bloomberg View, Matt Levine, a former corporate attorney and investment banker who is perhaps the only person in the world who writes in a laugh-out-loud manner about securities law, raises interesting points on two unrelated topics: startup valuation and plain English writing.
I always enjoy the reality show Shark Tank, where startups make appeals to a panel of well-known individual investors, seeking their venture investment. However, most of the negotiations are only focused on two deal points: how much will be invested, and what percentage of the company the investor will get. In my legal work, more often than not, these basic financial terms are already worked out by the time I get involved, and the heavy negotiation, particularly when the investor is a venture capital or private equity fund, is about special rights that the investor can obtain: board representation, veto rights over major (or minor) decisions, preferences upon sale or liquidation, anti-dilution rights, and many more.
At times, the rights sought by the investor can be pretty onerous. The investor will argue that they are necessary to induce the investor to make a risky investment. There is some validity to this reasoning, though I think it’s a bit overstated.
What if, however, a fund investor decided instead to take a Shark Tank-type approach and negotiate only the amount invested and valuation with no special rights – just common stock, no board representation, no economic preferences. (By the way, I have no idea whether the sharks on the show negotiate these sorts of rights as part of their deals – it would be too boring to describe to a network TV audience – but I’m just using the show to illustrate a point.) The approach on the part of the investor is that if a due diligence investigation shows that this is a promising venture, just give the company the needed funds and let the founders do their thing, providing advice only as requested by the company. Of course, some ventures won’t work out, but in any event the idea (particularly with venture capital funds) is to spread funds around many investments and wait for a few to pay off big. The rationale for stepping back like this is to make yourself attractive to companies seeking capital, allowing you to be more selective in the companies you invest in, hopefully leading to greater ultimate success.
I’d be curious to hear if any readers have experience with funds that take this approach. In my experience, I’ve seen exactly one example.
When startups are choosing a form of entity – usually either an LLC or a C-corporation in my experience – the common advice is to be an LLC (which by default is taxed as a partnership), unless the company expects to receive venture capital funding, in which case it should be a C-corporation. The conversion to C-corporation status can happen later – even concurrently with the venture capital funding – without tax impact. However, this short article in Inc. magazine by Ryan Feit argues that even startups expecting venture capital funding should resist this advice and remain an LLC. Feit notes that the double taxation of C-corporations (corporate-level tax plus income tax at the shareholder level) has a huge impact, which is why single-taxed LLC are the go-to default, and that the rationale for nevertheless using C-corporations – that the VC funds need it for their internal purposes – is misguided.
When companies are in need of financing, the threshold question is whether the financing will take the form of equity or debt. Of course, there are hybrid forms such as convertible debt, and some financings will involve equity investment completed simultaneously with a bank loan. And sometimes debt will not be an available option, particularly for start-ups with no steady revenue that a lender could rely on for assurance of payment. But in many cases, a company will have a choice of which way to proceed. [Read more…]
The short answer to the above question is “no,” but there are some caveats that we need to discuss (otherwise, this would be my shortest blog post ever).
Limited liability companies do not require ownership to be evidenced by physical certificates, though a company’s operating agreement can provide, voluntarily, that certificates will be issued. More often than not, in my experience, ownership in LLCs is set forth in a table attached to the operating agreement that is updated as ownership changes. This table can reflect either share-like units of ownership called, appropriately, “units” or percentage ownership. The latter is more unwieldy, I think, particularly with LLCs with many members, but you see it a lot particularly in more old fashioned forms.
For privately-held corporations, most states now permit the issuance of “uncertificated” shares, meaning as with LLCs that there is no physical certificate issued and the corporate records must reflect current ownership. Both New York and Delaware permit the issuance of uncertificated shares by resolution of the Board of Directors (Section 508 of the NYBCL and Section 158 of the DGCL, respectively). In some cases, the corporation will send a notice of issuance of stock to the holder. This open source form from Orrick resembles an actual stock certificate in some ways – it’s not really necessary to do it this way, but it may be more reassuring to old school investors who aren’t aware of the trend toward (and legality of) uncertificated shares.
Finally, there are public companies (usually corporations), where uncertificated shares have been more prevalent for a longer period. This SEC summary outlines the possibilities – if you don’t hold a physical certificate, you either have “street name” registration or “direct” registration (DRS). Since 2008, all public companies with stock listed on a major exchange have been required to have DRS-eligible shares.