4 posts categorized "March 2016"

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.

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