Archive for March, 2010

Dodd Banking Bill Aims Shotgun at Investor Fraud, Hits Early Stage Companies

March 30th, 2010

There has been a lot of news recently about Senator Christopher Dodd’s banking reform bill, which was introduced in the Senate a couple of weeks ago.  I dug into the details relevant to startup and private company financing transactions (with help from the comments on and an insightful piece on TechFlash), and thought a bit about how it would likely affect my client base.

Principal Terms
The entire bill runs 1036 pages, of which about 6 are relevant to angel and VC financings.

First, the proposal requires that the accredited investor dollar threshold be increased regularly to adjust for inflation.  The current requirement (which dates from 1996) is that an investor earn at least $200,000 per year or have a net worth of at least $1,000,000.  The Dodd bill requires that a retroactive inflation adjustment be applied to those figures and that they continue to be adjusted at least every 5 year going forward.  I haven’t tried to do the math, but pundits say this would increase the threshold to $450,000/$2,300,000.

Second, the bill kicks oversight of Regulation D transactions (the principal exemption from public offering registration requirements used by private companies) largely to state authorities.  The bill would (i) set a dollar threshold below which the SEC would not even try to regulate, saying that small transactions are exclusively overseen by state agencies, and (ii) for larger transactions provide a 120 day SEC review period, following which state authorities could also choose to review if the SEC did not.

Where This Comes From
The president of NASAA is also a Texas state securities regulator and in testimony to Congress explained NASAA’s belief that (i) fraud is most effectively prevented when SEC and state authorities can review/investigate problem cases, (ii) NSMIA prevents state authorities from preemptively investigating cases and only allows them to investigate after fraud has occurred, and (iii) lack of Reg D oversight contributed to the financial meltdown.

It looks to me as though NASAA is concerned about the Bernie Madoffs of the world and sees increased regulation over private securities transactions as the best way to reign in this type of fraud.  Clearly NASAA also does not believe the SEC is up to the job of policing this environment.

Things I Don’t Understand
I don’t understand how the 120 day rule would work and I would love to ask Sen. Dodd the following questions:

-Will private companies be required to wait 120 days before closing financing transactions?
-If not formally required to wait, will investors have a rescission right if the SEC or state authorities find noncompliance with procedural or substantive requirements?
-How would this rescission right be enforced?  Brokers are subject to bonding requirements so there is the possibility of recovery in a fraudulent sale by a stock broker, but seemingly none with early stage companies in particular.  Six months after closing an angel financing a company may have already spent a decent chunk of the financing proceeds.
-Will state pre-closing notice requirements apply even prior to the SEC’s review period, so that e.g. a company would need to file a notice (and forms!) in NY, file an SEC notice 2 weeks later and then wait 6 months to see if NY would be able to pick up again?

What I Will Probably End Up Telling My Clients
In the most practical terms as a California lawyer, if this bill passes I will probably tell my clients that there is a sliding scale for transaction costs and timing that depends on where investors reside.  My gut tells me neither the SEC nor the CA Department of Corporations wants to begin scrutinizing early stage investments, so my advice to clients will be to keep all their investors in CA, and if they have investors in XYZ other states then the cost of completing the transaction will be dramatically higher and riskier.  This will be unfortunate.

What I Plan to Do
I am going to write a letter to both of my senators raising the questions above and asking them to look carefully at how this language will affect companies in California, and also how the concepts might be revised to avoid penalizing startup companies for the sins of hedge fund managers and unscrupulous securities brokers.  I have also added my name to the online petition here: Apart from that, I plan to watch this closely to see how it plays out.

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LLCs and Corporations in New Entity Formation

March 20th, 2010

Limited liability companies (LLCs) have been around for 20 years now.  Until somewhat recently the conventional wisdom was that LLCs are useful for businesses whose ownership won’t change frequently (a huge range that covers retail businesses, service companies and investment funds) while corporations are better for businesses that plan to raise money from angel or VC investors.  That is changing fairly quickly and it is becoming more common to see LLCs set up in a way that looks a lot like an investment-driven corporation.

There are still big differences in the way ownership is divided among owners of LLCs and corporations.  This post will offer a quick example of how these differences can manifest themselves.  I need to emphasize that LLC structures are heavily tax-driven, I am not a tax lawyer and I am going to steer clear of tax discussion here as much as possible.  Tax experts reading this are encouraged to set me straight if I oversimplify or inadvertently mis-state tax concepts.

The example is from a situation that a client brought to me somewhat recently.  The client was a new company to be owned by two people.  One was the passive investor who put in $100,000 in seed capital and got 40% of the company.  The other owner was the day-to-day manager who invested nominal cash whose principal contribution was sweat equity and who was to own 60%. The question was whether to form a corporation or an LLC to do this.

As I have described in a couple of prior posts, the core principle behind stock in a corporation is that two people buying the same type of stock at the same time need to pay the same price per share.  If the client formed a corporation, Owner A’s $100,000 might buy her 1,000,000 shares at $0.10 per share.  To get 60% of the company using a single class of stock, Owner B would need to invest $150,000 and receive 1,500,000 shares.  We already know that Owner B is not going to do that, so if we use a corporation the only way to get the percentages to sync up with the amounts invested is to use preferred stock.  Owner B could invest $15,000 at $0.10 to get 150,000 shares while Owner A invests her $100,000 at $1.00 share to get 100,000 shares.  The table below is a simpler way to show how this works.

This gets the desired result but requires a lot of steps, two classes of stock, Owner B still needs to put in $15,000 and there is a 10x difference between the common and preferred stock prices that may or may not work well for accounting, 409A and general capitalization planning purposes.

LLCs are not restricted by this equal-price-per-share requirement.  Instead, one of the structural principles behind LLCs the the concept of a capital account- essentially a ledger of cash (or other assets) invested in the business, profit allocated back to the investor and cash (or other assets) paid out.  This accounting is also separate from voting, so we can easily set up an LLC that gives Owner A a 40% voting interest and a $100,000 capital account, while Owner B has a 60% voting interest with a $15,000 (or $1,500) capital account.  The voting interests and the capital accounts do not need to follow the same ratio.

The part that becomes non-intuitive is that we might want to make our company look like a corporation so that the owners have Units rather than just percentages.  Again, in a corporation we would need two classes of stock to get the desired result, but in an LLC we can provide that Owner A has 100,00 Units and Owner B as 150,000, meeting our desired a 60/40 ratio.  Voting is linked to the Units, while accounting and economic outcomes follow capital accounts.  We end up with a Units structure that looks similar to a corporation, but simpler because we only need one class of Units instead of the common/preferred shares described above.

Which is Better?
We can reach the desired outcome with either a corporation or an LLC.  In this case, the LLC provides a somewhat simpler way to get there and I have seen a number of situations recently where an LLC made more sense for clients with issues like this.  There are a half-dozen or so other factors to consider before deciding for sure which way to go (esp. ability to take tax losses for investment in the LLC and the likelihood that outside investors will be sought and that they will be comfortable with LLCs) so this is definitely not the beginning and end of the analysis.

This was a lot to pack into one post.  Feel free to post any questions or comments in the comment section or contact me directly.

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Key Considerations in Negotiating Earnouts when Selling a Company

March 6th, 2010

Last week the WSJ ran an article saying that Google is moving away from earnouts when it acquires companies.  Earnouts are a tricky thing whether you are a buyer or seller in an M&A deal.  The article gives a glimpse into some of the issues.  Here is a rundown on some of the background considerations.

Definition of an Earnout
An earnout means that if you are a key employee in a company being acquired, some of the total purchase price in the deal gets paid to you over time based on your continued work on the product post-acquisition.  The premise is that some people are passive shareholders who put in cash and don’t have a key role going forward, so they just get paid out at closing.  On the other hand, some team members may be necessary after closing to keep development moving on the product, so their compensation in the deal is linked to continued success of the selling company’s product post-closing.

Keeping the Product Going
Implicit in this formula is the idea that the buyer will keep the seller’s product alive post-closing so that both sides can measure success and the sellers have confidence in their ability to achieve the earnout.  The WSJ gives Disney’s purchase of Club Penguin as an example of this- Disney bought Club Penguin and has kept it as an independent product.  This makes it easy(ier) to measure Club Penguin’s future results and calculate whether earnout metrics have been met.

Compare this with Google’s acquisition of Grand Central.  The product essentially went dark for about two years and then re-emerged as the largely free Google Voice.  I don’t know if the Grand Central acquisition involved an earnout.  If it did, it would certainly be much more difficult to work out success metrics than in the Club Penguin situation.  Google buys a lot of companies for the teams or for product sets that can be worked into larger Google suites, so I can see why they would have trouble measuring earnouts.

Key Considerations
When an earnout is involved in a deal there are several important factors that buyers and sellers need to consider.

-The first is the most objective metrics the deal will permit.  Product revenue is ideal.  It is a pretty easy number to track and works well if the product will be independent post-closing.  If the product will be rolled into a suite of buyer’s products post-closing, or if the seller’s product is free then this metric doesn’t work as well.  On top of that, even if revenue is the main goal we need to think about what would happen if the buyer decides to close down the product line.  Would the earnout accelerate in that situation? Partially accelerate?

-Second is freedom to manage the business.  This usually comes down to “best efforts” language so that the seller has something in writing to say the buyer will put enough resources behind the product to allow the earnout to be met.  It is very hard to make an ironclad promise out of this, since the buyer usually wants freedom to change its business plans and goals as the market requires.

-The third factor is flexibility.  It is impossible to predict what will happen to a product or business, so an ideal earnout will provide enough wiggle room so that if the buyer’s business plans change, the seller can still claim right to payment of some or all of the earnout.

-The last factor is trust.  When a big part of the deal hinges on future performance, buyer and seller both need to have faith that everyone will behave going forward.  The buyer wants to know that the seller personnel won’t make decisions that guarantee their earnout at the expense of the larger business, and the seller needs to believe that the buyer will keep the product alive and manage it in a way that lets the seller achieve the earnout.

Earnouts are usually the most contentious part of M&A deals.  We always do our best to understand the other side’s needs and objectives in the deal, but there is inevitably a leap of faith on both sides that the deal will work out to everyone’s benefit.


Reading Agreements Critically with a Contract Playbook

March 1st, 2010

Followers of this blog may be aware that I avoid reading contracts front-to-back as much as possible.  I find that breaking a contract into chunks lets me read more quickly, more effectively and more critically.

To do that, a client and I recently adopted a strategy that I have used informally for a long time, which is to develop a playbook of preferred terms that we incorporate in our form documents so that when I sit down to read a contract I know exactly what I am looking for.

I start my review by comparing the contract against my playbook and making notes on any differences.  After I finish that I usually have a good sense of how the contract is structured, and I can then read through to put the sections together.

On top of the contract-review benefits, having a formal playbook makes it easier to coordinate contract strategy with clients, and also to maintain consistency over time.  When we have a clear sense of what “normal” is, we can develop a set of arguments to support our preferred terms, and also keep track of which deals required us to deviate from our standards.

A contract playbook is a great tool to read difficult contracts quickly, carefully and comprehensively.  I recommend it to anyone who needs to review a lot of documents.

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