General Corporate/M&A Matters

The Real Cause of Large Legal Bills

I was recently representing a seller in a proposed acquisition. The purchase price was under $20 million – in the context of M&A, a relatively small deal. The purchaser was represented by one of the top 10 most profitable law firms in the world. The firm organized a due diligence call, blocking off two hours for the attorneys to ask questions of the seller that related to legal matters. I was the sole attorney on the call for the seller. From the purchaser’s law firm, there were a couple of corporate/M&A attorneys, and then one representative from each of any applicable specialty practice area: tax, employee benefits, real estate, intellectual property, etc. As far as I could tell, each of these specialists spent the whole time on this long call, waiting their turn and then taking, like, five minutes to ask the specific questions applicable to their specialty. The presumptive cost of that call to the purchaser, aggregating all those high billing rates for a couple of hours each, was, to my boutique firm way of seeing things, completely unfathomable.

Clients assessing prospective law firms will often focus on a single number: the hourly rate of the highest-ranking partner assigned to the matter. Witness all the ink spilled in recent years on how rates for many partners at large firms have blown well past $1,000 per hour. (This helps my marketing efforts, frankly, as it’s easy for me to show that my firm’s rates are lower than those at large and mid-sized firms in New York.) After bills are rendered, clients will sometimes question the amount of time it took for a particular attorney to handle a particular task. But as my anecdote about the conference call illustrates, often the real driver of cost is the firm’s staffing practices and whether the firm will seek to prioritize efficiency. On most matters handled by my firm, I am the only person from the firm on any call. Other attorneys are very much involved in the matter, handling behind-the-scenes tasks such as drafting, but they will generally not spend those couple of hours on the call with me; rather, I briefly summarize for them the upshot of what they need to know. To the extent other specialty attorneys are involved on my team, they will also communicate with me separately and generally not participate in a group call unless it’s primarily about their area.

To be clear, I am not saying that having multiple attorneys on a call is necessarily inappropriate or part of a conscious effort to jack up fees. But I do think that if clients are looking to exercise some oversight on legal costs, they would be better served by looking at a calendar invite for a Zoom meeting, seeing how many attorneys have been asked to join and inquiring about whether that is necessary, as opposed to arguing after a bill is rendered that a particular agreement should take three hours to draft, rather than five hours, without really knowing exactly what’s entailed in the process of drafting one.

Deciphering Real Estate Jargon for Corporate Attorneys

A small but significant part of my firm’s practice involves doing corporate and securities work on real estate development deals. I’m not a real estate lawyer (or, a “dirt lawyer” as they sometimes call themselves, in a bit of rather harsh-sounding self-deprecation), who handles core real estate transactions like purchases and leases of real estate, but I collaborate with those attorneys by forming entities and drafting their operating agreements, and ensure compliance with securities laws when there are outside investors helping to fund the projects.

The operating agreements for the entities formed for the project need to address the economics of the deal, including how any earnings from the project are divvied up between the developer (or, the “sponsor”) and the outside investors. These structures tend to be quite complex, and they have their own jargon that corporate attorneys who practice outside the real estate industry will find quite forbidding, even those who have plenty of experience with sophisticated transactions. Therefore, I thought it would be helpful to decipher a bit of that jargon as a service to the uninitiated among the corporate attorney community. I won’t address here the various other terms of art in real estate finance (cap rates, loan-to-value ratio, etc.) that aren’t directly relevant to the attorney needing to draft the operating agreement, nor will I address operating agreement concepts that are common outside the real estate context on the assumption that, if you’ve made it this far in this post, you know them already.

Assessing the Costs of SPACs

The casual reader of the business pages has seen over the past year or so many articles about SPACs, the financial structure du jour, which have actually been around for a while. (I worked on some in the ‘00s.) The acronym stands for Special (or Specified) Purpose Acquisition Company. For those of my readers that are not corporate finance professionals, the way to conceptualize a SPAC is that it’s a private equity fund that is publicly traded. In other words, investors put funds in a newly created entity via an initial public offering (IPO). The entity has no operations other than a plan to acquire an operating company with the IPO funds within the next couple of years, with a management team that is tasked with doing the acquiring. From the perspective of the operating company being acquired, it’s a way to go public, by merging with the already-public SPAC, as an alternative to a traditional IPO. (In a traditional IPO, there is no merger; rather, a bunch of new shares in the private company are sold to the public, and poof, it’s a public company.)

The investment community has been abuzz recently about an academic paper, summarized here, that found the costs of going public via SPAC merger to be much higher on average than doing so via a traditional IPO. For my non-finance professionals out there, the most concise way I can put it is that the typical SPAC structure is designed to favor the initial sponsors and initial investors, over investors who buy shares in the open market after the SPAC’s IPO and the target company shareholders. This is because of two concepts present in most SPACs but not in most other contexts: the promote and warrants.

A promote is a form of compensation for the management team that forms the SPAC, brings it public and finds an acquisition target. Generally, this sponsor team gets, for nominal cost, 20% of the post-IPO shares of the company. Ultimately, these shares dilute the ownership of the SPAC investors and of the target company’s shareholders, post-merger, in a way that doesn’t occur in a traditional IPO.

Additionally, in most SPACs, the IPO is done as a sale of units, comprised of regular shares and warrants to purchase additional shares. The warrants (which are like stock options for those unfamiliar with the term) have an exercise price somewhat higher than the IPO price. The warrants are essentially a free add-on for the SPAC IPO investor. They can elect to have the company redeem their shares in advance of the merger and get their invested money back, but they still can keep the warrant and cash in if the stock pops. The additional shares that are issued when warrants are exercised constitute dilution to other holders, again in a way that wouldn’t occur in a traditional IPO. At least as compared to the promote, a warrant exercise for cash would bring funds into the company, but if the warrant is in the money (i.e., the market price exceeds the exercise price), then the shares are being purchased at a discount, which is not the kind of dilution that existing holders want to see.

Ultimately, there are some advantages for private companies in going public by SPAC merger over a traditional IPO. For example, whether an IPO can be completed can depend on general market conditions at the time of pricing of the IPO that are completely outside the company’s control. A SPAC merger may be the right choice for certain companies. But they need to be sure they are taking into account and fully understand the SPAC structure before choosing this option over other alternatives, like a traditional IPO, an acquisition by another operating company or private equity fund, or simply staying put as a private company.

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.

What We Can Learn from Changes in Public SEC Filings

Title III CrowdfundingPeter R. Orszag, writing in Bloomberg View, highlights a study of public SEC-filed Form 10-K annual reports, which found that companies that make changes to the disclosure in their 10-Ks from one year to the next tend to have lower stock returns than average after publication of those changes. The study found that a significant majority of the changes constituted disclosure of negative information, so the resulting decline in performance is not surprising.

The New York Times on Ownership of Real Estate by LLCs

Preserving Anonymity with LLCs | Andrew Abramowitz, PLLCBack in January, before they truly became household names, I wrote about how the publicity around Michael Cohen’s use of an LLC to pay off Stormy Daniels fell into a larger narrative of how Delaware LLCs were being portrayed (unfairly, in my view) as equivalent to offshore shell companies, i.e., mysterious entities being used for nefarious purposes. Now, The New York Times comes along with a lengthy expose of how LLCs are being used to own real estate and enable bad behavior. …

Share Buybacks as a Political Issue

A year or two ago, the phrase “share buybacks” was a phrase only known to those in and around the world of corporate finance. It refers to a company’s use of available cash to purchase its own shares in the open market. The effect of this is to reduce the total number of shares outstanding, which makes the remaining shares more valuable. Recently, however, share buybacks have become enmeshed in political debates as shorthand for actions taken by corporate America and encouraged by Wall Street that are not in the best interest of workers and society generally. For example, The New York Times recently reported on how cash freed up by the recent tax cuts are being spent on share buybacks, as opposed to more worthy uses such as hiring new employees.

Saving Time with Online Cap Table Services

Saving Time with Online Cap Table ServicesIn the past few years, my private company clients have been flocking to online, cloud-based cap table services, such as Capshare and Carta (formerly eShares), as a platform to manage the company’s back-office functions for their capital structure. Aside from presenting an online cap table for reference by potential new investors and others, these sites provide a number of other services, such as being an online repository for documentation like stock option agreements and facilitating company valuations under Section 409A of the Internal Revenue Code.

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.

The Merits of Angel Investing

Angel Investors | Andrew Abramowitz, PLLCThe Financial Samurai personal finance blog posted an argument against angel investing, based in part on the writer’s own experience with a seemingly successful investment that really wasn’t so great, upon reflection. Toward the end of the post, the author says that if you do angel investing, you should devote no more than 5-10% of your funds towards it, and don’t expect anything good to come of it. But who is really advocating for devoting half or more of your nest egg to illiquid, speculative investments, even if you have a lot of financial leeway? There are legitimate reasons for wealthy individuals to want to participate in angel investing, like the satisfaction of helping a founder with a promising idea to realize a dream. As long as these investors aren’t blowing their whole fortune on it, what is the harm?