Wednesday, November 9, 2016

FundersClub book: Understanding Startup Investments

Just recently, FundersClub, an online venture capital portal open to accredited investors, published a guide on startup investments. The guide is available online at their education center.  It's a great quick read for first time investors and startup founders who are raising capital for the first time.  The guide focuses on common vs preferred equity, SAFEs and convertible notes, - the instruments used to invest into early-stage startups.  To me (and many other lawyers, I am sure) FundersClub is best known as the author of a famous SEC no-action letter  from March 2013 that clarified the SEC's position on activities that did not require broker-dealer registration.

The guide is written in an easy-to-read language and is divided into five chapters. Below are several valuable lessons (but I encourage to read the entire guide):
  • Typically, seed and early-stage investors invest into SAFEs or convertible debt, and investors into later-stage startups (Series A or later) invest into preferred stock in priced rounds.
  • VC investments are not just about the money; they are also about the much needed connections and advice.
  • Convertible debt investors are not really giving a loan to the company, - they are effectively buying a percentage of the company's equity.
  • The concept of "total outstanding equity" of the company also includes shares issuable upon conversion of all convertible securities issued by the company, as well as outstanding options given to employees.
  • Founders typically hold common stock, investors - preferred stock, and employees - options that give them the right to purchase shares of common stock.
  • Preferred stock has a liquidation preference, - i.e., these investors get paid first if a liquidation event occurs (such as acquisition or bankruptcy). Preferred stock holders also typically get pro rata and anti-dilution rights.
  • Founders and investors nowadays typically agree on a broad or narrow-based-weighted-average anti-dilution rights rather than the full ratchet anti-dilution formula because they protect the investors while not excessively diluting common shareholders.
  • Convertible securities used in startup investing can be either convertible debt or convertible equity (SAFE - invention of Y Combinator, or KISS - invention of 500 Startups).
  • Startups prefer to issue convertible securities if they are not ready to establish a valuation.  Also, convertible securities deals are cheaper to execute.  
  • SAFEs differ from convertible debt in that there is no maturity date or interest rate, but caps, discounts, and conversion upon next qualified financing are still there (although caps and discounts are optional).
While FundersClub guide is a great read for the first timers, for an in-depth study of these topics, I recommend checking out the following two sources: the blog Startup Company Lawyer  and the book titled "Venture Deals" (note that a new edition of this book is coming out soon).

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 corporate, securities, and intellectual property law. 

Saturday, November 5, 2016

Innovation among crowdfunding portals: a PBC that accepts Bitcoin

Innovation in crowdfunding space continues, and I would like to report on two interesting developments.  Both have to do with the crowdfunding portal WeFunder, currently the largest Regulation Crowdfunding portal in the U.S.

First, WeFunder now accepts Bitcoin.  In the announcement in late October, WeFunder explained that the goal is "to make investments easier and cheaper" and to enable investors "to send money from outside the U.S. to bypass having to invest using an international wire transfer."  As confidence in Bitcoin increases, this development can truly facilitate cross border investments and further globalize the investment markets.  Let's see if other portals will follow.   WeFunder is working with BitPay and Silvergate Bank to facilitate this process, and has already had over $50,000 worth of Bicoin come in.

Second, WeFunder is now a public benefit corporation.  Here is an article about it.  WeFunder is the first registered Regulation Crowdfunding portal to do so, but not the first crowdfunding portal all together.  Kickstarter became a PBC in 2015.  WeFunder's charter states that they "aim to increase economic growth and lower wealth disparity, by sharing the rewards of capitalism more broadly, and destroying the barriers that reduce social mobility."  Among its commitments, WeFunder will donate 5% of its profits to programs that mentor more first-time entrepreneurs.  WeFunder is still a for-profit corporation, but now its directors must consider the corporation's public benefit purpose along with its regular corporate goal of generating profit, and report to shareholders regarding its progress in achieving the public benefit purpose.  I previously wrote about Delaware PBC's here.  

Now, a quick update regarding the status of crowdfunding offerings.  According to WeFunder status update, as of November 5, 2016, investors invested $11,782,334 in Regulation CF offerings (that is since May 16, 2016).  So far, there have been 49 successful offerings that reached the minimum funding targets.  Most of the offerings were conducted through WeFunder (34), followed by StartEngine (5) and NextSeed (6).  A total of 13,999 investments have been made.  Three companies raised the maximum of $1 million.

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 corporate, securities, and intellectual property law.

Wednesday, November 2, 2016

Intrastate Offerings Made Easy

Last week, the Securities and Exchange Commission (the "SEC") made an important step towards facilitating intrastate securities offerings.  Up until now, the intrastate securities offerings had to rely on Section 3(a)(11) and Rule 147 that was developed by the SEC in 1974 as a safe harbor for Section 3(a)(11) exemption.  This federal level exemption applied to the securities offerings  to persons resident in a single state, provided that the issuer of such securities was formed in, was a resident of, and was doing business within, such state.  The exemption was not widely used because many companies are registered in Delaware even though they are doing business in other states.

The SEC "modernized" Rule 147 while keeping it consistent with the requirements of Section 3(a)(11) exemption.  The final rules can be found here. The issuer is still required to be incorporated or organized in that state, have its principal place of business there, and be doing business within that state.  Offerings can only be made to residents of that state or to those who the issuer reasonably believes are residents of that state.  Obtaining a written representation regarding the residency is not sufficient to establish a reasonable belief.  The SEC is leaving it up to the issuers to determine which verification method to use in addition to the representation.

Amended Rule 147 will vary from the new Rule 147A only in two provisions: Rule 147 limits offers to in-state residents (i.e., no general solicitation allowed here) and issuers must be formed in the state where they conduct the intrastate offering.

The new Rule 147A is not a safe harbor for exemption under Section 3(a)(11).  It is a separate exemption from Section 5 registration requirements.  It allows the use of general solicitation and advertising (for example, it will be permissible to announce the intrastate offering on the company's website and therefore make offers to out of state residents) so long as the following requirements are met:

  • The issuer must be resident of the state (have its principal place of business in that state).  Note that it is no longer required that the issuer be formed in that state, which will enable more companies to rely on intrastate offerings to raise capital.
  • The issuer is doing business within the state (need to satisfy one of the four well-defined tests).
  • As opposed to offers, the actual sales of securities can only made to residents of that state (same reasonable belief standard as in Rule 147)
  • There is a six month restriction on resale of securities into other states.

The ability to use a whole array of advertising options, including online advertising, in Rule 147A offerings will facilitate state-based crowdfunding offerings that rely heavily on online platforms.

If companies rely on either Rule 147 or 147A, they still need to comply with the state blue sky laws.  However, they do not need to file Form D with the SEC. Rule 147 or 147A do not impose any restriction with respect to "accredited" or "sophisticated" status of investors (but states may do so).  Investors will continue to count for the purposes of Section 12(g) (it requires the issuer to register its securities with the SEC if its assets exceed $10 million and that class of securities is held by either 2,000 persons or 500 non-accredited investors). Some investors (Tier 2 offerings and Regulation Crowdfunding) do not count towards the totals.

Additionally (and importantly), the SEC revised Rule 504 of Regulation D (another private placement exemption that is rarely used) to increase the offering limit from $1 million to $5 million and applied bad actor disqualification provisions of Rule 506(d) to Rule 504 offerings.  It also repealed Rule 505 of Regulation D.

Amended Rule 147 and the new Rule 147A will be effective at the end of March 2017 (150 days from the publication in the Federal Register), and the amendments to Rule 504 will be effective in about two months (60 days after the publication in the Federal Register).

In conclusion, I'd like to note that these are exciting changes that will lead to an increase in intrastate crowdfunding offerings.  There are already a number of existing exemptions that startups and small businesses can use to raise capital.  These include Rule 147 under Section 3(a)(11) (and soon the new Rule 147A), Section 4(a)(2) for "transactions by the issuer not involving a public offering", Regulation A, Section 4(a)(6) for the Regulation Crowdfunding offerings, and finally Rules 504, 505 (for a little while longer), 506(b) and 506(c) of Regulation D.  Each exemption has its own limitations, and an experienced legal counsel can help you find the best suitable exemption for your company.

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 corporate, securities, and intellectual property law.

Friday, September 9, 2016

Title III Crowdfunding Update

I recently listened to a webinar regarding equity crowdfunding by the Angel Capital Association.  It was very informative, and I decided to share with you some insights.  You can listen to the full webinar here.  Here are their presentation slides.

After giving a helpful overview of the regulation, the speakers turned to the overview of the current crowdfunding landscape, about 3.5 months after the SEC rules regarding Title III crowdfunding became effective.  I found this to be the most informative part of the webinar.  Below is a brief summary.

The speakers mentioned that as of the end of August, 16 Title III crowdfunding portals were approved by FINRA.  Even though several of the portals are registered broker-dealers, the majority is not, and in fact have little operational experience in the crowdfunding space.  One of the portals, WeFunder, has been the portal of choice for about 92% of all money raised through Title III crowdfunding since May 16th (the effective date of the SEC rules).  Most of the existing crowdfunding platforms for accredited investors are still staying away from Title III crowdfunding until the market stabilizes.

In general, there was an expectation that there would be more Title III deals (like, 5-10 times more).  As of the end of August, only 22 companies had raised at least their minimum threshold amounts.  Most are local companies, not experienced in fundraising.  Many are in the food & beverage-related industry.

The fewer number of participants is not all that surprising given the high costs involved in raising the money through Title III crowdfunding campaigns, once you add all the marketing costs, platform fees, accounting costs, and the cost of preparing disclosure documents and other information.  Companies should also add $3,000-$5,000 ongoing yearly compliance once the offering ends.

As the Title III crowdfunding market develops and stabilizes, albeit slowly, we may see more crowdfunding regulation coming from Washington, where several legislative initiatives that aim at revising the final SEC rules are currently in the works.  

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 corporate, securities, and intellectual property law.

Thursday, August 25, 2016

Regulation Crowdfunding: Are You the Right Candidate for It?

As you all probably already know, in 2015 the Securities and Exchange Commission (or the SEC) adopted Regulation Crowdfunding to implement Title III of the Jumpstart Our Business Startups (JOBS) Act.  The Regulation Crowdfunding (or Regulation CF) became effective on May 16, 2016.  So, let's summarize the regulation and see how the Regulation Crowdfunding has been doing in its first three months of existence.

Offering Amount

Here is one of the most important (and limiting) limitations of offerings pursuant to Regulation CF: a company can raise only a maximum of $1 million in a 12-month period.  The good news is that this does not affect the amounts that the company can raise in other exempt (non-crowdfunding) offerings during that same 12-month period.  So, conducting a Rule 506(b) private placement to accredited investors and a Regulation CF offering at the same time is possible.

The Investors

The good news is that investors do not have to be accredited.  However, there are limits as to how much individual investors can invest.  They are:

  • if annual income or net worth is less than $100,000 - then $2,000 or 5% of the lesser of the investor's annual income or net worth; and  
  • if both annual income and net worth equals to or more than $100,000 - then 10% of the lesser of annual income or net worth.
In any 12-month period, an individual investor cannot invest more than $100,000 regardless of such person's annual income or net worth.  Spouses can calculate their net worth and annual income jointly.

The Portals

Each Regulation CF offering must be conducted exclusively through one of the funding portals registered with the SEC and FINRA.

The Issuers


First, let's talk about the issuers (i.e., the startup companies that can use this rule to raise money from the general public).  What type of companies can participate?  The Regulation tells us that certain companies cannot:
  • non-U.S. companies;
  • companies that are already public reporting companies;
  • certain investment companies;
  • companies that have been disqualified under the disqualification rules (see my earlier posts here and here)
  • companies that have already conducted an offering pursuant to Regulation CF and then failed to comply with the annual reporting requirements; and
  • companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company.

The issuers have to prepare and file an offering statement on Form C through the SEC's EDGAR system.  What information should be included in this offering statement?  Here is a list:
  • information about officers, directors, and owners of 20% or more;
  • a description of the company's business;
  • the use of proceeds of the offering;
  • the price to the public (or how the price is determined);
  • the target offering amount and the deadline to reach it;
  • whether the company will accept investments in excess of the target offering amount;
  • certain related-party transactions; and 
  • a discussion of the company's financial condition and financial statements.
The financial statements requirements depend on the amount offered and sold in reliance on Regulation CF in the preceding 12 months:
  • if no more than $100,000: financial statements of the issuer and certain information from the issuer's federal tax returns, both certified by the principal executive officer (unless CPA-audited or reviewed statements are available);
  • if more than $100,000 but no more than $500,000: financial statements reviewed by an independent public accountant (unless audited statements are available);
  • if more than $500,000: financial statements reviewed by an independent public accountant.
While the offering is ongoing, the issuer will need to amend Form C to disclose any material changes or updates (and then re-confirm all commitments).

The issuer may also need to file Form C-U to update on the progress towards meeting the target offering amount, unless the portal provides frequent updates.

Then comes an obligation to provide annual reports on Form C-AR on a yearly basis and post those on the website until one of the following takes place:
  • the issuer becomes a public company;
  • the issuer has filed at least one annual report and has fewer than 300 holders of record;
  • the issuer has filed at least three reports and has less than $10 million in total assets;
  • the issuer or another party purchases or repurchases all of the securities issued pursuant to the Regulation CF, or
  • the issuer liquidates or dissolves in accordance with state law.
These are onerous requirements that can become quite costly in terms of legal fees.  Fortunately, some portals assist companies with preparation of Forms C. There is also iDisclose, an exciting young company founded by lawyers, that can expertly generate for you a Form C (or a PPM, if needed). iDisclose actually works with SeedInvest, Republic, and several other portals on preparing Forms C for their crowdfunding clients.

Advertising, Communication, and Promoters

The company engaged in Regulation CF crowdfunding may not advertise, but it is allowed to provide factual information.  It can only post a notice directing prospective investors to the portal's platform.  The notice can include the following:
  • a statement that the issuer is conducting a Regulation CF offering;
  • the name of the portal it is using and a link to it;
  • the terms of the offering (amount, terms of the securities, price, closing date); and
  • information about the legal entity and business location of the issuer and a brief description of the business.
The issuer can communicate with investors and prospective investors through communication channels provided by the portal.  Of course, it doesn't mean that the company cannot talk to anyone at all outside of the portal.  The company representatives can still attend conferences and talk to prospective investors.  But they need to limit the information they give to the four points listed above, and avoid statements such as "my ... doughnuts ... are the best doughnuts in the world."

The issuer may compensate others to promote its offering through the portal, but needs to make sure that the promoter clearly discloses the compensation with each communication.

Need a Transfer Agent

When conducting a Regulation CF offering, companies should engage a transfer agent.  Here is why.  There is Section 12(g) of the Exchange Act that says that every issuer with total assets of more than $10 million and over 2,000 record holders of its securities (or 500 not accredited) must register that class of securities with the SEC.  There is an exemption.  Securities issued pursuant to Regulation CF are exempt from the holder count so long as the following criteria are met:
  • the issuer files its annual reports on Form C-AR on time;
  • it has less $25 million or less in total assets; and 
  • ***it has engaged the services of a transfer agent registered with the SEC.
Current Practice

According to Stratifund, in just one week after the Title III crowdfunding became available on May 16, 2016:
  • $21 million: Amount startups are seeking to raise
  • $1 million: Amount invested in startups in week 1
  • 32: Startups launched their campaigns.
As of August 24, 2016, 88 Form Cs (offering statements) have been filed with the SEC which means that 88 Regulation CF campaigns have been launched. Some of the Regulation CF funding portals are NextSeed, Wefunder, SeedInvest, FlashFunders, StartEngine, TruCrowd, and Republic.

The securities offered are all over the spectrum: debt, revenue sharing, SAFE, preferred stock, LLC units, convertible debt, and common stock.  Some portals have been developing new forms of securities that are specifically geared towards Regulation CF offerings (in an attempt to address the main problem: managing a large number of small shareholders).

Let's take a look at NextSeed, a crowdfunding portal in Texas.  It actually has two portals: one for Regulation CF projects, and another one registered with the Texas State Securities Boards that conducts intra state offerings.  Revenue sharing seems to be the preferred method of crowdfunding financing at NextSeed.  According to their disclaimer, NextSeed assists small businesses issue debt securities in the form of term notes, revenue sharing notes, and other debt products.

Here is one of the funded campaigns that closed on August 23, 2016: the Brewer's Table.  The minimum investment is $100, and there is no limit for accredited investors.  There are 190 investors and the company raised $300,000. The company is a Texas LLC, and is offering revenue sharing notes.  Investors will not receive equity in the company.  Following a startup up period of 5 months, investors will start receiving 5.25% of each month's gross revenue, distributed pro rata among them, up until each investor receives 1.5x their original investment.  If the investors have not been paid in full in 40 months, the company is required to promptly pay the entire outstanding balance.  The note is secured with the company's assets.

Let's now turn to WeFunder.  This portal suggests that Wefunder companies consider offering one of four types of securities specifically developed by them for Regulation CF offerings: WeFunder SAFEs, promissory notes (with or without discount or valuation cap), revenue loan agreement, and investor perks agreements (that can be combined with one of the other three types of offerings). All documents are available on their website free of charge.  For Regulation CF offerings, Wefunder charges investors up to 2% of their investment and the company up to 3% of their total funding volume.

Here is Hawaii Cider Company that is currently doing a raise on WeFunder.  The company is offering a SAFE with a $7 million valuation cap and a 10% discount with some additional interesting features. The company is also offering various investor perks based on investment amount.

On SeedInvest's website,  you can find ongoing offerings in three categories: Regulation CF offerings made through their SI Portal, Regulation A offerings, and offerings open to accredited investors only (need to log in first).  SI Portal receives cash compensation equal to 5% of the value of the securities sold and equity compensation equal to 5% of the number of securities sold.  At this time, there are only two companies raising money through SI Portal, both offering preferred stock.  


There can be no conclusion to this blog post.  The field of Regulation CF is rapidly developing, changing, adapting, and growing.  It is exciting to see some small businesses getting funded, and small investors finally being able to participate in the start-up community.  Let's keep on watching, learning, and investing!

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 corporate, securities, and intellectual property law.

Tuesday, March 8, 2016

Electronic Signatures: OK to Use?

This blog post focuses on the use and validity of electronic signatures. We will first investigate what constitutes an "electronic signature", we will then discuss the validity and enforceability of electronic signatures, and finally, we will talk about the risk involved with unauthorized use of electronic signatures and how to minimize it.

What are "electronic signatures"?

The federal law titled the Electronic Signatures in Global and National Commerce Act (also called ESIGN Act) defines an electronic signature as “an electronic sound, symbol, or process attached to or logically associated with an electronic record and executed or adopted by a person with intent to sign the record.” This broad definition allows flexibility in what may be considered an electronic signature and permits individuals and businesses to use different types of technologies and methods to create valid and legal electronic signatures. Examples of electronic signatures include:
  • Keyboard characters entered in a specific order, such as a PIN number or a password;
  • Clicking a button or checking a box to agree to the terms shown on a screen, called a “click wrap” system;
  • Signing an electronic keypad; 
  • A graphical representation, image or a scan of a handwritten signature; or
  • Agreeing to terms described in an email that would suggest acceptance of terms in the email.
Another type of electronic signature is a digital signature, which uses technology called a Public Key Infrastructure (PKI) to make a unique pattern that is coded into an electronic document. This acts as an identifier that is unique to the signer to guarantee identity, intent, and integrity of the document for verification purposes. Because of this technology, the digital signature is more secure than the traditional types of electronic signatures.

In the current environment where many communicate through email, the laws of electronic signatures also apply to email. A person can make enforceable agreements through email if the email contains the important and material terms of the agreement and clearly shows that both parties intended to agree to the terms set forth in the email. In this case, the electronic signature can come in the form of the signer’s name at the end of the email, though courts have found that automatic signature blocks at the end of an email are not sufficient for an electronic signature. In order to have a valid electronic signature in an email, the signature should show that the person manually entered the name with the intent to agree and sign. Suggested signatures in an email include:
  • Preceding or including a unique character in addition to the signer’s name, such as “/s/”;
  • Using a unique method of entering the signer’s name, such a cursive font or script; or
  • Using a graphical representation or image of the signer’s name.
Are “electronic signatures” valid?

The ESIGN Act protects the validity and enforceability of signatures made electronically. According to the ESIGN Act:
  1. a signature, contract, or other record relating to such transaction may not be denied legal effect, validity, or enforceability solely because it is in electronic form; and 
  2. a contract relating to such transaction may not be denied legal effect, validity, or enforceability solely because an electronic signature or electronic record was used in its formation. 
The ESIGN Act does not apply to certain transactions, which include:
  • Wills, trusts, and codicils;
  • Family matters, such as adoption and divorce; 
  • Most of the transactions covered by the Uniform Commercial Code; however, other statutes that relate to transactions under the Uniform Commercial Code allow electronic signatures for transactions that are exempt from the ESIGN Act; 
  • Notices of default, foreclosure or eviction; 
  • Termination of utility services; 
  • Termination of health or life insurance; 
  • Product recalls; and 
  • Documents related to the transportation of hazardous materials. 
The ESIGN Act does not require a person to use or accept electronic signatures if the parties prefer traditional methods of signatures. This means that there must be consent from the parties to enter into the transaction through electronic means. Consent can be explicit (such as a clear indication in writing that the parties intend to enter into the transaction through electronic methods) or implicit (such as a signer frequently accessing a website or repeatedly communicating through email and the terms of the agreement are set forth in the email – a one-time email may not be sufficient).

Unauthorized use of electronic signatures

Now, let’s discuss the legal consequences of somebody else using a person's electronic signature without authorization.  There is a risk that such person will be held liable even if hedid not authorize the use of the image containing his electronic signature.  However, there are ways to minimize this risk.  Remember that the ESIGN Act requires the signer to have “intent to sign the record.”  So, whoever signs electronically, should be able to confirm his identity and the “intent to sign.”  If a person's electronic signature was used without authorization, then such person should be able to prove the opposite: that it was not him who signed and that he did not have any intent to sign that particular document.  How to prove that?  Below are several suggestions:
  • Set up procedures to protect and limit access to your e-signature (PINs, passwords, restricted access);
  • Consider using a digital signature with PKI technology;
  • If an email is used, then always keep email trail that shows who had access to your e-signature; and
  • Keep records of computer systems that link computers and IP addresses to show who may have accessed the image or sent the agreement with the image.
Since the ESIGN Act requires “intent to sign the record,” any evidence that shows lack of intent helps the signer avoid liability in the event of unauthorized use of the image.

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 corporate, securities, and intellectual property law.

Wednesday, February 24, 2016

Winter 2016: raising funds may become more difficult for some startups

I attended several VC events in New York City recently, including Ask a VC forum on February 4, organized by DLA Piper, and the VC Summit on January 26, organized by Gotham Media.  I learned some interesting insights, which may be useful for those startup founders looking to raise capital now.

Current investment climate.  Everybody noted that the current investment climate has changed. VCs who participated in the panel discussions all agreed that the valuations have come down (some said "a bit" and others said "aggressively"), and that it now takes longer for companies to raise their first round of capital. Recent posts by Brad Feld and Mark Suster confirm that. As Mark said: "The startup industry may be “resetting,” which doesn’t mean a “crash” but rather just a resetting of valuations, timescales, winners/losers, capital sources and the relative emphasis of growth rates vs. burn rates." So, startups should perhaps re-think their valuations and allocate extra 1-2 months to raise the needed capital, stretching the capital raising efforts from 4 to about 6 months. Having said that, great startups will still get funded pretty quickly regardless of the current downturn.

How to find VCs that will fund you.  This has been talked about so much, that it is really no longer a mystery.  VCs will rarely fund companies that have emailed them at random.  VCs tend to consider only those companies that have been pre-filtered by a trusted referral source (other VCs, advisors, their portfolio companies, etc.).  VCs like to fund repeat entrepreneurs who have already successfully existed from at least one startup.  If you are not that, then you need to do your homework.  Select VCs that are likely to invest in your company (VCs that focus on your industry and  invest in seed rounds).  Read all you can about them.  Figure out which companies they've funded in the past.  Reach out to the portfolio companies founders, and see if you can get them to like you and your startup.  Then, they may introduce you to their VCs.  Also, do not despair if these introductions do not produce immediate funding results: establish connections with the VCs and keep in touch through regular updates. Funding from them may come at a later stage.

Angel investors vs VCs.  An interesting phenomenon has developed: the appearance of micro VCs (i.e., smaller venture capital firms that are focused on early stage financing).  In my experience, an average startup would first get funded up to $1 million by angel investors (wealthy, accredited individuals).  These may be family members and friends, or other accredited investors.  Angel investors don't typically get a seat on the board, or help out with industry expertise or connections (but I've seen exceptions).  Later stages of financing are typically handled by VCs.  Now, I see more VCs come in at the seed rounds, including convertible debt financings.  It is an overall positive development for the companies because VCs tend to invest in subsequent rounds as well, and have industry expertise and connections that may prove useful to the companies. Finally, VCs bring with them expertise in running a startup.  Of course, there are disadvantages as well (since VCs want board seats, there is always a danger that once they have control of the board, they may oust the founders).

How much money to raise in the seed round?  The rule of thumb seems to be: raise enough cash to last 18 months and give up 15-20% of your company in exchange.  Just remember to start your next fundraising campaign 4-6 months before you run out of money.

What are VCs looking for?  They are looking for a scalable business model.  VCs don't want beautiful power point slides or well-scripted presentations.  They want to see substance, such as a well-stated problem, the proposed solution, clear execution plan and milestones.  Also, be prepared to explain why you need this much money and how you plan to spend it.  During the presentation, the founders should be able to explain the whole business in 20 slides or less.

Finders.  Be careful about signing any agreements with finders (people who offer to make introductions to potential funding sources in exchange for a referral fee).  First, if they are not registered with the SEC, they may get themselves and your company into trouble.  I wrote about it here.  Second, VCs don't like to see their money going to pay somebody's referral fees.

In conclusion, please remember that only a small fraction of all startups gets funded by VCs at any stage of their development, and you need to prepare well for the fundraising campaign.  As for those who are not successful with the VCs: Regulation Crowdfunding, which becomes effective on May 16, 2016, will soon open more funding sources for startup companies.  More on this topic later.

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 corporate, securities, and intellectual property law.

Thursday, January 21, 2016

Why Companies Are Choosing to B Good: A Closer Look at Delaware Public Benefit Corporations

As of August 1, 2013, the Delaware Legislature added Subchapter XV to its Delaware General Corporation Law (“DGCL”) providing for the formation of a Public Benefit Corporation (“PBC”). As of now, 31 states (including the District of Columbia) have enacted similar statutes, with Maryland and Vermont leading the way by becoming the first states to do so in 2010.  You can check the status of benefit corporations in each state here. This blog, however, will focus only on Delaware PBCs. Delaware is home to over 1,000,000 corporations.  Approving a PBC entity structure in Delaware is an endorsement of corporate culture that aims to conduct business in a responsible and sustainable manner.

Similar to a regular corporation, a PBC is a for-profit corporation that, in addition to maximizing shareholder value, is committed to pursing a purpose that would create a public benefit. There are however key differences that set these two types of entities apart. This blog will discuss differences between the two entity structures and why this new corporate structure is so enticing to socially conscious entrepreneurs.

Formation and Purpose

In its certificate of incorporation, a PBC must identity itself as a public benefit corporation (that means that it is going to have “P.B.C.” or “PBC” at the end of the name rather than an "Inc.") and must list at least one public benefit that it intends to pursue.

Section 362 (b) of DGCL defines a public benefit as a “positive effect (or reduction of negative effects) on one or more categories of persons, entities, communities or interests (other than stockholders in their capacities as stockholders) including, but not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature.”

Responsibility and Reporting Requirements

Unlike in a traditional corporation, directors in a PBC must provide a biennial (once every two years) report to the shareholders describing the corporation’s promotion of the public benefit identified in its certificate of incorporation. The report has to include the objectives established by the board to promote the public benefit; the standards adopted by the board to measure the corporation's progress in promoting such public benefit; objective factual information based on those standards regarding the corporation's success in meeting its objectives; and finally an assessment of the corporation's success in meeting its objectives.

This requires taking additional corporate governance steps, including the development of clearly defined objectives and standards that can be measured and quantified in order to assess the corporation's success in meeting its public benefit goals.  

Fiduciary Duties

Directors owe fiduciary duties of care and loyalty to both the company and the shareholders. The duty of care requires directors to act in the same manner as a reasonably prudent person in their position would. The business judgment rule offers directors some protection in this category from any losses incurred under their watch as long as the decisions were made in good faith and with reasonable skill and prudence. The duty of loyalty is an affirmative duty to protect the interests of the corporation, and also an obligation to refrain from conduct which would injure the corporation and its shareholders such as self-dealing. 

A PBC's board duties are pretty much the same.  However, when making decisions, the directors are required to balance the "pecuniary interests of the stockholders, the best interests of those materially affected by the corporation's conduct, and the specific public benefit or public benefits identified in its certificate of incorporation." DGCL 365(a).

In a change of control situation, the business judgment rule standard of review applied to a regular corporation's board of directors is changed to that of enhanced scrutiny standard (remember the Unocal and Revlon decisions?) (Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985); Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. 506 A.2d 173 (Del. 1986)). At the time of a company sale or a takeover, directors are required to maximize the shareholders' value by seeking the highest price available. However, in a Delaware PBC, the board's duty to consider other constituencies and society as a whole does not go away in the context of a merger or a takeover. A Delaware PBC board cannot simply sell to the highest bidder. It needs to consider and which acquirer would be most suitable to continue furthering the corporation's public benefit purpose.

Benefit Corporation vs. B Corp Certification

Often used interchangeably, a PBC and a B corp should not be confused with one another. A PBC is a legal entity form (like an LLC or a corporation or a partnership), while a B Corp is a certification awarded by B Lab, a non-profit organization that serves the global movement of people using business as a force for good. In order to obtain the certification, the company must first become a benefit corporation in its home state. There is a strict process to become certified. Additionally, B Lab charges annual fees which are assessed on a sliding scale, starting at $500 for companies with revenues of less than $1 million to $50,000 for companies with revenues over $1 billion.  Etsy, Patagonia, Warby Parker, Plum Organics are all examples of companies that received certification as B corp companies.

Thinking of Converting?

A traditional corporation can easily be concerted to a PBC by filing an amendment to its certificate of incorporation with the DE Department of State. The amendment would require an approval of 90% of the outstanding shares of each class of stock (whether voting or nonvoting) of the corporation.  A merger or a consolidation with a domestic or foreign PBC also requires the same 90% vote.

Perhaps one of the largest recent converts from a traditional C corporation to a PBC (2015) is Kickstarter, PBC (formerly, Kickstarter, Inc.) Kickstarter, a crowdfunding platform, proudly lists their conversion on their website along with their mission statement “to help bring creative projects to life.”  Since its conversion, Kickstarter has received a lot of publicity regarding their new status and has been branded as one of the many companies that want to be apart of movement demonstrating they are not all about maximizing profits. Articles discussing their recent conversion to a benefit corporation can be found here and here.

Going Back

A two-thirds vote of the outstanding shares of each class of the PBC, whether voting or non-voting, is required to terminate the PBC status.  This makes it difficult for just one group within the corporation to decide to revert to a regular corporation status, unless supermajority of the corporation's shareholders also agree.

Is There Really a Downside?

This new entity type allows companies to legally use their resources to advance a public purpose that they believe in, while working towards increasing company revenue. How can there be a downside? Some say that small companies and start-ups choosing to register as benefit corporations may have harder time securing investors because benefit corporations may not always have the same returns as regular corporations.  However, this is changing. According to B Lab, many lead VC funds have invested into benefit corporations.  

Here is the list: Abundance Partners, Andreessen Horowitz, Baseline Ventures, Benchmark, Betaworks, Brand Foundry, Bullet Time Ventures, Capital, Freshtracks Capital, Claremont Creek Ventures, Collaborative Fund, CommonAngels Ventures, DBL Investors, Emerson Collective, First Round Capital, Forerunner Ventures, Formation|8, Founders Fund, Foundry Group, Generation Equity Investors, Good Capital, Greycroft Partners, Hallett Capital, Harrison Metal, Impact America Fund, Kapor Capital, Kortschak Investments, Learn Capital,Lighter Capital, Matrix Partners, New Enterprise Associates, New School Ventures, Omidyar Network, Pacific Community Ventures, Peterson Ventures, Prelude Ventures, Reach: New Schools Capital,Red Swan Ventures, Renewal Funds, Serious Change, SherpaVentures, Tekton Ventures,The Westly Group, Thrive Capital and Union Square Ventures.

Another disadvantage that a PBC must endure is their reporting requirement to the shareholders regarding whether or not the company is successfully working towards and fulfilling their public purpose. The good news here is that in Delaware, the reporting requirement is not as onerous as in several other states. Delaware PBCs are not required to (i) appoint a benefit director or officer; (ii) disclose the benefit report to the secretary of state; (iii) use a third party standard or assessment in connection with the report; (iv) prepare the report annually; or (v) consider the impact of every single corporate decision on a variety of stakeholders (shareholders, employees, customers, etc.).

So, being a benefit corporation may not be such a disadvantage after all.

Delaware PBC Act is flexible, and combined with the authority and weight of DGCL in general, may make a big shift in the US corporate culture towards a greater use of benefit corporations to conduct business. It just might pay to B good.

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 corporate, securities, and intellectual property law.

Wednesday, January 20, 2016

Potential Risks Companies Face When Engaging Unregistered Finders

When raising capital, some companies engage “finders” to make introductions to their substantial networks of potential investors. This sounds great so long as that finder also happens to be a broker registered with the Securities and Exchange Commission (the “SEC”). However, in practice not all finders are registered. Companies face some serious risks when engaging an unregistered finder. This blog’s purpose is to highlight the distinction between the two roles and explain the precise risks of using unregistered brokers.

Is the individual a broker?

The Securities Exchange Act of 1934 (the “Act”) defines a broker as any person engaged in the business of “effecting transactions in securities” for the account of others. “Effecting transactions” is broadly construed as soliciting, structuring, negotiating and/or executing securities transactions, identifying potential purchasers, handling money for someone else, or receiving transaction-based compensation.

Some examples of activity that may require registration as a broker-dealer include, but are not limited to:
  • Effecting securities transactions for the account of others for a fee or purchasing or selling securities at a regular place of business for the entity’s own account;
  • Operation of an electronic or other platform to trade securities;
  • Acting as a placement agent for the private placement of securities;
  • Acting as a finder of investors for issuers or the sale of securities;
  • Finding investors (even if in a “consultant” capacity) or customers for, making referrals to, or splitting commissions with registered broker-dealers;
  • Participating in a selling group or underwriting of securities, finding investment banking clients for registered broker-dealers;
  • Providing support services (such as clearing and settlement) to registered broker-dealers;
  • Finding investors for venture capital financings, including private placements;
  • Finding buyers and sellers of businesses where securities are involved; or
  • Advertising as a market maker or providing continuous quotes in securities.
The single most important factor in determining whether the person is acting in a broker capacity is the receipt of compensation tied to the success of the transaction. The SEC has made it clear that “a person’s receipt of transaction-based compensation in connection with these activities is a hallmark of broker-dealer activity.” We know this from the SEC’s no-action letters. A no-action letter is the SEC Staff’s response to a company’s inquiry. A no-action letter says that the SEC will not take an enforcement action against the company if it agrees with its interpretation of certain laws as they relate to that particular company’s actions. No-action letters are public, and other companies can refer to them as guidance. In one such relatively recent (2006) no-action letter, the SEC disagreed with the company’s position that the activity did not warrant broker registration. In that case, John W. Loofbourrow Associates, Inc. (“Loofbourrow”), a registered broker-dealer wanted to pay Eagle One Mortgage Solutions, Inc., (“Eagle”), an unregistered entity, a finder or referral fee for introducing potential investment banking clients to Loofbourrow. Eagle would (1) not be involved in structuring or placing the securities; (2) be limited to introducing the parties; (3) not be involved in any negotiations or make any recommendations; (4) not offer or sell any securities or solicit any offers to buy securities; and (5) not handle funds or securities. The fee paid to Eagle by Loofbourrow would be a commission-like arrangement tied to the ultimate size of the amount of securities offered, if and when Loofbourrow successfully placed the securities. (John W. Loofbourrow Associates, Inc. No-Action Letter (June 2006)). This no-action letter shows that the receipt of transaction-based compensation in connection with a securities transaction ALONE is enough to warrant registration.

Similarly, in a June 2007 no-action letter to Hallmark Capital Corp. (“HallCap”), the SEC stated that it appeared that HallCap would be required to register with the SEC as a broker-dealer. HallCap assisted small businesses with revenues under $25 million with their debt and equity capital needs. HallCap would prepare a confidential information summary describing the business, identifying broker-dealer firms that might be interested in working with the company, and arranging meetings leading to an engagement of the broker-dealer by the client company to raise capital. Once the broker-dealer was engaged, it had control of and oversight over all significant aspects of any securities transaction, including investor solicitation and execution of the transaction. HallCap was compensated with a modest upfront retainer and a fee based on the outcome of the transaction. (Hallmark Capital Corporation No-Action Letter (June 11, 2007).

Finder's Exception

There is a very very narrow exception from registration for individuals who merely act in the capacity of a “finder.” In deciding whether the person acted as a broker or a finder, the SEC typically looks at the totality of circumstances. The following questions typically get analyzed:
  • Does the individual receive transaction-based compensation, such as commissions or referral fees?
  • Does the individual engage in solicitation of potential investors?
  • Does the individual participate in the various aspects of a securities transaction, including solicitation, structuring advice, and negotiation? 
  • Is he or she an active rather than passive finder of investors? 
  • Is the individual otherwise engaged in the business of effecting securities transactions or was previously disciplined for such activity? and 
  • Does the individual handle securities or funds in connection with the transaction. 
If a company feels that, after reading all this, it still absolutely must engage an unregistered finder in connection with raising capital, then the following guidance might help avoid potential liability:

1. The finder should only be involved with making introductions to suitable, accredited investors.

2. The individual should not solicit or pre-screen any investors on behalf of the company.

3. The finder should also be sure to avoid any substantive discussions with any potential investors of your company.

4. The finder should not participate in any negotiations, discuss the value of the investment, handle any funds or securities involved with completing a transaction, or hold themselves out as providing any securities-related services.

5. The finder should also not assist an issuer or potential investor with the completion of any transaction.

6. The individual should avoid transaction-based compensation. Non-contingent fixed fee compensation may be acceptable but it should not be based on the success of the deal. The fee should be paid regardless of how the deal turns out.

7. The finder may perform ministerial function of facilitating the exchange of documents or information.

8. As an independent contractor, the finder should not have authority to speak on behalf of the company in any way.

Bad Things That Can Happen to the Company

There are many risks the company may face when engaging an unregistered finder.

1.  Rescission. Under Section 29(b) of the Act, contracts entered into in violation of the Act may be rendered void. Additionally, the company may also be violating state securities laws, and investors may again get rescission rights (i.e., they can demand their money back).

2.  Loss of Exemption from Registrations. The use of unregistered broker-dealer may cause the company to lose its exemption from the registration requirements of the Securities Act of 1933, and from applicable state laws. The SEC may issue a cease-and-desist order, seek civil money penalties, and even refer the matter to the attorney general for prosecution. In accordance with the bad actor disqualification provisions of Rule 506 of Regulation D adopted by the SEC in July 2013, an offering by an issuer would be disqualified if there was an SEC disciplinary order or a cease-and-desist order. This would be very damaging to the company’s reputation and ability to raise capital in the future.

3.  Risks relating to disclosure obligations. There is risk that a finder’s failure to disclose the fact that it is not registered as a broker-dealer could itself be characterized in regulatory enforcement proceedings or private litigation as the issuer's misleading omission that amounts to fraud on the issuer under Section 10b-5 of the Securities Act. This could prevent future investors from wanting to invest in the company and may prevent any legal counsel working on behalf of the company from issuing legal opinions in connection with a subsequent finding.

4.  Aiding and Abetting Liability. The issuer may be subject to civil and criminal penalties, including pursuant to Section 20(e) of the Act on the theory that the company aided and abetted an unregistered broker-dealer.

5.  Private Actions. There could be a private action brought by investors for damages suffered.

The SEC appears to be strictly enforcing regulations requiring broker-dealer registration. Although tempting, a company should strongly consider all potential risks prior to engaging a finder and not just evaluate an individual based on the size of their Rolodex.

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 corporate, securities, and intellectual property law.