The Significance of Accredited Investors vs. Non-Accredited Investors
The unfortunate reality of United States securities law is that your company cannot take investment money from just anyone.
One of the most important distinctions in the world of fundraising and securities law is “accredited” versus “non-accredited” investors.
An “accredited investor” is generally an individual with at least $1,000,000 in net worth excluding the equity in their primary residence, or at least $200,000 in income in the last two years and the expectation of the same in the year the investment takes place, or $300,000 with their spouse. A non-accredited investor is essentially everyone besides that. And securities law draws a hard line between the two.
Is this pup accredited or non-accredited? In other news, I really want a dog.
The two easiest and cheapest ways to raise money for startups are Rule 506(b) and Rule 506(c) under Reg D. Under Rule 506(c), non-accredited investors are completely forbidden in the offering. Under Rule 506(b), if you take investment money from only accredited investors, in terms of filings and paperwork, you need only file the Form D. There are no Private Place Memorandums, no additional disclosures, no nothing.
Under Rule 506(b), you can also take investment money from up to 35 non-accredited investors. But here is the problem.
In a Rule 506(b) offering, if you want to take funds from even one non-accredited investor, your disclosure obligations do not scale—they skyrocket. You walk off a legal expense and disclosure obligations cliff. You go from essentially observing the the anti-fraud rules, to public offering (e.g., IPO) level disclosure by taking investment money from even just one non- accredited investor.
Putting forth that amount of money and time just to raise a small amount of funds from a small amount of non-accredited investors is just not worth it.
Securities law assumes accredited investors with the financial means set forth in the law are sophisticated, knowledgeable parties that do not require any additional disclosures. On the flip side, securities law requires a myriad of disclosures to non-accredited investors to “make up” for this apparent lack of sophistication and knowledge. Whether this is actually true or not is besides the point until securities laws changes.
Conclusion
We do not agree with the current framework and have written the SEC (and were later quoted by it in its response) asking it to change it. We hope that they heed our comments and the rest of the legal community’s in doing so.
Until then, make sure you are fundraising pragmatically and within your economic limitations.
Note: if you are set on taking investment funds from non-accredited investors, the best way to go about it is Title III of the JOBS Act, the federal equity crowdfunding rules. We have written extensively on this exemption here and here.
If you have any questions about the above, please feel free to contact me.
Disclaimer: this post is for informational and educational purposes only. It is not intended to provide any legal advice.
Raising equity capital for a startup properly can be challenging, but it is the first step before starting a successful business. Read below more information.
Introduction
If you are raising money capital from investors for your startup, no matter how you do it, there are rules you must be careful to follow. If you do this wrong, you can find yourself personally responsible for investor losses, which is never where you want to find yourself.
In general, under both state and federal law, if you want to sell an equity stake in your business, you have to either:
Register the security with the SEC and/or state securities regulators (which is generally really, really expensive and time-consuming), or
Identify and carefully comply with an exemption from registration, and ideally, a safe harbor exemption.
In startup land, you almost always seek an exemption because the costs of registration are so dauntingly prohibitive.
And so, you might wonder, what are these exemptions, and how hard and expensive are they to comply with?
We have summarized the six most common securities law exemptions startups use to raise investor money and ranked them by degree of difficulty and expense below.
Be sure not to fall into….whatever it is they’re standing above.
From The Least Burdensome and Easiest to Use to the Hardest and Most Expensive
(1)The All Accredited Investor Rule 506(b) Offering
By far the easiest and least expensive exemption to use for raising equity capital for your startup is known as an “all accredited investor Rule 506(b) offering.”
An “all accredited Rule 506(b) offering” has the least requirements of probably any security offering anywhere.
The salient characteristics of an “all accredited investor Rule 506(b) offering” are these:
You can raise an unlimited amount of money.
You can accept investments only from “accredited investors.” An “accredited investor” is generally an individual with a $1M net worth excluding the equity in their primary residence or at least $200,000 in income in the last two years and the expectation of the same in the year of investment, or $300,000 with a spouse. The reason this type of offering is the easiest is because you are only taking money from accredited investors. If you accept funds from even 1 non-accredited investor, you have to provide registered offering level disclosure, which is a very substantial expense.
You can’t generally solicit or generally advertise the offering. Meaning, you can’t post about it on Facebook, or LinkedIn, or Twitter, or send mass emails, etc.
You have to file a Form D with the SEC and generally with each state where your investors are residents within 15 days of first taking money.
Rule 506(b) does not have any specific information disclosure requirements.
With this exemption, you can begin your fundraising quest with your pitch deck, an executive summary, and a 1-page term sheet. The legal expense involved in this step is minimal.
Once you have commitments sufficient to close, you can then proceed to document the deal. This means your legal fees are generally coincident with the money coming in, which means you don’t have to pay your lawyer for the vast majority of the work until you have money coming in with which to pay the legal fees.
(2) Rule 506(c)
Rule 506(c) is the next easiest and least expensive type of offering to execute.
The salient characteristics of a Rule 506(c) offering are:
You can raise an unlimited amount of money.
You can only take money from accredited investors.
You have to file a Form D with the SEC and generally each state in which your investors are residents, and your headquarter state within 15 days of making money.
In Rule 506(c) offering, you can generally solicit and advertise your offering. Meaning, you can put on your company’s website that you are selling securities in the business, or on Twitter, our Facebook, or LinkedIn, mass emails, etc. (This is a massive difference from Rule 506(b)).
But, you have to “verify” that the investors are accredited. Meaning, you have to ask the investors for copies of their tax returns or personal financial statements and run a credit report to confirm that they are accredited (you can’t rely on a simple verification from them like you can in Rule 506(b) offering). If you want, you can use a third-party service to provide this service.
(3) Rule 504
If you are a Washington company, and you want to raise money from both accredited and non-accredited investors resident in the State of Washington, then you might want to take a look at Rule 504 when it comes to raising equity capital.
The salient characteristics of a Rule 504 offering are these:
You can raise up to $1,000,000 during any 12-month period from both accredited and non-accredited investors.
You have to file a Form D 10 days in advance of the first sale of the securities with the Washington State Department of Financial Institutions (DFI). They may comment on your offering materials.
You can only take money from a limited number of non-accredited investors. For offerings to Washington State residents, this limit is 20. You can accept subscriptions from an unlimited number of accredited investors, up to the $1,000,000 limit.
You cannot advertise the offering.
You have to provide adequate disclosure. For offerings to Washington State residents, the Washington State Securities regulator (the WA Department of Financial Institutions) refers you to the Small Company Offering Registration (SCOR) form as a good guide to the types of disclosures you will need to make. If you want to get an idea of the type of disclosures you will be required to put together, please take a look at the SCOR form, which you can find a link to this page: https://dfi.wa.gov/small-business/small-company-offering-registration.
You have to have reasonable grounds to believe, after making the reasonable inquiry that, as to each purchaser, one of the following conditions, (i) or (ii) of this subsection, is satisfied:
(i) The investment is suitable for the purchaser upon the basis of the facts, if any, disclosed by the purchaser as to his other security holdings and as to his financial situation and needs. For the purpose of this condition only, it may be presumed that if the investment does not exceed ten percent of the purchaser’s net worth, it is suitable. This presumption is rebuttable; or
(ii) The purchaser either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he or she is or they are capable of evaluating the merits and risks of the prospective investment.
Unrelated but relevant: it is currently mid 60s in Seattle, and we are 1/3 of the way through July, which is making one of the authors of this post exceptionally unhappy.
(4) Title III Equity Crowdfunding / Regulation CF
Title III equity crowdfunding is the type of equity crowdfunding created by the JOBS Act. The salient characteristics of the law are:
You can raise up to $1,070,000 during any 12-month period.
You can raise money from both accredited and non-accredited investors throughout the United States.
You have to go through a registered broker-dealer or registered funding portal (such as Wefunder.com) and pay their commissions and fees.
If you are a first time user of the law and you are raising up to $1,000,000, your financial statements have to be “reviewed” by an independent accounting firm.
There are the same individual investor limitations as summarized in the section above on Washington State equity crowdfunding.
You can conduct a Title III equity crowdfunding and a Rule 506 offering at the same time, as long as you comply with the requirements of both offerings.
You can sell any type of security in a Title III equity crowdfunding, including revenue loans.
Title III Equity Crowdfunding offerings are exempt from the applicability of 12(g) shareholder limits.
Washington State has its own equity crowdfunding, and raising equity capital law. The salient characteristics of the law are:
You can raise up to $1,000,000 during any 12-month period.
Your financial statements must be prepared in accordance with GAAP, but they do not need to be audited or reviewed.
You have to file the Crowdfunding Form and the Washington State Department of Financial Institutions must approve your form before you can start selling securities.
You can only sell securities to Washington residents.
You can sell convertible debt or convertible equity, preferred stock, common stock, or LLC interests, but you can’t sell revenue loans. (A revenue loan is a loan that is repaid by making monthly or quarterly payments that are a percentage of gross or net income until a multiple of the loan amount is repaid. Revenue loans can be an ideal way for a business to raise money in an equity crowdfunding.)
You can advertise, but the advertisements have to be pre-approved by the DFI.
You must use an escrow agent to hold the funds until the minimum amount is raised.
Accredited investors can invest an unlimited amount.
Non-accredited investors can only invest the lesser of
$2,000 or 5% of their net worth or annual income if their net worth or annual income is less than $100,000, or
10% of income or net worth, if income and net worth are above $100,000.
Under state law equity crowdfunding, you do have a Section 12(g) exemption because of the intra-state nature of the offering. Section 12(g) of the Exchange Act, in certain circumstances, limits the number of equity holders you may have before you must register your securities with the SEC (2,000 holders of record or 500 unaccredited investors).
(6) Regulation A+
Of the different types of exempt offerings summarized here, a “Regulation A+” offering is probably the most difficult to execute. There are two types of Regulation A+ offerings – Tier 1 and Tier 2. The salient characteristics of the law are:
You can raise up to $20,000,000 in a Tier 1 offering and $50,000,000 in a Tier 2 offering in any 12-month period.
You must submit your offering materials for review and comment to the SEC and/or applicable state securities regulators. They will comment on your filed materials, and you will have to revise your materials and reply to their comments. Sometimes this review process can take months (even with consolidated review), and really can drive up the costs of your offering.
You must have financial statements that at the very least have been reviewed by an independent accounting firm, and in a Tier 2 offering they must be audited.
You have a Section 12(g) exemption from the shareholder limits in a Tier 2 offering. 12(g) still applies to a Tier 1 offering.
There are certain eligibility restrictions for Regulation A+ use, most notably your company cannot be a development stage company that either (a) has no specific business plan or purpose, or (b) has indicated that its business plan is to merge with an unidentified company or companies.
Seriously though Seattle it’s time to warm up.
What About Section 4(a)(2)?
4(a)(2) is probably not relevant for the purposes of raising money from your company, at least in this context.
To qualify for this exemption, which is sometimes referred to as the “private placement” exemption, the purchasers of the securities must:
either have enough knowledge and experience in finance and business matters to be “sophisticated investors” (able to evaluate the risks and merits of the investment), or be able to bear the investment’s economic risk; and
have access to the type of information normally provided in a prospectus for a registered securities offering.
As the SEC states:
“The precise limits of the private placement exemption are not defined by rule. As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the offering qualifies for this exemption. If your company offers securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.”
What’s more, 4(a)(2) is not a “safe harbor” exemption. In “safe harbor” exemptions, the company is deemed to have satisfied securities laws if it complies with certain safe harbor exemptions, e.g., 506(b) and (506(c). Since 4(a)(2) is not a “safe harbor” exemption, if an investor were to bring suit against your company, your company would bear the burden of proof that it disclosed all required facts, did not omit any material disclosures, etc. In the court system, this becomes what is called a “question of fact,” which is extremely expensive to establish in your favor.
In sum, the “private placement” exemption comes with so much risk, and there are so many better alternatives, that we do not generally recommend it.
Summary
In summary, when you plan your offering, think through your exemption strategy carefully to ensure that the exemption you use matches your fundraising goals and the specific attributes of your investor group (e.g., accredited, location, etc.). A modest amount of forethought will make the entire process much more painless and perhaps even enjoyable. Receiving funding is an exciting time in the life of your business. Make sure to choose the right exception so any compliance issues do not overshadow your success.
If you have any questions about the above, please feel free to contact Joe Wallin or James Graves.
Disclaimer: this post is for informational and educational purposes only and is not intended to be an exhaustive list of all securities law exemptions that are available. It is not intended to provide any legal advice
Any time a company grants stock options or compensatory equity awards of any kind, the company must comply with the registration requirements of federal and applicable state securities laws or find an applicable exemption from the registration requirements.
If you are a startup, the securities law exemption you will probably rely on the most in issuing options or other types of compensatory equity awards is Rule 701.
Rule 701 is a federal securities law exemption that allows you to grant your employees or independent contractors compensatory equity issuances under the Equity Incentive Plan you (hopefully) adopted when you formed your company.
For example, if you want to grant your employees or independent contractors stock options, you would typically rely on Rule 701 as your exemption.
Happy almost Fourth of July!
What to Watch Out For
However, Rule 701 has several qualifications, conditions, and limitations you need to familiarize yourself with. One of the issues we frequently run into is startups attempting to grant compensatory equity under Rule 701 to non-individuals, e.g., somebody’s consulting LLC.
Rule 701 says you can grant options or compensatory equity incentives to employees and consultants, and advisors as long as they are natural persons. Here is its plain language:
(1)Special requirements for consultants and advisors. This section is available to consultants and advisors only if:
(i) They are natural persons;
(ii) They provide bona fide services to the issuer, its parents, its majority-owned subsidiaries or majority-owned subsidiaries of the issuer’s parent; and
(iii) The services are not connected with the offer or sale of securities in a capital-raising transaction and do not directly or indirectly promote or maintain a market for the issuer’s securities.
The SEC’s Advisory Committee on Small and Emerging Companies has recommended that this rule be changed, but it is still the rule of writing this blog post.
Practical Guidance
Thus, if someone wants their compensatory equity titled in the name of their consulting LLC or other business entity, you have to tell them no. You cannot do that under Rule 701. You need to find a different securities law exemption. For example, if your award recipient was an accredited investor, you could grant them under Rule 506(b), but you would then need to make sure you are fully complying with all the requirements of that particular securities law exemption.
You also probably can’t grant the compensatory equity award to any non-individuals under your Equity Incentive Plan because your Plan probably limited eligible award recipients to individuals eligible to receive awards under Rule 701. Thus, you have to grant them under some other exemption other than outside Rule 701 and outside your Equity Incentive Plan.
Always have a separate ledger in your cap table for options or other compensatory equity award issuances outside Rule 701 and your Equity Incentive Plan.
Our federal tax system, the public policy, makes it unnecessarily difficult for private companies to share stock with their employees, contractors, advisors, and other service providers.
The problem lies in our tax law.
The Problem with Issuing Shares to Workers
Why doesn’t your employer bonus your shares? Because the IRS treats any share bonus as if the company paid you cash equal to the value of the shares, and then you used that cash to turn around and buy the shares.
This means that if you are an employee and your employer bonuses your shares, you actually have to write the company a check (!) — so that the company can send the IRS the income and employment taxes it was required by law to withhold from you.
Frequently, employees can’t bear the tax burden associated with a share award. For example, suppose your employer wanted to award you 100,000 shares, and the shares were valued at $1.00 per share based on the company’s most recent 409A valuation. That would be $100,000 in taxable income. The tax withholding that the employer must make from the employee on a $100,000 cash bonus is significant.
The current supplemental wage withholding rate is 22%. Therefore, the employer must ask the employee to write the company a check for $22,000.
Plus, the company must also withhold the employee-side FICA tax — an additional 7.65% of all compensation until you hit the FICA wage base, and then only hospital insurance tax of 1.45% needs to be withheld.
To add to this tax problem, also remember that you cannot turn around and sell any of the shares you receive because there is no market for the shares and the securities laws place restrictions on your sale of the shares, and your company’s documents probably contain restrictions on transfer (such as a right of first refusal) as well.
All in all, this makes it difficult for employers and employees alike to share in a company’s equity by issuing stock awards.
What if the shares are subject to vesting?
Issuing the shares subject to vesting doesn’t solve any problems. In fact, it makes the tax matters worse. You can file an 83(b) election and be taxed on all the shares upon receipt, despite them being subject to vesting. Or you can not make such an election and be taxed when the shares vest at their value at that time. This means if the stock goes up in value, you owe even more—sometimes way, way more—in taxes.
The Alternatives: Stock Options Priced at No Less than Fair Market Value
To solve this problem, private, non-public companies typically turn to stock options priced at not less than fair market value (FMV) at the time of grant.
Stock options are frequently used by private companies as a substitute for share awards because as long as the stock option is priced at not less than FMV at the time of grant, there are no immediate tax consequences to the optionee or the company. Instead, the tax event is deferred until the options are either exercised or cashed out.
However, this deferral comes with downstream difficulties.
Many companies take 7-10 or more years to have a liquidity event—IPO or acquisition—and employees typically wait to get cashed out on their options in connection with such a liquidity event. So employees typically have to stay with the same company through that entire time to reap the benefits of their options. Often times, an employee is taking the job at a startup for a lower than market salary in exchange for the upside of options, which is always a gamble.
And what about the many employees who don’t stay 7-10 years? Many companies provide former employees only 90 days after leaving to exercise their options. However, this is a problem for a lot of optionees for reasons similar to companies bonusing employees shares—because it can be cost-prohibitive to (i) pay the exercise price, and (ii) pay the company all the income and employment taxes so the company can remit it to the IRS. So if an optionee leaves the company, they need to dig (sometimes deep) into their own pocket to keep their equity; otherwise, they lose it forever.
ISOs Don’t Solve the Problem
Wait, you say—don’t incentive stock options solve this problem? No. If there is a spread on the exercise of an ISO, the alternative minimum tax consequences can be severe and untoward.
What About Restricted Stock Units (RSUs)?
RSUs don’t solve any problems with private companies because when your RSU vests and is “settled,” you receive fully vested shares of stock. This is not good because, at this point in time, you now owe tax on the value of the shares received as if your employer gave you the cash and you used the cash to buy the stock. See the discussion of tax withholding above.
RSUs work great for companies like Microsoft and Amazon because those companies have robust public markets for their shares, and employees can turn around and immediately sell half the shares received so that the taxes can be paid. But this doesn’t work in the private company context for the reasons described above.
So, What’s the Solution?
We Need Congress To Fix The Problem
Congress should pass a law that says that transfers of stock to workers are not taxable if the company is not public. Instead, the tax will be levied when the shares are sold. This would allow companies to share equity with workers without having to go through convolutions and contortions from a legal and tax perspective to do so. The government won’t lose much money because right now, these transfers largely don’t take place anyway because of the tax.
This is a chance for Congress to do something which would have a positive impact on many lives and businesses.
Disclaimer: this post is for informational/educational purposes only. It is not intended to provide any legal advice.
We are frequently asked by clients to review Non-Disclosure Agreements (“NDAs”) in various contexts. It goes without saying that you should be careful of what kind of NDA you sign and not be afraid to negotiate any terms you do not like.
Nondisclosure or confidentiality agreements come in a wide variety of forms and styles, and they should always have provisions covering non-use by the receiving party–not just a restriction on disclosing such information to third parties. Many NDAs you encounter will be fine to sign as is, but you will also often receive one that contains objectionable terms. This simple guide will better acquaint you with the basics and help you spot common red flags.
What information should NDAs cover?
If you are the disclosing party, you want to make sure the definition of “Confidential Information” is as broad as possible. Typically, every NDA will cover confidential, proprietary, technical, financial, or other non-public information, including intellectual property rights, trade secrets, software source and object code, etc. A “trade secret” is any information that is valuable and whose owner has taken reasonable steps to remain secret, such as encryption mechanisms, password protection measures, physical protections, requiring employees and others to execute NDAs, etc. Examples of trade secrets are the KFC recipe, the Coke recipe, Google’s search algorithms, software source code, manufacturing processes, and customer lists. Trade secrets may or may not be patentable.
There are typically always customary exclusions from what would be considered confidential, including information that is (a) already in the public domain at the time of or after disclosure, (b) rightfully in the recipient’s possession free of any obligation of confidence or not otherwise obtained unlawfully, (c) independently developed by the recipient without use of the discloser’s confidential information, and (d) required to be disclosed in connection with a court proceeding.
In which scenarios should you sign a NDA?
NDAs should be signed by two parties in advance of entering into discussions or evaluating a certain business relationship or transaction. Here are some common scenarios:
Commercial agreements and IP/technology development deals
Mergers and acquisition transactions
Financing transactions in which investors are conducting due diligence
Joint ventures
Requests for proposals
As a catch all, any scenario in which you are receiving or sharing sensitive or confidential information with another person or entity.
Another point to note is that there are one-way NDAs and mutual NDAs. With a one-way NDA, only one party will be disclosing confidential information, and therefore only the recipient will be obligated to protect it. In a mutual NDA, both sides will exchange information and be under such obligations.
As a practical tip, if you are the only side making disclosures, make sure to use a one-way NDA so you don’t also sign yourself up for unnecessary confidentiality and non-use obligations.
When should you enter into an NDA?
The answer is simple: as early as possible, and ideally prior to any discussions, meetings, or negotiations have occurred. If the parties have disclosed confidential information prior to the execution of the NDA, make sure that the NDA explicitly covers such prior disclosure.
This chipmunk is cute, not confidential. Important distinction.
What are some red flags and nuances to watch out for?
The duration of your confidentiality obligations. If you are the recipient, you want these to be shorter (1-2 years) and vice versa if you are the discloser. 2-5 years is typical.
Make sure if you are disclosing any trade secrets that the NDA obligates the recipient to keep it confidential and not use the trade secrets indefinitely, which generally means until such trade secret enters the public domain.
We recommend that you avoid disclosing your highly confidential “secret sauce” trade secrets if you can avoid it, even if the NDA adequately obligates the recipient to protect them.
The purpose and use of the confidential information. The NDA should explicitly say that the recipient may only use your confidential information for a predefined purpose, such as its obligations under an agreement or in connection with the evaluation and negotiations of a proposed business relationship or transaction.
To whom the confidential information may be disclosed. Typically, the recipient will be allowed to disclose the confidential information to its officers, directors, and key employees. But you should consider whether it is appropriate for the recipient to share the confidential information with its independent contractors, consultants, advisors, and other professionals like accountants and lawyers, who are essentially third parties outside the scope of the recipient company. If this is appropriate, then you should make sure the NDA provides that the recipient may only disclose to such parties if they have executed an agreement providing for confidentiality and non-use on terms no less restrictive than the NDA you and the recipient entered into, and that the recipient will be liable for any breach by its independent contractors.
Many times lower level employees of a recipient should not have access to your confidential information, so we recommend adding that the recipient may disclose such information only to employees only on a “need-to-know basis.”
Any unwarranted provisions. Make sure there are not any Non-Solicitation or Non-Competition obligations. Sometimes the other side will attempt to sneak in these clauses, which are not typically appropriate.
A “residuals” clause. Sometimes the recipient will attempt to include a “residuals” carveout to the non-disclosure and non-use obligations by allowing its employees to use the discloser’s confidential information they remember from their “unaided memory.” A residuals clause is most often employed by large, sophisticated corporations especially when they think they have leverage over a smaller company. This clause should be deleted every time you see it.
The relationship or engagement between the parties being included as confidential information. Oftentimes the NDA will state that the presence of the NDA and such negotiations or engagement or relationship is confidential. This isn’t necessarily a dealbreaker, but you should consider whether it is appropriate for the situation. For example, you may be excited to announce to your investors or prospective investors that you have entered into negotiations with a big customer like Amazon or Microsoft, but be aware of whether this would be a breach of confidentiality and consider striking such provision in the NDA upfront.
A license for the recipient to use the confidential information. Double check to make sure you are not granting a license to any of your confidential information. If you and the other side intend to eventually enter into a licensing arrangement for some IP, this provision should be negotiated separately and housed in a License Agreement.
Obligations to destroy confidential information. You should make sure the other party has an obligation to destroy any confidential information it has received during the engagement after it is over. But there should be a carveout to this exception that states you do not have to go back into your automatic email archiving system and delete any information there. This makes it far less burdensome on you.
Injunctive relief. The NDA must provide that, in the event of a breach (or alleged breach) by the recipient, the discloser is entitled to seek an injunction from a court to prevent any further unauthorized disclosure or use by the recipient and any third parties.
A Liquidated damages clause should be deleted if present. Double check and see if the other party has tried to sneak in such a provision, meaning the NDA states that you have to pay a certain monetary amount for each breach. Depending on the amount, this could add up quickly.
An Attorneys’ fees clause. Make sure the NDA provides that the prevailing party in any legal action to enforce the NDA is entitled to be reimbursed its attorneys’ fees and related costs.
There are of course more issues that may come up, but this will be a great start for you as you begin your own NDA review.
Convertible notes, SAFEs, and every other type of convertible equity instrument are to startup financings what bread is to a sandwich, or Ringo is to the Beatles—not the most exciting part, but they’re almost always there, and you’re kinda stuck with them.
In our experience, most early-stage companies use some form of convertible instrument for their initial fundraising round, and I’ll bet that all such companies have at least considered using them.
The use of convertibles is well known and generally a great way for startups to raise money. They are quick, easy, and relatively inexpensive from a legal fee perspective to generate. However, their ubiquity has led to their over-use and misuse. The point of this post is to muse on the convertibles, as our group sees a lot of them, in hopes that our observation of the permutations of what can go right and wrong with their usage might be helpful.
Note and SAFE “Rounds”
The idea of a “Note Round“ or ”SAFE Round“ gets thrown around a lot, and that should probably stop. Convertibles need to be viewed for what they are: a bridge to a fixed-price preferred stock round (think Series Seed, A, B, etc.). Investors don’t jump into a convertible note or SAFE expecting that to be the final destination. Generally speaking, it is usually in a startup’s interest to convert them sooner rather than later, especially when notes have interest accruing.
Viewing a convertible as its own “round” seems to often lead to a behavior of printing convertibles like money and then sitting on them without actively pursuing a preferred stock round, when they really should be deployed as a short-term bridge to get a startup to their next financing ASAP.
Letting convertibles sit outstanding generally leads to i) interest accruing (which leads to holders getting more shares upon conversion) and ii) raising the possibility of you converting folks at the valuation cap, which almost always is undesirable from the perspective of the founders/employees’ common stock ownership.
More Convertibles = More Problems
Investors and founders abhor a complex cap table. When convertible instruments are too heavily relied upon, they can lead to headaches (and even migraines) when you eventually arrive at a fixed price round.
The reality is that you can not sell the same convertible instrument forever, the value of the company will change, and as such, terms like the discount, valuation cap, the interest rate will change over time as the business grows. Other features, like most favored nations clauses, participation rights, information rights, board observer rights, etc., will probably materialize. The first few permutations of a company’s convertibles can be managed; however, as time goes on, the amount of variants can stack and can lead to major diligence issues when you arrive at your round.
More convertibles also mean more conversion math and investor relations to manage when it comes time to get your financing completed. Even with majority amendment clauses (which are, and should be, in most convertible instruments these days), lead investors in fixed priced rounds will often require all convertible holders sign onto things like stock purchase agreements, voting agreements, and investor rights agreements when it comes time to close your round. If you have a lot of disparate convertible holders, this can turn into a huge burden and resource drain when you’re trying to get your financing over the finish line, as needing anyone’s signature invites a host of bad outcomes, like people looking to re-trade transaction points or simply being unavailable.
I think a good number of individual convertible holders is something to the tune of 10 – 20 maximum, and make a point of keeping your instruments homogeneous – avoid signing too many side letters conferring special rights to individual investors or issuing convertibles with differing rights from your other convertibles.
Liquidation Overhang
One less talked about aspect of the valuation cap that is included in many convertibles is how convertible holders who convert at the valuation cap interact with common elements of a fixed price round like liquidation preference and anti-dilution calculations.
In a fixed price round, liquidation preferences are usually tied to the price per share paid by the new investors participating in the financing. Many of these incoming investors take issue with convertible holders (who may be converting their instruments at a substantial discount, especially if they convert at the valuation cap) getting the full liquidation preference received by new investors paying full price for their shares in the round.
This will often lead to investors requiring convertible holder concessions or carving out separate subclasses of preferred to prevent convertible holders from getting a liquidation preference “overhang” in excess of what they effectively paid for their shares.
The question often becomes, “what are the convertible holders entitled to?” Are they only entitled to a liquidation preference that matches the money they have put in, or are they entitled to the same liquidation preference as the new money? Many forms of convertibles are silent or ambiguous to this point, so it’s critical for attorneys drafting these instruments to be clear as to what will happen to these instruments in the event there is an overhang.
SAFEs vs. Notes
A common debate among early-stage companies and investors (generally angel investors) is whether companies should be using convertible notes or SAFEs.
Assuming that the form of these documents is more or less standard, this conversation often revolves around security – what will happen if the company goes to zero, who gets paid?
Most camps will agree that for an investor, a note likely provides more protection. SAFEs are expressly not debt; thus, they reside on the equity side of the balance sheet. Convertible notes are debt on the balance sheet. Thus noteholders have a better likelihood of getting paid something as a general creditor in a wind-down scenario before funds are distributed out to shareholders (though most SAFEs also try to accomplish this, albeit contractually).
That said, I believe this is a false debate. Tech startups, just as an example, are asset lean businesses. In the event of a wind-down, any code or IP is often worthless without the founding team in place to drive it. That leaves desk chairs and MacBooks, which are usually not enough in the aggregate to pay off a bunch of convertible instrument investors. You cannot squeeze blood from a stone.
This brings me back to my earlier point: convertible instruments are not components of a “round,” nor are they a final destination. They are a bridge to a fixed priced financing. Investors and companies alike should target and strive to convert notes as soon as possible. The ownership, rapid capitalization, and growth of startups are where the best outcomes lie for everyone involved.
To wrap this up, convertible instruments, such as convertible notes, are a solid and well-known instrument in the toolbox companies have to raise investment. That said, it’s possible to have too much of a good thing, so pay attention, talk to your attorney and other advisors, and proceed responsibly and sustainably, people.
If you have any questions on the above, please don’t hesitate to reach out. For more related articles, please visit our website, here.
When you set up your company, you hopefully set up a stock option plan (also known as an equity inventive plan) at the same time so that you have a plan that is properly adopted and ready to be used when you are about to grant options or other equity incentives to service providers.
When you decide to grant stock options or other forms of equity compensation to service providers, we recommend you call us. We have seen many instances in which a mistake is made in administering a stock option plan, and the mistake results in a lot more time and expense incurred than wanted or needed if we had been used to administer the plan in the first place.
Here is a list of things you will need to consider when you grant options:
First, the Board has to approve all option grants. If you do not have the Board properly approve option grants, this can cause problems down the road when the option exercise price has increased, and you have to go back and document approvals. Options are not considered “granted” until the Board has correctly approved them, not just the number of shares underlying the options but also other essential terms of the options such as the vesting schedule and exercise price. This can be achieved either pursuant to a fully executed unanimous written consent of the Board or at a properly noticed and duly called meetings of the Board which is minuted properly. It is generally easier to approve things via written consent if all the directors are in agreement.
Second, you must remain in compliance with state and federal securities laws. There are a number of technical legal requirements when you grant options, which include, but are not limited to:
Possible filings with state securities agencies (e.g., California).
Not granting options under Rule 701 to entities (we see this mistake made frequently). You can only grant options to individuals under Rule 701.
Issuing the wrong type of option to independent contractors (you can grant ISOs only to employees).
Third, you must make sure your operating documents and cap table are up to date and correct and that they allow for the option grant. For example, your company’s equity incentive plan only allows for a certain number of options to be granted. Another example is that stock options are treated differently from stock awards on your cap table.
Fourth, board approval is the first step of granting stock options, not the only step. You still need to give your service providers a copy of the stock option agreement and a copy of the company’s up-to-date stock option plan to review and sign. These documents would govern the stock options and provide more details to the service providers about the terms of the stock options, such as how long the service providers can exercise the vested options, how they can exercise the vested options and, whether they need to pay any withholding to the company besides the exercise price.
In summary, because of what is at stake, we recommend you use us to help you administer your plan.
Personally Identifiable Information (“PII”) has become a buzzword in the privacy law world the last few years, and it is heavily protected by rules and regulations around the world, such as the General Data Protection Regulation (GDPR). Companies that fail to comply with regulations such as the GDPR, or that suffer a data breach, face steep penalties and/or burdensome, mandated mitigation and reporting requirements.
Because of this, companies, both large and small, across the world, have started to familiarize themselves with the term and their obligations with respect to it.
As per usual, this picture has literally nothing to do with the content of this post. But it’s soothing, so we’ll keep it.
So, that begs the question: what exactly is it?
At the risk of being a jerk: it depends on who you ask! Changes to privacy laws have been rapid-fire over the last few years, and the definition of what’s considered “personally identifiable information” expands each time a new law is enacted.
Generally, PII is one or more pieces of data that can be used to identify a person with particularity. Below, we’ve compiled a (non-exhaustive but exhausting!) list of things that may be considered PII under the law. Some of these may only currently apply in certain states or jurisdictions. But, as the trend in privacy law is to add to this list instead of delete from it, we want to present you with the most inclusive list possible. Here we go!
* Name * Alias * Online identifier (e.g. social media handles) * IP address * Unique device IDs * Account name * Postal address * Street address * Email address * Telephone number * Social security number * Driver’s license number or state identification number * International ID number (e.g. passport number, other international governmental ID number) * Other unique personal identifiers * Physical characteristics or descriptions of a person * Geolocation data * Family and lifestyle details * Genetic data * Biometric data * Racial/ethnic/color data * Political opinion or affiliation data * Religious or philosophical beliefs data * Trade union membership data * Sex life, sexual orientation, and gender identity data * National origin * Citizenship status * Disability * Insurance policy numbers * Educational background * Current employer * Employment history * Bank account numbers * Credit card numbers * Debit card numbers * Other financial information * Medical/health information * Health insurance information * Commercial information, including records of personal property, products or services purchased, obtained, or considered, or other purchasing or consuming histories or tendencies. * Internet or other electronic network activity information, including, but not limited to, browsing history, search history, and information regarding a consumer’s interaction with an internet website, application, or advertisement. * Audio, electronic, visual, thermal, olfactory, or similar information (e.g. voice recordings) * Inferences are drawn from any of the information identified in this subdivision to create a profile about a consumer reflecting the consumer’s preferences, characteristics, psychological trends, predispositions, behavior, attitudes, intelligence, abilities, and aptitudes.
We’ll continue to update this list as new privacy laws are enacted. Please check back regularly for updates! Questions? Contact us at privacygroup@carneylaw.com.
For more related posts, please visit our main website, here.
Autumn bench: existential crisis due to lack of certainty over whether the CCPA applies to it edition (2020).
The California Consumer Privacy Act (“CCPA”) became effective at the start of 2020. Its purpose is to protect the personal identifiable information (“PII”) of California consumers. The bad news for businesses is that the California Consumer Privacy Act’s legal requirements are murky at best. And, even in its infancy, the CCPA has been in a perpetual state of revision. Months after the CCPA became law, businesses are scrambling to answer the question, “Does the CCPA apply to me?”
We’ve endeavored to create a short question and answer list to help you determine whether or not some – or all – of the CCPA applies to your business. Let’s get started!
QUESTION 1: Does your business buy, receive, share, sell, collect, or process, any personally identifiable information of any California consumer?
QUESTION 2: Are you a “business” as defined by the CCPA?
If your business:
(a) has a gross revenue of $25M or more per year; or (b) annually buys, receives, shares, or sells 50K or more of California consumers’ PII, or (c) derives 50% or more of its annual revenues from selling CA consumer PII
then the CCPA applies to you.
If your business does not meet any of these thresholds, you may still be bound by the CCPA’s requirements if you meet the definition of either a “service provider” or “third party”, so read on!
QUESTION 3: Are you a “service provider” as defined by the CCPA?
A “service provider” is:
(a) a for-profit legal entity that (b) processes California consumer PII (c) on behalf of a “business” (as defined above) (d) pursuant to a contract that prohibits the service provider from processing the information for any purpose other than those specified by the “business.”
If one or more of these 4 factors doesn’t apply, then you aren’t considered a “service provider” under the CCPA.
If all 4 factors apply to your company, then please contact a member of our team to determine what aspects of the CCPA apply to your business.
QUESTION 4: Are you a “third-party” as defined by the CCPA?
A “third party” is:
(a) a legal or natural person that is NOT a “business” or a “service provider” (both as defined by the California Consumer Privacy Act); that (b) receives California consumer PII from a “business.”
If one or both of these factors doesn’t apply, then you aren’t considered a “third party” under the California Consumer Privacy Act.
If both of these factors apply, then please contact a member of our team to determine what aspects of the CCPA apply to your business.
Have other questions regarding the CCPA? Please contact us at privacygroup@carneylaw.com for more assistance!
Disclaimer: This post is for informational/educational purposes only. It is not intended to provide any legal advice.
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The California Consumer Privacy Act (“CCPA”) has some twisty definitions of who is – and isn’t – considered a California consumer. The text of the CCPA says a business who “alone or in combination, annually buys, receives for the business’s commercial purposes, sells, or shares for commercial purposes, alone or in combination, the personal information of 50,000 or more consumers, households, or devices” is under the jurisdiction of the CCPA. So how do you know if the data you are collecting, etc., is from a “consumer,” “household,” or “device”?
We’ve attempted to provide you with the current and proposed parameters of each of these terms below. Check back regularly for updates!
Consumers: Generally, California consumers are California residents. An important distinction is made for people who are physically located inside – or outside – of California if their physical status is “temporary” or “transitory.” For example, a person is still a California consumer if they are domiciled in California, but are temporarily outside the state when you happen to collect their data. The corollary of this works as well. A person’s temporary or transitory visit to California does not make them a “California consumer” under the CCPA.
Households: The original CCPA language was a bit vague about what constituted a “household.” The current proposed definition of household is a person or group of people who: (1) reside at the same address, (2) share a common device or the same service provided by a business, and (3) are identified by a business as sharing the same group account or unique identifier. (“Business” means a business as defined under the CCPA.)
Devices: A consumer can also be identified by their device. This definition is the most straightforward of the lot. A “Device” is “any physical object that is capable of connecting to the internet, directly or indirectly, or to another device.” CA CIVIL Sec. 1789.140.
Still not sure if the data you’ve got is for a California consumer? Please contact a member of our team at privacygroup@carneylaw.com.
Disclaimer: this post is for informational/educational purposes only. It is not intended to provide any legal advice.
