Friday, August 22, 2014

New Seed Financing Documents (500 Startups and Y Combinator)

The startup industry keeps on coming up with new innovative solutions to seed financing.  The latest trend is convertible equity.  Two startup venture funds and incubators, 500 Startups and Y Combinator, recently released their versions of convertible equity documents.


In 2013, Y Combinator, a well-known seed incubator and venture fund, released its own version of equity securities that it refers to as SAFE (simple agreement for future equity).

Benefits of SAFE

SAFE securities are not convertible notes because they don't have the common features of debt instruments: maturity and interest rate.  This means that there is no debt on the startup's balance sheet.  Since this investment does not mature, it removes the risk of startup insolvency in the case of non-repayment and non-conversion into equity.  Terms are simple, with valuation cap being the only negotiated item.  By investing in a SAFE security, the investor gives money to the startup in exchange for a promise to receive preferred stock in the event of future equity financing.  There is no deadline and there is typically no minimum size of equity financing.  SAFE securities terminate either at IPO or change of control or conversion into equity.

Different Types of SAFE Securities

There are essentially four types of SAFE securities proposed by Y Combinator.

1.  SAFE with a cap and a discount.
2.  SAFE with a discount, but no cap.
3.  SAFE with a cap, but no discount.
4.  SAFE without a cap or a discount, but with an MFN provision, which says that if the company were to issue another SAFE with more favorable terms, this SAFE documents will be amended to benefit from similar terms.  However, there is no automatic conversion into equity unless the amount of equity financing is at least $250,000.

SAFE securities are designed to protect the investor in the case if the startup valuation decreases in time for that equity financing.  So, if the SAFE valuation happens to be higher than the valuation at the time of a priced equity round, then SAFE converts into the preferred stock at the same lower valuation of the preferred stock.  If the SAFE valuation is lower than the valuation of the company right before the equity financing, then the holder of SAFE securities gets shares of preferred stock calculated using its own valuation cap, not the higher valuation of the equity financing.  Then, SAFE securities convert into a Series SAFE preferred (also referred to as "shadow preferred" or "sub-series preferred", which has the same features as the preferred stock that the company is issuing except for the conversion price, liquidation preference (which still equals to the original investment amount into SAFE securities) and dividend rate.  In the event of the company sale, the SAFE security holders get a choice of either converting its securities into shares of common stock based on its valuation cap, or having the investment returned.


However, investors may still feel weary of using SAFE equity or other convertible equity structures because they are too favorable to the companies.  There is just too little protection for the investors in the event that the company fails to raise any equity financing.  There is no maturity and no interest rate, so it is not possible for the investors to declare default.


On July 3, 2014, a well-known business incubator and fund 500 Startups released its own deal documents named KISS (keep it simple security) for convertible debt and convertible equity financings developed in collaboration with Gunderson Dettmer.

KISS Convertible Debt

I personally like their convertible note document.  It is clear and simple, and has no surprising terms.  Its maturity is 18 months, and the notes accrue interest at 5% that can be paid by the Company in cash.  It provides for an automatic conversion to preferred stock if the company raises a qualifying priced round ($1 million).  Conversion occurs at the lesser of a cap and a discount.  At a change of control event, investors have an option of either cashing out at a multiple of 2X or converting into common stock at the cap.  I particularly like that the KISS convertible note agreement addresses what happens at maturity in case of non-payment.  It provides for an option to convert into a newly created series seed shares using model documentation or explore other options (for example, extension of maturity).  This is not mandatory and is decided by the majority of note holders.  All KISS investors receive an MFN treatment and major investors (those who invested more than $50,000) receive basic information and participation rights.  

KISS Convertible Equity

KISS Equity securities have no interest rate (company-friendly feature) BUT have a maturity date of 18 months.  Just like the KISS convertible notes, they automatically convert into equity at the next round of equity financing but only if the financing is for $1 million or more (unlike SAFE securities that do not have a minimum financing amount unless this is SAFE with the MFN clause).  KISS Equity securities have both the discount and the valuation cap, and convert at the lesser of the two.  SAFE, on the other hand, has options in terms of how to structure the security (cap and discount or either cap or discount or none of the above but with an MFN treatment).  Treatment of KISS Equity in the case of a change in control or at maturity is the same as KISS Debt.  Like with convertible debt, the convertible equity securities offer the same MFN protection and major investors receive additional information and participation rights.  The convertible equity securities are treated on pari passu with other KISS securities and convertible debt securities, including in terms of repayment.

So, as far as I can see, the main difference between KISS Equity and KISS Debt is that KISS Equity securities do not have an interest rate.  Is it sufficient to treat these securities as "equity"?


In conclusion, I would like to thank 500 Startups for developing a solid convertible debt purchase agreement.  I would definitely resort to it in the future. However, as of now, I am unlikely to recommend to my clients to use convertible equity structures, although it is good to know that this option exists.

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.

Unregistered IPOs of Bitcoin Companies Do Not Go Unnoticed By the SEC

As I previously discussed in my blog here, the SEC does not have a mandate to regulate Bitcoin. Not unless it is used in a securities offering, especially in an unregistered initial public offering conducted over the Internet in violation of the securities laws. As Andrew J. Ceresney, director of the SEC's Division of Enforcement said, "We will continue to focus on enforcing our rules and regulations as they apply to digital currencies."

This was the case when the SEC issued a cease-and-desist order on June 3, 2014 against Erik T. Voorhees, a 29-year old Bitcoin activist, for "publicly offering shares in the two [Bitcoin-related] ventures without registering them."  The SEC's press release is here.

What Mr. Voorhees did was pretty straight forward: he published prospectuses on the Internet and solicited the general public to buy shares of his online ventures, SatoshiDICE and FeedZeBirds.  The only problem was that Mr. Voorhees neglected to register the offerings with the SEC or conduct them in compliance with an available exemption from registration.  It looks like Mr. Voorhees never bothered with retaining a securities lawyer (or any corporate lawyer for that matter) to advise him.  I used to give a talk to the entrepreneurs awhile back, listing the top ten legal mistakes that many of them make.  Conducting a securities offering without even realizing it was #8 on my list.  It appears that Mr. Voorhees did just that.

The first unregistered offering took place in May 2012, when FeedZeBirds issued 30,000 shares in exchange for 2,600 bitcoins.  The price per bitcoin was around $5 back then, so overall he received $15,000.  FeedZeBirds promised to pay bitcoins to Twitter users who would forward its sponsored text messages. The shares of FeedZeBirds were listed on an entity known as the Global Bitcoin Stock Exchange, which operated the Bitcoin stock exchange.  Although Mr. Voorhees published a prospectus for this offering, it was never filed with the SEC.  Mr. Voorhees also engaged in general solicitation to sell the FeedZeBirds shares over the Internet (on website BitcoinForum, Facebook and other Bitcoin-related websites).

Then, SatoshiDICE sold 13 million shares for 50,600 bitcoins ($722,659 in total) in offerings conducted from August 2012 through February 2013.  SatoshiDICE was a gaming site that paid winnings in bitcoins.  The shares of SatoshiDICE were listed on MPEx, a Bitcoin trading platform based in Romania.  Mr. Voorhees issued a prospectus for these offerings, and it was broadly disseminated over the Internet.  Mr. Voorhees again engaged in general solicitation by advertising the offering on various websites.  However, in July 2013, Mr. Voorhees announced that SatishiDICE was being sold, and that prior to the sale it would buy back all outstanding shares from investors.  Given that the exchange ratio between Bitcoin and USD had significantly appreciated, the repurchase price that was offered was at 277% premium over the original share sale price.  So, investors who in aggregate invested $722,659 just a year or so before were paid back approximately $3.8 million.  Not a bad return.

As a penalty for violating securities laws, Mr. Voorhees agreed to pay back $15,000 from the FeedZeBirds offering and a fine of $35,000.  In addition, he agreed not to participate n any issuance of any security in an unregistered transaction in exchange for any virtual currency including Bitcoin for five years.

According to the new rule 506(d) that I described here, the entry of the SEC cease-and-desist order makes Mr. Voorhees a "bad actor" and disqualifies him from relying on Rule 506(b) and 506(c) of Regulation D.  That, in my opinion, is worse than the financial penalties as it prevents Mr. Voorhees from participating in any Rule 506 private placement for at least a year.

In conclusion, it is clear that the SEC is paying particular attention to the investment funds or ventures that involve Bitcoin or other virtual currencies.  Only last year, the SEC  charged Trendon Shavers with defrauding investors in a Bitcoin-related Ponzi scheme.  I wrote about it here.  Founders of Bitcoin-related enterprises should be aware of this attention, and should make sure that they are in full compliance with the U.S. federal securities laws.

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.

Wednesday, August 6, 2014

Crowdfunding Right Now (Fund Model, Broker-Dealer Model, Lending Platforms and Intrastate Offerings)

We are still waiting for the SEC to issue final rules with respect to the Title III crowdfunding that will allow the U.S. companies to issue up to $1 million in securities to non-accredited investors through the online funding portals. So, while we are all waiting, crowdfunding in the U.S. is alive and happening. And I am not talking here about rewards-based crowdfunding like campaigns on Kickstarter. I am referring to the equity / debt crowdfunding.

In the U.S., it is currently being done in several different ways. Here is a short summary of each.

Crowdfunding through the accredited investor portals: the fund model

This crowdfunding model came out of the two no-action letters: the AngelList LLC and the FundersClub Inc., both issued in March 2013. I previously wrote about them here. Essentially, both are online platforms that aim to invest accredited investors’ money in the startup companies. However, they do so indirectly. Each aims to pool investors’ money into a separate investment fund that in turn invests into the startup. A new fund is formed for each investment. Accredited investors become members (or limited partners) of the fund in a Rule 506(b) offering. Only accredited investors can participate in these types of offerings. Both FundersClub and AnglelList operate as investment advisers, which means that they either have to register with the SEC as such or comply with an available exemption. They receive carried interest (a share of profits distributed at the termination of an investment) from their funds. However, since they are not broker-dealers, they cannot accept any transaction-based fees.

Crowdfunding through the accredited investor portals: the broker-dealer model

Alternatively, funding portals can partner with registered broker-dealers in order to be able to receive transaction-based compensation (a percentage of the total offering proceeds). A good example is CircleUp Network, Inc. CircleUp itself is an online portal, but all securities-related activities are conducted through Fundme Securities LLC, a wholly owned subsidiary of CircleUp Network, Inc., which is a registered broker-dealer and a member of FINRA/SIPC.  In this model, securities of the startup itself, not the fund, are sold to accredited investors in a Rule 506 offering. This crowdfunding model can be used for any type of startup, irrespective of its industry. However, this model has its challenges, beginning with the need to find an interested broker-dealer and having to compete with the more established platforms and broker-dealers.

Lending platforms

LendingClub Corporation and Prosper Marketplace, Inc. have adopted a different crowdfunding model, that of the peer-to-peer lending. Each company is an online platform that enables individuals to borrow up to $35,000 from a large number of lenders each of whom commits only a very small amount. These platforms have been tremendously successful. However, these offerings are not exempt from registration with the SEC. Each platform has filed a registration statement on Form S-1 that allows them to engage in a continuous offering to the general public .  The LendingClub investors do not invest directly in loans (the minimum investment is only $25) but instead purchase Member Dependent Notes from LendingClub.  Loans are issued by WebBank, an FDIC insured Utah-chartered bank, that then assigns the loans to the LendingClub in exchange for money received from the investors.  The platforms earn a transaction-based fee on each loan as well as servicing fees while payment are made on the loans.

Crowdfunding within a single state (intrastate offerings)

It is permissible under Section 3(a)(11) and Rule 147 of the Securities Act to conduct an offering of securities to the general public that is not registered with the SEC so long as the securities are only offered to the residents of a single state by an issuer that is registered and doing business in that state.  These exemptions were available even before the JOBS Act.  However, now these exemptions are being actively used by intrastate crowdfunding portals.  All intrastate offerings must comply with the applicable state registration and offering requirements (which vary from state to state).

On April 11, 2014, the SEC issued new Compliance and Disclosure Interpretations ("CDIs") relating to intrastate securities offerings made pursuant to Rule Section 3(a)(11) and Rule 147 of the Securities Act.  The new CDIs provided guidance and clarification with respect to the recent numerous state crowdfunding exemptions that are rapidly increasing in number.  One aspect in particular was previously unclear: how and whether the use of general solicitation and advertising, including social media and online crowdfunding portals, in intrastate offerings could be reconciled with the requirement that offers only be made to persons resident in the issuer's home state.  You can find a good analysis of the new CDIs here.

According to this blog, as of June 2014, 12 states (Alabama, Colorado, Georgia, Idaho, Indiana, Kansas, Maine, Maryland, Michigan, Minnesota, Tennessee, Washington and Wisconsin) have intrastate crowdfunding exemptions in place and 14 states (Alaska, Arkansas, California, Connecticut, Florida, Illinois, Missouri, North Carolina, New Jersey, Pennsylvania, South Carolina, Texas, Utah and Virginia) are in various stages of enacting/considering sponsored legislation regarding such intrastate crowdfunding.

It may, in fact, be easier for the companies to comply with such intrastate requirements than to comply with the much expected crowdfunding rules. The disadvantages of such offerings include (i) the fact that the offers can only be made to made to residents of a single state; (ii) resales to out-of-state residents are restricted; (iii) if the offerings are subject to that state’s regulatory approval, if such approval is not obtained, the offering will never take place.

In conclusion, I find that the crowdfunding industry is not waiting in one place for the enactment of the SEC rules relating to Title III of the JOBS Act.  The crowdfunding is already taking place now, whether it is done through a broker-dealer portal, as a lending platform or in instrastate offerings.

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.