William Carleton, Counselor @ Law

Boldly embracing one's vowel-deficient ways

I saw somebody on Twitter quote the comedian Albert Brooks, to the effect that Yahoo should next spend some money to buy a vowel (Tumblr being a second, prominent acquisition of a company that lacked the letter "e" in its name; Flickr being the first).

So I thought this Flickr ad, which I got by mail today, was especially funny.

If you don't got it, flaunt your lack of it!

Wilson Sonsini's 2012 private financing report

The new Wilson Sonsini report on private company financing trends is out, and it's even more interesting than usual.

In addition to keeping tabs on median valuations by round and other trends in VC preferred stock investment terms, the 2012 report is now tracking convertible note terms.

You've always been able to go the latest WSG&R report to buttress your argument, say, that pari passu liquidation preferences were normative and trending stronger. Well, now you can go to the report and confirm that a 20% discount on a pre-Series A convertible note is normal.

And there is new, useful, graphic rendering of historical data in the report.

This chart, from the report, shows the impact of first-round equity deals, in which Wilson Sonsini has been involved for the past five years, on the relative equity split between founders and investors. Among other things, it shows that founders keep more of the company post Series-A.

But the founders' line includes the option pool. This passage from the report explains:

"Many founders assume that the split in ownership between investors and founders in the first financing is about even. Since the option reserve almost always comes out of the founders' share, this would result in an approximate split of 50%/30%/20% among investors, founders, and employee stock option plans. The study, however, shows that founders actually have done considerably better than this at almost all times during the past five years. Except for a relatively short period during mid-2009, founders' and investors' percentages have varied in opposition in a narrow band between 45%/35% in favor of investors and 45%/35% in favor of founders through the end of 2011 (again, with a constant 20% for the option reserve)."

Chart from the Wilson Sonsini Goodrich & Rosati Entrepreneurs Report 2012.

The 1202 Planning Opportunity

Since Joe Wallin first broke the news nationally (best I can tell) that the fiscal cliff bill included revival of a previously expired 100% exclusion from capital gains tax for certain holdings in QSB stock, people have been wondering on Twitter why no branded financial or tech media outlet has picked up the story.

It's a fair question, particularly when you consider that big media properties have been reporting on other "tax extenders" in the fiscal cliff bill. 

A partial answer may be that there is nothing outrageous or scandalous about the QSB exclusion. Whereas the tax breaks in the fiscal cliff legislation for Hollywood movie production, for electric scooter manufacturing, for NASCAR race tracks, and the like, are laughable, or tragic, or both, and so more fun to talk about. (See for example this entertaining piece by Brad Plumer in the Washington Post, From NASCAR to rum, the 10 weirdest parts of the ‘fiscal cliff’ bill.)

A better answer may be that the exclusion for QSB stock is so difficult to explain.

Here's a paragraph from a post Joe wrote in the summer of 2010, summarizing what QSB stock is:

In general, 'qualified small business stock' is stock in a C corporation acquired by a taxpayer at its original issue if as of the date of issuance such corporation was a 'qualified small business,' and during substantially all of the taxpayer’s holding period for such stock, the corporation met certain active business requirements and was a C corporation. A 'qualified small business' in general means a business with less than $50 million in gross assets. The active business requirements require that at least 80 percent (by value) of the assets of the corporation be used by the corporation in the active conduct of 1 or more 'qualified trades or businesses.'

Much to chew on there, and you must also slog through the analysis of whether or not you are dealing with one of the "qualified trades or businesses."

Get those fundamentals settled, and you're still not done: you have to hold the stock for 5 years. And the exclusion from capital gains tax applies *only* to your initial $10 million in gain.

Among the planning opportunities this fiscal cliff tax benefit affords:

• A chance to weigh whether a C corp makes more sense for the structure of your new business than an LLC or other alternatives;
• Whether you should convert your LLC into a C corp before the benefit expires at the end of 2013;
• From the investor perspective, whether you can negotiate reps and covenants in your investment documents to give you and others in the deal a fair shot at meeting the requirements of the exclusion; and
• From the perspective of an employee, whether you should exercise a stock option in a timely way.

This is complicated stuff. Even if you master the rules in the abstract, you are likely to yet need advice from a good accountant and/or a tax lawyer. But it may be worth the effort.

Here are some references to help us all get (re)started (caution, all of these were prepared in the context of the exclusion in prior incarnations):

• QUALIFIED SMALL BUSINESS STOCK - TAX ALERT, by Asher Bearman, from The Venture Alley in October 2010.
• SECTION 1202 QUALIFIED SMALL BUSINESS STOCK (pdf), by David B. Strong, a Morrison Foerster white paper from August 2011 hanging out on the open web.
• IF YOU ARE AN LLC, CONSIDER BECOMING A C CORPORATION BEFORE YEAR END, by Joe Wallin, from his Startup Law Blog in October 2010.
• A comment from lawyer George Grellas on Hacker News from 2010, with an overview of the subject, including the provocative point that founder shares can potentially qualify.

Photo: Tom Magliery / Flickr.

Circling back to find the IPO on ramp

In the newsprint edition of the Seattle Times this morning (what a pleasure to get to flip copy in three dimensions, as well as to fold and to snap: paper papers are underrated), I read an article (detail pictured) about how Impinj has formally pulled its stale IPO filing, and has simultaneously announced the closing of a significant round of private financing.

The article says that Impinj means to try again later to go public. But next time, it intends to use the IPO on-ramp provided by the JOBS Act.

I went to GeekWire to see what John or Todd have to say on the subject, and this piece by John reports the same. John says Trulia is doing the same thing, i.e., circling back so it can exit via the IPO on ramp.

One thing I find interesting is that Impinj relied on Rule 506 and so filed a Form D in connection with the recent private capital raise. Both the Times and GeekWire report that the round was subscribed by existing investors. John's piece names them, all institutional.

There's a trend among some VC-backed companies to skip Form D filings - or I should say, to rely on 4(2) or another exemption that does not require an SEC filing.

Not so here.

The Impinj Form D reports that $21,648,933 has been raised so far, and $6,110,942 remains available.

C Class Citizens

One way for founders or inside groups to retain control of a growing company is to cause the company to authorize "Class B" Common shares, with supervoting rights.

Another way is demonstrated by what Google has just done: amend the company charter to establish a "Class C" of non-voting shares.

Google's newly amended charter calls the new class, not "Class C Common," but "Class C Capital Stock." This perhaps emphasizes that the stock is not to have voting rights.

Here's the key, operative provision from the amended charter:

"Except as otherwise required by applicable law, shares of Class C Capital Stock shall have no voting power and the holders thereof, as such, shall not be entitled to vote on any matter that is submitted to a vote or for the consent of the stockholders of the Corporation."

At the same time, the amended charter goes on to spell out rights of the Class C, to make clear that the holders have economic rights comparable to those of voting common stock. Here's a general statement of fundamental equality (qualified, of course, by the proviso at the beginning of the sentence):

"Except as expressly provided in this Article IV, Class C Capital Stock shall have the same rights and privileges and rank equally, share ratably and be identical in all respects to the Common Stock as to all matters."

There's even a kind of backstop protection, in that the Class C Capital Stock is made to convert into Class A Common Stock in certain circumstances:

"Immediately prior to the earlier of (i) any distribution of assets of the Corporation to the holders of the Common Stock in connection with a voluntary or involuntary liquidation, dissolution, distribution of assets or winding up of the Corporation pursuant to Section 2(c) or (ii) any record date established to determine the holders of capital stock of the Corporation entitled to receive such distribution of assets, each outstanding share of the Class C Capital Stock shall automatically, without any further action, convert into and become one (1) fully paid and nonassessable share of Class A Common Stock."

Should you value a non-voting share differently to a share with a vote?

Photo: gaelx / Flickr.

The IPO On-Ramp in the JOBS Act: Saviour, Scoundrel, or Hardly Relevant?

One of the key pieces of the recently passed JOBS Act - the one lobbied for by venture capitalists, and perhaps the only key piece  not waiting on SEC rulemaking before taking effect - has to do with lowering the burden of what is required for an emerging company to go public, and then to lowering the burden of compliance requirements, once the company has had its IPO.

The most rabid advocates for the IPO on-ramp herald it as the way to re-awaken IPO activity, as though regulation, not other market forces, pinched the flame. Some IPO on-ramp advocates think a vigorous IPO market is the very key by which to unlock the US economy. See for example this Seattle Times interview of Joe Shocken.

Muckraking journalists, on the other hand, mark the passage of the IPO on-ramp as one more shameful confirmation of Wall Street's unremitting control of national politics. See for example this NY Times piece by Andrew Ross Sorkin, which audaciously suggests that Groupon could have fooled more of the people more of the time, had the IPO on-ramp provisions been in effect a year or two ago.

There's a third hand to consider here, too. In this view, the IPO on-ramp provisions are neither panacea nor the product of plutocratic short-sightedness. In this view, the IPO on-ramp provisions are hardly relevant.

The best expression of this third view, I quoted at length in a prior post. But the remarks (from an experienced securities lawyers who wishes to remain anonymous) bear repitition:

"I personally think that the IPO changes are largely illusory. There has been a lot of noise about simplified regulation. But the SEC has done the equivalent of taking 1,000 pages of regulations and reducing them to 950. Big deal. Plus, the Sarbanes-Oxley stuff has become relatively routine. I also think that the decline in IPOs has little to do with over-regulation, even though it is a factor. It has more to do with what law firms and accounting firms are charging for routine SEC work.

"Tech companies that would have been a plum assignment for Alex. Brown or H&Q in 1999 wouldn’t come close to being eligible today. The boutique investment banks have largely disappeared, and the big ones want big deals. In 1999, $20 million in revenue and a good story was all it took. Plus I’m told the economics are radically different given the huge growth in off-market trading.

"The only way back for the small IPO is a change in the economics at investment banks, and a public resurgence in interest in buying those shares. Some of the changes eliminate much of the periodic SEC reporting regime. Brilliant. Who is going to buy shares in a company and how is it going to trade if there is inadequate public information?"

As if to ring a bell on this anonymous analyst's last point, check out this disclosure in ClearSign's IPO prospectus last week:

'We are an "emerging growth company" under the JOBS Act of 2012 and we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.

 

'We are an “emerging growth company”, as defined in the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), and we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. We cannot predict if investors will find our common stock less attractive because we may rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile.

 

'In addition, Section 107 of the JOBS Act also provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We are choosing to take advantage of the extended transition period for complying with new or revised accounting standards.

 

'We will remain an “emerging growth company” for up to five years, although we will lose that status sooner if our revenues exceed $1 billion, if we issue more than $1 billion in non-convertible debt in a three year period, or if the market value of our common stock that is held by non-affiliates exceeds $700 million as of any June 30.

 

'Our status as an “emerging growth company” under the JOBS Act of 2012 may make it more difficult to raise capital as and when we need it.

 

'Because of the exemptions from various reporting requirements provided to us as an “emerging growth company” and because we will have an extended transition period for complying with new or revised financial accounting standards, we may be less attractive to investors and it may be difficult for us to raise additional capital as and when we need it.  Investors may be unable to compare our business with other companies in our industry if they believe that our financial accounting is not as transparent as other companies in our industry.  If we are unable to raise additional capital as and when we need it, our financial condition and results of operations may be materially and adversely affected.'

Photo: "Saviours Comet" by Bridget Christian / Flickr.

The Transcript: What Will the JOBS Act Mean for US Startups?

Yesterday's live chat on the Wall Street Journal, "What Will the JOBS Act Mean for U.S. Start-Ups," flew by quickly, but left a transcript in its wake.

The questions were fantastic. People are obviously reading and thinking about the the JOBS Act and what it means.

Among other points, we discussed the individual investment limits under the crowdfunding exemption, including the responsibility of funding portals to police the individual limits; the "daylight" afforded the SEC to make changes to current practices around verifying who is and is not an accredited investor, for purposes of Reg D Rule 506 offerings; and even differences between the crowdfunding exemption and the reformed Reg A, in terms of transferability of the purchased shares. All "inside baseball" stuff.

I tried to lend my sense of how the JOBS Act was cobbled together, as well. That's reflected a bit in certain answers that were tweeted, as pictured here.

I see Eric Cantor's press office tweeted notice of the event.

I want to thank Angus Loten for moderating and Allison Lichter for producing. They got me trained on the system, called ScribbleLive, that the WSJ uses, and coached me through the event.

Props to Mr. Bay, his typing class I took in 8th grade, and the manual Underwood on which I learned to type. Can't think of any training that has been more useful for digital life in the early 21st Century.