Friday, January 13, 2023
Chromecast to TV speaker group bug
https://support.google.com/youtubemusic/thread/187463261/casting-to-speaker-group-with-google-tv-with-chromecast-fails?hl=en
Tuesday, June 25, 2013
Friday, August 17, 2007
Startup Bonds -- Introduction
The existing model of funding startups--through venture capital preferred stock investments--hands control of the company to the investors, significantly dilutes the shares of the founding entrepreneurs and results in the vast majority of startup ventures failing, with significant losses. Although this model has become the standard VC investment structure in Silicon Valley, it is an unusual financial instrument in many ways, and would not be accepted outside of the startup sector, where there is a significant imbalance of power between the VC investors and the founding entrepreneurs. There are alternative investment structures available.
The world market capitalization of bonds is actually larger than that of equity. Where a note is a long term commitment, bonds and debentures are long-term commitments—usually longer than 5 years.
Bonds are often issued by governments, but they are issued by all types of organizations, including private and public corporations. Some of the characteristics of bonds are:
Good Timing for Startup Bonds?
Of course VC's prefer the preferred stock model, but the Startup Bond may become increasingly appealing due to the following trends:
The world market capitalization of bonds is actually larger than that of equity. Where a note is a long term commitment, bonds and debentures are long-term commitments—usually longer than 5 years.
Bonds are often issued by governments, but they are issued by all types of organizations, including private and public corporations. Some of the characteristics of bonds are:
- Senior or subordinated
- Secured or unsecured
- Floating or fixed rate of interest
- Callable or non callable
- Convertible or straight
The Preferred Stock Model
Preferred stock is a hybrid of debt and equity offering the best of both worlds—for the investor. Preferred stock is essentially common stock plus additional contractual rights. These rights usually allow the preferred stockholder to control:
- If company is sold
- If company raises new funding
- Appointment of directors
- Other provisions
Public (Wall Street) investors won’t accept the structure, so preferred rights are eliminated at IPO.
Why Entrepreneurs Dislike the Preferred Model
The preferred stock model is unpopular with entrepreneurs for a number of reasons:
- The founders lose ultimate control to the investors
- Management owes fiduciary duties to the investors
- Ratchets and anti-dilution provisions can dilute the founders
- Liquidation preferences can harm the founders at M&A
Investor syndication leads to standardization in the way all VC's structure their deals—so there's remarkably little choice/variety in the investments offers made to entrepreneurs by competing VC funds.
Startup Bonds
A Startup Bond is essentially a convertible note or debt instrument that is sold to investors by the company to raise funds. Interest accumulates on the loan over the period.
One of the following trigger events enables the loan to be converted to common stock at a pre-set price:
- IPO
- Acquisition
- Liquidation
Redemption
The bond can be structured so that investors can put note to company for payment after, say, 5 years. Price may be a multiple of the initial investment
Legal Framework
The SEC and federal securities laws govern the issuing of bonds, as they are classified as 'securities'. This means that the security must be registered (with the SEC, like an IPO), or qualify for an exemption from registration, such as a private placement.
The private placement exemption is available for accredited investor only--individuals or corporations with high net worth or high incomes.
Until bond converts to common stock, management does not owe a fiduciary duty to the noteholders as they would to shareholders--corporate law is for stockholders but contract law is for debtholders.
Advantage of the Startup Bond
A significant advantage of the startup bond is that the founders retain control of:
- Board of directors
- Management
- Exits
- Fundraising
The bond is also relatively easy and inexpensive to setup. Simple contracts are required (but the registration exemption and SEC filings are still necessary).
Other advantages are:
- Liquidation preference provided by bankruptcy law
- Can be offered to all accredited investors (not restricted to VC’s)
- Simple syndication to multiple investors
Good Timing for Startup Bonds?
Of course VC's prefer the preferred stock model, but the Startup Bond may become increasingly appealing due to the following trends:
- Growing sophistication and business skills of entrepreneurs (that don’t need VC’s to tell them how to run a company)
- Low interest rates
- Growing number of startups too small for VC funding (that do not want/need $5m from VC’s Lower startup costsInternet marketing
- Interoperability of technology components and development tools reduces the cost of product development--products are created by assembling components.
- Growth of private equity funds and other sources of funding
Resistance from the VC Community?
Investors prefer the preferred model as it offers more control to VC. But law firms have also become attached to the preferred model--it helps lawyers win business from VC's. Lawyers seldom question the appropriateness of the preferred stock model for startup clients and some will resist the move away from preferred stock.
Startup Bonds—Other Effects?
The emergence of Startup Bonds as funding instruments for startup companies could go hand-in-hand with a new portfolio model for participating investors. This may involve an investor making a larger number of smaller investments and taking a passive role when it comes to managing the company. A $1bn fund may translate into several thousand startup investments while it currently translates to less than 100 investments using the prevaling VC business model.
This form of investment may lead to more innovative new technologies coming to market, and more hot new products being acquired and marketed by large corporations with existing routes to market.
Currently, the VC model relies upon a small number of 'home run' returns from the portfolio of investments--so VC's often use their preferred stock control rights to veto company sales if they are less than $500m. Under the Startup Bond model, the veto rights may not exist and the decision to sell will rest in the hands of the founding entrepreneurs and other common shareholders. This will result in acquisitions offers of $100m or less being accepted by startup companies--and more products being acquired by large corporations looking for new products and revenue streams.
Trends opening up the possibility of smaller rounds of funding
Currently, convertible notes and other alternative financing structures for startups are available only where the funds required by the entrepreneur are smaller than the typical VC investment. For investments of $2m or more, the VC-Preferred model is still the only significant option available to entrepreneurs[1]. There are some trends that are leading to the reduction in cost of setting up certain types of technology startups and possibility of startup companies being funded solely through Startup Bonds and other structures.
Significantly for many software and media-based startups, the cost of operating and hosting Internet websites has dropped rapidly in recent years. New software development tools automate tasks and enable engineers to achieve more with fewer resources. Combined with interoperability trends, it is quicker and easier to develop new software-based products and technologies. Interoperability essentially involves creating new products from building blocks—components that are available off the shelf instead of building them from scratch. These building blocks are available as the result of new software standards and initiatives such as Microsoft .Net, OASIS, SOAP[4], Open Source[5] movement, Java and Javabeans[6].
Interoperability applies to other technology sectors such as Semiconductors, but the costs involved in designing a new hardware chip is significantly higher than experienced in the software sector.
Outsourcing of development and engineering tasks to countries like India, Vietnam and China can reduce the product development costs. The Internet has brought down the cost of reaching customers resulting in reduced sales and marketing for companies that are able to reach customers in this way.
So, as VC’s raise larger funds and focus on multi-million dollar rounds of funding, there are an increasing number of entrepreneurs that are able to form startups and grow their businesses with smaller financings raised in the form of convertible notes. If properly structured, these entrepreneurs may be able to retain control of their startups and they will not be forced to adopt the VC-Preferred model.
[1] Fenwick & West quarterly review.
[2] The .NET framework created by Microsoft is a software development platform focused on rapid application development, platform independence and network transparency. .NET is Microsoft's strategic initiative for server and desktop development for the next decade. According to Microsoft, .NET includes many technologies that are designed to facilitate rapid development of Internet and intranet applications.
[3] Open Artwork System Interchange Standard (OASIS (TM)) is a specification for hierarchical integrated circuit mask layout data format for interchange between EDA software, IC mask writing tools and mask inspection tools.
[4] Simple Object Access Protocol. SOAP is a lightweight XML based protocol used for invoking web services and exchanging structured data and type information on the Web.
[5] In general, open source refers to any program whose source code is made available for use or modification as users or other developers see fit. (Historically, the makers of proprietary software have generally not made source code available.) Open source software is usually developed as a public collaboration and made freely available.
[6] A reusable component that can be used in any Java application development environment. JavaBeans are dropped into an application container, such as a form, and can perform functions ranging from a simple animation to complex calculations.
Significantly for many software and media-based startups, the cost of operating and hosting Internet websites has dropped rapidly in recent years. New software development tools automate tasks and enable engineers to achieve more with fewer resources. Combined with interoperability trends, it is quicker and easier to develop new software-based products and technologies. Interoperability essentially involves creating new products from building blocks—components that are available off the shelf instead of building them from scratch. These building blocks are available as the result of new software standards and initiatives such as Microsoft .Net, OASIS, SOAP[4], Open Source[5] movement, Java and Javabeans[6].
Interoperability applies to other technology sectors such as Semiconductors, but the costs involved in designing a new hardware chip is significantly higher than experienced in the software sector.
Outsourcing of development and engineering tasks to countries like India, Vietnam and China can reduce the product development costs. The Internet has brought down the cost of reaching customers resulting in reduced sales and marketing for companies that are able to reach customers in this way.
So, as VC’s raise larger funds and focus on multi-million dollar rounds of funding, there are an increasing number of entrepreneurs that are able to form startups and grow their businesses with smaller financings raised in the form of convertible notes. If properly structured, these entrepreneurs may be able to retain control of their startups and they will not be forced to adopt the VC-Preferred model.
[1] Fenwick & West quarterly review.
[2] The .NET framework created by Microsoft is a software development platform focused on rapid application development, platform independence and network transparency. .NET is Microsoft's strategic initiative for server and desktop development for the next decade. According to Microsoft, .NET includes many technologies that are designed to facilitate rapid development of Internet and intranet applications.
[3] Open Artwork System Interchange Standard (OASIS (TM)) is a specification for hierarchical integrated circuit mask layout data format for interchange between EDA software, IC mask writing tools and mask inspection tools.
[4] Simple Object Access Protocol. SOAP is a lightweight XML based protocol used for invoking web services and exchanging structured data and type information on the Web.
[5] In general, open source refers to any program whose source code is made available for use or modification as users or other developers see fit. (Historically, the makers of proprietary software have generally not made source code available.) Open source software is usually developed as a public collaboration and made freely available.
[6] A reusable component that can be used in any Java application development environment. JavaBeans are dropped into an application container, such as a form, and can perform functions ranging from a simple animation to complex calculations.
Other Sources of Funding for Startup Entrepreneurs
Although the VC-Preferred model is now widely accepted by VC’s and the legal community as the standard structure under which investments are made, technically there are a wide range of alternatives available. The entrepreneur, under the guidance of an attorney that is not wedded to the VC-Preferred model could create an investment structure that leaves control of the Company with the founders and the common shareholders. However, this may not be acceptable to VC’s and may only be a realistic option currently for smaller rounds of funding.
Note with warrants
Klein, in his paper “The Convertible Bond: A Peculiar Package”[1], explains that a convertible note is ‘basically a debt financing, with the conversion privilege as a “sweetener”. He argues that a better alternative is to issue a bond with warrants—rights to acquire common stock.
Instead of conversion, the startup investment could be structured as a note accompanied with warrants to acquire common stock. The note will be redeemed in case of acquisition or liquidation, but the warrant could provide the holder with the right to purchase common at a preferential, pre-defined, price and participate in the upside potential.
Like a convertible note, the warrant doesn’t carry fiduciary duties or control power unless it is exercised. In addressing whether warrantholders were entitled appraisal rights in a takeover situation, and deciding in the negative, the Court in Aspen Advisors LLC v. UA Theatre Co[2]., confirmed that the Company does not owe fiduciary duties to warrantholders: “A warrantholder is not a stockholder… A warrantholder is only entitled to the rights of a shareholder.. after they (convert) to stock ownership”. The Court in Aspen also confirmed that the rights of warrantholders and preferred stockholders should be construed narrowly by the Courts: “Warrants are contractual entitlements. The exclusive rights and remedies of warrantholders must appear in the contractual provisions of the warrants.”
Klein’s discussion of the warrant structure as superior to the convertible note fails to properly address the cash flow concerns of the startup entrepreneur and recognize that the convertible note is an either/or model where the warrant is not. The entrepreneur with a convertible note either redeems the note or converts it to common. Under the warrant structure, the warrants remain after the note is redeemed. If the investor converts the convertible note to common stock, then the Company is not required to redeem the note. This is a significant cash-flow advantage to the entrepreneur and the convertible note may remain the better alternative for the startup entrepreneur.
Guaranteed credit facility
In many countries bank debt forms the most significant source of startup financing. However, in the U.S. venture capital is more prevalent and many startups have difficulties raising bank debt. Credit facilities are offered by U.S. banks but collateral is a problem for most technology startup entrepreneurs as the only asset available from the Company is usually intellectual property. The entrepreneur seeking a bank facility is usually forced to provide his/her house as collateral or have the loan guaranteed by another.
Instead of asking an investor to put cash into the startup company, the entrepreneur could ask the investor to act as guarantor. The advantage for the investor is that he/she can retain the cash for other purposes. The advantage for the entrepreneur is the lower interest rate payable to the bank, and with an overdraft facility there is more flexibility on the amount borrowed. The disadvantage when compared with equity financings (involving the sale of shares) is that the loan has to be repaid to the bank, with interest.
Of course, as the bank is acting as a lender, no fiduciary duties are owed to the bank by the management of the Company. The bank is clearly a creditor, but warrants to guarantors may trigger fiduciary duties unless the warrant are restricted from being exercised until a liquidity event like a sale of the Company.
The issue for most entrepreneurs is finding the guarantor. Perhaps several individuals, or organizations, could guarantee the facility. In the situation with multiple guarantors the question would arise as to who would be held liable if the Company were to fail and the debt remain unpaid. Perhaps the joint guarantors would be held jointly and severally liable. Currently, the banks in the U.S. do not offer a wide range of financing options for technology startups and refer entrepreneurs to the VC community. The banks dealing with small businesses tend to focus on SBA loans.
SBA loans
The Small Business Administration (“SBA[3]”) was established on July 30, 1953, by the United States Congress with the passage of the Small Business Act. Its function was to "aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns." Also stipulated was that the SBA should ensure a "fair proportion" of government contracts and sales of surplus property to small business. This was accomplished primarily through the Small Business Innovative Research program and government "set-asides."
The SBA itself does not grant loans to startups. Instead, the SBA guarantees against default certain portions of business loans made by banks and other lenders that conform to its guidelines[4]. The SBA loan guarantee is only available to small businesses. What qualifies as a small business depends on the industry and sector[5].
Repayment ability from the cash flow of the business is a primary consideration in the SBA loan decision process but good character, management capability, collateral, and owner's equity contribution are also important considerations. All owners of twenty percent (20%) or more of the business are required to personally guarantee SBA loans. The SBA does not deny approval for a SBA Guaranty Loan solely due to lack of collateral; however, it can be used as a reason, in addition to, other credit factors.
The SBA has directly or indirectly helped nearly 20 million businesses and currently holds a portfolio of roughly 219,000 loans worth more than $45 billion making it the largest single financial backer of businesses in the United States. The size of loan available through the SBA program ranges from $150,000 to $4m, but the SBA will only guarantee up to $1.5m.
Entrepreneurs and founders holding significant blocks of shares have to put their own assets on the line as personal guaranties are required by all owners holding 20% of the Company stock. SBA loans are criticized as equivalent to or many times worse than what the banks offer themselves, so a customer of that bank might choose the normal bank product more often than their SBA product. However, like a bank loan the SBA loan is pure debt, so fiduciary duties are not owed by management to the bank, or the SBA, so the entrepreneur does not gain rights to board seats, voting rights or other forms of control.
An SBA guaranteed loan is a viable alternative to venture funding for entrepreneurs that wish to retain control of their startup companies, however, it is a huge commitment as it usually means providing the entrepreneurs own personal assets as collateral.
[1] 123 U. Pa. L. Rev. 547. 558-68 (1975).
[2] 861 A.2d 1251.
[3] http://www.sba.gov
[4] http://www.sba.gov/smallbusinessplanner/start/financestartup/SERV_SBA_LOAN_TOPICS.html
[5] The SBA uses the North American Industrial Classification System (NAICS) in determining size standards.
Note with warrants
Klein, in his paper “The Convertible Bond: A Peculiar Package”[1], explains that a convertible note is ‘basically a debt financing, with the conversion privilege as a “sweetener”. He argues that a better alternative is to issue a bond with warrants—rights to acquire common stock.
Instead of conversion, the startup investment could be structured as a note accompanied with warrants to acquire common stock. The note will be redeemed in case of acquisition or liquidation, but the warrant could provide the holder with the right to purchase common at a preferential, pre-defined, price and participate in the upside potential.
Like a convertible note, the warrant doesn’t carry fiduciary duties or control power unless it is exercised. In addressing whether warrantholders were entitled appraisal rights in a takeover situation, and deciding in the negative, the Court in Aspen Advisors LLC v. UA Theatre Co[2]., confirmed that the Company does not owe fiduciary duties to warrantholders: “A warrantholder is not a stockholder… A warrantholder is only entitled to the rights of a shareholder.. after they (convert) to stock ownership”. The Court in Aspen also confirmed that the rights of warrantholders and preferred stockholders should be construed narrowly by the Courts: “Warrants are contractual entitlements. The exclusive rights and remedies of warrantholders must appear in the contractual provisions of the warrants.”
Klein’s discussion of the warrant structure as superior to the convertible note fails to properly address the cash flow concerns of the startup entrepreneur and recognize that the convertible note is an either/or model where the warrant is not. The entrepreneur with a convertible note either redeems the note or converts it to common. Under the warrant structure, the warrants remain after the note is redeemed. If the investor converts the convertible note to common stock, then the Company is not required to redeem the note. This is a significant cash-flow advantage to the entrepreneur and the convertible note may remain the better alternative for the startup entrepreneur.
Guaranteed credit facility
In many countries bank debt forms the most significant source of startup financing. However, in the U.S. venture capital is more prevalent and many startups have difficulties raising bank debt. Credit facilities are offered by U.S. banks but collateral is a problem for most technology startup entrepreneurs as the only asset available from the Company is usually intellectual property. The entrepreneur seeking a bank facility is usually forced to provide his/her house as collateral or have the loan guaranteed by another.
Instead of asking an investor to put cash into the startup company, the entrepreneur could ask the investor to act as guarantor. The advantage for the investor is that he/she can retain the cash for other purposes. The advantage for the entrepreneur is the lower interest rate payable to the bank, and with an overdraft facility there is more flexibility on the amount borrowed. The disadvantage when compared with equity financings (involving the sale of shares) is that the loan has to be repaid to the bank, with interest.
Of course, as the bank is acting as a lender, no fiduciary duties are owed to the bank by the management of the Company. The bank is clearly a creditor, but warrants to guarantors may trigger fiduciary duties unless the warrant are restricted from being exercised until a liquidity event like a sale of the Company.
The issue for most entrepreneurs is finding the guarantor. Perhaps several individuals, or organizations, could guarantee the facility. In the situation with multiple guarantors the question would arise as to who would be held liable if the Company were to fail and the debt remain unpaid. Perhaps the joint guarantors would be held jointly and severally liable. Currently, the banks in the U.S. do not offer a wide range of financing options for technology startups and refer entrepreneurs to the VC community. The banks dealing with small businesses tend to focus on SBA loans.
SBA loans
The Small Business Administration (“SBA[3]”) was established on July 30, 1953, by the United States Congress with the passage of the Small Business Act. Its function was to "aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns." Also stipulated was that the SBA should ensure a "fair proportion" of government contracts and sales of surplus property to small business. This was accomplished primarily through the Small Business Innovative Research program and government "set-asides."
The SBA itself does not grant loans to startups. Instead, the SBA guarantees against default certain portions of business loans made by banks and other lenders that conform to its guidelines[4]. The SBA loan guarantee is only available to small businesses. What qualifies as a small business depends on the industry and sector[5].
Repayment ability from the cash flow of the business is a primary consideration in the SBA loan decision process but good character, management capability, collateral, and owner's equity contribution are also important considerations. All owners of twenty percent (20%) or more of the business are required to personally guarantee SBA loans. The SBA does not deny approval for a SBA Guaranty Loan solely due to lack of collateral; however, it can be used as a reason, in addition to, other credit factors.
The SBA has directly or indirectly helped nearly 20 million businesses and currently holds a portfolio of roughly 219,000 loans worth more than $45 billion making it the largest single financial backer of businesses in the United States. The size of loan available through the SBA program ranges from $150,000 to $4m, but the SBA will only guarantee up to $1.5m.
Entrepreneurs and founders holding significant blocks of shares have to put their own assets on the line as personal guaranties are required by all owners holding 20% of the Company stock. SBA loans are criticized as equivalent to or many times worse than what the banks offer themselves, so a customer of that bank might choose the normal bank product more often than their SBA product. However, like a bank loan the SBA loan is pure debt, so fiduciary duties are not owed by management to the bank, or the SBA, so the entrepreneur does not gain rights to board seats, voting rights or other forms of control.
An SBA guaranteed loan is a viable alternative to venture funding for entrepreneurs that wish to retain control of their startup companies, however, it is a huge commitment as it usually means providing the entrepreneurs own personal assets as collateral.
[1] 123 U. Pa. L. Rev. 547. 558-68 (1975).
[2] 861 A.2d 1251.
[3] http://www.sba.gov
[4] http://www.sba.gov/smallbusinessplanner/start/financestartup/SERV_SBA_LOAN_TOPICS.html
[5] The SBA uses the North American Industrial Classification System (NAICS) in determining size standards.
The Startup Bond
Convertible notes have been used in seed stage startups for years, but they are usually used as a bridge to a preferred-stock round of funding. The concept behind the concept of the Startup Bond is that this form of financial instrument can be used in place of the preferred stock structure--and can be used to provide all the funding a startup needs.
Notes[1], bonds, loans and debentures are all forms of debt financing. Debt is attractive to the entrepreneur in that it does not provide the lender with an equity interest and the entrepreneur does not have to give up the same degree of control as he/she would expect under the VC-Preferred model. The downside to debt from the entrepreneurs perspective is that it needs to be paid back, with interest. The investor likes debt in that it puts them in the position of creditor if the Company fails and is forced into liquidation. The problem with debt from the perspective of the investor is that they do not get to participate in the upside profits if the Company is sold or reaches a successful exit.
The interests of both investor and entrepreneur can be achieved through a Startup Bond—a convertible debt instrument that converts to stock under certain pre-defined conditions. From the investor’s perspective, the beauty of the Startup Bond is that the investor has the upside of an equity position if the Company does well, but also has the protection of being a creditor, with priority over shareholders, if the Company does not perform well and winds up in liquidation. From the founders perspective, this structure is appealing as the noteholder is not a shareholder until conversion takes place, so has no fiduciary rights to vote or control the Company.
Fiduciary duties to noteholders
Delaware and other jurisdictions have well settled law that the fiduciary duties owed to a shareholder are not extended to the holder of a convertible note until the note is indeed converted to shares. Essentially, the holders of a convertible note are treated as creditors until they convert to stock—at which time they become shareholders. The court in Simons v. Cogan[2] found that the corporation and its directors did not owe a fiduciary duty to the debenture holders because the convertible debenture did not represent an equitable interest in the issuing corporation.
If the right to conversion can take place only at the closing of a liquidity event, such as acquisition or IPO, then the investor has very little control over the Company and the founders and existing management is free to operate the Company without worrying about fiduciary duties to outside investors.
Standing to bring derivative suits
A derivative suit is a civil lawsuit filed by shareholders on behalf of a corporation asserting rights of the corporation in the absence of corporate action to protect such rights—a suit by shareholders to enforce corporate rights against directors or other insiders. The standing of shareholders to sue is derived from the rights of the corporation. Although shareholders have standing to bring a derivative suit, under Delaware law[3], creditors do not. So, the holder of a note is unable to bring a derivative suit until the note is converted to equity, at which time the holder becomes a shareholder and fiduciary duties attach.
Usary laws
Debt usually carries interest, and the level of interest that can be charged by an individual is capped by state usary laws. Consumers are often treated differently than business borrowers, with different conditions and usary law caps. In California, the legal rate of interest is 10% for consumers; the general usury limit for non-consumers is more than 5% greater than the Federal Reserve Bank of San Francisco's rate. Currently in Delaware the legal rate of interest for all borrowers is 5% over the Federal Reserve rate. When arranging a note with an individual angel investor, the usary laws may be triggered so it is important to investigate the current interest rate and statute for the state in which the transaction takes place.
Redemption
The whole purpose of investing is to inject money now in the hope that it will be returned, with interest, at some point in future. By enforcing the Securities Exchange Act of 1934, the SEC prevents unregistered securities such as shares and notes issued to closely held corporations, from being traded on the secondary markets. So, investors in non-reporting companies run the risk of having their investments locked up and unavailable for redemption if the Company fails to reach an exit.
For this reason, it is important that the convertible note carry a redemption provision such as this:
Term Redemption
The Company agrees to redeem the notes four years after the issue by returning a total of [ ] times the principal to the noteholder. So, a $100,000 note issued in 2007 will be redeemed by the Company for $200,000 in 2011.
Early Redemption on Acquisition
The noteholder shall have the right to put the notes to the Company for early redemption in the case of a sale of the Company, or the sale of all, or substantially all, of the Company’s assets. So, if the Company is acquired prior to redemption of the notes, a holder of a $100,000 note putting the note to the Company shall receive the full redemption value of $200,000. However, it is anticipated that noteholders would elect to convert to common in the case of acquisition under the terms below.
As noted above, the usary laws can prevent the interest rate being set too high. The drafter of the provision can overcome this by using language referring to a “2x redemption” value in, say 4 years, instead of a “50% p.a. interest rate”.
An alternative that is more appealing to the investor is to give the investor the right to put the note to the Company for redemption after a certain period of time has passed and the Company has the funds to redeem the note with interest:
Right to Put the Note to the Company for Redemption
At any time after the [ ] year anniversary of the issuing of the note, the noteholder can put the note to the Company for redemption. Within [ ] days, the Company will redeem by returning a total of [ ] times the principal to the noteholder. So, a $[ ] note issued in 2007 could be put to Company in [ ] for a redemption value of [ ].
This would allow the investor to liquidate his/her funds if the Company is not acquired and there is no other liquidity event such as an IPO.
Conversion rights
Angel investors are accustomed to notes with conversion provisions anticipating a preferred round of funding. If there is no preferred round anticipated, then the note needs to allow for conversion at other triggering liquidity events such as the sale of company, sale of control, or sale of the Company’s assets.
Common Stock Conversion Rights
Immediately preceding a sale of the Company, or the sale of all, or substantially all, of the Company’s assets, or IPO, the noteholder shall have the right to elect to convert the note to common stock. The conversion rate shall be calculated at $[ ] per share, reflecting a pre-funding valuation of $[ ]. So a note acquired for $[ ] would convert to [ ] shares of common stock.
This allows the investor to benefit from the upside in an acquisition or exit by conversion to common stock, but by pushing the point of conversion to the time immediately preceding such event, the fiduciary duties owed by management to the investor are only triggered for a brief moment in time between the conversion and the closing of the transaction (such as the sale of the Company). This structure allows the entrepreneur to maintain control over the Company and avoid being forced to answer to the investors. Decision-making regarding dividends, exits and other significant matters are left with the entrepreneur.
Of course, the investor would like to have the option of converting to preferred stock if a VC-Preferred round were to take place, and a provision could be made in the note allowing for this:
Preferred Stock Conversion Rights
Management does not envisage the Company needing to raise significant rounds of funding and currently has no plans to raise a venture round of funding. However, if conditions change and preferred stock is issued, then the noteholder shall have the right to convert the note to such preferred stock. In such case, the redemption value of the note shall be used to calculate the number of shares of preferred stock that shall be issued to the noteholder. So, a $100,000 note with a redemption value of $200,000 could acquire preferred stock with a value of $200,000.
Exemptions from registration
Under the 1933 Securities Act and the 1934 Securities Exchange act, it is illegal to sell securities unless they are registered with the SEC, or qualify for a valid exemption from registration. Under the definitions and enumerated lists defining the scope of instruments classified as security in both the 1933 and 1934 acts, the preferred stock investment and the convertible note would fall within the scope of a ‘security’. So, the convertible note would need to be registered with the SEC or qualify for an exemption. The intra-state exemption can easily be accidentally voided by solicitation to a potential investor out of state. So, Regulation D, the private placement safe harbor provision of section 4(2) provides the most obvious source of exemption. Under Regulation D, a Form D would need to be filed with the SEC, this can be done online through the Edgars system, and either of Rules 504, 505 or 506 selected. Rounds less than $1m in value can qualify for Rule 504, rounds under $5m would seek the exemption of Rule 505, and rounds larger than that would need to be exempted under the more strenuous conditions of Rule 506.
Founders using these exemptions when raising funds for their companies need to be extremely careful that they do not solicit the offering. Each of the rules (504-506) has its own solicitation guidelines and state law also governs solicitation of securities to investors. Companies should be advised to take extreme care not to advertise the offering and to focus on face-to-face solicitations wherever possible.
Disclosure
The securities regulations and SEC enforcement activities focus on disclosure. Issuers of securities (in this case startup companies raising funding) are required to provide accurate disclosure of material information to investors. Information is considered material if a reasonable investors would consider the information when making a decision to buy or sell the security, or to cast a shareholder vote. A lawsuit based on fraud can be brought by a shareholder or investor as the result of a mis-statement or omission of a material fact under the 10b-5 section of the 1933 Act. Section 11 also allows for a claim of fraud in the prospectus, but this only applies to situations of IPO or issues of new securities by post-IPO reporting issuers.
So, what does the entrepreneur need to disclose to the investor to avoid an action based on 10b-5 fraud? There are no bright-line rules but form SB-1 or SB-2 could be used as guideline of the type of information that should be provided to investors. Although it sets a higher bar in terms of what needs to be disclosed, SB-2 may be the safer option for issuers to select as it incorporates a requirement to disclose the risk factors. By failing to disclose such risk factors, founders may find themselves less-than perfectly prepared to defend a 10b-5 suit from disgruntled investors later on.
New convertible note offerings from VCs
Charles River Ventures[4] (CRV), a Silicon Valley VC recently launched an interesting new form of investment structure for companies raising smaller rounds of funding. The CRV program works as follows:
CRV has created an innovative program to eliminate these issues and help entrepreneurs get up and running quickly - the CRV QuickStart Seed Funding Program. CRV QuickStart provides select entrepreneurs with a loan to fund the work needed to build out your idea, enabling you to explore its potential in its earliest stage before you raise a round of formal equity financing. By offering up to $250,000 in the form of a loan (also referred to as a “convertible note”), we’re providing the capital to fuel ideas without that painful seed-stage dilution.
Here is how the loan works:
A standard interest bearing loan will be made to a corporation, which we will help you establish if you do not already have one in place. CRV will not seek a personal guarantee and will not hold you personally responsible for repaying the loan.
The loan converts into equity only if and when your company closes its next round of funding (typically a Series A round). If the Company successfully raises its next round, in exchange for sharing the risk with the entrepreneur, CRV receives a discount on the conversion price when the loan is rolled into that next round. the discount will be a maximum of 25% (determined ratably at five percent per month, depending on how long it takes to close the financing, up to the maximum) off of the per share price.
A simple example: if CRV loans your company $100,000 with a six percent interest rate, and six months later the Company closed a Series A round, at that point the loan balance (with interest) would convert at a 25% discount (value = loan dollar amount plus interest / .75) into $137,333.33 worth of Series A stock. Given that seed funding amounts are typically very small compared to the amounts one might expect to raise in a Series A round, as the example illustrates, the aggregate discount amount, in this case $37K, is a tiny fraction of what tends to be a multimillion dollar Series A financing.
In addition, CRV would like the opportunity to support the Series A financing and will have an option to invest equally with other new investors in the Series A equity funding. For example, if you raise a $3M Series A round, and the entrepreneur wanted 2 venture firms or investors, CRV would be allowed to contribute up to $1.5M of the round (e.g. $3M divided by 2). If the entrepreneur wanted 4 firms or investors, CRV would be allowed to contribute up to $750K of the round (e.g. $3M divided by 4). Whatever number of investors the entrepreneur wants, we will happily support the ability to split the investment equally among the investors.
This type of structure bridges the gap between angel funding and VC, and it is important in that it provides new options and alternatives to entrepreneurs.
[1] A note is usually less than 5 years in duration, a bond is longer than 5 years and a debenture is unsecured.
[2] 549 A 2d 300. Delaware. 1988.
[3] Kusner v. First Pennsylvania Corp., 531 F.2d 1234.
[4] http://www.crv.com/AboutCRV/QuickStart.html
Notes[1], bonds, loans and debentures are all forms of debt financing. Debt is attractive to the entrepreneur in that it does not provide the lender with an equity interest and the entrepreneur does not have to give up the same degree of control as he/she would expect under the VC-Preferred model. The downside to debt from the entrepreneurs perspective is that it needs to be paid back, with interest. The investor likes debt in that it puts them in the position of creditor if the Company fails and is forced into liquidation. The problem with debt from the perspective of the investor is that they do not get to participate in the upside profits if the Company is sold or reaches a successful exit.
The interests of both investor and entrepreneur can be achieved through a Startup Bond—a convertible debt instrument that converts to stock under certain pre-defined conditions. From the investor’s perspective, the beauty of the Startup Bond is that the investor has the upside of an equity position if the Company does well, but also has the protection of being a creditor, with priority over shareholders, if the Company does not perform well and winds up in liquidation. From the founders perspective, this structure is appealing as the noteholder is not a shareholder until conversion takes place, so has no fiduciary rights to vote or control the Company.
Fiduciary duties to noteholders
Delaware and other jurisdictions have well settled law that the fiduciary duties owed to a shareholder are not extended to the holder of a convertible note until the note is indeed converted to shares. Essentially, the holders of a convertible note are treated as creditors until they convert to stock—at which time they become shareholders. The court in Simons v. Cogan[2] found that the corporation and its directors did not owe a fiduciary duty to the debenture holders because the convertible debenture did not represent an equitable interest in the issuing corporation.
If the right to conversion can take place only at the closing of a liquidity event, such as acquisition or IPO, then the investor has very little control over the Company and the founders and existing management is free to operate the Company without worrying about fiduciary duties to outside investors.
Standing to bring derivative suits
A derivative suit is a civil lawsuit filed by shareholders on behalf of a corporation asserting rights of the corporation in the absence of corporate action to protect such rights—a suit by shareholders to enforce corporate rights against directors or other insiders. The standing of shareholders to sue is derived from the rights of the corporation. Although shareholders have standing to bring a derivative suit, under Delaware law[3], creditors do not. So, the holder of a note is unable to bring a derivative suit until the note is converted to equity, at which time the holder becomes a shareholder and fiduciary duties attach.
Usary laws
Debt usually carries interest, and the level of interest that can be charged by an individual is capped by state usary laws. Consumers are often treated differently than business borrowers, with different conditions and usary law caps. In California, the legal rate of interest is 10% for consumers; the general usury limit for non-consumers is more than 5% greater than the Federal Reserve Bank of San Francisco's rate. Currently in Delaware the legal rate of interest for all borrowers is 5% over the Federal Reserve rate. When arranging a note with an individual angel investor, the usary laws may be triggered so it is important to investigate the current interest rate and statute for the state in which the transaction takes place.
Redemption
The whole purpose of investing is to inject money now in the hope that it will be returned, with interest, at some point in future. By enforcing the Securities Exchange Act of 1934, the SEC prevents unregistered securities such as shares and notes issued to closely held corporations, from being traded on the secondary markets. So, investors in non-reporting companies run the risk of having their investments locked up and unavailable for redemption if the Company fails to reach an exit.
For this reason, it is important that the convertible note carry a redemption provision such as this:
Term Redemption
The Company agrees to redeem the notes four years after the issue by returning a total of [ ] times the principal to the noteholder. So, a $100,000 note issued in 2007 will be redeemed by the Company for $200,000 in 2011.
Early Redemption on Acquisition
The noteholder shall have the right to put the notes to the Company for early redemption in the case of a sale of the Company, or the sale of all, or substantially all, of the Company’s assets. So, if the Company is acquired prior to redemption of the notes, a holder of a $100,000 note putting the note to the Company shall receive the full redemption value of $200,000. However, it is anticipated that noteholders would elect to convert to common in the case of acquisition under the terms below.
As noted above, the usary laws can prevent the interest rate being set too high. The drafter of the provision can overcome this by using language referring to a “2x redemption” value in, say 4 years, instead of a “50% p.a. interest rate”.
An alternative that is more appealing to the investor is to give the investor the right to put the note to the Company for redemption after a certain period of time has passed and the Company has the funds to redeem the note with interest:
Right to Put the Note to the Company for Redemption
At any time after the [ ] year anniversary of the issuing of the note, the noteholder can put the note to the Company for redemption. Within [ ] days, the Company will redeem by returning a total of [ ] times the principal to the noteholder. So, a $[ ] note issued in 2007 could be put to Company in [ ] for a redemption value of [ ].
This would allow the investor to liquidate his/her funds if the Company is not acquired and there is no other liquidity event such as an IPO.
Conversion rights
Angel investors are accustomed to notes with conversion provisions anticipating a preferred round of funding. If there is no preferred round anticipated, then the note needs to allow for conversion at other triggering liquidity events such as the sale of company, sale of control, or sale of the Company’s assets.
Common Stock Conversion Rights
Immediately preceding a sale of the Company, or the sale of all, or substantially all, of the Company’s assets, or IPO, the noteholder shall have the right to elect to convert the note to common stock. The conversion rate shall be calculated at $[ ] per share, reflecting a pre-funding valuation of $[ ]. So a note acquired for $[ ] would convert to [ ] shares of common stock.
This allows the investor to benefit from the upside in an acquisition or exit by conversion to common stock, but by pushing the point of conversion to the time immediately preceding such event, the fiduciary duties owed by management to the investor are only triggered for a brief moment in time between the conversion and the closing of the transaction (such as the sale of the Company). This structure allows the entrepreneur to maintain control over the Company and avoid being forced to answer to the investors. Decision-making regarding dividends, exits and other significant matters are left with the entrepreneur.
Of course, the investor would like to have the option of converting to preferred stock if a VC-Preferred round were to take place, and a provision could be made in the note allowing for this:
Preferred Stock Conversion Rights
Management does not envisage the Company needing to raise significant rounds of funding and currently has no plans to raise a venture round of funding. However, if conditions change and preferred stock is issued, then the noteholder shall have the right to convert the note to such preferred stock. In such case, the redemption value of the note shall be used to calculate the number of shares of preferred stock that shall be issued to the noteholder. So, a $100,000 note with a redemption value of $200,000 could acquire preferred stock with a value of $200,000.
Exemptions from registration
Under the 1933 Securities Act and the 1934 Securities Exchange act, it is illegal to sell securities unless they are registered with the SEC, or qualify for a valid exemption from registration. Under the definitions and enumerated lists defining the scope of instruments classified as security in both the 1933 and 1934 acts, the preferred stock investment and the convertible note would fall within the scope of a ‘security’. So, the convertible note would need to be registered with the SEC or qualify for an exemption. The intra-state exemption can easily be accidentally voided by solicitation to a potential investor out of state. So, Regulation D, the private placement safe harbor provision of section 4(2) provides the most obvious source of exemption. Under Regulation D, a Form D would need to be filed with the SEC, this can be done online through the Edgars system, and either of Rules 504, 505 or 506 selected. Rounds less than $1m in value can qualify for Rule 504, rounds under $5m would seek the exemption of Rule 505, and rounds larger than that would need to be exempted under the more strenuous conditions of Rule 506.
Founders using these exemptions when raising funds for their companies need to be extremely careful that they do not solicit the offering. Each of the rules (504-506) has its own solicitation guidelines and state law also governs solicitation of securities to investors. Companies should be advised to take extreme care not to advertise the offering and to focus on face-to-face solicitations wherever possible.
Disclosure
The securities regulations and SEC enforcement activities focus on disclosure. Issuers of securities (in this case startup companies raising funding) are required to provide accurate disclosure of material information to investors. Information is considered material if a reasonable investors would consider the information when making a decision to buy or sell the security, or to cast a shareholder vote. A lawsuit based on fraud can be brought by a shareholder or investor as the result of a mis-statement or omission of a material fact under the 10b-5 section of the 1933 Act. Section 11 also allows for a claim of fraud in the prospectus, but this only applies to situations of IPO or issues of new securities by post-IPO reporting issuers.
So, what does the entrepreneur need to disclose to the investor to avoid an action based on 10b-5 fraud? There are no bright-line rules but form SB-1 or SB-2 could be used as guideline of the type of information that should be provided to investors. Although it sets a higher bar in terms of what needs to be disclosed, SB-2 may be the safer option for issuers to select as it incorporates a requirement to disclose the risk factors. By failing to disclose such risk factors, founders may find themselves less-than perfectly prepared to defend a 10b-5 suit from disgruntled investors later on.
New convertible note offerings from VCs
Charles River Ventures[4] (CRV), a Silicon Valley VC recently launched an interesting new form of investment structure for companies raising smaller rounds of funding. The CRV program works as follows:
CRV has created an innovative program to eliminate these issues and help entrepreneurs get up and running quickly - the CRV QuickStart Seed Funding Program. CRV QuickStart provides select entrepreneurs with a loan to fund the work needed to build out your idea, enabling you to explore its potential in its earliest stage before you raise a round of formal equity financing. By offering up to $250,000 in the form of a loan (also referred to as a “convertible note”), we’re providing the capital to fuel ideas without that painful seed-stage dilution.
Here is how the loan works:
A standard interest bearing loan will be made to a corporation, which we will help you establish if you do not already have one in place. CRV will not seek a personal guarantee and will not hold you personally responsible for repaying the loan.
The loan converts into equity only if and when your company closes its next round of funding (typically a Series A round). If the Company successfully raises its next round, in exchange for sharing the risk with the entrepreneur, CRV receives a discount on the conversion price when the loan is rolled into that next round. the discount will be a maximum of 25% (determined ratably at five percent per month, depending on how long it takes to close the financing, up to the maximum) off of the per share price.
A simple example: if CRV loans your company $100,000 with a six percent interest rate, and six months later the Company closed a Series A round, at that point the loan balance (with interest) would convert at a 25% discount (value = loan dollar amount plus interest / .75) into $137,333.33 worth of Series A stock. Given that seed funding amounts are typically very small compared to the amounts one might expect to raise in a Series A round, as the example illustrates, the aggregate discount amount, in this case $37K, is a tiny fraction of what tends to be a multimillion dollar Series A financing.
In addition, CRV would like the opportunity to support the Series A financing and will have an option to invest equally with other new investors in the Series A equity funding. For example, if you raise a $3M Series A round, and the entrepreneur wanted 2 venture firms or investors, CRV would be allowed to contribute up to $1.5M of the round (e.g. $3M divided by 2). If the entrepreneur wanted 4 firms or investors, CRV would be allowed to contribute up to $750K of the round (e.g. $3M divided by 4). Whatever number of investors the entrepreneur wants, we will happily support the ability to split the investment equally among the investors.
This type of structure bridges the gap between angel funding and VC, and it is important in that it provides new options and alternatives to entrepreneurs.
[1] A note is usually less than 5 years in duration, a bond is longer than 5 years and a debenture is unsecured.
[2] 549 A 2d 300. Delaware. 1988.
[3] Kusner v. First Pennsylvania Corp., 531 F.2d 1234.
[4] http://www.crv.com/AboutCRV/QuickStart.html
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