Startup Matters

The SEC Proposes a Clear Finder Exemption

I’ve noted in several blog posts (most recently here) that the SEC had not provided definitive guidance on an exemption for so-called “finders” from broker-dealer registration requirements. Now we have that guidance, at least in proposed form, which if enacted would provide clarity for issuers and would-be finders. The proposal was approved by the SEC Commissioners on a 3-2 vote (because it’s 2020 and of course it’s contentious), so there is perhaps a greater than usual possibility of changes to the rules before finalization.

The SEC’s Proposed Expansion of Accredited Investors

When to use a Private Placement Memorandum | Andrew Abramowitz, PLLCThe SEC has issued a proposal to expand the definition of “accredited investor” as used for the Regulation D safe harbor for private offerings. This press release/fact sheet summarizes the changes. There are a number of technical updates to reflect developments in how business is now conducted, e.g., LLCs with sufficient assets would qualify in the same manner as corporations now do. However, the change that would likely have the most impact, at least in my practice, is the inclusion as accredited investors of natural persons with appropriate professional certification, such as holders of a Series 7 securities license, even if they don’t qualify under the existing standards for natural persons for income or net worth. I’m not aware of any significant opposition to this concept and assume it will be enacted by the SEC after public comment.

However, any time the topic of the accredited investor definition is raised serves as a trigger for me to raise the issue of investment limits in private offerings. Crowdfunding offerings under Regulation CF, enacted in recent years and still used far less than Regulation D, impose investment limits on investors that are based on a percentage of the investor’s income or net worth. Accordingly, the structure precludes a total financial wipeout of the individual investor as a result of a failed investment. …

The Challenges of Startup Legal Representation

When I am having initial discussions with potential startup clients, they often say they’re looking for a firm that understands the particular challenges of running a startup. Perhaps this can be a reference to the substantive transactional matters that startups deal with – like negotiating an agreement among founders or raising capital using methods particular to early-stage companies – that attorneys who’ve been trained by representing Fortune 500 companies may not understand. But often the subtext of the question is that startups are frequently short of cash and may not be in a position to pay legal bills on a regular basis. The challenge for the attorney is to secure these sorts of clients and still manage to make a living after doing so.

Theranos and Giving Thought to Board Composition

Theranos and Giving Thought to Board CompositionOver the holidays, I finally got around to reading Bad Blood, the story of the rise and fall of the blood testing startup Theranos and its founder, Elizabeth Holmes, written by the Wall Street Journal investigative reporter, John Carreyrou, who broke the story that led to the company’s downfall. I cannot recommend the book more highly. However, you’re not here for book reviews, so let’s move on.

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 Limits of Networking

Business professor Adam Grant, writing in the New York Times, argues that business networking activities are overrated. (Grant is the author of Give and Take, one of the rare business advice books that I have actually read. It’s worthwhile.) Formalized networking events, Grant argues, are not only uncomfortable (we knew that already), but they’re ineffectual as a means of building real professional connections. Instead of using networking to seek to achieve things, he contends, we should reverse the order and use our great achievements to build a network.

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.

Does It Help Startups for Founders to Cede Control?

The Wall Street Journal reports on a study finding that startups that have a founder staying on as chief executive or chairman past the first two years following inception have a significantly lower valuation, on average, than companies who replace their leadership during that period. The study’s author attempts to explain the difference in valuation by focusing on the relative attributes of founders versus executives that are brought on later. In other words, founders may have the inspiration to get the startup conceptualized and off the ground, but professional executives have a different and necessary skill set that the company needs at a later stage.

Should vendors provide services in exchange for equity?This may be part of the explanation, but it seems to me to be confusing correlation and causation. There may be a reason other than the qualities of the founders themselves that account for the different performance. One possible alternate factor is the manner in which startups are funded. Startups that receive venture capital funding are, in my experience, more likely to see a change in leadership, sometimes imposed by the venture fund as a condition to investment. On the other hand, startups that are funded by less heavy-handed capital sources (friends and family money, bank loans, etc.) are more likely to have the founders continue in their role indefinitely.

Venture capital firms can contribute far more to a company’s success other than providing new executives to replace the founders. Particularly if the firm focuses on a specific industry, the firm will have seen and invested in many similar companies and will be able to provide useful advice that would not be available to startups that rely on non-VC funding. Such expert guidance from investors could account for significant differences in company valuation. In addition, VC firms generally invest more than a startup needs to spend immediately, so the simple fact of there being more cash in the bank could lead a VC-backed startup to have a higher valuation than one that isn’t VC-funded.

Recent Trends in Financing Startups

start-up-financingThe Wall Street Journal recently detailed trends in how startups are financing themselves. If you don’t have a Journal subscription, this article will likely be behind a paywall, but to sum it up, young businesses are using bank loans and home equity loans less than in the past, owing to continued cautiousness from lenders following the Great Recession. Instead, they are relying on their own savings and family loans and high interest personal credit card debt.

Bank loans to businesses still exist, but they typically require two years of business activity. This is of course no help to businesses that require a cash infusion to get started, though it can be helpful for more established businesses who want to expand their business or to smooth cash flow. Personal credit card debt is relatively easy to obtain, but the interest rates are high, and if your business fails, you’re in a far worse position than when you started.

For those who want to start a business but don’t want to potentially blow their personal savings on a venture or be stuck with high interest credit card debt, the lower risk alternative is to sell equity to outside investors. You are giving up some of your business’s upside, but receiving financing that does not immediately (or perhaps ever) need to be paid back may be worthwhile for some companies. The Journal article mentions crowdfunding as a means to obtain equity capital, and while this is a young and developing form of offering equity, it has the potential to be a common and viable method for startups to finance themselves. Even when crowdfunding does become more commonplace, it will likely still be hard for completely new businesses to receiving financing, unless the founders have already had demonstrated success with other ventures. However, there is always the possibility of friends and family equity financing to jumpstart ventures to get to the point where they can then seek financing from the crowd.

Finally, even though there are many challenges involved with fundraising for new businesses, the silver lining is that in many cases, the cost of starting a business is far less than in the past as a result of recent developments in technology and the rise of the gig economy. Taking my own business of launching a law firm, in the past, I would have had to rent expensive office space, hire an assistant and full-time attorneys, etc., all of which requires a significant initial outlay. Now, a lawyer can run a virtual firm and have work performed on a pay-as-you-go, project-by-project basis. Pretty much the only significant initial outlay is the cost of a website. Accordingly, despite the challenges in raising funds in the current environment, it’s as good a time as any to launch a business because, in many cases, less financing is required.

Startup Valuations and Plain English

Start Up Valuations | Andrew Abramowitz, PLLCWriting 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.