Financing Transactions/Securities Offerings

Reluctance to Engage in Accredited Investor Verification

Reluctance to Engage in Accredited Investor Verification | Andrew Abramowitz, PLLCRule 506(c), the provision arising out of the JOBS Act that enables companies to raise capital using general solicitation and advertising while still being exempt from SEC registration requirements, has always had the potential to revolutionize the capital raising process. With the ability of companies to connect easily with potential investors anywhere via the internet and social media, one could imagine a world where this supplants private placements under Rule 506(b), in which the investor base is, by definition, limited based on existing relationships with the company or its broker-dealer. While the use of Rule 506(c) has grown since enactment, it has nowhere near the usage rate of Rule 506(b). In 2017, Rule 506(c) offerings represented only 4% in dollar amount of all Regulation D offerings.

Series Seed Preferred Stock Documents

Series Seed Preferred Stock DocumentsAs a general matter, the complexity of the documentation used for private company capital raising transactions is correlated with the amount raised. If a company is raising, say, $5 million or more from an institutional investor like a venture capital fund, the deal documents will often be based on the model legal documents prepared by the National Venture Capital Association (NVCA). While the standardization, easy availability and wide acceptance of these forms have been helpful in reducing legal costs and negotiation time, they are still over 100 pages spread over several agreements with many negotiable provisions. But in the context of the amount being raised, the associated costs are relatively small.

The Development of “SAFE” Instruments

In early 2015, I wrote about SAFE instruments, which I then had heard about but not yet seen in my practice, with a gently mocking but grudgingly intrigued tone, which likely resulted from the trend having originated on the West Coast. (As a native New Yorker, I have been trained to roll my eyes at each new development from California and then promptly forget about that when I incorporate it into my life.) With over three years of experience with SAFEs in my practice, I thought it appropriate to update my post, less the cynicism, since they have become pretty common and accepted in the world of early stage corporate finance.

A SAFE instrument (Simple Agreement for Future Equity) is an alternative to convertible notes for startups seeking bridge financing to keep the lights on until they can raise substantial funds in a true equity round.  Y Combinator offers open source SAFE equity forms with some background information.  With a convertible note, the seed investor acts temporarily as a lender, with the note being converted to equity if and when the company completes a qualifying equity financing.  With SAFE equity, the investor simply receives the right to receive preferred equity when the qualified financing is completed, without the need to temporarily treat it as a loan.  There is no interest, maturity date, repayment terms or any other provisions that you’d associate with a debt instrument.

SAFE promoters correctly point out that these seed investors are not ultimately seeking a debt-like steady return on their investment.  As early-stage equity investors, they have more of a high risk/high reward orientation. Convertible notes are usually not repaid in cash. The more likely scenarios are that (1) they are converted into equity, or (2) the company fails to complete a financing and realistically is not able to pay back the note. In the first scenario, the accrued interest adds to the amount of shares issued upon conversion, giving the investors a windfall that they would not have expected by making a simple equity investment. With SAFEs, the investment is treated like an equity instrument, which reflects the intent of both parties.

The SAFE folks also tout the relative simplicity of the SAFE documentation.  There is only one five-page document to be executed, and there aren’t a lot of moving parts requiring much customization.  Essentially, the parties need to only agree on whether there is a cap on the valuation of the later financing for purposes of determining the number of shares to be issued to the investor, and whether the investor receives a discount on the conversion price when the later financing is completed.  In fairness, convertible notes are themselves fairly simple and are used because they are themselves much simpler than VC equity documents, but SAFE equity appropriately combines simplicity with avoiding introducing debt concepts where not intended.

Finally, the absence of a maturity date with SAFEs takes the time pressure off of the company to complete the equity offering within a particular timeline, though investors may prefer having such a deadline in place to incentivize a quick completion of an offering.

The Presumed Sophistication of Accredited Investors

The Presumed Sophistication of Accredited InvestorsA recent Wall Street Journal article highlighted how sketchy brokers have been marketing problematic private placements to accredited investors. While the article focused on the brokers, I was struck by the identity of one of the investor victims noted in the article as having lost a lot of money: George Stephanopoulos, the ABC News anchor and former Clinton Administration official. I don’t mean to cause Mr. Stephanopoulos any further embarrassment by highlighting this here (though I’m guessing that the readership of my blog is far less than that of the Journal), but the fact that he was scammed is a useful illustration of the misguidedness of the accredited investor definition and associated rules.

The current definition of “accredited investor” under SEC rules essentially uses wealth as a proxy for sophistication, as an individual can qualify by either having an annual income of $200,000 or a net worth of $1 million not including the value of one’s primary residence. An offering made to all accredited investors does not have an information requirement, meaning the investors do not need to be provided with a similar level of disclosure that would be associated with a registered public offering.

Simultaneous Regulation CF and Rule 506(c) Offerings

Simultaneous Regulation CF and Rule 506(c) OfferingsBack when the equity crowdfunding rules were proposed following passage of the JOBS Act, the $1 million offering limit per year for what are now known as Regulation CF offerings was viewed as making this procedure impractical. The amount raised would not be sufficient in light of the legal, accounting and other costs needed to prepare for the offering. However, as crowdfunding is now a reality and companies are giving it a shot, a fix to the dollar limit has evolved: raise funds not just under Regulation CF, but under other exemptions that are not subject to that dollar limit.

Secondary Market Trading by Private Companies

Secondary Market Trading by Private CompaniesMatt Levine, writing in Bloomberg View, makes a good point about Spotify’s reported direct listing plan: When Spotify flips the switch, and trading of its shares on a public stock exchange commences, that won’t be the first time Spotify shares have traded hands. Like other large private companies that have been around a while, some of its early investors and employees have had the opportunity to sell some of their shares to existing or new stockholders, either in purely private transactions or ones facilitated by service providers that specialize in secondary market transactions. These private transactions help to establish a valuation for the company and ensure that, when public trading commences, investors won’t be flying completely blind in determining what the price should be in the absence of an initial price set by an IPO.

Spotify’s Possible Direct Listing

Spotify's Possible Direct Listing | Andrew Abramowitz, PLLCThe political website Axios, not known, at least to me, as a source of breaking business news, reports that the music streaming service Spotify has filed papers with the SEC on a confidential basis to go public via direct listing. …

A Possible Change to the “Accredited Investor” Definition

Accredited InvestorSecurities offerings that are exempt from the SEC’s registration requirements often hinge on whether some or all of the investors are “accredited investors.” There are various categories of accredited investors for business entities, but for individuals, the categories relate to the investor’s annual income, net worth or whether the individual is a director or executive officer of the issuer.

The underlying policy of the current definition of accredited investors is that rich people (a term not used in the actual rules, obviously) can be assumed to have a level of financial sophistication such that they would conduct adequate due diligence before making an investment. Accordingly, accredited investors require less disclosure about proposed securities offerings. This assumption is, shall we say, not attuned to human reality. The obvious group of accredited investors that are not necessarily sophisticated is heirs and spouses of wealthy business people, who may have no background at all in finance and investment matters. But even for those accredited investors who have directly earned the money that grants them that status, plenty are in fields such as sports and entertainment where the particular skill that is remunerative to them has nothing to do with investing. Additionally, many white collar professionals such as doctors, engineers and even some attorneys may be highly educated, but they are not able to make heads or tails of a balance sheet and income statement. …

A Possible Expansion of Regulation A+

Regulation A+On September 5, 2017, the U.S. House of Representatives overwhelmingly approved a bill that would allow already-public reporting companies to use the provisions of so-called Regulation A+ to make securities offerings. Regulation A+ in its current form is, in essence, a mini-IPO, allowing private companies to raise up to $50 million, offerings that are too small to attract the interest of large investment banks who underwrite traditional registered IPOs. If the current bill is enacted, public companies could take advantage of this process, which involves somewhat less disclosure than required for a full Form S-1 registration statement.

Are 409A Valuations a “Shell Game” and a “Dirty Little Secret”?

409A Valuations | Andrew Abramowitz, PLLCWilliam D. Cohan, writing in the New York Times’ DealBook, characterizes the third-party valuations of private companies under Section 409A of the Internal Revenue Code as Silicon Valley’s “dirty little secret” and a “shell game.” Especially in the aftermath of the financial crisis, there has been plenty of populist rhetoric about practices in the business world, and much of that criticism has had basis in fact, but this take on 409A valuations seems awfully strained.

As described in Cohan’s article, Section 409A and the related rules require that companies obtain independent valuations in connection with their issuance of equity-based awards to employees, and failure to comply results in tax penalties. Cohan details the fact that various service providers charge significant fees to undertake these valuations, using words like “supposed” experts to make the whole enterprise seem like a racket, but the reality is that the rules do exist, and these valuations have to be done. If it was possible for just anyone to make up a valuation for a bargain-basement fee, heck, I would consider doing it as a side gig from my legal work. But the rules actually go into detail as to the required qualifications for firms providing these services. Cohan notes in the article that the SEC would not comment on these practices, but this is really more of an issue of tax law than securities law. What constrains companies and their hired valuation help from simply making up numbers out of thin air is the fact that their decisions are subject to later IRS scrutiny and sanctions.