Monday, December 7, 2020

Startup Cap Table 101: Reflecting a New Equity Financing

In the first blog post about cap tables, we talked about setting up equity compensation pools.  In this blog post, let's learn how to add a new equity investment to the cap table.  Let's assume that our startup has 2,000,000 founder shares outstanding, a 500,000 equity compensation pool, and a pre-money valuation of $1 million.  The investor is investing $200,000.

So, the cap table pre-financing looks like this:

                           Type of shares        # of shares        % fully diluted
Founder                Common                1,000,000            
Founder                Common                1,000,000
Pool                      Common                500,000
Total                                                    2,500,000            100%

To get the price per share that the investor will pay, we use the following formula:
pre-money valuation / # of shares outstanding, which in our case will be $1 million / 2.5 million shares = $0.40 per share.

Investor will own 16.7% of the company following its investment.  We get there by using the following formula: Investment amount / post-money valuation = % ownership, which in our case is $200,000 / $1,200,000 = 16.7% (BTW, post-money valuation equals pre-money + the amount of investment).

To find out the number of shares that the investor will get, we need to divide the investment amount by the price per share, which is $200,000 / $0.40 = 500,000 shares.

So, our new post-investment cap table looks like this:

                            Type of shares        # of shares        % fully diluted

Founder                Common                1,000,000            33.3%
Founder                Common                1,000,000            33.3%
Investor                Preferred                500,000               16.7%
Pool                      Common                500,000               16.7%
Total                                                    3,000,000            100%

We can get the same results by using different formulas.  Imagine that, as in the previous example, all you know is the following: (i) number of outstanding shares pre-financing, (ii) the startup pre-money valuation, and (iii) the amount of financing.  

                            Type of shares        # of shares        % fully diluted

Founder                Common                1,000,000            IV
Founder                Common                1,000,000            IV
Investor                Preferred                II                           16.7%
Pool                      Common                500,000               III
Total                                                    I                         100%

Using the known information, we can fill in the missing amounts.  We know that the investor will own 16.7% post financing by dividing $200,000 / $1.2 million post-money valuation.  

Let's solve for I:  We know that III+IV = 83.7%.  We also know that 83.7% equals 2,500,000 shares.  This means that I equals 3,000,000 shares (2,500,000 / 0.837).  

Let's solve for II:  If 100% equals 3,000,000 shares, then 16.7% will equal 500,000 shares.  Therefore, investor will receive 500,000 shares.  

Let's solve for III:  We can calculate III by dividing 500,000 shares by the total 3,000,000 shares.  

Let's solve for IV:  With the pool and investor shares taking 16.7% each, we have 66.6% left, split equally, to the two founders holding 2,000,000 shares.  This gives us 33.3% ownership for each founder.  

Since we know that a $200,000 investment buys 500,000 shares, then the price per share will be $0.40.

Although some numbers may be somewhat off due to rounding errors, the formulas should work.  

Next, time, let's see how to reflect the conversion of convertible notes at the time of the financing.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Wednesday, December 2, 2020

Startup Cap Table 101: Introducing an Equity Compensation Pool

 I have to admit: cap table calculations are not easy and not all startup lawyers enjoy this part of their jobs.  However, no matter how hard it can get, being able to make sense of the cap table is an essential skill for startup lawyers.  Since I have just finished teaching this to students at Fordham Law's Entrepreneurial Law class, I thought I would share some of the calculations here with you.  

Let's start with your basic cap table:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        50%
Founder B            Common        1,000,000        50%
Totals:                                         2,000,000       100%    

This example shows that the startup has two founders, each holding 50% of the issued and outstanding stock.  BTW, this startup has authorized 5,000,000 shares of common stock, $0.00001 par value.

The Board of Directors has just approved the issuance of an equity compensation pool of 20%.  The stockholders of the company (ie, both founders) have also unanimously approved the pool.  Now, let's reflect it in the cap table:

First, let's find out how many shares will be allocated to the pool.  To get there, we use the following formula: 

Total New Shares Outstanding = Existing shares outstanding / 1 - options pool %, which means: 2,000,000 shares / 0.8 = 2,500,000 shares.  So, with the pool, the startup will have 2,500,000, which means that the pool will have 500,000 shares of common stock allocated to it.  Our cap table now looks like this:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        40%
Founder B            Common        1,000,000        40%
Pool                      Common        500,000           20%
Totals:                                         2,500,000       100%    

As you can see, the creation of the pool diluted both founders.  Obviously, if the pool were to be created after an equity financing event, it would dilute both the investors and the founders.  That's why investors always want the pool shares to be created on a pre-money basis, diluting the founders alone.  

In the next blog post, let's look at how to add a Series A financing to this cap table.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Sunday, November 29, 2020

The SEC Modernizes US Securities Laws – Part I – Amendments to the “Accredited Investor” Definition

This Fall 2020 has seen an unprecedented number of rulemaking by the Securities and Exchange Commission (the “SEC”) that will be remembered for years to come.  I will attempt to summarize the changes for you in a series of blog posts.  Altogether, the changes will have lasting ramifications for the U.S. capital markets, enabling (I predict) an even greater flow of capital to the private markets.  The changes come at an important time when, due to the pandemic, many have lost jobs and may be launching their own ventures.

Below are the notable changes:

1. A revised definition of “accredited investor”;

2. Introducing two exemptions for finders;

3. Proposing changes to Rule 701 enabling to issue equity to the participants in the gig economy;

4. Adopting sweeping changes to Regulation CF; and

5. Rule amendments to Regulation A+, integration, and other rules.

Today, I will focus on the amendments to the “accredited investor” definition.  Subsequent blogs will cover the remaining rulemaking.  

On August 26, 2020, the SEC published its final rules amending the “accredited investor” definition.  These rules become effective on December 8, 2020.  The definition of accredited investor is the cornerstone of private placements made pursuant to Regulation D and has not been substantially amended since its adoption in 1982 (except for the 2011 amendment excluding the value of the primary residence from the net worth test).  Regulation D is the most relied upon exemption from registration requirements of the Securities Act for private placements of securities in the United States.  According to the final rules, in 2019, out of $3.9 trillion raised by companies in the United States, Regulation D private placements accounted for $1.56 trillion.  

Regulation D consists of Rule 504 (not frequently used) and Rules 506(b) and 506(c).  Rule 506(b) allows issuers to offer and sell securities to an unlimited number of accredited investors and up to 35 non-accredited but financially sophisticated investors (although from 2009 to 2019, only between 3.4% and 6.9% of all Rule 506(b) offerings included non-accredited investors).  Another popular rule within Regulation D, Rule 506(c), allows sales only to accredited investors.  Therefore, being an accredited investor is essential for being able to participate in the private placements of securities by startups, which could at times be extremely lucrative.  

Prior to the changes, the status of accredited investor, as applied to individuals, was determined based on such person’s wealth, with wealth being the only proxy for financial sophistication.  The SEC estimates that approximately 13% of the U.S. households currently meet the wealth-based accredited investor tests.  The final rules expand the definition by adding to the list of accredited investors those who hold certain professional degrees and are in good standing: the Licensed General Securities Representative (Series 7), Licensed Investment Adviser Representative (Series 65), and Licensed Private Securities Offerings Representative (Series 82).  This list is subject to ongoing revision by the SEC based on the nonexclusive list of attributes that the SEC will consider in determining additional qualifying professional certifications.  Although there are over 700,000 individuals who are currently Registered Securities Representatives and State Registered Investment Adviser Representatives, it is unlikely that the universe of qualifying investors will increase by that same number, given that some of these individuals may already qualify under the wealth tests.  Even though this change will not have a significant effect on the number of qualifying individuals, it signals a change in the overall approach towards defining who accredited investors are.

Another new category of individuals who are now accredited investors are the “knowledgeable employees” of “private funds” (private equity or hedge funds that are investment companies but qualify for Section 3(c)(1) or 3(c)(7) exemptions).  The term “knowledgeable employees” is already defined in Rule 3c-5(a)(4) under the Investment Company Act.  Starting on December 8, 2020, such employees can participate in the private fund’s investments as limited partners.  Making such individuals be accredited investors for the purpose of investing in the private fund for which they work (or are affiliated with) is reasonable and helps align their interests with the interests of the other limited partners.  

The SEC has also added several categories of entities to the list of accredited investors:

any investment adviser registered under federal or state law (and Exempt Reporting Advisers relying on Section 203(m) or 203(l) of the Investment Advisers Act of 1940) – this also applies to sole proprietorships;

any rural business investment company (RBIC);

any entity that owns investments in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;

any family office with at least $5 million in assets under management and that was not formed for the specific purpose of acquiring the securities offered, and whose investment is directed by a person capable of evaluating the merits and risks of the prospective investment; and

any family client of a family office described above whose prospective investment is directed by that family office.

The SEC also clarified that limited liability companies with $5 million in assets and not formed for the specific purpose of acquiring the securities offered qualify as accredited investors.

Lastly, the SEC allowed natural persons to include joint income and net worth from spousal equivalents when calculating the wealth-based tests.  “Spousal equivalent” is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.  

Here is a helpful blackline prepared by Pillsbury that shows the changes to the definition of accredited investor.

In conclusion, the amendments to the definition of accredited investor will significantly increase the pool of qualifying investors, although mostly among entities rather than individual investors.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Tuesday, May 5, 2020

Temporary Rules Make Crowdfunding Easier

Yesterday, on May 4th, the Securities and Exchange Commission (the "SEC") adopted temporary rules (through the end of August) making it easier for smaller companies affected by COVID-19 to raise capital through a Regulation Crowdfunding offering.  To rely on these temporary rules, the issuers will need to disclose to the investors that they are specifically relying on them as well as meet certain enhanced eligibility requirements, one of which is that the company has been in existence for over 6 months.  The SEC press release provides a good overview of the temporary rules.

In particular, the rules allow companies to initially omit financial statements, which is an important amendment.  In our experience, preparing financial statements often delays the campaigns.  The companies can now accept investment commitments without having to wait until the closing, so long as their offering statement includes the financials.  For smaller campaigns (not exceeding $250,000), the financial statements do not have to be reviewed by a CPA but can be certified by the principal executive officer.  Sales are permitted as soon as the issuer has received binding investment commitments covering the targeted amount (no need to wait 21 days, which is the minimum offering length).  Investment commitments become binding 48 hours after they are given, and cannot be canceled after that unless there is a material change in the offering.  Early closing is permitted as soon as binding commitments reaching the target amount are received.

These measures will simplify and, what is most important, will expedite the crowdfunding campaigns, allowing the smaller companies to raise much-needed funds.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Monday, May 4, 2020

Открытие Бизнеса в США: Практические Советы

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Wednesday, January 29, 2020

LEGAL PERSPECTIVE ON RUNNING A SUCCESSFUL CROWDFUNDING CAMPAIGN

Although Regulation Crowdfunding (or Reg CF in short) is a great way to get funding for companies that otherwise would have been overlooked by angel or VC investors, running a successful and compliant Reg CF campaign is not an easy undertaking. Based on experience working with Reg CF issuers, in this blog I describe and discuss three key legal challenges that all Reg CF issuers should know about: restriction on advertising, hiring promoters, and putting together a complete and accurate Form C.

First, the issuer cannot generally solicit and advertise its Reg CF offering. All communications must be done through the portal. According to Rule 204 of Reg CF, the issuer can make factual statements and then direct potential investors to its page on the portal. Such factual statements are limited to the following information: the fact that the issuer is conducting a Reg CF offering; the terms of the offering (amount, nature of securities, price, and closing date), and factual business information about the issuer. While the first two categories are straight forward, issues can arise when talking about the factual business information. Such information cannot include predictions or opinions and must be limited only to facts, such as name, address, website of the issuer and a brief factual description of its business.

Second, Rule 205 of Reg CF allows issuers to hire promoters for their offerings as long as the promoters work within the portal page and the issuer takes reasonable steps to ensure that the promoter discloses the fact that they are compensated. Outside of the portal, the promoters are restricted to providing the same factual statements that are described above. Again, the issuer must take reasonable steps to ensure that the promoters disclose that they are being paid by the company. As a separate issue, companies should not pay promoters a commission or a success-based fee. Such transaction-based compensation is a red flag to the SEC that the promoters are acting as unregistered broker-dealers, which may invalidate the entire offering. Compensation should be in the form of a flat fixed fee, rather than be tied to the success of the sales efforts.

Third, prior to launching a Reg CF offering, the issuer must file a disclosure document called Form C with the SEC. Even though its disclosure requirements are less extensive than for other offerings (such as Regulation A or an IPO), Form C must still be taken seriously. Form C requires the company to provide a description of its business and the anticipated business plan, the team bios, use of proceeds, and the risk factors that describe in depth the risks of investing in the company as well as the risks related to the company’s operations. Further, Form C asks for disclosures related to the ownership and capital structure of the company and rights of all securities that have been issued by the company prior to the offering. The company must list all of its other securities offerings for the past three years. This has often proven to be a challenge for some younger companies that may not realize that they were conducting securities offerings when, for example, they sold a SAFE to a neighbor or a couple of convertible notes to unaccredited friends, fail to file Form Ds for prior offerings, or comply with the offering exemption requirements. When preparing Form C, issuers should remember that under Rule 10b-5 of the Securities Act they have liability for any material misstatements or omissions in their Form Cs.

Additionally, even the younger companies must include US GAAP financial statements. For offerings of $107,000 or less, the financial statements must be certified by the principal executive officer of the issuer; for offerings between $107,000 and $535,000, they must be reviewed by a public accountant independent of the issuer; and for the offerings over $535,000, the financial statements must be audited (although the first-time issuers could provide reviewed financials instead).

Consequences for violating these rules can be severe. Regulation CF is a safe harbor exemption from the general requirement that a company must register its securities with the SEC. If violated, the offering may be deemed to be void, and all investors in the offering could receive recession rights (i.e., the right to get their money back). Additionally, the SEC may impose sanctions and shareholders may file civil lawsuits against the company. Further, the company itself may be deemed to be a “bad actor” and be prevented from conducting private placements of its securities in the future.

In conclusion, running a successful and compliant crowdfunding campaign is not a simple task. The key to success often lies in finding the right advisers: a funding portal that would be willing and able to support its issuers throughout the entire crowdfunding campaign, and an expert legal adviser that can prepare Form C, ensure that the company’s legal records and corporate governance documents are in order, and guide the company through the maze of legal rules and forms of Regulation Crowdfunding.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Saturday, January 18, 2020

Amending the Definition of "Accredited Investor"

The definition of an “accredited investor” is the cornerstone of Regulation D that provides a safe harbor exemption for private placements of securities by startups and more mature companies. Only in 2018, $1.7 trillion was invested into the startup sector by means of Regulation D offerings, out of which $228 billion was raised by companies rather than investment funds. Nearly all of the investors in such offerings were accredited. Now, the definition of an accredited investor may be changing to include new categories of people. This will open the extremely risky but yet extremely lucrative startup investment opportunities to more participants.

This blog focuses on certain proposed changes to the definition as it relates to natural persons.

The definition of “accredited investor” came about in 1982 together with the adoption of Regulation D (although the concept of an “accredited person” was first introduced by Rule 242 in 1980). The following categories of natural persons are deemed to be accredited:

  • Any natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
  • Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1 million (excluding the value of primary residence); and
  • Directors, executive officers, and general partners of the issuer or of the general partner of the issuer.
Other than expanding the income test to include a joint income component in 1988 and excluding the value of one’s primary residence from the net worth calculation as part of the Dodd-Frank Act in 2011, the SEC has not revised the definition since 1982.

On December 18, 2019, the SEC issued proposed rules to amend the accredited investor definition. The rules are currently in the 60-day comment process, so anyone who cares deeply about the outcome is encouraged to submit a comment to the SEC.

The main premise of the proposed rules is the fact that the SEC no longer believes wealth to be a proxy for financial sophistication, and I fully support this conclusion. There should be other criteria for establishing financial sophistication. Hence, the SEC is proposing to add the following new categories of natural persons to the category of accredited investors: (i) those who hold certain professional “certifications, designations or other credentials recognized by the Commission” and (ii) “knowledgeable employees” of a private fund who are investing in that fund. Since I fully agree with adding “knowledgeable employees” to the accredited investor definition list, I will focus my discussion on the persons with professional certifications.

With respect to the professional degrees, the SEC has proposed an initial list of accepted certifications, to be revised and amended from time to time. The initial list includes:
  • A Licensed General Securities Representative (Series 7);
  • A Licensed Investment Adviser Representative (Series 65); and
  • A Licensed Private Securities Offerings Representative (Series 82).
As currently proposed, the list of acceptable professional certifications is narrow and substantially limits eligible persons to those professionals working for broker-dealers (most of whom may already be accredited by other means). These individuals must be sponsored by a FINRA member firm to be allowed to take the Series 7 or 82 exam and first pass an introductory-level Securities Industry Essentials examination. There are no similar requirements for the Series 65 exam. As previously mentioned, taking a Series 7 or 82 exam assumes that such an individual is employed by a FINRA member firm. My view is that those individuals who are not working for a FINRA member firm should also be allowed to take the examinations, and if they pass, become “accredited investors.” In a sense, these exams, if stripped of the sponsorship requirement, should become tests for the minimum expertise necessary to be deemed to be an accredited investor. There should also be annual re-certification to ensure that these individuals keep abreast of all relevant developments in the financial and legal markets. Allowing everyone to take these exams, whether or not affiliated with a FINRA member firm, would render it unnecessary to consider other professional degrees such as a Ph.D. in finance or a Master’s degree in a similar field. All persons, regardless of the professional or educational background, should be able to take the tests and qualify to be an accredited investor. It could make sense, however, to impose investment limitations on those investors who qualify to be accredited solely based on the professional certifications criteria.

Additionally, harmonization of the various definitions that are currently used in different securities laws would go a long way towards simplifying and streamlining the compliance process. Currently, in addition to the definition of an “accredited investor” found in Rule 501(a) of Regulation D under the Securities Act, we have the definition of a “qualified purchaser” under the Investment Company Act of 1940, a “qualified client” under the Investment Advisers Act of 1940, and a “qualified institutional buyer” in Rule 144A under the Securities Act. All of these definitions generally refer to wealthy entities and individuals but vary somewhat with respect to the thresholds and scope.

In conclusion, the proposed rules are a big step forward towards democratizing the definition of “accredited investor.” Having more accredited investors willing and interested to invest in startups will fuel the growth of the startup economy and should result in producing more jobs.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.