Secondary Sales and An Investor Covenant You Don’t Want To Miss

Dear Readers: This is a post I co-wrote with Joe Wallin, who has published the almost identical post here.

If you are investing in early stage companies, there are certain deal terms you want.

Most you probably know already: if it’s a round of convertible notes, you want a discount and a cap; if it’s a priced round, you want a liquidation preference. Etc.

But there is a new thing you need to add to your list of “must haves.”

You now want your investment documents to include a Section 4(a)(7) covenant.

What the heck is Section 4(a)(7)?

Section 4(a)(7) is a new federal securities law that basically says, it’s OK for you to sell your investment in a private company, as long as you don’t generally advertise the securities for sale, sell to another accredited investor, and the company cooperates with certain information requirements.

The new federal law trumps state law. So state law won’t hold you up.

Unlike the existing resale exemption most commonly used, there is no holding period required under this new law.

What is a Section 4(a)(7) covenant?

This new law is great—but you need the company’s assistance to access it, because the law requires the company to provide certain information to the purchaser.

So, get this covenant in your investment documents, and it may be easier for you to later sell your shares.

You can find draft covenants to include in your securities purchase agreements here.

And if you’re a founder or exec, don’t despair: Section 4(a)(7) will work for you, too. For a longer, in depth discussion of the new law, see this article in TechCrunch.

A Gift from Congress to Angels

The picture here was taken by Joe Wallin, who was on a panel with me, Gary Kocher of K&L Gates, Tom Alberg of Madrona Ventures, and Dan Rosen of the Alliance of Angels, talking to the Angel Capital Association's NW Regional Meeting about all the new laws and regulations and SEC guidance recently hatched or in the works that impact angel investing. Really great spirit and energy among the angels who assembled.

CdOv0FCW4AAJ1lgOne thing we talked about was a new law that should make it easier for angels to sell private company stock, provided they find an(other) accredited investor interested in buying, and provided that the company cooperates and provides certain information.

You can read about this more in a TechCrunch article that Joe, Josh Maher and John Myer wrote which ran yesterday. Go here to see a model pair of covenants that Joe, Gary and I prepared to share with the attendees of the ACA NW Regional Meeting. When negotiating with a company on including such covenants in your angel investment, no doubt the company is going to have its own thoughts and priorities, and in every case you will need to customize any model covenants to fit your own circumstances (in other words, the models are not legal advice; consult your lawyer).

Looking for Mr. 506(c)

"On a relative basis, issuances claiming the new Rule 506(c) exemption have accounted for only 2.1% of the reported capital raised pursuant to Rule 506 since becoming effective in September 2014."

Download (1)So reads a key finding of a report, Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009-2014, by Scott Baugess, Rachita Gullapalli and Vladimir Ivanov, staff at the SEC's Divisio of Economic and Risk Analysis. They are speaking about the way Rule 506 under Reg D was reformed by rulemaking pursuant to the JOBS Act, to permit general solicitation while preserving a Rule 506 exemption that is preemptive of state law, as long as all purchasers are verified to be accredited investors.

Rule 506(c) should be a big deal, and we should be seeing more "public" private offerings, like the one from the brewpub chain McMenamins, which my colleague, Jordan Rood, wrote about here.

But we aren't, not yet.

So far, old Rule 506, now re-styled Rule 506(b), is the Donald Trump to Reg D's Jeb Bush. The authors of the SEC staff report have ideas why:

The novelty of the 506(c) provisions after decades on non-permissibility of general solicitation in Regulation D offerings may be one reason why Rule 506(b) continues to dominate the Regulation D market. In particular, issuers with pre-existing sources of financing and/or intermediation channels may not yet have a need for the new flexibility. Other issuers may become more comfortable with market practices as they develop over time, including among other things, certainty over what constitutes general solicitation. There may also be concerns about the added burden or appropriate levels of verification of the accredited investor status of all purchasers, for which efficient market solutions may develop over time.

And might there be a whiff of the taint of adverse selection that one would readily associate with Title III crowdfunded deals. The authors allow that this might be so:

It is possible that some sophisticated investors may perceive the election of the 506(c) exemption as a signal that issuers anticipate difficulties in raising sufficient capital and consequently consider it a less attractive offering, which could also dissuade issuers from utilizing the new exemption for their financing needs.

I yet think this will change. Just not any time tomorrow.

Image: scene from Looking for Mr. Goodbar.

Giving up on ISOs - the right thing to do?

An interesting campaign launched this week. The key argument is that 90 day post-termination exercise requirements - typical for stock options granted by startups - are not fair to rank-and-file employees.

The case is well made by Harjeet, in what appeared to be a coordinated brace of posts on Medium, published yesterday:

Those of you familiar with tax law requirements for ISOs (incentive stock options) will be quick to say, "well, that tight exercise window is required by the law; it's part of the tradeoff for the employee getting the favored tax treatment of ISOs."

6108085408_8d79bbe1c2_bBut Harjeet is arguing that the tax benefits of ISOs are outweighed by the impracticalities of the 90 day post-termination exercise window.

And are those tax benefits as significant as many assume? Here's part of his discussion of the tax benefit lost on exercise of the stock option as a non-qualified stock option, which is necessarily what you get when you extend the post termination exercise window and so fall outside ISO requirements:

"ISO: Employee now owes AMT (Alternative Minimum Tax) on the difference between the amount they paid to exercise their options (the exercise price) and the fair market value of that stock today. Calculating exactly AMT can be tricky, most likely you’ll pay 28% on the difference."

"NSO: Employee owes Ordinary Income Tax (38%) on the difference between the exercise price and fair market value of the stock."

So ISO treatment is not as compelling for tax reasons as one might suppose. My friend, the startup lawyer, Joe Wallin, has been pointing this out for years.

There are company-side factors in favor of a 90-day post-termination exercise window that are not emphasized by Harjeet's posts. Startup founders, management teams and boards are going to want to consider these other factors. At the same time, Harjeet's posts are  very well done and make a compelling, pro-employee case. I think his arguments are a great contribution to the discussion.

Photo credit: Nisa Yeh, Creative Commons license.

Posner's Reflections on Judging and on Scalia's Originalism

Richard Posner's "Reflections on Judging" is not a new book. It was published in 2013, and it appears to adapt prior articles and other writings of Judge Posner on the same themes. But I only just read the book over a short vacation in Palm Springs, California, and in any case it hasn't dated in three years (except perhaps with respect to his very brief discussion of MOOCs). I say it remains current because I want to encourage you to pick it up and read it.

9780674725089Come to think of it, with the passing of Antonin Scalia, "Reflections on Judging" couldn't be more timely. One of Judge Posner's arguments - perhaps the central one, or at least a facet of his thesis that complexity is threating to overwhelm justice - is that Justice Scalia's championing of "originalism" has distracted judges from engaging the complexity of the real world, making law a poorer servant to society than it should be. It's quite fun - I hope less in a mean-spirited way than in a civicly-minded intellectual way - to see Judge Posner ridicule Justice Scalia's performances as amateur historian.

Nor is it the case that justice is simplified (simplification might at least be a beneficial byproduct, you might think) when emulating Justice Scalia's stubborn refusal, at least professionally speaking, to live in the present. In aid of his life-long campaign of distraction, Scalia propounded "canons of construction," or rules of interpretation, that, according to Posner, are highly complex and internally inconsistent. Study and practice of these cannons focus a judge's attention ever inward, train him to fetishize texts which to a normal person appear plainly imperfect. For all the close reading, meaning is beside the point, and law is an afterthought. As you might suspect, methods of interpretation that forbid reference to society, culture, the economy, demographics, values and facts give the judge unrestricted license to pursue personal political agendas.

Refreshingly, Judge Posner says that Scalia's cannons of construction are a waste of time. Not a single one is helpful! He feels interpretation is a natural function of the human mind, and it is this more natural human function which not just welcomes but runs with intellectual curiosity to the world as it is, to the facts on the ground, to the understandings of science, to the study of cultures, for reference, context and guidance.

Posner does get meta with respect to interpretation in this respect: he believes that social science and psychology show that humans have cognitive biases that make their memories and opinions unreliable, and that it behooves a judge to be cognizant of these and self-reflective of her own inevitable biases. (One of these he calls out in this book is the cognitive heuristic of "anchoring," which I had not known of before. I educated myself on this concept by reading a Wikipedia article. This was, I now know, a very Posner-like strategy to obtain a working knowledge of a concept in the service of a task at hand.)

The best thing about this book is that Judge Posner's prose style is entertaining and completely non-judicial. And apparantly he writes his judicial opinions in the same voice!

I'm going to read more of Judge Posner's work. If you know of a discussion group organized around his writing, please let me know.

$20k Soon to Be the New Standard Minimum Angel Investment?

$25,000 is a common minimum investment in startup financings, at least for those conducted offline (not through an accredited crowdfunding platform).

I wonder if that will change, if new SEC staff recommendations for the accredited investor definition are adopted. 
CaptureThe SEC staff recommendations are broad and potentially positive for the startup financing ecosystem: they call for expansion of the means by which an investor may qualify as accredited, which may mean more individuals may eventually be eligible to participate as angels.
However, on preserving the existing financial thresholds for natural persons to qualify as accredited, the recommendations are muddy. Granted, the staff state that the existing thresholds should stay in place; but they also recommend that the current standards should be indexed to inflation, going forward, and that investors be limited in how much they can invest, unless they meet significantly higher financial qualification thresholds.
Here's a quote from the report on the concept for limiting how much the typical angel may invest:
"The Commission could consider leaving the current income and net worth thresholds in the accredited investor definition in place, but limiting investments for individuals who qualify as accredited investors solely based on those thresholds to a percentage of their income or net worth (e.g., 10% of prior year income or 10% of net worth, as applicable, per issuer, in any 12-month period)."
If the investment cap for the majority of angels ends up being 10% per issuer per year, then I'd predict we'll see downward pressure on the $25,000 minimum rule of thumb, and possibly find $20,000 will become a new de facto standard minimum.
I derive that figure from the $200,000 income threshold. Ten percent of that minimum threshold is $20,000. Though if you go with the $1M net worth standard (as refined by Dodd-Frank), you get $10,000.
What will happen is, the issuer will ask the angel, "unless you are super accredited, what is the maximum you can invest, under either the income or net worth tests?" And the investor will say, "none of your business; I meet the standard, that's all you need to know, here's $20k (or $10k) accordingly - don't ask what my income (net worth) is." This reaction hurts startups insofar as it lowers the average investment, but helps in terms of transaction costs insofar as it bypasses (presumably?) any verification requirement that new rules might impose to enforce individual angel investing limits.

NW Brewpub Chain McMenamins Uses Own Site to Openly Solicit Accredited Investors

Those of you that enjoy beer or securities laws (or both), may have recently seen news articles from various Puget Sound media outlets amorphously mentioning “crowdfunding” when reporting on the development and grand opening of the new McMenamins Anderson School entertainment complex in Bothell. In developing the Anderson School project, McMenamins applied its expertise in creating funky, yet accessible, recreation properties to transform an old, empty middle school building into a complex with a hotel, brewery, restaurants, bars, music and event space and a public swimming pool, in partnership with the City of Bothell.

CaptureThe project has a successful precedent in the McMenamins Kennedy School complex in Portland, and the early reviews on the Anderson School have been quite positive, so much so, that McMenamins recently announced that it would be moving forward with a similar project at the old Elks Lodge in Tacoma.

However, beyond applying its tried and true aesthetic to transform the Anderson School, McMenamins broke new financing ground by using the Rule 506(c) private offering exemption to generally solicit accredited investors via the internet. The company raised approximately $6.3 million (with $250K as the minimum investment) in four months to obtain the initial equity for kickstarting development in the property. This experiment worked so well, the Company intends to use it again in connection with financing the forthcoming Tacoma project.

For those curious about the completed Anderson School deal terms, the offering website is still up, and you can still access all the LLC unit offering documents here. Additionally, a similar site is now up for the Elks Lodge project with initial information about the project and investment terms, however, the offering documents appear to be forthcoming, and no securities appear to be offered yet. Though it does appear similar to the Anderson School project, in that investors will receive a preferred return of 8% flowing from the proceeds of the long-term lease of the property to a McMenamins entity, among other terms.

Conducting private offerings publicly over the internet may sound like a contradiction in terms, and until recently that was the case. However, as part of the federal JOBS Act of 2012, Congress instructed the Securities and Exchange Commission to implement rules allowing general solicitation in a private offering if securities are sold only to accredited investors. As a result, the SEC amended Rule 506 to create Rule 506(c), which allows for general solicitation in a private offering, so long as the issuer takes reasonable steps to verify that sales are made only to accredited investors.

This “verification” standard is a heightened requirement in comparison to the “old-fashioned” Rule 506(b) exemption, which only requires issuers to have a “reasonable belief” that investors are accredited, which may include self-certification by the investor. Although the SEC has provided a set of non-exclusive safe harbors for 506(c) verification, including by bank/brokerage statements, tax returns or statement by a third-party attorney or accountant, this requirement has had a chilling effect on the use of Rule 506(c), as the admission of even one unaccredited investor will disqualify the issuer from use of the exemption, and if any general solicitation has occurred, the issuer will be disqualified from relying on any other exemptions from registration, which could result in significant civil and administrative penalties. As such, using Rule 506(c) has been described as similar to walking on a tightrope without a net.

But back to McMenamins, who rather than worry about the lack of net, just followed the clear rules set forth by the SEC to make sure they didn’t lose their balance. In particular, even though all of the offering information was publicly available on the internet, each prospective investor had to fill out a questionnaire, and submit it to the company counsel with supporting documentation to meet the aforementioned verification steps. Only once the company had “verified” a prospective investor’s accredited status, would any subscription be accepted.

Although some investors may not wish to undergo such scrutiny, this did not seem to be an obstacle for McMenamins, a brand with significant brand and consumer cachet. The Tacoma News Tribune reported that the company raised the $6.3 million from 23 investors (in an offering up to $8 million, per the SEC filing and company offering documents), and now intends to raise up to $10 million for the Elks Lodge project (with a $150K minimum investment), with preliminary indications of interest already received from prior investors.

The use of Rule 506(c) by a company like McMenamins is instructive. By working with competent counsel to safely stay within the investor verification guidance set forth by the SEC, the company was able to broadly reach out to its natural constituency of fans as prospective investors. Simultaneously, it was also able to avail itself of the broad benefits of the Rule 506 exemption, including the ability to raise an unlimited amount of money from an unlimited number of accredited investors, blue sky preemption and “relaxed” disclosure standards, as sales were only made to accredited investors (that said, the company did provide fulsome disclosure materials to prospective investors).

Accredited “crowdfunding” as a concept is generally associated with technology startups and angel investors, but the success McMenamins has had demonstrates that Rule 506(c) is a viable and potentially attractive, offering alternative for companies across a range of industries that may be able to draw widely upon accredited investor interest, rather than being subject to the limited personal networks required by the “substantive, pre-existing relationship” standard of Rule 506(b).

In addition to monitoring the development of these projects, I intend to personally kick the tires at the Anderson School soon by enjoying a McMenamins Terminator Stout, and the always delicious Cajun tater tots.

Image: detail from McMenamins webpage.