The Problem

As every founder knows, starting and scaling a company is an extremely difficult and multi-faceted undertaking. In addition to the primary goals of developing a viable product, finding (and in some cases building from scratch) a robust market, and raising the capital necessary to sustain their business and operations, founders and their core teams also grapple with the day-to-day management and operations of a growing enterprise, whether that be personnel issues, forecasting cash needs and burn rates or tackling the legal and regulatory hurdles that often go hand-in-hand with the creation of disruptive technologies. Unfortunately, given the size and complexity of the average founder’s workload, it is no surprise that emerging companies of all sizes occasionally neglect to heed the advice of their attorneys and ensure that any and all corporate actions taken by the company and its officers are properly authorized and, if necessary, approved by the company’s Board and stockholders.

The Exposure

Copyright: tang90246 / 123RF Stock Photo

Under the Delaware General Corporation Law (the “DGCL”) otherwise permissible corporate acts that do not satisfy the consent and other procedural requirements of the DGCL, the corporation’s organizational documents or any other agreement to which the corporation is a party, are deemed to be “defective corporate acts” and are generally held to be void and of no legal force and effect.[i] The pre-2014 historical body of Delaware case law held such corporate acts, taken without “scrupulous adherence to the statutory formalities” of the DGCL, to be acts undertaken “without the authority of law” and therefore necessarily void.[ii] Prior to the enactment of Sections 204 and 205 of the DGCL, the relevant line of Delaware case law held that corporate acts, transactions and equity issuances that were void or voidable as a result of the corporation’s failure to comply with the procedural requirements of the DGCL and the corporation’s governing documents could not be retroactively ratified or validated by either (i) unilateral acts of the Corporation intended to cure the procedural misstep or (ii) on equitable grounds in the context of litigation or a formal petition for relief to the Court of Chancery.[iii] In short, there was no legally recognized cure for such defective actions and the company was left forever exposed to future claims by disgruntled shareholders, which could ultimately jeopardize future financings, exits and ultimately the very existence of the company.

The Statutory Cure

Luckily, for those founders who make the potentially serious misstep of failing to obtain the required consents and approvals before taking a particular action (e.g. issuing options to employees or executing a convertible note or SAFE without the prior consent of the Board), in 2014 Delaware enacted Sections 204 and 205 of the DGCL, which served to clarify the state of the law in Delaware and fill a perceived gap in the DGCL by providing new mechanisms for a corporation to unilaterally ratify defective corporate acts or otherwise seek relief from the Court of Chancery.[iv]

While both Sections 204 and 205 were intended to remedy the same underlying issue and provide a clear process for ratifying or validating a defective corporate act, the mechanics set forth in the respective sections take disparate routes to arrive at the intended result:

  • Section 205 provides a pathway for ratification that runs through the courts, allowing a corporation, on an ex parte basis, to request that the court determine the validity of any corporate act.
  • Section 204, on the other hand, is considered a “self-help statute” in the sense that the procedural mechanic provided for in the statute allows a company to ratify the previously defective act unilaterally, without the time and expense involved with petitioning the court for validation of the corporate act in question.

In the case of early stage companies, the expenditure of the heavy costs and valuable time associated with seeking validation in the Court of Chancery render Section 205 a less than ideal tool for curing defective acts. This post therefore focuses on Section 204, which provides a far less onerous mechanic for ratifying defective corporate acts, allowing a corporation to cure past errors “without disproportionately disruptive consequences.”[v]

Section 204 in Practice

Section 204 provides Delaware corporations with a procedure to remedy otherwise void or voidable corporate acts, providing that “no defective corporate act or putative stock shall be void or voidable solely as a result of a failure of authorization if ratified as provided in [Section 204].”[vi] Pursuant to Section 204, a corporation’s Board may retroactively ratify defective corporate acts by adopting written resolutions setting forth:

  • the specific defective corporate act(s) to be ratified;
  • the date on which such act(s) occurred;
  • the underlying facts that render the act(s) in question defective (e.g., failure to obtain the authorization of the Board or inadequate number of authorized shares); and
  • that the Board has approved the ratification of the defective corporate act(s).

Additionally, if a vote of one or more classes of stockholders was initially required to authorize the defective act at the time such act was taken (e.g., the approval of a majority of the Series A preferred stockholders in the case of an act that falls within the purview of the Series A protective provisions), then ratifying resolutions of the relevant class of stockholders are also required in order to cure the prior defect in the corporate act.

In sum, founders and their Boards should, at minimum, undertake the below listed procedural steps* in order to ensure that otherwise defective corporate acts are cured and ratified in the manner prescribed by the DGCL.

  • A resolution by the Board setting forth (i) the defective corporate act to be ratified, (ii) the date of the defective act, (iii) if shares or other equity is involved, the number, class and date of the equity issuance, (iv) the reason for the defect, and (v) the approval and ratification by the Board of the defective corporate act.
  • Approval of the stockholders or a particular class of stockholders (in the form of a written consent) if such an approval was required at the time of the defective corporate act.
  • Proper notice of the ratification sent to all stockholders (including stock that may have been invalidly issued). The notice must include a copy of the ratifying resolution/consent and an explanation that any claim that the ratification in question is not effective must be brought before the Court of Chancery no later than 120 days from the effective date of the ratification.
  • In certain circumstances, the filing of a “Certificate of Validation” with the Delaware Department of State to cure the defective corporate act being ratified (e.g., if shares were issued without filing the necessary Certificate of Amendment to increase the authorized shares of a corporation).

*This list should not be considered all-inclusive. Each situation is unique and further actions may be required depending on the underlying facts and the cause of the defect in question.

Startups represented by seedling growthTakeaways

The potential adverse impact of an uncured defective corporate act cannot be understated. For an early stage company seeking to raise capital from venture investors or other outside parties (or eventually exit through an acquisition), the risks associated with such defective acts are particularly acute. As a practical example, a corporation’s failure to observe the proper procedures in the election of a director can result in the invalidation of such election. In the event of such a defective election, actions taken by, or with the approval of, the improperly elected Board may be void or voidable. This or other defective corporate acts may result in the corporation being in breach of representations and warranties in any number of contracts, including stock purchase agreements executed as part of a financing round or M&A transaction.

Generally speaking, relatively extensive due diligence is typically the first step in all venture financings and other major corporate transactions. As part of this process, counsel for the investor or acquiror will undoubtedly review all material actions of the company along with the corresponding Board and stockholder consents as a means of “tying out” the company’s cap table. Any defective corporate act that was not later ratified by the company in accordance with Section 204 or 205 will at best need to be ratified or validated in advance of the closing of the transaction, and at worst may result in either (i) a reduction in the company’s valuation due to the perceived risk that past actions are ultimately void or unenforceable, or (ii) in extreme situations, the abandonment or termination of the transaction.

In an ideal world, companies of all sizes would always observe the proper procedures in authorizing corporate acts and ensuring that all other necessary steps are taken to ensure the validity of such actions. Unfortunately, in the fast-paced and often frenzied world of a startup, certain “housekeeping” items occasionally fall by the wayside. Upon the discovery of a defective corporate act by a company or its counsel, it is vital that the proper ratification procedures be undertaken in order to ensure that any and all past actions that could potentially be rendered defective are rectified and ratified in accordance with Section 204 (or in some cases Section 205) of the DGCL.


[i] A “defective corporate act” includes any corporate act or transaction that was within the power granted to a corporation by the DGCL but was thereafter determined to have been void or voidable for failure to comply with the applicable provisions of the DGCL, the corporation’s governing documents, or any plan or agreement to which the corporation is a party. See 8 Del. C. § 204(h)(1); See also, e.g., Blades v. Wisehart, C.A. No. 5317-VCS, at 8 (Del. Ch. Nov. 17, 2010) (requiring “scrupulous adherence to statutory formalities when a board takes actions changing a corporation’s capital structure”); STAAR Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991) (“stock issued without authority of law is void and a nullity”).

[ii] See, e.g., Blades v. Wisehart, C.A. No. 5317-VCS, at 8 (Del. Ch. Nov. 17, 2010) (requiring “scrupulous adherence to statutory formalities when a board takes actions changing a corporation’s capital structure”); STAAR Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991) (“stock issued without authority of law is void and a nullity”).

[iii] Id.

[iv] See H.B. 127, 147th Gen. Assemb., Reg. Sess. (Del. 2013): “Section 204 is intended to overturn the holdings in case law . . . that corporate acts or transactions and stock found to be “void” due to a failure to comply with the applicable provisions of the General Corporation Law or the corporation’s organizational documents may not be ratified or otherwise validated on equitable grounds.”

[v] In re Numoda Corp. S’holders Litig., Consol. C.A. No. 9163-VCN, 2015 WL 402265, at 8 (Del. Ch. Jan. 30, 2015).

[vi] 8 Del. C. § 204(a).

Ethan Zook and Jacob Oksman write:

Attracting and retaining high-performing employees is critical to the success of any emerging company. A key ingredient to securing the right talent base is an attractive and aligned remuneration plan. Most emerging companies will structure their remuneration plan leveraging three key elements: a competitive base salary, a short-term bonus plan, and a long-term incentive plan (LTI) that typically comes in the form of a stock option plan. The base salary and bonus plan are typically structured to align the individual and the company against critical objectives, and normally present in the form of cash compensation. The LTI plan, on the other hand, is structured with a longer-term horizon in mind, and is intended to align the company, employees, and shareholders for long-term value creation.

Business Taxation
Copyright: yupiramos / 123RF Stock Photo

While an integral way for emerging companies to attract top talent, employees need to understand the type of LTI vehicle used, and tax implications from a vesting, exercising and selling perspective.

In general, there are two basic kinds of stock options: statutory stock options and nonstatutory stock options (NSOs). Both generally allow the recipient to buy stock at a fixed price for a defined number of years into the future. By doing so, the option holder takes part in the overall value creation of the company. The award will typically vest over a pre-determined period of time, or upon certain milestone achievements. Once shares are vested, the holder has the option of selling the earned shares. There are, however, significant differences between the two types of awards from a tax perspective.

Statutory stock options include incentive stock options (ISOs) and options granted under employee stock purchase plans. Upon grant and exercise of ISOs, there are generally no tax consequences to the employee. However, the employee may be subject to alternative minimum tax in the year of exercise. Upon sale of the stock received by exercising the ISOs, the employee will generally have capital gain or loss if the stock acquired on exercise is held for at least two years from the date of grant and one year after the ISOs were exercised.

NSOs are not taxed to the employee receiving them when granted unless the options have a readily ascertainable fair market value at that time (this generally includes marketable securities). If the options do not have a readily ascertainable fair market value when granted, the employee is taxed on the gain from the options at the time of exercise or transfer (even if the fair market value becomes readily ascertainable before the exercise or transfer). Unlike statutory stock options, upon exercise of NSOs, an employee will have compensation income (taxed as ordinary income) equal to the difference between the fair market value of the stock at the time of exercise and the price paid for the stock (if any). If the options are sold, then the employee will have compensation income equal to the gain on disposition. The sale of the stock received by exercising NSOs will generally result in capital gain or loss (and are not subject to the special holding period requirement discussed above for ISOs).

ISOs are generally considered more tax friendly than NSOs, but both employees and employers need to be aware of the tax scheme.

Navigating the tax treatment of options can get complex quickly; it would be wise to reach out to a tax professional before making the ultimate decision of receiving or exercising equity compensation.


Ethan Zook is an associate in the firm’s Corporate Department, resident in its Exton, PA office.

Jacob M. Oksman is an associate in the firm’s Taxation & Wealth Planning Department, resident in its New York office.

The Trump administration recently announced it is delaying – and likely rescinding – the Obama-era International Entrepreneur Rule (the “Rule”). The Rule was slated to go into effect on July 17, 2017. It would have made it easier for foreign entrepreneurs to establish startup companies in the U.S. We blogged in detail on the final Rule when it was published in early 2017.

The White House, Washington, D.C.Now the Rule’s effective date has been delayed until March 14, 2018; however, implementation seems highly unlikely: the delay is to allow the Department of Homeland Security (DHS) an opportunity to obtain public comment on a proposal to rescind the Rule.

The Rule establishes criteria for granting “parole” (temporary permission to be in the U.S.) to certain foreign entrepreneurs to permit them to oversee and grow their stateside startups. To obtain parole, entrepreneurs would need to show that their startups have potential to grow rapidly, create jobs and provide a significant public benefit to the United States. Startups would be judged by, among other things, how much venture, angel or accelerator capital and/or government grants they’d received.

DHS decided to delay the Rule after President Trump signed an executive order on January 25, 2017 relating to border security and improving immigration enforcement. The order required DHS to ensure that parole is only granted on a case-by-case basis involving urgent humanitarian reasons or a significant public benefit. DHS is seeking public comment on the delay until August 10, 2017.

The move has drawn criticism from notable investors, business leaders and other stakeholders, including the National Venture Capital Association, a trade association for startup investors. Critics note the substantial contributions made by immigrants to the U.S. entrepreneurial ecosystem, especially in the tech sector. For example, 60% percent of the top 25 tech companies and 42% of Fortune 500 companies were founded by first- or second-generation Americans according to a 2013 report published by the venture-capital firm Kleiner Perkins Caufield and Byers. The Rule is not dead yet, but the prognosis is grim. The uncertainty alone seems likely to make the U.S. less competitive in the global market for ambitious and innovative minds.

A study of interest for those in the Philadelphia region has recently been released.

Philadelphia skyline
Copyright: sepavo / 123RF Stock Photo

Rising two spots from last year, Philadelphia has been ranked fifth on the list of life science clusters in the United States recently published by professional services and research firm JLL.  Following Boston, San Francisco, San Diego and Raleigh-Durham, Philadelphia was cited as the leader in the “Breakout Cluster”, which are regions “making strides in life sciences through new development and a growing scientific community.”  The study weighted various factors such as life science employment concentration, venture capital funding, lab supply, employment growth, establishment concentration, NIH funding, market occupancy rates and average asking rent.

The study states, “The Greater Philadelphia region is home to many elite academic and research institutions, as well as numerous hospitals and a strong pharmaceutical industry. Nearly 400,000 students attend one of the region’s 90 plus colleges or universities. The region is a top winner in federal research funding, attracting $900 million in NIH awards in 2016. As of 2015, 567,000 people in the Philadelphia metropolitan area worked in the “eds and meds” sectors. Eds and meds institutions are proactive partners in the life sciences economy.”

From The Navy Yard, a hub of life science activity, and the expansions at Drexel University in the city proper to activity throughout the suburbs, including the planned expansion of the Pennsylvania Biotechnology Center in nearby Bucks County, the region’s boasts a growing life sciences sector. The study cites as a priority for the future the growth of access to regional venture capital.

Congratulations Philadelphia!

Fox Partner Jean Frydman recently wrote an article on the 21st Century Cures Act for the Food and Drug Law Institute’s member magazine Update. In it, Jean describes the significant potential of the Act to transform the life sciences sector.  She outlines the key provisions of the law and how their implementation during the next five years will impact standards and practices within the industry. These provisions include the use of Real World Evidence (RWE) in regulatory decision-making, patient-focused drug development, patient access to regenerative medicine, breakthrough medical devices, and Healthcare Economic Information (HCEI).

We invite you to read the full article on the Fox Rothschild website.

Medical research
Copyright: kentoh / 123RF Stock Photo

Changes to the Illinois Limited Liability Company Act that took effect on July 1, 2017 may impact either your current Illinois LLCs or your future ventures. The changes generally conformed Illinois law more closely to a model law for limited liability companies drafted by the National Conference of Commissioners on Uniform State Laws that has already been adopted by 15 states and the District of Columbia.

Copyright: tashatuvango / 123RF Stock Photo

Among the changes to the Illinois law are:

Default Member Management
An LLC will now be member-managed by default unless there is explicit language in the operating agreement stating that the LLC is to be manager-managed. Similar to Delaware, you are no longer required to specify in an LLC’s Articles of Organization whether it will be member-managed or manager-managed, but instead are only required to provide information regarding each manager and each member with management authority.

Oral Operating Agreements
Oral and implied operating agreements are now permitted and are also expressly exempted from the statute of frauds.

Designating Specific Authority of Members and Managers
Illinois LLCs can now establish or limit the authority of a member or manager to transfer real estate or enter into other transactions on behalf of the LLC by filing a document with the Illinois Secretary of State.

Waiver of Fiduciary Duties
With the exception of the duty of care, fiduciary duties may be restricted or eliminated by including clear and unambiguous language in the operating agreement. The operating agreement can now alter the duty of care so long as it does not authorize intentional misconduct or a knowing violation of law.

Limitation of Member’s or Manager’s Liability
An operating agreement can now eliminate or limit a member or manager’s liability to the LLC and the other members, unless such liability relates to a breach of certain specified fiduciary duties, a financial benefit to which such member or manager is not entitled, an intentional infliction of harm on the LLC or another member, or an intentional crime.

Elimination of Assumed Agency Status
A member of an LLC is no longer considered an agent of the LLC solely as a result of being a member.

Access to Books and Records
The provision regarding rights of members to inspect the books and records of an LLC has been revised to clarify the distinct rights held by members, disassociated members and transferees, and to permit LLCs to impose reasonable conditions and restrictions on access to information.

Authorized Signatories for State Filings
Documents to be filed with the Illinois Secretary of State may now be signed by any person authorized by the LLC, not just a manager or member, provided that both the name and title of the person signing are typed or printed where indicated on the applicable form. In addition, digital signatures will now be accepted by the Illinois Secretary of State.

Conversion and Domestication
Illinois now allows the conversion of a general partnership, limited partnership, business trust or corporation into an Illinois LLC, and vice versa. Prior to the changes to Illinois law, an entity other than a partnership could only convert to an Illinois LLC through a multi-step process involving a merger. Now, the converting entity simply files Articles of Conversion with the Illinois Secretary of State. The revised Act will also permit a foreign LLC to become an Illinois LLC through the filing of Articles of Domestication with the Illinois Secretary of State.

Please note that the summary above is not comprehensive, and is only intended to provide an overview of some of the significant changes to Illinois LLC law. Accordingly, we recommend that you consult with legal counsel to determine how the changes to Illinois law may affect your current Illinois LLCs or any Illinois LLCs that you may wish to form in the future.

An incentive plan is a tool used to motivate and reward employees to grow a business and exceed goals. A common form of an incentive plan for startups is an equity incentive plan. An equity incentive plan rewards key employees with equity, which is ownership in a company. Equity can be a company’s stock if it is a corporation or its membership interest if it is a limited liability company. For startups, equity incentive plans can be a great way to motivate and retain early employees when the company does not have the financial resources to pay high salaries or large bonuses.

The concept behind the equity incentive plan is that employees are given equity when the value of the company is relatively low (because the company is just getting started and not yet profitable), but as the company grows and becomes profitable, the value of the equity grows and the holders realize large financial gains. The two most common forms of equity incentive plans are restricted stock and stock options.

Restricted stock is exactly that, stock in the company that is restricted by the company in some form. The most common restriction is “vesting”. Vesting is the process where the employee gains ownership of the stock over a period of time, most often a number of years. Vesting protects the company because it incentivizes employees to stay with the company instead of leaving for a different job. Depending on the details in the plan documents, if an employee leaves before his or her restricted stock has fully vested, he or she forfeits some or all of the restricted stock. For example, a startup may give an early employee 50 units of restricted stock in the company as a bonus but with the restriction that the stock does not “vest” with the employee for three years. If the employee leaves one year later, the company retains the restricted stock because the employee did not complete the three-year vesting process.

Stock options are the right to buy a certain number of shares of stock in the company at a set price, regardless of the current value of the stock. For startups, stock options can be another great way to reward and incentivize key employees. Most stock option plans include a vesting period like the restricted stock discussed above. Once vested, stock options allow the holders to realize financial gains if the company’s value has increased since the stock options were granted. For example, if the current value of a share of stock for a company is $10, the company can grant a stock option to an employee to purchase 100 shares of company stock at that $10 value. Once the employee’s stock option has vested, he or she would have a set period of time in order to exercise the option. If during the employee’s option period the value of a share of stock rises to $20, the employee can use the stock option to purchase the allotted 100 shares of the stock at the $10 option value and create a $1000 gain based on the option price paid versus the current value of the stock.

Both restricted stock plans and stock options allow startups to reward employees without jeopardizing the current financial status of the company. With the expectation that the company will succeed and grow in value, equity incentive plans can be a great benefit to both the employee and the company. If you have any questions about restricted stock plans, stock options, or equity incentive plans in general please contact Kevin P. Dermody at kdermody@foxrothschild.com or 215-444-7159.

Copyright denphumi / 123RF Stock Photo

Ethan Zook writes:

As was alluded to in a prior blog post, one of the major changes that has been enacted through Pennsylvania’s Act 170 is the ability, through the operating agreement, to contractually vary fiduciary duties of members and managers in Pennsylvania limited liability companies.

What Fiduciary Duties?

Pennsylvania flag icon
Copyright: somartin / 123RF Stock Photo

There are two major fiduciary duties to be aware of: the duty of care and the duty of loyalty. The fiduciary duty of loyalty is comprised of five subsections which can be summarized as follows:

  1. account to the company and hold as trustee for it any property, profit or benefit derived in the conduct or winding up of the company’s activities;
  2. do not use the company’s property for personal gain;
  3. do not appropriate a company opportunity for personal gain;
  4. refrain from engaging in self-dealing with the company; and
  5. refrain from competing with the company in the conduct of the company’s activities and affairs.

The duty of care is to refrain from engaging in gross negligence, recklessness, willful misconduct or knowing violation of law. Lastly, there is an obligation of good faith and fair dealing to be aware of, however, it is not a fiduciary duty.  Rather, it is treated as a contractual obligation, and as will be discussed, can be contractually altered by the operating agreement.

A member of a member-managed limited liability company owes to the company and the other members the fiduciary duties of loyalty and care. Managers of manager-managed limited liability companies owe to the company and the members those same duties.

Contracting Around Fiduciary Duties

The Act gives tremendous deference to the operating agreement, the main governing document for Pennsylvania limited liability companies.  If not manifestly unreasonable, the operating agreement may alter subsections 1), 2), and 4) of the duty of loyalty stated above.  Subsections 3) and 5) can be eliminated altogether.  Further, if not manifestly unreasonable, the operating agreement may also identify types of activities that do not violate the duty of loyalty, may freely alter the duty of care, and may prescribe the standards by with the performance of the contractual obligation of good faith and fair dealing is to be measured. Any other fiduciary duty can be altered or eliminated though the operating agreement, if not manifestly unreasonable.

Manifestly Unreasonable?

In any dispute regarding the reasonableness of the terms of the operating agreement, courts will decide whether those terms are manifestly unreasonable as a matter of law. That determination will be made as of the time the challenged term became part of the operating agreement by considering circumstances existing only at such time. This does not shed much light on what will be considered manifestly unreasonable under the terms of the Act. Instead, for now, we are left with intuition in deciding what is manifestly unreasonable.

Despite the ambiguity surrounding “manifestly unreasonable”, the Act makes it clear what fiduciary duties can be altered and eliminated. With that, it has become more important than ever to review the operating agreements of investment, potential partner, and current parent and subsidiary companies to see how loyal that company has chosen to be to itself and its members.


Ethan Zook is an associate in the firm’s Corporate Department, resident in its Exton office.

Issuers and investors are well advised to document their deal in a term sheet.  Though generally non-binding, they add significant value.  Detailed term sheets raise issues early when there is still ample negotiating time. They also make drafting the definitive documents more efficient, saving on legal fees. However, parties must be vigilant to document the deal properly, especially when using terms of art.

Cumulative dividends
Copyright: seamartini / 123RF Stock Photo

For example, one commonly negotiated item on preferred stock is the dividend. Dividends can be cumulative (aka accruing) and either simple or compounding. The terms “cumulative” and “compounding” are sometimes (incorrectly) used interchangeably. But the differences are measurable in real dollars. 

Dividends are one feature that makes preferred stock preferable. Dividends are structured in (at least) three common ways. NVCA publishes a sample term sheet that includes these options.

  1. Dividends can be paid on the preferred when (and if) they are paid on the common. The preferred holders have no dividend preference – they are treated as common holders and paid as if converted to common.
  2. Dividends can be paid on the preferred when (and if) declared by the Board of Directors. If the Board does not declare dividends, they are forfeited.  Here, the preferred holders enjoy a preference on dividends but may not receive them.
  3. Finally, as described in detail below, dividends can be cumulative and perhaps even compounding.

Cumulative vs. Compounding

Emerging companies rarely have the ability to pay dividends to preferred holders. As a solution, companies often agree to pay dividends upon a liquidity event (e.g., sale of the company).  But how much will investors receive? This is where the terms of art (cumulative, accruing, compounding, simple) become very important.

Cumulative (aka accruing) dividends provide investors with a certain annual return, typically expressed as a percentage of the original per share price of the preferred stock (e.g., “8% of the Series A Original Issue Price”).  Thus, the term “cumulative” refers to the fact that dividends accrue over the years and will be paid upon a liquidity event.

Cumulative dividends can be calculated on a simple or compounding basis.  “Simple” means the dividend is based only on the original per share price.  “Compounding” means the dividend is based on the original per share price plus the dividends that accrue over time.  Thus, the terms cumulative and simple refer to how cumulative dividends are computed.

For example:

Cumulative and Simple (aka Non-Compounding):

Suppose an investor invests $50,000 and receives 100,000 shares of preferred stock ($0.50 per share) with an annual 8% cumulative, simple dividend. In 5 years, the company is sold. The 8% annual dividend is calculated on the original per share price. The investor has earned $4,000 in dividends each year and, upon liquidation, the company must pay the investor $20,000 in dividends.

Cumulative and Compounding:

Suppose the same facts, but dividends are now cumulative and compounding. The 8% annual dividend will be calculated on the original per share price and on the accrued and unpaid annual dividends that accumulate over the years. This is similar to a promissory note with compound interest: the original per share price is like “principal” and the 8% annual dividend is like a compounding 8% interest rate. In this scenario, the investor earns $23,466.40 in dividends.

Clearly, there is a measurable difference between simple and compound dividends. And at first glance, the $3,466.40 difference may not seem overly significant. But the proper use of term sheet terminology has a greater value. A detailed and thoughtful term sheet helps maintain deal flow and good will during negotiations, can decrease legal fees and helps avoid disputes down the road.  For issuers and investors at the outset of a long friendship, these benefits can be immeasurable.

As mentioned in the first post of this series, the goal of many entrepreneurs is to seek venture capital financing or ultimately sell their company in an “exit” merger or acquisition. Upon making representations and warranties (which are essentially, assurances) associated with any of these transactions, the seller opens itself up to risk. If these assurances turn out to be false or are breached, the seller is subject to suit for breach of contract. Often, however, the parties negotiate an additional protection mechanism called indemnification.

So why is indemnification expected?

Puzzle pieces representing mergers & acquisitions
Copyright: bas121 / 123RF Stock Photo

In a traditional acquisition, the seller affirmatively agrees to indemnify the buyer for damages or costs related to various things; most notably, breach of a representation or warranty. The seller agrees upfront to hold harmless and to reimburse the buyer for any and all expenses related to their breach. For example, if the seller represented that its equipment was in working condition and it turns out it was not, the seller must make the buyer whole. Essentially, the seller is insuring the buyer on its purchase. Just like an insurance policy, this agreement to insure lasts for a certain period and covers certain events. As this creates ongoing obligations and future potential liabilities for the indemnifying party, the indemnification provisions in transaction documents, and particularly the scope and extent thereof, are often heavily negotiated and should be approached with extreme caution.

There are many protections that can be built into indemnification provisions and transaction documents that limit the scope of the seller’s liability beyond simply excluding scenarios which are covered. For example, the seller may agree to indemnify the buyer but only:

  • when the damages or costs exceed a certain amount in the aggregate (what’s known as a “basket”);
  • when the damages or costs exceed a certain amount for a particular claim (a “mini basket”);
  • in the aggregate up to the purchase price or some other set number (a “cap”); and/or
  • for a set period of time from Closing (the “indemnification period”).

Takeaway

In the transactional context, indemnification serves as the enforcement of representations and warranties. A buyer can truly rely on the seller’s representations if the seller has also agreed to hold harmless and reimburse the buyer if the representations are false or breached. The seller can effectively affirm the value of its business, but in doing so exposes itself to risk as a de facto insurer. As this is generally unavoidable in the context of a transaction, limiting the scope of this risk is key for sellers. For these reasons, indemnification provisions should be approached and drafted with extreme caution.