Fockler-Spring 2016-Venture Capital
Fockler-Spring 2016-Venture Capital
Fockler-Spring 2016-Venture Capital
PROFESSOR FOCKLER
SPRING 2016
INTRODUCTION TO WORLD OF VENTURE CAPITAL
1
iv. Exit objectives
1. Primary goal is to maximize financial return by existing through a sale or IPO
2. VCs are not looking for strategic alliances
3. But long time frame for return 🡪 funds last about 10 years
v. Funding internal growth of companies
1. Investment proceeds are used to build new businesses, not acquire existing ones
c. Organization
i. A VC is an investment pool (funds of $10M - $2B) organized as a limited partnership (LP)
ii. Funded by investors of their own as Limited Partners
1. Pension funds, university endowments, alternative investment funds, wealthy families,
previously successful entrepreneurs
2. Note: angel investors use their own money, VC’s use other peoples money
iii. Managed by professional managers as General Partners
1. Organized as a firm of GPs managing multiple Funds with overlapping investing periods
2. GPs are compensated through:
a. Management fee based on funds under management
b. Plus “carried interest” of 20-30% of profits
c. Sometimes also a parallel “Affiliates” fund just for themselves
d. Terms vary with prestige of Fund and track record of previous funds
d. Operation and motivation
i. Ten-year life for each Fund
1. Five years to invest
2. Five years to harvest
ii. Raising a new Fund depends on results of last one
iii. One Fund may see thousands of Business Plans per year, but invest in less than 10 (5?)
iv. Must have possibility of 10x return within five years on $5-20 million total investment or it’s
not worth their time
v. IPO, M&A, or Bust 🡪 Traditionally a “Homers” business
1. 7 of 10 investments fail
2. 2 break even or have modest returns
3. 1 drives the whole fund’s return
vi. M&A makes up much more of overall liquidity events (about 5x more in 2014)
1. But getting to an IPO takes about 7 years and also about 7 years to get to an M&A event
2. IPOs are must lucrative exits, but are harder to do
a. A typical IPO underwritten by a top investment bank will sell at least $50M in
new stock and have total equity value of at least $200M
3. Sale to a strategic buyer is easier to come by
e. Differences from Private Equity
i. Much earlier stage investments
ii. Limited information available to make investment decision
1. New idea/market
2. No publicly available information
iii. Companies need much more than just cash 🡪 they need operational skill of VCs
iv. Investment terms look the same on the surface
1. But the points of emphasis and economics are very different
2. Much more about control and less about fines economic points
v. No use of leverage debt
vi. Any cash generated by Companies will be plowed back into development and marketing rather than
paid out to investors as interest
vii. Investments are not liquid
1. Stock not publically trade
2. Must create own public market
viii. Generally, less obscene returns in absolute dollars
2
1. But targets are mind-boggling in percentage terms
ix. Even failures are different 🡪 Not with a bang but with a whimper
3
V. The Lawyer’s Role
a. Business objectives trump scoring negotiating points
b. Pace is rapid and demanding
c. Basic legal questions
i. How do you divide
1. the control of and
2. the profits, if any,
3. from a barely formed business:
a. that has limited personnel and cash resources,
b. that operates in a rapidly changing cut-throat environment,
c. and whose entire existence is premised upon doing something that no one else has
done before?
ii. Do rules of fiduciary duties work for a situation where the owners are the ones actually
making the management decisions
1. Those rules were developed for a situation where the owners and managers of a business
are greatly disintermediated
d. Lawyers wear many hats:
i. Master of the forms, rules and procedures
ii. Somewhat experienced voice on merits of the business idea
iii. Counselor re business issues in general
iv. Source of investment leads
v. Educator of Founders
vi. Marriage counselor among Founders
vii. Only adult in the room
viii. Sometimes also an Investor
4
c. Website selling eco-friendly, healthy ingredient dog food
d. Biometric measurement device that sticks on back of high-end watches
e. Oil filters for cars and trucks that last the life of the vehicle
Pre-Formation Issues
e. Solicitation of Coworkers
i. Entrepreneur can be liable if his conduct leads coworkers to violate any restrictive covenants of
their employment agreement
1. Tort of intentional interference with contract
2. Misappropriation of trade secrets
ii. No-raid clauses 🡪 agreements that employee cannot solicit coworkers
iii. Distinction drawn b/w soliciting coworkers and telling them about future plans
5
iv. Key employees 🡪 even in the absence of a no raid clause, a key employee who induces another
employee to move to a competitor is liable for breach of fiduciary duty
v. Good strategy 🡪 tell people you are leaving to start a new business and give them a phone number
1. This way the entrepreneur does not solicit
f. Contractual restrictions
i. No moonlighting
1. A no-moonlighting clause prohibits the employee from engaging in any business activities
(even after hours) unrelated to the employee’s job with the employer
ii. Non-compete
1. Reasonable in time, place and scope for legitimate purpose
2. But not in California
iii. Non-solicit
iv. Non-disclosure agreement
1. Prohibits employee from using or disclosing any of the employer’s trade secrets (e.g.,
customer list) without authorization
2. Prohibition often continues for a period of time after the employee quits
3. Unauthorized use or disclosure of an employer’s trade secrets is generally prohibited
during and after employment
a. All courts will enforce an agreement not to disclose trade secrets belonging to
a former employer
4. Trade secret 🡪 info that is not generally known nor readily ascertainable in the industry
and that provides a business with a competitive advantage
a. Two factors used to determine if trade secret exists
i. Value of information to business and competitors (nonobvious, provides
competitive advantage)
ii. Amount of effort made to maintain secrecy of information
5. Inevitable disclosure doctrine 🡪 some courts will enjoin a former employee from working
for a competitor firm for a limited period of time if the former employer can prove that the
new employment will inevitably lead the employee to rely on former employer’s trade
secrets
v. Invention assignment agreement
1. These agreements requires the employee to assign to the employer all inventions
conceived, developed, or reduced to practice by the employee while employed by the
company
2. May provide for the assignment of inventions not only during the time of employment
but also within a year after termination of employment
3. Consideration?
g. LEAVE ON GOOD TERMS
i. Entrepreneur should be honest about reasons for leaving
ii. May be appropriate to offer employer opportunity to invest in new venture
1. Easy funding, generates good will b/w the parties, may allow entrepreneur to hire
coworkers
6
i. Relate at the time of conception or reduction to practice of the invention to the employer’s business,
or actual / anticipated research or development of the employer; or
ii. Result from any work performed by the employee for the employer.
e. Consultants may own what they develop, even if paid for it by someone else
III. Allocating equity among founders
a. Considerations in allocating Founders’ equity
i. Original idea and IP contribution
ii. Leadership and organizational duties
iii. Future in Company
1. CEO/CTO/CFO/Other VPs/Non-officers
b. “Co-Founder” vs. “Employee” vs. “Consultant”
c. Vesting before the VCs require it
V. Building a team
a. Allocation of roles among founders
b. Working for “sweat equity”
c. Beyond the Founders
i. Employment contracts
ii. “Consultants” who are really employees
7
o Employee equity possible, but in weird form o Double taxation, though losses may be usable against
later profits
o Relatively inflexible forms of equity interests
8
b. Three almost completely separate regimes for corporate names:
i. Official name in records of state of incorporation
1. There can only be one company in each state with a given name
2. Availability of name in other states where doing business?
ii. Trademarks
1. Can someone stop you from using this name?
2. Can you stop someone else from using this name?
iii. Internet domain name
1. watch out for cybersquatters
c. Holding one of the above does not mean you hold the others
9
VII. Basic Incorporation Actions and Documents
a. Corporate Charter (aka certificate or articles of incorporation) 🡪 public document that amounts to a contract
b/w the corporation and the state
i. Includes basic items such as company’s name, address, nature of business, description of stock,
gives snapshot of capital structure
ii. Establishes legal existence of corporation (and legal name)
iii. Establishes number of shares and fundamental rights and preferences of corporation's capital stock
iv. Defines any limits on duties and obligations of officers and directors
1. e.g., Exculpation of directors from monetary damages for breach of fiduciary Duty of Care
(not Duty of Loyalty)
v. Various other fundamental organizational structures and authorizations
1. For example, size of Board of Directors in some cases
vi. Amendment requires both Board and stockholder approval
b. Bylaws 🡪 internal document that sets forth the details regarding governance rules of the corp
i. Focuses on internal corporate procedures
1. e.g., organizational matters like the size of the board
ii. Substantial restatement of applicable state law
1. Often written to provide maximum flexibility
iii. Can generally can be amended with Board approval alone
1. At least in Delaware
2. Other states may require SH approval
c. General Timeline
i. Attorney collects necessary information usually in Questionnaire and prepares documents based
thereon; questionnaire asks for the following
1. Name of Corporation
2. Address of Corporation
3. General description of business
4. Names of Founders
5. Who will be the Board of Directors
6. Who will be the Officers
7. How will the initial equity be divided percentage-wise
8. What are the terms of the initial equity
9. A lot of other administrative information, like individuals’ addresses and taxpayer ID
numbers
ii. Incorporator (generally the Founder) executes Certificate of Incorporation
iii. Certificate filed with Secretary of State
iv. Incorporator adopts Bylaws and appoints first Board
v. Board holds first meeting or acts by Unanimous Written Consent to appoint Officers and complete
organizational matters
vi. Company issues stock to Founders in exchange for business plan and IP
vii. Copy of Certificate filed with any other states where Company will do business
d. First Board Meeting
i. Appoints Officers and grants them authority
1. Must have President/CEO, Treasurer/CFO, Secretary
2. Can have others, like Vice Presidents and Chairman of the Board
10
ii. Ratifies adoption of Bylaws
iii. Approves initial stock issuances to Founders
1. In exchange for contribution of cash, business plan, IP, everything else relating to business
2. This is done through the Founders Stock Purchase Agreement
3. Stock subject to Company right of repurchase if Founder leaves (“Vesting”)
b. Officers
i. Run day-to-day affairs of corporation
c. SHs
i. Usually only have influence over extraordinary corporate actions (merger, sale, amendment to
charter)
X. Hiring Employees
a. Company needs to file an SS-4 with the IRS to get an EIN
11
Initial Equity Matters
IV. Vesting
a. Idea 🡪 starting the company is only the beginning; to earn the right o participate in future rewards of the
company, the founder/employee should have to continue working for the company for some period of time
b. Common cliff vesting over 4 years
i. Vest a portion of the stock at the time of issuance
12
ii. Vest an additional portion after one year
iii. Vest the remaining stock monthly over the next 36 months
c. Vesting = the company has the right to repurchase Founder/employee stock at original purchase price upon
termination of employment
i. Repurchase right declines progressively over time
1. Founders 🡪 on a monthly basis over a four-year time period
2. For non-founders, usually a one year cliff before monthly vesting starts (with vesting
starting at 25%)
d. Typically NOT tied to the circumstances of termination
e. Key item in negotiations between Founders and Investors
i. How much should be “unvested”
ii. Should vesting accelerate on certain types of termination or other events, like a change in control?
f. But Founders need to consider benefits of vesting with respect to each other
13
2. Shareholder approval of Plan
3. Employees only
4. Special rules for 10% stockholders
5. No more than $100,000 of Shares may vest in any One Year
6. Two Year Holding Period from Date of Grant
7. One Year Holding Period from Date of Exercise
14
VI. § 83(b) Elections
a. Generally, an individual who receives stock (not options) in connection with the services is taxed at ordinary
income rates to the extent the FMV of the stock exceeds the amount paid for it
i. However, if the stock is subject to a substantial risk of forfeiture, the taxable event is delayed
until the risk of forfeiture lapses
ii. Restricted stock (i.e., stock that is subject to vesting) is subject to a substantial risk of forfeiture
b. Thus, if a founder is issued stock that will vest over a period of time, she recognizes taxable income on each
vesting date equal to the difference b/w the FMV of the stock on the date it becomes vested and the purchase
price paid (which was usually when the stock was granted earlier)
i. If the stock increases in value, this could result in the founder having to pay huge tax bills without
having the benefit of being able to sell the stock
c. § 83(b) election allows the founder to pay tax at the time the stock is purchase in an amount equal to what
would be due if the stock was not subject to vesting
i. i.e., if the founder pays FMV at the time the stock is purchase, she will not owe any tax
ii. Once the election is made, subsequent vesting of the stock will not be taxable 🡪 it is ignored
iii. Must be filed within 30 days of the initial purchase of the shares
1. Likewise, if an employee early exercises an option, the election must be filed within 30
days of that exercise
d. Generally, you want to file this
i. Might not be advantageous if the stock is being offered at a big discount upfront, b/c you would
owe tax on the different right away.
I. Overview
a. As a founder, your idea is worth about 7.5% of the company
b. Authorized Stock
i. “Authorized Shares”
15
1. Share number set forth in Certificate of Incorporation
2. Maximum number of shares that Board has authorization to issue without further approval
from stockholders
ii. “Authorized Common Stock”
1. Common Stock share number in Certificate of Incorporation
iii. “Authorized Preferred Stock”
1. Preferred Stock share number in Certificate of Incorporation
2. Initially, Undesignated or “Blank Check” Preferred
iv. “Designated Preferred Stock”
1. Preferred Stock whose rights and preferences have been defined in the Certificate of
Incorporation
2. Usually issued in, and designated by, series
c. Outstanding Stock
i. “Outstanding Shares”
1. Entitled to vote and share in proceeds from acquisition
ii. “Outstanding Common Stock”
1. Founders
2. Initial Employees
3. Exercised Options
4. Converted Preferred Stock
iii. “Outstanding Preferred Stock”
1. VCs
2. Angels
3. Strategic Investors
d. Other Stock Terms
i. “Shares Issuable under Outstanding Rights to Acquire Shares”
1. Shares issuable upon conversion of outstanding Convertible Notes
2. Shares issuable upon exercise of outstanding Warrants
3. Shares issuable upon exercise of outstanding Options
ii. “Option Reserve”
1. Shares in option plan reserved for issuance upon exercise of options that may be granted in
the future
iii. “Vested Shares/Options”
1. Shares/options that holder has right to keep notwithstanding termination of employment
e. Total Stock Terms
i. “As Converted Outstanding Shares”
1. Outstanding Common Stock + Outstanding Preferred Stock on an “As-Converted” basis
a. Each Series of preferred multiplied by its Conversion Ratio
2. Generally the total number of votes that can be cast by stockholders
ii. “Fully Diluted Shares”
1. As Converted Outstanding Shares + Shares Issuable under Outstanding Rights to Acquire
Shares + Option reserve (in VC financings)
2. In VC Financings, also includes the Option Reserve
3. In M&A, generally includes only the Vested Shares/Options with respect to any
shares/options that are subject to vesting
16
a. As additional stockholders are added, there are more slices to the pie, and each Founder holds less of the
corporation
b. As the corporation creates value, each slice of the pie is worth more
c. Everything depends on the which of the above happens faster
17
d. VCs may take majority of Board
e. Professional CEO may be demanded by VCs
f. Effect of Preferred Stock price on Fair Market Value of Common Stock and thus on setting of
exercise prices for subsequent Option grants
i. Sale to outsider is best indicate of current FMV
ii. But stock being sold is Preferred not Common, so some discount may be appropriate
Sources of Funding
III. VC Funding
a. Take the money 🡪 having a minority position in a well-financed start-up is preferable to being firmly in
control of a venture that goes bankrupt because it was underfinanced
b. Advantages to VC Funding
i. Best source of capital
18
1. Access to substantial amounts relatively quickly
2. Deep pockets for later funding rounds/not just 1M in the beginning but they plan to
continue
ii. Best source of all-round non-monetary assistance – “Smart Money”
1. Experience with startups
2. Expertise in industry sector
3. Contacts within VC ecosystem
iii. Sophisticated investors
1. Understanding of possibility of failure
2. Clear what their objectives are
iv. Prestige of being able to attract VC funding
c. Disadvantages to VC Funding
d. Disadvantages to VC Funding
i. Loss of control
1. At least partial, sometimes total
ii. Possibly loss of job
iii. Dilution
1. Although consider time to market lost if raise less money
iv. Potentially conflicting objectives between Founders and VCs
1. Target of liquidity event
2. Time horizon to that liquidity
3. Growth rate necessary to achieve liquidity with that time
v. Typical investors rights and preferences – e.g., liquidation preference, anti-dilution provisions, veto
powers
19
20
non-equity = kickstarter
V. Lifestyle Companies
a. Funding your business off of your customers
b. NRE
i. Customers give you money ahead of time to develop a product
ii. This is how everyone got working capital back the 80's
iii. The idea of giving away equity for working capital came in the 90's
c. Founders have more benefit from these types of companies
i. “A startup’s job is to grow big enough to provide a good return to its investors. A lifestyle
company’s job is to provide a great quality of life to its owners.”
Seeking VC Funding
21
I. VC Mating Dance
a. Network and get introduced to a VC
b. VCs will focus on three things 🡪 viability of the concept, size of the opportunity, and the team
c. Courtship process typically takes 2-3 months
i. Means you should engage more than 1 VC at a time
22
3. Your solution
4. Challenges to your solution
5. Market size and dynamics
6. Competition and why you’re different
7. Product
8. Business model (i.e. how do you make money)
9. Team
10. How much money do you need, and what you are going to do with it
23
ii. “We’re interested in someone else in the space, but want to use you to get free information that we
can use for them.”
iii. “We’re not interested.”
1. “. . . unless you come up with something great or the guys across the street invest.”
2. Or “No.”
24
ii. VC Preferred Stock is not intended as standalone financial instrument
1. The detailed economic terms are really not for financial purposes, but to:
a. Justify a price differential, and
b. Give the VC some extra measures of protection and control
d. Example
i. What the VCs say:
1. We’ll put $2 million in at a $3 million Pre-Money Valuation
2. We need to have 40% of the Fully Diluted Shares in exchange for our investment of $2
million
ii. What they mean in either case:
1. Pre-Money Valuation i fdilutions $3 million
2. Post-Money Valuation is $5 million
3. VCs get 40% of Company = 40% of Post-Money Fully Diluted Shares
4. Founders keep 60% of the Company
a. Less if the VCs also specify an Option Plan Reserve/ less if the VCs specify a
post deal reserve for future employee issuances
5. All on a Fully Diluted basis
e. Terminology
i. Fully Diluted Shares = Outstanding Common, plus common issuable upon conversion of
outstanding Convertible Securities or exercise of outstanding Options, plus common available for
future Option grants
ii. Pre-Money Valuation = What the Company is worth immediately before the VC investment (Pre-
Money = Pre-Deal)
iii. Post-Money Valuation = Pre-Money Valuation + Amount Invested
iv. Post-Money Option Plan Reserve Percentage = Portion of Fully Diluted Shares after financing
reserved for future issuances of equity for employees (so the company can compensate and
motivate future employees)
1. VCs always want reserve to be increased before their investment rather than after, to
avoid being affected by the dilution
a. This is because VCs base ownership on a fully diluted basis, so all shares are
factored in
b. Any subsequent increases will generally require their approval
c. If found has any leverage, they should try to get VCs to increase the option pool
after funding
i. Could also try to get a higher pre-money valuation so that the founders’
ownership percentage is not as diluted
2. Founders must balance of dilution with need for adequate reserve for anticipated hires
without having to go back to the VCs to soon
a. Create option granting budget over next 18 months, plus some cushion for
particular key hires
b. Reserve will be increased in next financing round, in any case
3. Usually between 15% and 20% of Fully Diluted Shares
a. Closer to 15% if most executive positions already filled
25
f. How to actually value a company
i. Discounted Cash Flow Method
1. Method
a. Estimate future cashflows in and out
b. Then discount each to its present value using an appropriate discount rate that
reflects both:
i. Time-value of money
ii. Risks of the venture
c. Add up the discounted cashflows to get net present value
2. Problem
a. SV Startups generally don’t generate positive cashflows for a long time
i. All cash generated is plowed back into the business, they don’t give back
to investors really, so no outflow
b. Risk discount rate is highly determinative of the result (But also highly uncertain,
can screw up calcuation)
3. So, the errors are likely to overtake the result, this is not good for VCs
26
a.example: 8 mil t or minus 1 million. the +/- creates a wide range.
i. If VC puts in 2 million +/- 500 thousand. And the valuation is 4 mil +/- 1
million, then the valuation is possibly +/- 8 million
ii. Comparisons to Comparable Company Metrics
1. Method
a. Find out various financial metrics of comparable companies whose valuation is
known
b. Derive ratios between those metrics and companies’ valuations
c. Apply those ratios to the Company’s metrics to calculate Company’s valuation
2. Problem
a. It’s difficult to find comparable companies with known valuations
b. It may even be difficult to find any truly comparable companies, regardless of
whether valuation is known
c. It’s also difficult to get financing information about them
i. Information is usually available only for public companies, but how
comparable are they to a raw startup?
3. So, the errors are likely to overtake the result, this is not good for VCs
27
g. What realistically affects valuation?
i. Most reliable way to drive up the price is having multiple term sheets on the table
ii. If you don’t need money immediately can get to cash flow neutral, you can probably add 10-20% of
your valuation
iii. Valuation is subjective and all market driven
1. What is a VC willing to pay?
2. Can you get a second VC willing to pay more?
iv. But it’s the Number One issue in a financing
Positive factors affecting valuation (increasing price) Offsetting factors affecting valuation (decreasing price)
● Technology and business milestones met ● VCs’ expertise, contacts and therefore ability
to add value
● Size of market opportunity
● VCs’ prestige and track record
● Current fundraising environment in general
● Extent to which the Company needs the
● “Hotness” of space
money immediately
● Founders’ prestige, experience and track record ● Absence of any other funding alternatives
● Deal terms (don’t vary much, thus doesn’t affect
price much)
● Multiple termsheets (competition btw investors)
28
iii. When voting together, Preferred and Common each have one vote (on an as-converted to Common
basis)
1. Only actual outstanding shares count
2. Options don’t vote
3. So when looking at voting, we are looking at “as converted shares outstanding”
iv. Class votes mandated by law
1. Preferred and common vote separately and must separately approve the following:
a. Amendments to the Certificate of Incorporation
b. Liquidations
c. Mergers – at least in California
v. Series votes rights mandated by law (Series A preferred v. Series B preferred)
1. Amendments to the Certificate of Incorporation that change the rights of that Series
adversely in a way different than for other Series
2. Generally amendments of Class rights are OK, while amendments of Series rights may not
be, even if same result
vi. Voting rights negotiated in Certificate of Incorporation – “Protective Provisions”
1. There are certain actions for which the company must obtain the approval of the holder of
preferred stock voting as a separate class, even if the preferred stock represents a minority
of the outstanding shares
a. Acquisition/sale of Company
b. Creation/issuance of equal or senior securities
c. Amendments of Certificate that change rights of Preferred
d. Dividends or stock repurchases
e. Sometimes other stuff that get into control of management
i. Incurrence of debt over a specified level
ii. Related party transactions
iii. Change in size of Board
iv. Increases to the Option Plan
v. Changes in Business Plan
2. Generally, Class votes are OK; Series votes are blocking rights
a. Don’t want to allow each series to have to vote a majority on these changes b/c
then a single investor (the largest in a given series) has blocking power
b. If there are no series votes, the company has greater flexibility
c. The interests of each series may differ due to different pricing, different risk
profiles, and a false need for overall control 🡪 this could make passing a proposal
difficult
V. Exits
a. Upside Exits 🡪 IPO or acquisition
i. Preferred converts to Common
ii. Valuation/percentage ownership is what matters
b. Downside Exits 🡪 Acquisition or liquidation
i. Preferred gets first claim on proceeds – “Liquidation Preference”
1. How big is the preference?
2. What is its priority vs. other Classes and Series?
3. How are the proceeds distributed after the Liquidation Preference has been satisfied?
ii. Liquidation preference is what matters here
c. And nobody gets anything if the Company fails
Securities Laws
29
a. Every Sale of a Security in the U.S. must be approved by both Federal and State governmental
authorities or must come under Exemptions under both entities’ laws
i. Relevant rules:
1. Section 5 of the Securities Act of 1933
2. SEC regulations and rules
3. Blue Sky Laws of individual states
ii. Translation 🡪 sell only to:
1. People and entities rich enough that they should know how to protect themselves (Rule 506
under Regulation D)
a. People with > $1 Million net worth
b. People with > $200,000 net income in each of three successive years
c. Entities with >$5 Million in assets
2. Family and friends where the relationship is so close that they can be expected to get
adequate information about the Company that way
a. And so that it’s reasonable to say that a “public offering” is not involved (Section
4(2) of the Securities Act of 1933) because the people are close enough around
you
b. Any Omission or Misstatement of a Material Fact in connection with the Purchase or Sale of a
Security is a violation of the law
i. Relevant Rules
1. Section 11 and 12 of the Securities Act of 1933
2. SEC Rule 10b-5 and other regulations and rules
3. Blue Sky Laws of individual states
ii. Translation
1. Is this something that the average investor would want to include among the things to
consider in making an investment decision?
2. If you think it might make them reconsider investing, that’s exactly what you have to
tell them
30
ii. Dollar and share limits based on Company assets and shares outstanding
iii. Disclosures to recipients required if over $5 million
f. Rule 506(b) 🡪 Most VC deals done under this safe harbor
i. Unlimited dollar amount
ii. Unlimited purchasers who are Accredited Investors
1. Must have “reasonable basis to conclude” they are Accredited
iii. Up to 35 purchasers who are not Accredited Investors
1. Specified disclosure requirements if any Unaccredited Investors
2. Such disclosure, if given, must go to all
iv. No General Solicitation or General Advertising
v. State Blue Sky Laws preempted
g. Rule 506(c)
i. Unlimited dollar amount
ii. Unlimited purchasers who are Accredited Investors
iii. State Blue Sky Laws preempted
iv. General Solicitation and General Advertising permitted
v. But no Unaccredited Investors
vi. Issuer must take affirmative steps to verify that all purchasers are Accredited Investors
1. Beyond mere “reasonable basis to conclude”
2. Pay stubs, bank/brokerage account statements, tax returns
3. This is why VC’s don’t take advantage of this 🡪 too burdensome
a. And verification is a separate step 🡪 if an investor is not verified, company could
lose exemption even if the investor turns out to be accredited
vii. Problems with this exemption
1. Accredited Investor verification hassles and risks
2. Need to be able to prove adequate verification process
3. Likely to attract less sophisticated investors
a. Still no specific disclosure requirements, but likely to need more formal and more
extensive disclosure materials
b. Disclosure also likely to need to be written for laymen
c. And more likely to be questioned after the fact
4. Likely to cause legal and administrative hassles later:
a. Lots of little stockholders
b. Many of them unsophisticated
5. No mixing/matching with Section 506(b)
6. Loss of Section 4(2) exemption fallback
viii. Is anyone using it?
1. Maybe just as protection from inadvertent General Solicitation/Advertising in formerly
506(b) offerings
a. Referrals through attenuated networks of contacts
b. Large Angel group presentations
c. Pitch Events and Demo Days
d. Company FaceBook pages and Twitter feeds
e. Interactions with “normal” advertising/marketing activities
2. Both General Solicitation/Advertising for a financing and General Solicitation/Advertising
for a presentation regarding a financing are covered
h. Crowdfunding
i. Up to $1 million within a 12 month period
ii. Anyone can invest
1. BUT: potential for too many stock holders that are probably unsophisticated
iii. Must be through independent Internet-based “Portals”
1. BUT: this is procedural overhead
31
iv. Limits on each Investor’s total Crowdfunding investments in any year tied to income/net worth 🡪
Each investment must be small
v. Company must provide significant amount of disclosure
1. E.g., audited financing statements
2. BUT: this is more procedural overhead and expense
vi. States can’t add extra requirements, but can police deals
vii. Public offering-type strict liability (unlike in private offerings)
1. These companies are probably the least likely to be able to provide full and fair disclosure
viii. SEC has put out proposed rules, but not yet adopted
I. Overview
a. Rights inherent in the preferred stock 🡪 rights built into the company’s certificate of incorporation
b. Preferred stock gets special rights and downside protections
c. Since a company may need multiple rounds of funding, they should consider how the rights granted to first
round investors will affect future negotiations
i. It is unusual for investors in subsequent rounds to accept fewer rights than were granted in a prior
round
d. Remember, a lot of the terms the preferred stock gets are there to justify for tax purposes that the preferred
is worth more than the common stock
e. Most important terms
i. Valuation
ii. Liquidation preference
iii. Founders stock/option vesting
iv. Voting/Vetoes/Board control
v. Operational/Administrative Hassles
vi. Everything else
32
i. Anything other than 1X is rare, at least in early rounds
ii. If the proceeds aren’t large enough to cover the Liquidation Preference in full:
1. Preferred takes it all, shared based upon total amount each invested
2. Common gets zero
c.
33
i. Theory is that Company is now successful enough that Investors don’t need the protection of the
Preferred Stock rights
ii. There might be certain criteria that the IPO must meet to auto convert
1. E.g., firm underwriting, offering must raise a certain amount of money, etc.
iii. May also be automatically converted upon a vote of some specified percentage of the preferred
stock (either majority or supermajority)
c. Initially convertible one-for-one
i. But rate is subject to adjustment upon certain events
ii. “Anti-dilution protection”
iii. Conversion ratio = initial preferred purchase price divided by the conversion price
34
b. Second, the Series B investors end up buying less of the company than they
bargained for, which can push down their price even further and lead to more
dilution and more adjustments.
c. Third, and perhaps most unfairly, all of the Series A stock is repriced regardless of
the size of the issuance of Series B stock
4. Rarely used for more than a limited time period
a. Might be appropriate to have full ratchet for 6-12 months with reversion to
weighted average thereafter
b. E.g., due diligence suggests company is overvalued and may need cash sooner
than expected; some foreseeable event may be occurring soon that could have a
big valuation impact (patent filing); mezzanine investors may be concerned
company is overvalued and down round will be necessary if public market
window closes
vi. Weighted Average
1. Vast majority of VC deals use a weighted average approach
2. Partial adjustment to an average of new and old prices, taking into account amount invested
at each price
a. It is an adjustment to the conversion price based on the relative amount of the
company being sold at a lower price
3. Old investors get upon conversion number of Common shares based upon blended price
between two financings
4. Two types of Weighted Average anti-dilution:
a. Narrow-based 🡪Only actually outstanding shares (including as converted
Preferred) included in calculation
b. Broad-based 🡪 Quasi-fully diluted shares (outstanding options but not Option
Plan Reserve) included in calculation
35
VI. Voting and protective provisions (Inherent)
a. Voting rights
i. Preferred votes with the Common on all matters
ii. Preferred votes on an as-converted to Common basis
1. 1 vote for each shares of Common issuable upon conversion at time of vote 🡪 so this would
take into account anti-dilution adjustments
b. Board Seats
i. Board seats generally reserved for each Series of Preferred 🡪 Built into the Certificate of
Incorporation
ii. All major stockholders agree to elect the VCs’ designee[s] to those seats 🡪 contractual right in
Voting Agreement
c. Protective Provisions
i. In addition to votes required by law, preferred consent as a separate class is required on add’l
matters:
1. Amendment of Certificate of Incorporation to change authorized number or rights of
Preferred shares
2. Creation of shares having dividend or liquidation rights equal (“pari passu”) or superior to
existing Preferred
3. Any merger, reorganization or sale of substantially all assets
4. Dividends and stock repurchases (other than unvested shares)
5. Increase in Option Plan Reserve
6. Change in size of Board
7. Sometimes, operational matters
a. Incurrence of debt over a specified level
b. Changes in Business Plan
36
ii. Generally required vote threshold is simple majority of Class/Series
1. But sometimes higher threshold set, especially if there is one large Investor that controls a
majority of entire Class/Series
iii. In addition to Class votes, sometimes additional Series votes are required on some matters
1. Can provide one set of Investors a blocking right, even though they do not even control the
Preferred
iv. In either case, is this appropriate protection or is it a means to inappropriately hold up a transaction?
1. Depends on which side you’re on
37
i. Demand Rights 🡪 right to force Company to undertake a public offering just so Investors can sell
some of their shares
ii. Piggyback Rights 🡪 right to have Company include Investors’ shares among shares being sold in
Company public offering
iii. S-3 Rights 🡪 same as Demand Rights once Company qualifies to use simpler Form S-3 Registration
Statement form
d. There are usually about 20 pages of terms dealing with these rights
i. But a lot of these details don’t matter very much
ii. If Company is able to go public, people are surprisingly willing to waive rights and make
accommodations
e. Things that do matter:
i. Ensuring that none of these rights can mess up Company IPO
1. Investors’ shares can be excluded completely from IPO merely if Underwriters “request” it
(UWs usually unwilling to permit existing SHs to sell in IPO b/c it could affect the market
of the stock)
ii. As quid pro quo for receiving these rights, Investors agree they will not sell any of their Company
stock for 180 days (in most cases) after Company’s IPO
1. “Market Stand-off” or “Lock-up”
2. Assists Underwriters in maintaining orderly trading market shortly after IPO
38
iii. Acceleration of vesting upon termination without “cause” or resignation for “good reason”
(“Constructive Termination”)
1. 6 to 12 months acceleration (12.5% to 25%)
2. Longer end for Founder CEO; shorter end for others
iv. Acceleration of vesting upon similar termination or resignation within 12 months after an
acquisition
1. More generosity here, on assumption that acquisition is a good outcome and Founder has
high risk of being fired by new owner
2. 50% to 100% of unvested shares/options
I. Basic Documents
a. Stock Purchase Agreement
i. Representations and warranties
ii. Conditions to closing
b. Amended Certificate of Incorporation
i. Rights inherent in the Preferred
c. Voting Agreement
i. Agreement to vote for Board designees
d. Investor Rights Agreement
i. Information rights
ii. Registration rights
iii. Right of first refusal over future Company issuances
e. Right of First Refusal and Co-sale Agreement
f. Legal opinion of Company counsel
39
iv. Wrong team members
40
1. Although this can be easily blown by actions Counsel may not know about, so usually
based on some assumptions
iv. Presence/absence of any litigation
1. Not really a legal judgment
d. Matters that should never be covered
i. Whether the Company is in compliance with all laws generally
ii. Whether the Company is in compliance with all it contracts
iii. What the likely outcome will be in any litigation
iv. Whether provisions of the financing documents not normally in financing documents are actually
enforceable
I. Overview
a. Four different cases demonstrate the conflict between different groups in VC backed companies
b. Silicon Graphics – Founders vs. Management
c. Alantec – Founders vs. VCs
i. Fiduciary duties
ii. Down-Round financings (three main issues)
d. Benchmark and Watchmark – New Investors vs. Old Investors
i. Pay-to-Plays
e. Trados – Preferred vs. Common
II. Case 1: Silicon Graphics 🡪 Conflict between founders and “professional” management
a. Conflict b/w founder with strong views and professional management
b. Jim Clark - built the geometry engine -- does intense calculations for computer graphics
i. Clark was not a good manager, went to Mayfield VC fund
ii. Took a lot more money than Clark thought to build a hardware company
iii. Glenn Mueller was the VC that invested, didn't get along with Clark
c. When Mayfield invested, one of its conditions was bringing in professional management
d. When company got off the ground, Clark disappeared, and all the grad students did the work
e. Clark went on to found Netscape with Marc Andreessen
III. Case 2: Alantec 🡪 relationships b/w entrepreneurs / founders and investors / VCs
a. This case involves a down round and fiduciary duties
b. What do you do when a company needs more money and the only people willing to invest are the existing
investors?
i. Investors who control the company at the time and thus sit on both sides of the table in any further
investment?
c. Putting in more money is fraught with peril
i. How do you ensure that the inside down round is really the only alternative?
ii. Even if it is, how do you ensure that the terms of the inside down round, especially price, are
market terms that are fair to those stockholders who don’t or can’t participate?
iii. How do you demonstrate all this years later in court when the company has become a wild success?
d. Fallout from a Down-Round Financing
i. Capital structure is often a mess
41
1. Massive dilution of existing shareholders, both Preferred and Common
2. Hugely bloated number of shares
3. Extremely low per share value
4. Most existing employee options now deeply underwater
5. Messy, semi-neutered series of Preferred held by investors who didn’t invest
ii. So the financing is often followed by:
1. Reverse stock split to shrink the capital structure
2. Option replenishment program for management/employees
3. An outright recapitalization, with all old Preferred converted into Common
iii. It’s amazing the company can survive to be successful
e. Legal issues in a down round
i. Massive dilution to existing shareholders
1. Management/employees get brought back up
2. Existing investors can participate to offset dilution
3. So impact falls mainly on former Founders, ex-employees and investors who do
not/cannot participate
ii. Possible additional loss of rights by failing to participate (“Pay-to-Play”)
1. Pay to play 🡪 a solution to incentivize investors to participate in a down financing
a. Basically, investors that do not participate to their full pro-rata percentage of the
financing are punished by losing certain rights.
b. Pay to play provisions tied to dilutive financings provide that only investors that
participate in the dilutive financing are entitled to the benefit of the anti-
dilution formula in effect.
c. Investors that do not participate do not receive any anti-dilution protection.
2. Might in fact be more fair -- and thus better from legal point of view -- to convert all
existing Preferred to Common regardless of participation
iii. Investors are on both sides of transaction
1. Who is looking to see if terms are fair?
2. Why an inside-led financing rather than one led by someone independent?
3. Why this terms and not others?
4. Why this price and not a different one?
5. So, due to the conflict, VCs will not get business judgment rule protection but will instead
have to prove entire fairness (fair price + fair dealing)
f. Methods to reduce legal risk 🡪 because this is an interested transaction (VCs on both sides), the VCs need to
prove that the transaction was fair to the minority stockholders
i. Extensive search for alternative sources of financing
ii. Disinterested director approval
1. Committee of disinterested directors is even better
iii. Open disclosure to all shareholders in advance
iv. Shareholder approval
1. Disinterested shareholder approval is better
v. Invitation to all shareholders to participate – “Rights Offering”
1. Benefits only those who have the cash and are Accredited
vi. Price determined by third party valuation expert
1. No one likely to give up this control (or pay the expense)
vii. Fairness opinion from Investment Bank
1. Even larger expense that valuation expert so no one does this
viii. Clear Board record of distress and lack of choice
42
IV. Case 3: Benchmark and Watchmark 🡪 New investors v. old investors
a. Benchmark
i. Preferred stock rights are “contractual in nature,” and all rights must be “expressly and clearly
stated” and will not be “presumed or implied”
1. Even though the merger was extremely dilutive to Series A and B, it was routine within the
corporate group and did not trigger consent requirements of A and B preferred
2. No amendment was made to the Company’s Certificate of Incorporation; changes were
made through a merger
3. “Other financing or economic rights” was not specific enough to be enforced
ii. Why not a breach of fiduciary duty?
1. The board doesn’t owe a separate fiduciary duty to the preferred holders
2. Board owes a duty to the stockholders as a whole and to the common shareholders as
residual owners
b. Pay to Play Financings
i. In order to create additional “incentive” for Existing Investors to participate in the financing,
Company imposes punitive terms on Existing Investors who do not invest
ii. Pay-to-Play”
iii. Investors that don’t invest or invest less than their pro rata share suffer some diminution of their
Preferred rights
1. Loss the rights such as Liquidation Preference or Anti-Dilution Protection, or
2. Complete conversion of their Preferred Common
iv. Investment required to avoid consequences may be all or nothing or proportional
v. Implementation requires amendment of terms of existing Preferred in Certificate of
Incorporation
1. So majority of Preferred must be willing to go along
c. Look for intra-group mergers as a means to get around the consent requirement of early rounds of preferred
stock
43
2. Throwing a nickel to the Common
ii. What about when Company value is less than aggregate Liquidation Preference?
1. Debt obligations are generally contractual in nature
2. But when Company is insolvent, Board must take into account what’s best for creditors in
a fiduciary-like manner
3. Why isn’t Preferred treated the same way, when its Liquidation Preference is endangered?
iii. How can you protect the company?
1. Independent Director approval
2. Form an Independent Director Committee
3. Throw a nickel to the Common
4. Majority vote of Common (mandatory in California)
5. Drag Along Rights
6. Waiver of Dissenters’ Rights
7. Force the Sale provision? Serendipitous Redemption rights?
Fiduciary Duties
Directors owe duties of care and loyalty to the corporation and its stockholders
I. Duty of Care
a. When making decisions or acting on behalf of the corporation, the duty of care requires directors to act with
the care that a person in a like position would reasonably believe appropriate under similar circumstances
i. CA Corp. Code § 309 🡪 Directors must act on an informed basis after due consideration of relevant
materials and reasonable deliberation
b. Analysis of process not substance 🡪 Courts focus on the process used in making the decision rather than
the substance of the decision (employing the BJR)
i. Did the Board review all information reasonably available?
1. Was there appropriate input from management and qualified advisors?
2. Directors may rely on such input, but it can’t substitute for their independent judgment
ii. What were the nature and extent of deliberations?
1. Time spent
2. Director participation
3. Meeting environment
iii. Was there consideration of alternatives?
c. Liability standard is “gross negligence”
d. But generally Directors are completely insulated from actual monetary damages for breach of Duty of Care
due to Van Gorkem and § 102(b)(7) of the DGCL
i. Exculpation clause in Certificate of Incorporation
ii. Mandatory indemnification in Bylaws “to the maximum extent permitted by law”
iii. Mandatory advancement of legal and other expenses of litigation also in Bylaws
1. Subject to repayment if later found by Court to not be indemnifiable
iv. Directors and Officers liability insurance
1. May be available to cover things that aren’t indemnifiable
2. Very important if Company has no cash or is no longer around
44
2. No usurping corporate opportunities
iv. Interests of Company and its stockholders come first
b. No exculpation in Certificate of Incorporation for breach of Duty of Loyalty
i. Directors can be held personally liable for monetary damages
ii. Indemnification likely to not be permitted
iii. Advanced expenses have to be repaid
iv. Even insurance may or may not cover
c. We are more concerned with this duty, since VC sits on both sides of table
d. Once VCs have control of the board, and they will invest in future rounds, they have an inherent
conflict 🡪 directors owe a duty to the stockholders as a whole, not just a certain group
i. Conflict situations can be dealt with through:
1. Full and accurate disclosure of interest, and
2. Either:
a. Approval by disinterested directors, or
b. Approval by stockholders
i. Do they have to be disinterested too?
3. OR, Board bears burden of proving actions were entirely fair
ii. If none of the above can be shown, the transaction is automatically voidable
45
a. As a result, it is difficult to get litigation dismissed before massive expense of
extensive discovery and full trial
Introduction
I. Pros and Cons of Going Public
Benefits Drawbacks
● Large amount of new capital ● Disclosure obligations
o Burden
● Liquidity for investors/employees
46
o Loss of confidentiality
● Future access to capital markets
● Increased legal exposures
● Currency for acquisitions
o Disclosure claims
● New types of equity o Fiduciary duty claims
compensation (more flexible) ● Expense, effort and staff
● Prestige (of being on NYSE) o Preparation and offering ($2M in
legal fees, 7% to UWs)
● Fulfillment of IPO dream o Long-term
● Tyranny of quarterly results
47
v. Employee Stock Purchase Plan
f. Implement public company corporate governance
i. Public company Board of Directors and committee structures
1. Majority of Board must be “independent”
2. Committees generally must be entirely “independent” (under various different definitions)
a. Audit Committee
b. Compensation Committee
c. Nominating and Corporate Governance Committee
ii. Public company corporate policies
1. Conflict of Interest Policy
2. Insider Trading Policy
3. Code of Conduct
4. Board Governance Guidelines
iii. Many Sarbanes-Oxley, SEC and NYSE/Nasdaq requirements
48
***Remember, with JOBS Act, you can submit doc with the SEC confidentially first (as opposed to filing it on Edgar)
V. Overlapping Timelines
49
VII. Pre Filing Period Overlapping Efforts of Key Parties
a. Selling
i. Stopping all selling and anything that looks like selling
1. SEC-mandated strict limits on Company publicity in general and prohibition of mentioning
offering specifically
ii. Positioning business for long-term performance
1. Dynamic and rapidly growing market
2. Problem/opportunity/inadequacy/pain not being addressed
3. Solution offered by Company
iii. Developing mid-term strategies to achieve long-term goals in next few years
iv. Creating the Story
1. Explanation of the foregoing
2. Investment thesis for buyers in offering and against which Company will be judged in first
4-12 quarters after IPO
v. Determining appropriate timing for IPO
1. Highly dependent on Company’s market
2. But also on quarterly financial cycle, seasonality and SEC review process
vi. Locking up all outstanding shares and options
1. Assists Underwriters in making an orderly trading market post-IPO
2. No sales, hedges, pledges of any Company stock by current SHs for 180 days after IPO
b. Drafting the Registration Statement
i. Purpose:
1. Explain Company and its business to investors and convince them to buy Company’s stock
2. Protect Company, Board, Management, Underwriters and Accountants from liability for
failure to disclose all material information about Company completely and accurately
3. Protect investing public from buying stock without adequate information about the
Company and understanding of the risks involved
ii. Requires significant amount of management time and participating 🡪 but best results come when the
lawyers draft it
iii. Consists of two parts
1. Prospectus 🡪 Actually selling document
2. Part II 🡪 SEC procedural stuff, exhibits and signatures
iv. Multiple versions of the Prospectus
1. Draft Prospectus
2. SEC-compliant Prospectus
3. Red Herring Prospectus
4. Time of Sale Prospectus
5. Final Prospectus
v. Main sections of the prospectus
1. Summary
a. Responsible parties:
b. Bankers, Entire Group
2. Contents:
a. Main investment thesis
b. Short versions of rest of document
3. Business Section
a. Responsible parties: Company, Bankers, Company Counsel
b. Contents:
• Longer version of main investment thesis
• Market → Problem → Solution → Strategy
50
• Details of Company’s products, technology, R&D process, sales and
marketing process
c. Details of intellectual property, litigation, competition, employees
4. Financial Statements
a. Responsible parties:
• Written by Company, Financial Statement Consultant
• Audited by Accountants
b. Content:
• Annual results for past 3 years
• Quarterly results for past 2 years and since last year-end
5. Management’s Discussion and Analysis of Financial Condition and Results of Operation
(“MD&A”)
a. Responsible parties: Company, Company Counsel, Accountants, Financial
Statement Consultant
b. Content: Explanations of what’s going on in the Financial Statements
c. Main place to get sued
6. Risk Factors
a. Responsible parties: Company Counsel, Company
b. Content: Everything that can go wrong, no matter how remote
c. Main defense if sued
7. Management
a. Responsible parties: Company Counsel, Company, Compensation Consultant
b. Content: Biographies of Officers and Directors, Board governance matters and
structures, Compensation, Compensation Disclosure and Analysis (“CD&A”),
Related party transactions
8. Stock matters
a. Description of rights of capital stock
b. Principal stockholders
9. Offering Matters
a. Underwriting terms
b. Selling stockholders, if any
c. Pro forma effects of IPO on Financial Statements and Capitalization
c. Verifying / Due Diligence
i. Why due diligence?
1. All material facts about Company must be disclosed in Registration Statement accurately
and completely
2. Company is strictly liable for any misstatements or omissions
3. Directors, Officers and Underwriters can be personally liable unless they were duly diligent
in investigating accuracy and completeness of disclosures in Reg. St.
ii. Business due diligence
1. Company’s business, customer relationships, etc.
a. Internal – Does Company actual do what it says it does?
b. External – What do customers say about Company’s products
2. Parallel purpose of weekly drafting sessions
iii. Financial due diligence
1. Underwriters build financial models mirroring Company’s
2. Underwriters and Underwriters’ Counsel interview Company’s Accountants re their views
of financial operations, processes and controls
iv. Legal/document due diligence
1. Company sets up data room of all material documents plus a some others
2. Junior corporate attorneys discover the reason for their existence
3. Underwriter Counsel interviews attorneys handling litigation, IP matters, regulatory
compliance
51
VIII. SEC Review Period / Waiting Period Overlapping Efforts of Key Parties
a. Selling rules during SEC Review portion of Waiting Period
i. Oral offers can now be made
ii. But no written offers unless accompanied by a § 10(b) prospectus
1. No handouts, no emails
iii. “Testing the Waters” meetings can be held
1. But no actual commitments can be made
2. Presentation must be consistent with what is in Registration Statement
3. SEC will ask to see presentation and check
b. Selling
i. Negotiating the Underwriting Agreement
1. UWs will buy stock from Company at a discount and then resell to the public at full IPO
price
a. Firm Commitment vs. Best Efforts offerings
b. Over-allotment option or “Green Shoe”
2. Key Sections
a. Representations by the Company
b. Indemnification for misstatements and omissions
c. Opinion of Company Counsel
d. Closing conditions and expenses
3. Participation by Selling Stockholders (if any)
a. Representations
b. Indemnification
c. Inability to back out
ii. Stock exchange matters
1. Nasdaq or NYSE?
2. Both have elaborate listing application processes
3. Both have minimum standards of qualification relating to assets, revenues, profits,
shareholders and market makers
iii. FINRA matters
1. Review of underwriter compensation
iv. Blue Sky compliance
1. Federal preemption if listed on NYSE or Nasdaq, so generally not necessary
v. Near end of SEC Review Period:
1. Underwriters and Company prepare Roadshow presentation
a. Presentation must flow out of and not go beyond disclosures in Registration
Statement
2. Underwriters provide anticipated price range for offering
a. Need to analyze effects of range
b. Is a stock split needed? 🡪 Underwriters will want to sell stock in IPO at $10 to $15
per share regardless of actual value of Company or stock pre-offering
c. Is bottom of range high enough to ensure Preferred Stock will convert
automatically? 🡪 If not, stockholder vote to force conversion may be needed
d. “Cheap Stock” issues
• SEC compares recent option exercise pricing to anticipated offering
price
• If too big a discrepancy, SEC will force Company to revalue options on
its Financial Statements
c. Drafting
52
d. Drafting
i. Every sale of a security in the US must be registered with the SEC
1. SEC doesn’t judge whether investment is good or bad
2. SEC does require full and fair disclosure so Investors can make their own decision
3. “Disclosure-based,” rather than “merit-based” system
ii. SEC review process
1. Draft Registration Statement filed with SEC electronically through EDGAR system
2. Confidential initially (so not officially “filed” at this stage)
3. Pricing information and share numbers left out, until price range determined
4. SEC provides comments roughly within 30 days
a. “Justify claims of performance or uniqueness.”
b. “Balance positive statements with additional risk factors.”
c. “Provide missing required disclosures.”
d. “Explain how the Company’s accounting practices comply with accounting rules.”
e. “Rewrite bad writing in ‘plain English.’”
• No technical jargon
• No defined or capitalized terms
• Use • and – rather than (i), (ii) . . .
• Use “we” instead of “the Company”
5. Company Counsel and Accountants prepare responses to comments along with proposed
revisions to language in Registration Statement
a. Amendment to Reg. St. then refiled with SEC along with comment response letter
6. Multiple rounds of back-and-forth comments and responses with SEC, progressively
clearing comments
a. May take 30-60 days
b. Sometimes long enough that Financial Statements must be updated to next quarter
c. Amendment filings, SEC comment letter and Company’s response letters still
confidential at this stage
e. Preparing and Governance
i. Board and shareholder approvals
1. Revise Certificate of Incorporation and Bylaws to public company forms
2. New Equity Plans
ii. Corporate governance
1. Complete implementation of corporate governance structures and policies
2. Complete establishment of independent Board and committees
3. Adopt any desired “defensive” measures
a. Classified board
b. Limits on calling stockholder meetings and actions in writing
f. Verifying
i. Due diligence continues
ii. Complete anything not done before first filing
1. Should be mostly confirmatory at this stage
2. Changing text in the Registration Statement is possible, but:
a. May draw SEC questions and comments
b. After public filing, may draw comments, even ridicule, in press
c. Looks sloppy
3. But incorrect or incomplete things must be fixed regardless
iii. Negotiate Comfort Letter
1. Accountants provide written confirmation to Underwriters of accuracy of all financial
numbers in Reg. St. 🡪 But not to the level of an audit or “expertization”
53
iv. Must be sensitive to new events or changing circumstances
1. Accuracy and completeness are measured at the time of the offering, do diligence
never stops through end of process
54
X. Post Effective Period
a. Now the company is publicly traded
i. Company now evaluated based on performance in eyes of new set of shareholders and Wall Street
expectations
ii. Execution of business plan critically important
iii. Missing projected numbers – even if not from Company itself – will punish stock
iv. Company now has public shareholders as new constituents in its business decisions and governance
b. SEC Matters
i. Prospectus must be updated for material events for 25 days following IPO
ii. Company usually files additional registration statements for employee equity plans
iii. Insider trading rules, restrictions and filings now come into play
c. Communications
i. Company under continued restrictions for 25 days
d. Public company status
i. Company must ensure corporate governance structures and disclosure controls and procedures are
in fact effective for proper governance and timely and accurate reporting
ii. Time to start prepare for first periodic SEC filing under the Securities Exchange Act of 1934
Securities Laws
55
II. Securities Act of 1933 Overview
a. Disclosure-based, not merit-based, regulation
i. Investors judge merits of investment themselves, based upon full, fair and accurate disclosure from
the Company
b. Section 5 makes it illegal to:
i. Offer to sell a security orally unless a Registration Statement is on file with the SEC
ii. Offer to sell a security in writing other than by means of an SEC-compliant Prospectus
iii. Actually sell a security unless preceded or accompanied by delivery of a Prospectus contained in a
Reg. St. declared effective by the SEC
c. Section 12(a)(1):
i. Violating Section 5 entitles investors to rescind the transaction and get their money back
56
V. Guidelines for Publicity
a. Avoid content, manner, timing, or targeted audiences that would suggest a stock selling effort is underway
i. Stick to factual matters and avoid “puffing”
ii. Avoid off-limits topics
iii. Is this communications really crucial?
b. Stick to the trade press and avoid the financial press
c. Be consistent with existing practices in ordinary course timing and form
i. Avoid starting new practices
d. In everything, there should be just one story, and that story should be the one in the Prospectus
e. Press releases:
i. Product focus for trade press consistent with past practice
ii. No offering matters
f. Articles and interviews:
i. Careful on content and timing 🡪Early interviews can come out at crucial times much later
1. Can’t prevent quotes being taken out of context
2. Simple fact-checking may be OK
ii. Company shouldn’t be seen as participating or initiating
iii. Social media
g. General advertising and marketing activities
i. Not the time to start a new campaign
h. Presentations and speeches.
i. General industry/technology maybe
ii. No Company- or market-specific materials
i. Conferences and trade shows.
i. Probably OK, if really trade and not investor focused
ii. Careful about marketing collateral
57
j. Company website:
i. No puffery, projections and anything inconsistent with or beyond Prospectus.
ii. SEC will review
k. Social media 🡪 be careful, lawyer’s nightmare
l. Employee communications
i. IPO is Company confidential information, and employees should not discuss it with outsiders,
including through: Social media; Emails, web postings and chat rooms; Conversations with friends
ii. Random inquiries should be directed to the CFO or GC
m. Off limit topics
i. Financial information
1. Revenues, profitability, margins, and anything else relating directly or indirectly to
historical or projected financial performance, growth or valuation
ii. Corporate strategy and tactics
iii. Any discussion or comparison with competitors
1. Other than possibly unadorned, concrete, factual comparisons of the Company’s
products/services with competing products/services
iv. Market opportunities, market dynamics, and forecasts or projections on market growth
v. Any expectations about the future for any of these matters
58
VIII. Material Fact
a. Positive or negative info that an investor would consider important in deciding whether to buy or sell
i. Anything that might affect an investor’s decision to buy the stock is exactly what must be
disclosed
b. Examples:
i. Market size, characteristics and opportunities
ii. Product capabilities and competitive position
iii. Significant research and development activities and results to date
iv. Future development plans
v. Relationships and agreements with licensees, customers, suppliers and partners
vi. Financial results
vii. Known trends in the business
viii. Litigation and threats of litigation
ix. Experience and background of members of management
x. All risks that the Company may not achieve its objectives, succeed or even survive
59
XI. Reasonable Investigation Cases
a. Barchris 🡪 You are going to be responsible for whatever documents you signing
i. So you better read those documents
ii. And check on things that don’t seem right
iii. And make sure the junior associates do their jobs
b. In re Software Toolworks 🡪 diligence done right
i. Underwriters are not held to same accounting knowledge as auditing Accountants and do not have
to second-guess them, unless brought face to face with obvious evidence of potential wrongdoing
by Company or Accountants
1. Underwriters uncover memo indicating Company was backdating contracts to recognize
revenue improperly; UWs properly launched an investigation – demanded info from
auditors, required other firm to attest that the practices were acceptable
2. Absurd for plaintiff to suggest that Underwriters, who are not accountants, possibly could
have known of any mistakes by auditors.”
a. “No defendant other than auditors could be liable on this basis.”
c. In re Worldcom 🡪 diligence done wrong
i. Underwriters’ due diligence for a shelf registration offering consisted of: One phone call with CFO
memorialized in memo by legal counsel; Review of minutes and public filings; Comfort letter from
Arthur Andersen, independent accountants
ii. Did the underwriters conduct a reasonable investigation?
1. BarChris: Underwriters must make some reasonable attempt to verify the information
submitted to them
2. Underwriters cannot merely listen to management’s explanations
iii. OK to rely on Financial Statements certified by Accountants but only if:
1. Financial Statements are included in Registration Statement
2. Financial Statements are actually audited with Accountants’ opinion; and
3. Accountants consent to inclusion of their opinion in Reg. St.
4. Comfort Letters though useful, do not meet this requirement
iv. UWs must follow up on “Red Flags” rather than just relying on audited Financial Statements
1. Any information that “strips [an offering participant] of his confidence in the accuracy of
information premised on the audited Financial Statements, whether or not it relates to
accounting fraud or audit failure” requires further investigation
2. Here, specific “Red Flags” were:
a. Divergence of WorldCom's communications line cost ratio to those of its
competitors
b. Asset write-downs taken by Sprint and ATT, but not WorldCom
v. Very different standard from In re Software Toolworks
1. “Red Flags” here were not in Financial Statements themselves
a. They weren’t even within Company itself
b. They were facts in industry that were absent at Company
2. Underwriters should have applied outside knowledge to second-guess Company’s and
Accountants’ accounting decisions in Financial Statements even though they were
audited
60
XII. Who does Diligence on What?
• Lawyers
● Underwriters ● Accountants
o Factual statements
o Industry environment o Financial statements o Corporate organization and authority
and projections o Accounting issues o Capitalization
o Customers, suppliers o Accounting systems o Ownership of assets and properties,
and competitors and financial especially IP
o Financial projections controls o Management-related information
and business model o Comfort letter o Litigation and regulatory matters
o Capital expenditure o Contracts (All material contracts must
plans be filed as Exhibits to Registration
o Sources of other capital, Statement)
such as credit facilities
61
d. Legal due diligence
i. Docs to review
1. Charter and bylaws
a. Capital structure
b. Rights of outstanding stock that can affect the offering
2. Board and shareholder minutes and other actions for Company and principal subsidiaries
3. Matters and documents relating to Company financings and other issuances of all
outstanding securities
a. Warrants and other rights
b. Securities law compliance in previous issuances
c. Registration rights agreements (any waiver necessary?)
4. Agreements with and/or among shareholders
5. Customer, supplier, business partner contracts
a. Any consents needed to be disclosed or filed?
b. Anything triggered by an IPO?
6. Loan agreements, lines of credit, indentures
7. Acquisition agreements
8. Compensation documents
a. Employment agreements
b. Severance agreements
c. Employee equity plans
9. Litigation and investigation files
10. Other government filings and matters
a. Environmental
b. Regulations particular to business (e.g., FDA)
ii. Beyond docs to review
1. Statements disprovable with one example or not at all
a. “Unique”
b. “State of the art”
c. “Next generation”
d. “The leading”
2. Belief” statements
3. Projections
a. Quantitative
b. Qualitative
XIII. Typical diligence issues
a. Customers and suppliers
i. Who’s a “customer”? Is there a binding contract in the document review?
ii. Cherry-picked customer list
1. How recently did they buy?
2. How much did they buy?
3. Are they a distributor or an actual end-user?
4. Do we need their consent to being named?
iii. Does Company have any sole source suppliers?
1. No guaranteed supply
2. Have their been past interruptions?
3. How stable is the supplier’s business?
4. Does Company have contingency plans?
iv. Product claims
1. Do products actually perform as claimed?
2. Are comparisons with competitors’ products accurate and objective?
62
3. Is there independent third-party verification for both of the above, rather than just internal
marketing hype?
v. Contracts
1. Do any contain conflicts with doing an IPO?
a. Confidentiality clauses
b. Change in control clauses
c. Consents required to issue stock
2. Do any raise business issues?
a. Unusual commitments
b. Unusual exposures
b. Intellectual Property
i. Ownership of patents, trademarks, copyrights
1. Did all founders properly assign all their rights to Company
2. Any consultants who did not explicitly assign their rights?
3. What is the scope and duration of any IP licensed into Company?
4. What is the scope and duration of any IP licensed out by Company?
5. Are things claimed as “proprietary” really proprietary?
ii. Infringement claims, threats and/or vulnerabilities
1. What products are covered?
2. Did Company get a non-infringement opinion?
3. Can a license be obtained and at reasonable cost?
4. likelihood of litigation and monetary and injunctive exposure in a negative outcome?
c. Litigation
i. Financial impact of current litigation
1. Has Company set aside adequate reserves for loss?
2. What is impact of ongoing expenses even if win?
ii. Non-financial impact
1. What are the possible effects on business and/or sales?
2. What is the effect of the distraction of management time and attention?
d. Capitalization
i. Were all stock and options issued with proper corporate actions and approvals?
ii. Is stock really owned by whom Company thinks it is?
iii. Is description of stock being sold accurate?
iv. When can existing shareholders sell their stock after the IPO?
e. Securities laws
i. Have there been any Gun-jumping violations
ii. Website content
1. Is it consistent with the Registration Statement
2. Is there anything material there that isn’t in the Reg. St.?
3. Is there anything there that couldn’t go in the Reg. St.?
iii. Employee equity issues
1. Did Company properly comply with Rule 701?
2. Maximum amount of stock that can be issues
3. Proper delivery of Financial Statements and Risk Factors if over certain threshold
iv. Foreign securities law
1. Any large issuance of securities in foreign jurisdictions?
f. Employees and consultants
i. Stock/option matters
1. Were all Section 83(b) tax filings done on time?
2. Does anyone’s vesting accelerate because of the IPO?
ii. Prior employment matters for key employees
1. Is any of them subject to an enforceable non-compete agreement
63
2. Is any of them covered by any non-solicitation or non-hire obligations that could implicate
Company
3. Is Company improperly using any trade secrets from their prior employers
g. Management
i. Backgrounds
1. Any involvement with bankrupt companies?
2. Any involvement with questionable securities law practices?
3. Any involvement in other questionable activities?
ii. Executive compensation
1. Is all historical compensation disclosed?
2. What are future compensation arrangements/commitments?
3. Are there any benefits triggered by a change-in-control or termination without cause?
iii. Stock ownership
1. Are all holdings completely and properly described?
iv. Related-party transactions
1. Does anyone have any interest on the opposite side of any Company transaction?
h. Regulatory compliance
i. Sales practices
1. Any issues of bribery on foreign countries or other Foreign Corrupt Practices Act issues?
2. Does Company have all necessary export licenses?
3. Are Company’s products such that Department of Defense clearance is needed for certain
exports?
ii. Environmental/occupational safety matters
1. Does Company use any hazardous materials?
2. Do employees engage in any hazardous activities?
iii. FDA matters (for MedTech)
1. What is the timing of FDA action?
2. What indications have been approved for use?
3. Are claims being made supportable?
i. Past Company public statements
i. Historic
1. Any discussions of historical financial performance, especially if inconsistent with that in
Registration Statement?
ii. Future
1. Any discussions/predictions of future financial performance?
2. Any mention of IPO plans?
3. Any predictions of stock performance post-IPO?
Registration Statement
I. Form S-1
a. Used for:
i. IPOs
ii. Original issuances by companies who can’t use Form S-3
iii. Any offering for which there isn’t another specific Form
b. Contents
i. Business
ii. Properties
iii. Financial Statements
iv. Management
v. Stockholders
64
II. Registration Statement Contents
a. Cover Page
i. Name of company
ii. Amount and title of securities
iii. UWs and counsel
b. Prospectus
i. Summary
1. Description of business, statement of problem, how issuer solves it
2. Size of offering
3. Use of proceeds
ii. Business Section
1. Description of business
2. Market sizing
3. Market → Problem → Solution → Strategy
a. Business section of every registration statement uses this format
b. Market 🡪 overview of market for type of products that the Company makes
c. Problem 🡪 Problem that this type of product is intended to solve
d. Existing alternatives 🡪 Short general discussion of ways people have tried to
address this Problem, but without mentioning specific competitors
e. Inadequacies 🡪 Why all of the existing alternatives don’t really solve the Problem
f. Needs 🡪 What characteristics would be required for a true solution to the Problem
g. Solution 🡪 What the Company offers customers that uniquely (and miraculously)
solves the Problem and has every one of the required characteristics mentioned in
Background
h. Strategy 🡪 How the Company is getting (or will in next few years get) its Solution
out to customers
i. Strategy for selling to customers
ii. Strategy for expanding markets
iii. Strategy for developing new products that embody Solution
4. Rest of business section
a. Technology behind our solution
b. Details of what we sell
c. Who we sell it to
d. How we sell it
e. How we make it
f. Who we sell against
g. A lot of facts and risk-factory type stuff
5. Goals
a. Craft a tight convincing story for Company with a clear business strategy and
investment thesis
b. Provide general business information and financial disclosures
c. Prepare sales force to create demand
d. Secure sophisticated, high-quality, long-term investors
iii. Financial Statements
iv. MD&A (Management’s Discussion and Analysis of Financial Condition and Results of Operations)
65
v. MD&A (Management’s Discussion and Analysis of Financial Condition and Results of Operations)
1. Provide investors information to help them understand Company’s financial condition,
changes in financial condition and results of operations
2. Discussion of key indicators of financial condition and operating results
a. “Financial condition” = Balance Sheet
b. “Results of operation” = Income Statement
c. “Changes in financial condition” = Cashflow Statement
3. Areas of focus:
a. What are the main drivers of Company’s revenues, expenditures and cash
generation?
b. What caused increases or decreases in numbers?
c. What are one-time events vs. ongoing conditions?
i. Effects of seasonality
ii. Offsetting factors and “Masking”
d. Material trends and uncertainties
i. Most valuable disclosure and crux of litigation, for good or ill
4. Principal objectives:
a. Enable investors to see Company and its financial operations through eyes of
mgmt
b. Enhance overall financial disclosure and provide context within which numerical
financial results should be analyzed
c. Provide information about quality – and potential variability – of revenues, profits
and cashflows, so that investors can ascertain to what extent future performance
can be projected from past performance
vi. Risk Factors
1. Identify and prioritize key factors affecting business, operating results, and financial
condition
c. Part II
i. SEC-only disclosures
ii. Acknowledgements of SEC policies
iii. Exhibits
iv. Signatures
66
iii. SEC-mandated “Real-time Disclosure” 🡪 Form 8-K
1. Company generally must file a Current Report on Form 8-K describing triggering event
within four business days
2. Typical events triggering filing:
a. Material changes in financial condition or operations generally
b. Entry into/termination or amendment of material agreement not in ordinary course
c. Material financial obligation created, default on or accelerated
d. Material write-offs, restructuring charges or impairments of assets
e. De-listing of Company’s securities or non-compliance with listing standards
f. Unregistered sales of equity securities by Company
g. Changes in management or management compensation
3. Implications of failing to file Form 8-K on time
a. Inability of insiders to sell Company securities until filing is made
b. Loss of ability to use short-form Registration Statement on Form S-3 for offerings
for next 12 months
c. Quasi-mandatory disclosure
i. Quarterly financial results press release and earnings call
1. Press release generally within 20 to 30 days after quarter end
2. Conference call or web-cast for securities analysts and public to discuss results, provide
more details and answer questions
3. Release of previously unreleased material information regarding historical financial results
triggers SEC requirement to “furnish,” not “file,” copy of press release on Form 8-K
a. “Furnished” information technically has lower level of liability than “filed”
information
b. Rule 10b-5 liability rather than overt liability for misstatements in SEC filings
4. Company will also generally post press release and recording or transcript of conference
call on Company web-site
ii. Press releases for major events
1. “The Duty to Disclose”
a. Silence, absent a duty to speak, is not misleading
b. When does a Duty to Disclose arise?
i. Periodic Reports / Registration Statements
1. Past events
2. Known trends and uncertainties in MD&A
ii. Nasdaq/NYSE requirements
iii. Stock sales by Company or Insiders
iv. To correct past incorrect statements (“Duty to Correct”)
1. But not to update correct statements that are no longer true
2. No “Duty to Update”
2. Materiality” revisited
a. Are some events so material that they have to be disclosed?
i. Duty to Disclose says no
ii. But general practice is to do so
b. Magnitude of materiality also heightens likelihood of leaks
c. How does one determine the magnitude of materiality?
i. “Price and Structure” Test
1. Have the parties actually reached an agreement on the basic
business terms?
ii. Basic v. Levinson Test
67
1. Multiplicative analysis: (Impact of Event) X (Likelihood of
Occurrence)
2. New customer win – modest impact, so likelihood must be high
3. Acquisition of Company – huge impact, so likelihood doesn’t
have to be much
iii. Reasonable Investor Test”
1. Would a reasonable shareholder consider it important in deciding
to trade in stock or vote shares?
d. Discretionary disclosure
i. Presentations to investors and Wall Street Analysts
ii. Forward-looking information – “Guidance”
1. Regulation FD
iii. If Company chooses to speak, it must speak completely and not misleadingly
iv. So why would you do it, if you don’t have to?
1. For Wall Street Analysts
a. Key information intermediaries
b. Providing interpretations and glosses on Company disclosures
c. Providing their own models and forecasts of Company performance
2. Analyst coverage is vital for new public companies
a. Avoiding the Land of the Living Dead
b. Importance in choice of Underwriters
v. Issues in dealing Wall Street Analysts’ reports and forecasts
1. No duty to correct their mistakes
2. In fact, once Company starts doing so
a. It may be seen as endorsing accuracy and completeness of report and thus become
liable for contents
b. It may create expectations that it will correct mistakes in future reports
3. But Company may nonetheless choose to do so:
a. To maintain credibility – and thus goodwill – with Analysts
i. Surprising the Analysts is not a good idea
b. To avoid divergences of Analysts forecasts from reality that can lead to
precipitous drop in stock price
i. Surprising the market is a very bad idea
4. Selective disclosure and tipping
a. Now prohibited by Regulation F-D (in addition to Rule 10b-5)
vi. Forward-looking information – “Guidance”
1. No duty to provide Guidance
2. But realities of relationships with Wall Street Analysts may force Company to provide it
a. Goodwill
b. Dangers of divergence
3. MD&A requires disclosure of “Material Known Trends and Uncertainties” in Registration
Statements and Periodic Reports
4. SEC provides safe harbor for “Forward-Looking Statements”
a. Must identify the forward-looking statements
b. Must discuss risks why such statements may not come to pass
c. Doesn’t apply to IPOs
vii. Regulation FD
1. Whenever:
a. A public Company or person acting on its behalf . . .
b. discloses previously unreleased material information . . .
c. to certain enumerated persons . . .
i. In general, securities market professionals and holders of Company’s
securities who may trade on basis of the information
68
2. Then Company must make a public disclosure of that same information:
a. Promptly, for unintentional disclosures
b. Simultaneously, for intentional disclosures
3. Impact:
a. Serious liability for failing to comply
b. Lowering of quantity/ quality of publicly available information?
69
70
71