Thursday, March 29, 2012

Start-up Seed Financing in 2011: Analyzing the Trends

Fenwick & West LLP, a law firm that represents emerging growth companies, has published a survey of seed financing transactions, comparing the terms of such deals in 2011 to 2010. The survey was based on 56 transactions closed in 2011 and 52 – in 2010, mostly on the West Coast. The full text of the survey is found here: http://fenwick.com/publications/pages/seed-finance-survey-2011.aspx

The survey highlighted several trends that I would like to bring to your attention:

1. Venture capital investment into seed rounds increased by 52% from 2010 to 2011 (three most active investors were 500 Startups, SV Angel and First Round Capital).

2. Investing by angels has been on the rise since 2009.

3. There has been a mushrooming of accelerators/incubators for start-ups (and not just on the West Coast).

4. The deals tend to be more founder- friendly, as preferred stock valuations, convertible note usage and convertible note cap amount are increasing.

5. The seed funded companies have hard time receiving subsequent venture funding. In fact, less than half of the companies with seed funding received venture funding within 18 months.

6. The use of convertible notes increased by 10% in 2011 as opposed to 2010; their median size increased from $662,500 to $1 million; and the median valuation cap increased from $4.0 million to $7.5 million. Note that only in 4% of the convertible note deals in 2011 investors received a board seat, as opposed to in 8.3% of such deals in 2010.

7. The pre-money valuation in preferred stock offerings increased from $3.4 million to $4.0 million for internet/digital media deals.

Overall, the survey shows that the changes in the seed funding have been founder-friendly, which is an encouraging sign for the start-ups.

This post is a summary of the 2011 Seed Financing Survey, available here: http://fenwick.com/publications/pages/seed-finance-survey-2011.aspx. For any questions about it, please refer to the survey and contact its authors.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Monday, March 26, 2012

The JOBS Act Passed the Senate

On March 22, the JOBS (Jumpstart Our Business Startups) Act passed the U.S. Senate in a 73 to 26 vote. Since the Senate amended the version that passed the House, the bill now has to go back to the House of Representatives for another vote. President Obama has already indicated that he would sign this Act into law.

Among other things, the JOBS Act aims to facilitate investment by non-accredited individuals into startups. However, the last minute amendments to the crowdfunding provisions of the JOBS Act placed restrictions on the ability to raise capital by startups. One of such changes is the introduction of investment caps. According to the version of the bill passed by the Senate last week, individuals making less than $40,000 per year can only invest 2% of their annual income in startups, whereas those earning over $100,000 can only invest 10%.

These changes to the bill show that there is a tension between the growing need of startups for capital and the necessity to regulate crowdfunding to prevent fraud. It is unclear whether the House of Representatives will approve the current version of the Act.

Let’s wait and see what happens next.

The text of the Act and the amendments are available here: http://thomas.loc.gov/cgi-bin/bdquery/D?d112:3:./temp/~bssUuSy::

Read a good summary and discussion of the Act and the latest amendments here: http://www.avc.com/a_vc/2012/03/the-jobs-bill.html

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Monday, March 5, 2012

Penn Law Receives a Cease and Desist Letter from Louis Vuitton

Being a Penn Law graduate, I could not not write about this interesting recent development affecting the Law School.

Here is what happened: the IP student group at the University of Pennsylvania Law School (also known as Penn Law) organized an intellectual property law symposium "IP Issues in Fashion Law" scheduled for March 20th. They designed a flyer for the event using artwork that was a parody on Louis Vuitton marks. An image of the flyer can be found here as Exhibit A.

On February 29th, Michael Pantalony, the Director of Civil Enforcement for Louis Vuitton sent to Penn Law's Dean Michael Fitts a cease and desist letter regarding the flyer, available in the same pdf as above. In his letter, Mr. Pantalony claimed that the flyer was a "serious willful infringement" on LV's trademarks and that it "knowingly dilute[d] the LV Trademarks".

Robert Firestone, the Associate General Counsel of the University of Pennsylvania was quick to respond on March 2nd. In his letter, found here, Mr. Firestone disagreed with the statements made in the LV cease and desist letter. Mr. Firestone noted that the flyer couldn't possibly be a "serious willful infringement" since it wasn't used as trademark (the parody artwork in question was not used to identify any goods or services in interstate commerce). Also, it is unlikely that any of the LV trademarks were in class 41 that would cover educational symposia. Further, Mr. Firestone pointed out that even if the artwork were a mark, there is an explicit exception to any liability for dilution for any "noncommercial use of the mark". Finally, the artwork clearly constitutes a fair use.

Mr. Firestone also invited Mr. Pantalony to the symposium.

Penn Law, - I am proud to be your alum.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

Thursday, March 1, 2012

Some Thoughts on Friends and Family Financing for Startups

Many founders I speak with are interested in obtaining financing for their businesses first from their friends and family members, and then from professional investors. I agree, this seems to be the common path. However, many founders do not realize the importance of complying with applicable federal and state securities laws when asking friends and family for money.

Typically, a friends and family round of financing can be done by either issuing stock to investors in exchange for their money or by giving them a promissory note (typically convertible into equity). If friends and family members receive stock, no matter how small their investment is, it is likely to be deemed a securities offering. The definition of what constitutes a security is very broad. Courts have determined, for example, that an investment contract can be a security, if a person invests his or her money in a common enterprise with an expectation of profit derived solely from the efforts of others. There is no requirement to issue formal certificates to such investors. So, if a founder’s friend invests in the startup but does not partake in actively running it, his or her contract with the startup is probably a security.

A promissory note may also be a security. Under the Securities Act, promissory notes are defined as securities except for notes with maturity of less than 9 months. There are numerous exceptions to this general rule. Here is a link to a great discussion of whether a promissory note is a security. To summarize, the question of whether a promissory note is a security turns on whether the note looks like a security and whether the selling of the note looks like a securities offering. Factors to consider include the number and sophistication of the investors/lenders, whether the note is collateralized, whether the investors/lenders are also owners of the business they are lending money to, etc. It is likely that in a family and friends round of financing, where the business is raising money for its general operations, and the investors are investing with an expectation of return, the promissory note will be deemed to be a security.

Every offering of securities has to be either registered with the Securities and Exchange Commission or comply with one of the applicable exemptions from registration. Regulation D is where the most commonly used exemptions are found.

The most frequently used rule under Regulation D is Rule 506 that allows unlimited amount of securities to be issued to an unlimited number of accredited investors AND up to 35 sophisticated non-accredited investors. See description of Rule 506 here. Accredited investors’ definition includes individuals who have (i) a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase (not including the value of the primary residence); or (ii) income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000 for those years) and a reasonable expectation of such income level in the current year. If the founders’ friends and family members who are willing to invest are all accredited investors, then the compliance is quite simple: there is no need for extensive disclosure, although some disclosure is still recommended. The offering then must be conducted without general solicitation or advertising; issued securities are restricted, and the company must file a Form D with the SEC within 15 days of the first sale of securities.

If, however, not all of the investors are accredited, founders need to provide more disclosure to the investors, including a full-blown private placement memorandum, risk factors and financial statements. Also, note that all non-accredited investors in a Rule 506 offering must be sophisticated, which means that the company must reasonably believe that non-accredited investors (either alone or together with their investment representatives) have sufficient financial and business knowledge to allow them to evaluate the risks and merits of an investment. Regulation of Rule 506 offerings is preempted by federal laws. States can generally only require a notice and a filing fee but cannot impose their own regulations. Most states ask for a copy of Form D (which the companies have to file with the SEC within 15 days of the offering) and a fee (typically, about $300). Of course, regulation varies by state, and about five states require pre-filing.

The problem arises when the founders’ friends and family members are not accredited and not sophisticated. What can startup founders do then?

They can resort to Rule 504 of Regulation D that allows to raise up to $1 million from non-accredited and non-sophisticated investors. Compliance with Rule 504 is more difficult, it involves preparation of complex and costly disclosure statements. Unlike Rule 506 offerings, state securities laws regulate Rule 504 offerings and the amount and type of disclosure that needs to be provided.

Many securities lawyers will not represent a company that is conducting an offering of securities to non-accredited investors because of the high risks involved. Some professional investors will not invest if the company has non-accredited investors. If challenged, the offering will raise problems when the company is conducting a round of VC financing, being sold, or is doing an IPO. At the IPO process, the Securities and Exchange Commission will study all prior equity issuances by the company and ask the company to cure any deficiencies or violations of securities laws, which can delay or even kill the IPO.

In conclusion, it is advisable that founders obtain their friends & family financing only from accredited investors. Although raising funds from non-accredited and non-sophisticated investors is possible, risks involved in dealing with such investors often outweigh the benefits of receiving such funding.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.