New employee:  “I want Founder Stock”

Me:  “I see, you want to buy Common Stock”

New employee:  “No, I want Founder Stock, just like the founders received.”

Me:  “There is no such thing as Founder Stock, you are talking about Common Stock.”

New employee: “I’m confused.”

Just to clear up the confusion, legally speaking, there is no such thing that is commonly known as “Founder Stock.”  

For all practical purposes with startups, stock in a corporation is either Common Stock or Preferred Stock.  Let’s ignore Preferred Stock for now, as that is primarily issued to investors.[1]

When a company is set up, the founders purchase Common Stock.  The price of that Common Stock is typically very low (almost zero) because the company has just been set up and presumably has very little value – for example, $0.0001/share.  If the founder is issued 5,000,000 shares, the purchase price would be $500.

Why does this matter?  Because often times when later employees say they want “Founder Stock,” what they really mean is that they want to receive Common Stock at the same price that the founders paid.  However, there is a basic rule in tax law that says that if you are a service provider to a company and you receive property (stock), then you have compensation income equal to the excess of the fair market value of the stock on the date of grant over what you paid for that stock.  So, let’s assume the new employee is receiving 250,000 shares six months after the founders bought their Common Stock, and because of growth in the business and its prospects, the company’s value has increased such that the fair market value of the Common Stock has increased to $0.05/share.  The value of those 250,000 shares is $12,500, so the employee would have to either pay $12,500 to buy the shares, or if the shares are issued without payment, she would have taxable income of $12,500 (and there is a related withholding obligation on the part of the Company for that income, which can be complicated if cash is tight).  This problem gets worse over time as the company gets more valuable, which is one of the reasons that companies issue options.[2]

So-called Founder Stock is also a way that people sometimes refer to stock with different vesting or acceleration terms.  For example, the Common Stock issued to the founders might vest over 4 years monthly without a cliff, while stock to employees typically vests over 4 years with a 12 month cliff (i.e., no stock vests before the first year of employment).  It might have different “acceleration terms”, meaning rights to accelerated vesting upon the occurrence of certain events such as an acquisition of the company.

So the next time you are joining a company and think that you want to acquire Founder Stock, remember that you are actually either going to acquire Common Stock or an option to acquire Common Stock.[3]  And if you’re hiring your first employees and trying to figure out your company’s approach to stock-based compensation, make sure to factor the tax consequences to the company and the new employees in making the decision to issue stock vs. options.

*              *              *

[1] This is to be distinguished from so-called “Series FF Stock” which is a hybrid between Common Stock and Preferred Stock.  I have also purposefully ignored infrequently implemented two-tier common structures, Class F stock and other cap table engineering designed to vest disproportionate control in a subset of stockholders.

[2] If the new employee doesn’t want the $12,500 of income (or the $12,500 payment obligation), she could be issued an option to purchase 250,000 shares with an exercise price (or purchase price) per share of $0.05/share.  However, options do not put the individual in the same position as stock, as both have their pros and cons and differing tax treatment, which is beyond the scope of this post.

[3] Some later stage companies, such as Facebook and Zynga, have issued “Restricted Stock Units” (or RSUs) in advance of their IPO.  These rights to acquire stock are highly tax driven and are beyond the scope of this post.

Thanks to my partners Peter Werner and Craig Jacoby for reviewing this post in advance.

Overall, our data pointed to a year marked by slowing deal volumes and stabilizing valuations. In 2012, we saw aggregate dollars raised reach $4.9 billion, down from $6 billion in 2011. The decrease in both deal volumes and invested capital was driven by a slowing financing environment during the second half of 2012. Median pre-money valuations were relatively flat across all deal stages with the exception of Series B transactions. We saw an increase in up versus flat/down rounds. Up rounds represented 75% of all financings in 2012, a level not seen since 2007. Additionally, the percentage of recapitalization transactions fell in 2012, as well as the number of tranched deals. Deal terms also mirrored the financing statistics. The utilization of fully participating preferred provisions was relatively flat from 2011 and we witnessed a decrease in pay-to-play provisions in 2012, compared to the prior year.

The full report can be downloaded here.

Highlights of the report include:

• Overall, the data pointed to a quarter marked by slowing deal volumes and decreased invested capital during the quarter.
• In Q3 2012, we saw median pre-money valuations decline in Series A and B transactions. Additionally, the data showed a decrease in up versus flat/down rounds from the prior quarter.
• Up rounds represented 71% of all financings in Q3, down from 77% in Q2.
• The percentage of tranched transactions increased in Q3 to over 20% of all deals, though the percentage of recapitalization transactions decreased.
• Deal terms in Q3 2012 remained mixed. We observed increases in the use of fully participating preferred and pay-to-play provisions in Q3, compared to the prior quarter. The data pointed to increased utilization of greater than 1x liquidation preferences in Series A and C deals, while showing a decrease in Series B and D+ transactions. Additionally, we saw a decrease in the use of drag-along provisions during the quarter.

The full report can be downloaded here.

The privacy policy generator can be found here.

The text of the press release is pasted after the link.

Cooley Launches Online Privacy Policy Generator

Palo Alto, Calif. – September 17, 2012 – Cooley LLP announced today that it has launched a publicly-available online Privacy Policy Generator for emerging companies doing business in the United States. Attorneys from Cooley’s nationally acclaimed Privacy group developed the Privacy Policy Generator based on their collective experiences representing hundreds of businesses on online privacy issues.

The Generator, which is intended as a starting point for generating privacy policies for US-based, consumer-targeted websites, will help companies:

• Better understand internal data collection, use, and disclosure practices;
• Build consumer trust by conveying what information they collect and how they may use consumer information in a simple and easy-to-understand manner; and
• Start the process of complying with applicable privacy laws

“Companies will be able to complete the online process in minutes,” states Susan Lu Lyon, co-chair of Cooley’s Privacy group. “Cooley wants to help the most innovative and disruptive new companies achieve and surpass their aims. As these early stage companies gain new customers and enter markets during periods of rapid growth and slender resources, this Privacy Policy Generator can help companies maintain their pace and build customer trust with a cost-effective tool that starts them down the path of privacy compliance. Creating and maintaining an online presence is a key component to the success of any startup company, and developing an online privacy policy has never been a more important part of that success.”

The Privacy Policy Generator is the first in a suite of resources Cooley will make available online. Visit Cooley LLP’s Privacy and Emerging Companies pages to access the Generator and learn more about how the firm is dedicated to helping startups achieve their goals.

The SEC’s proposed amendments would:

• permit a company (or another person acting on its behalf) to make a “general solicitation” or engage in “general advertising”¹ in connection with a sale of its securities to accredited investors made in reliance on Rule 506 of Regulation D, so long as the company takes reasonable steps to verify that all purchasers of the securities are accredited investors; and
• eliminate the practical prohibition on publicizing offers of securities intended to be resold in reliance on Rule 144A under the Securities Act.

The SEC confirmed that:

• Offshore offerings pursuant to Regulation S and concurrent Rule 144A/Rule 506 offerings under the proposed rules would not be integrated; and
• Because Rule 506 transactions are non-public offerings for purposes of Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act, privately offered investment funds would be allowed to make a “general solicitation” pursuant to amended Rule 506 without losing their ability to rely on those sections for exemption from registration as an investment company.

The proposed amendments are subject to a 30-day comment period, after which the SEC will determine whether to adopt the amendments as proposed or with further modifications.

Background

Section 201(a) of the JOBS Act required the SEC to act to remove the prohibition on general solicitation in Rule 506 private placements and Rule 144A transactions meeting certain conditions. At the SEC open meeting held on August 29, 2012, the SEC proposed rules to implement the requirements of Section 201(a) of the JOBS Act.

Proposed Rule 506(c)

The SEC proposes to eliminate the prohibition against general solicitation in offers and sales of securities made pursuant to a new Rule 506(c) of Regulation D. Currently under Rule 506, an issuer cannot sell securities through any form of general solicitation.² New Rule 506(c) would eliminate this prohibition so long as:

• all purchasers of such securities are “accredited investors” as defined in Rule 501(a) of Regulation D;
• the issuer takes reasonable steps to verify that the purchasers of such securities are accredited investors; and
• the issuer otherwise satisfies other terms and conditions applicable to Rule 506.³

The requirement that all purchasers be accredited investors will be satisfied if either (1) they actually fall within one of the enumerated categories of persons that qualify as accredited investors or (2) the issuer reasonably believes that they do, in either case at the time of the sale of the securities. The new verification requirement would only apply to offerings of securities conducted pursuant to the new Rule 506(c). The proposed amendments also would amend Form D to add a new check box to indicate that an issuer is claiming an exemption under new Rule 506(c).⁴

Verification requirement

The proposed rules do not specify uniform verification methods to determine whether an issuer has taken reasonable steps to verify that purchasers of securities are accredited investors, but instead provide that such a determination would be objective, based on the facts and circumstances of each particular transaction, and would take into account a number of interconnected factors including:

• the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
• the amount and type of information that the issuer has about the purchaser (which may include publicly available information); and
• the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

The SEC’s release explains that solicitations of new investors through a generally-accessible website or a broadly disseminated email or social media platform likely would require an issuer to take greater steps to verify accredited investor status than solicitations of new investors from a database of pre-screened accredited investors set-up and maintained by a reasonably reliable third-party, like a registered broker-dealer. With respect to the former, an issuer would not have taken reasonable steps to verify that a person is an accredited investor simply by requiring that such person check a box in a questionnaire or sign a form, without other information indicating that such person is an accredited investor. By contrast, an issuer that has a reasonable basis to rely on a third-party’s verification of a person’s status as an accredited investor would be entitled to rely on such verification. A required minimum investment amount would be an example of an offering term that also may be relevant under this factor. If the minimum investment is high enough such that only accredited investors could reasonably be expected to meet it, the SEC indicated that it may be reasonable for the issuer to take no steps other than to confirm that neither the issuer nor another third party is financing it. The SEC’s release states that it would be important for issuers to retain sufficient records that document the steps taken to verify that a purchaser of its securities was an accredited investor, regardless of the particular steps it took, and that if an issuer claims the new exemption, it would have the burden of showing that it is entitled to the exemption.

The proposed amendments modify only the regulatory safe harbor provided by Rule 506 (and not the broader private placement exemption provided by Section 4(a)(2) of the Securities Act), and would not affect an issuer’s existing ability to conduct Rule 506 offerings without using general solicitation.

Forms of advertising

Interestingly, the SEC’s proposed amendments do not impose any limitations or restrictions on the forms of advertising or promotion, or other manner of sale, that can be employed in connection with sales of securities in reliance on new Rule 506(c). Rather, the SEC opted to focus solely on the nature of the purchasers (accredited investors) and the steps an issuer must take to verify accredited investor status. This is not to say issuers and intermediaries will have free reign to engage in deceptive marketing practices because federal and state antifraud rules will still apply, and state regulatory agencies retain their authority to bring enforcement actions based on fraud.⁵

Rule 144A—offerings to persons other than QIBs

The SEC also proposed amendments to Rule 144A to allow issuers of securities intended to be resold to Qualified Institutional Buyers (QIBs) in reliance on Rule 144A to more broadly disseminate the offer of such securities beyond persons reasonably believed to be QIBs, thereby effectively permitting the same type of general solicitation as contemplated by new Rule 506(c). Rule 144A is a regulatory safe harbor exemption from the registration requirements of the Securities Act for resales of restricted securities to QIBs, and is used to facilitate a primary offering of securities by an issuer to one or more financial intermediaries, which is followed by an immediate resale of such securities to QIBs. Although existing Rule 144A does not contain an express prohibition against general solicitation, “offers” of securities pursuant to Rule 144A can only be made to QIBs, which has the same practical effect. As amended, Rule 144(A)(d)(1) would eliminate the references to “offer” and “offeree” and require only that securities be sold to a QIB or to a purchaser that the seller or any person acting on behalf of the seller reasonably believes is a QIB.

Possible impact of the proposed rules

It is difficult to predict how far-reaching the impact will be from eliminating the prohibition on general solicitation in private placements (both in offerings pursuant to new Rule 506(c) and amended Rule 144A). The proposed amendments could represent a watershed moment in how private placements are conducted. With the amended rules, the SEC effectively is removing the “private” from “private placements” and will open the door to broadly marketed, unregistered offerings and sales of securities, albeit in offerings limited to purchases by accredited investors. Examples of the potential impact include:

• Privately held companies and intermediaries now will be able to advertise offerings of their securities in any medium—Internet, print media, radio and television—without impacting an issuer’s ability to effect a Rule 506(c) private placement.
• Web-based securities platforms that match issuers, buyers and sellers of securities and facilitate securities transactions among them (assuming such platforms otherwise comply with the new and existing rules) will be further legitimized.
• Companies with publicly traded securities will be able to effect widely-marketed private placements of their securities, which may change the manner in which “PIPE” transactions are effected.
• Private companies looking to go public may explore the relaxed private placement rules, together with the new provisions permitting companies to “test the waters” in connection with an IPO, to engage in simultaneous public and private offerings under “Black Box” (the SEC no-action letter that first permitted concurrent public and private offerings) or subsequent SEC interpretative guidance, provided that integration concerns are appropriately managed.

Until the SEC publishes final rules, companies must still adhere to existing rules that prohibit general solicitations in connection with private placements and effectively similar constraints in Rule 144A transactions.

NOTES

1. Rule 502(c) of Regulation D sets forth manner of sale limitations for private placements exempt under Rules 504, 505 and 506 of Regulation D, including the current requirement that neither the issuer nor any person acting on the issuer’s behalf sell securities by means of “general solicitation” or “general advertising.” In its release proposing amendments to Rule 506, the SEC explained that its discussion of “general solicitation” is intended to refer to both general solicitation and general advertising.
2. Existing Rule 506(b)(1) specifies that an issuer seeking to rely on the exemption provided by Rule 506 must satisfy the conditions specified in Rule 502, which includes the prohibition on general solicitation set forth in Rule 502(c).
3. Rules 501 (definitions), 502(a) (integration of previous and subsequent offerings) and 502(d) (limitations on resale) would apply to any sale effected pursuant to new Rule 506(c).
4. Under Rule 503 of Regulation D, an issuer is required to file a Form D with the SEC for each new offering of securities made in reliance on an exemption provided by Regulation D, and such filing is required to be filed no later than 15 calendar days after the first sale of securities in the offering.
5. The authority of state securities regulatory authorities to bring enforcement actions based on fraud is preserved in Section 18(c) of the Securities Act.

This summary was prepared by my colleagues at Cooley.  A link to the original news release by Cooley can be found here.

First, kudos to Yokum, TheFunded and Founder Institute for attempting to further the causes of document standardization, lowering friction in fundraising and achieving greater balance between the forms of investment known as convertible debt and equity.  This is something that all of us in the startup ecosystem strive for, even, ahem, the lawyers.

Since then, many of us in the startup community have been asked by clients and others about this form of investment structure, and I thought I would make my thoughts known publicly.

Many of the questions I have received center around “how does this differ from convertible debt and why is it better?”  As I review the terms of the convertible equity, they are remarkably similar to convertible debt. The stated benefits of convertible equity over convertible debt seem to focus around the following primary issues:

• No accruing interest
• No maturity date for repayment of debt

Starting with the interest accrual, this is certainly a feature that, if removed, is more beneficial to founders because interest equals dilution (unless repaid in cash). Accrued interest at the time of conversion effectively increases the conversion discount on convertible debt (in other words, a 20% discount rate with a 5% interest rate will have, roughly, a 25% discount after one year). It also compensates investors for risk. On the flip side, market interest rates are currently very low, and startups that are issuing capped convertible notes are generally negotiating the lowest possible interest rate (use the minimum rate AFR rate if possible, which hovers around 1%) because the investor can be compensated for risk by using an appropriate valuation cap and conversion discount. So, while it’s certainly more founder-favorable to remove, this is a small “problem” at most.

The bigger problem that convertible equity purports to solve is the “maturity date” problem, where it is posited that startups face a day of reckoning when their debt comes due if they have not raised a round of financing by the maturity date (which is often 12-24 months from the inception of the debt). Again, it’s decidedly more founder-friendly to not have to negotiate with your investors at maturity about whether repayment is due. Additionally, if the intention is for the “debt” never to be repaid (as would be the case with equity), founders could solve the same problem by requesting note maturity far past any possible success horizon (say, 3 years).

However, in my experience, the “maturity date” problem is rarely an issue in practice. First, most seed-round companies that have raised debt face a binary outcome: they either raise additional funding (and thus the debt is converted) or they fail to raise funding and shut down. In the unusual middle case where a company doesn’t raise funding but is still bouncing along when the debt comes due, I have rarely seen investors demand repayment and put a company into default. In most cases the repayment date is extended by the investors or some other mutually agreeable outcome is achieved. (As a side note, there is an argument that repayment at maturity is actually founder-favorable, rather than a negative, because if the company succeeds without having to raise money, the debt can be repaid in cash without diluting the founders. Unfortunately this is best judged in hindsight.)

In fact, it is a fairly common term of convertible debt that the debt can be converted (either optionally or mandatorily) at maturity into equity of the company at a pre-defined valuation, and indeed this term is included in the convertible equity as well (as an option). If a mandatory conversion into equity (either common stock or a new series of preferred stock) is included in a company’s convertible debt documents, there is no “forced repayment” issue any longer. Companies that include a “conversion at maturity” feature typically consider using a pre-defined valuation that is at or below the valuation cap to be used to determine the conversion price in connection with a financing.

Another founder-friendly feature that was not expressly discussed (and is possibly an oversight) is the removal of the concept of a liquidation preference. To recap, a liquidation preference is a basic (and accepted) protection of investors that provides that, if the company is liquidated, the investor gets its money out first (which is the case in preferred stock, in the form of a liquidation preference, or in debt, by virtue of the fact that debt is a senior security and is repaid before equity). For example, assume the company raises $500K of convertible equity and after spending $250K decides (for whatever reason) to shut down and liquidate. In a company that had raised typical preferred stock or convertible debt, the remaining $250K in cash would be returned to investors. With the current iteration of convertible equity, that money would go to the common stock holders (the founders). I think this oversight will need to be corrected for investors to embrace this structure.

Most of the discussion around convertible equity seems to be focused on business terms, but there are situations where convertible equity may be preferable to convertible debt for tax reasons. For example:

• When there are original issue discount (OID) issues (which can result in phantom income for lenders);
• When there may be cancellation of debt issues for the issuer if the debt ends up being forgiven; or
• To avoid withholding tax issues where the lenders are foreign (or limited partners in a fund that is foreign).

However, convertible debt may at times qualify as equity rather than debt for tax purposes if the terms of the convertible debt instrument and other circumstances indicate that the investment has more equity characteristics than debt characteristics under the applicable tax law test. In these cases, if the parties include language in the legal documents agreeing to treat the investment as equity for tax purposes rather than debt, these tax arguments for preferring convertible equity to convertible debt may not apply.

In summary, convertible equity seems to be an instrument that attempts to tip the scales in the founders’ favor.  It remains to be seen whether convertible equity is widely accepted by investors, and whether the changes in terms are sufficiently meaningful to warrant a re-inventing of the convertible debt wheel.

Highlights of the report include:

• The percentage of up rounds rose to over 82% of deals, a level not seen since 2006.
• Average valuations for Series A, B and D+ rounds reached levels not seen in the last eight years.
• A number of Q2 trends pointed to a move toward more company-favorable terms.
• The percentage of deals with pay-to-play provisions and the percentage of tranched deals decreased from the prior quarter, signaling investor confidence.

The full report can be downloaded here.

My partner Mike Platt is one of the best.

http://www.cooley.com/mplatt

See question on Quora

Another option is CapMX, which is owned by Solium (and formerly Silicon Valley Bank). Many firms use that.

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No.  Just keep in your files.

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