Venture Capital Finance

On Fox’s Franchise Law Update blog, partner John Gotaskie recently discussed an important upcoming deadline for businesses, including emerging companies, and entrepreneurs that operate websites that accept user-generated content:

If your franchise–or your franchisees–operate a website that accepts user-generated content, NOW is the time to contact the Copyright Office.

Whether you realize it or not, your website probably accepts user-generated content. Examples of such content include e-commerce websites that accept product reviews, franchise-sponsored blogs that publish user comments on posted articles, and brand fandom sites that permit users to share photos or videos.

It can be very difficult for you to determine whether user-generated content posted to your brand’s website was created by the user who posted it, or whether the content infringes someone else’s copyright.

To learn how to protect your brand from liability for copyright infringement in such content, we invite you to read John’s full discussion.

Over $1.5 billion has been raised by token offerings – also known as initial coin offerings or ICOs – so far in 2017. Not surprisingly, many startups are eager to capitalize on this possible funding source.

Initial Coin Offering (ICO) concept illustrationAlthough ICOs can be a useful method of raising capital, a number of legal issues must be considered in structuring and completing an ICO. One such issue is whether the tokens being offered in an ICO will be considered securities. A report issued by the SEC late this summer highlights the issue.

The SEC’s report was related to a token offering by an organization called The DAO. In its report, the SEC concluded that the tokens issued by The DAO were securities. Prior to the issuance of the SEC’s report, some advisors were telling startups that ICOs would not raise the same sort of securities concerns as traditional capital raises. Although the SEC has not issued formal guidance or regulations in this area, the report makes it clear that at least some tokens will be considered securities and that some platforms will be considered securities exchanges.

Many practitioners argue that there is a distinction between “security tokens” (designed to raise capital) and “utility tokens” (designed with some functionality and not purely to raise capital). The analysis in determining whether a token is a utility token is complex. Some tokens with utility characteristics may even be securities.

The law surrounding ICOs and the treatment of tokens is still evolving. Startups wishing to purse an ICO should seek legal advice early in the process. The danger of not doing so can be dramatic – since the date of the SEC’s report, at least one ICO was cut short after the SEC launched an inquiry into the ICO. The founders had not considered securities implications of conducting the ICO and ultimately decided to refund the funds raised to investors.

 

Venture capital is playing a growing role in the country’s emerging legal cannabis industry. Attorneys Emily J. Yukich and Matthew R. Kittay of Fox Rothschild’s Emerging Companies & Venture Capital Practice will conduct a panel discussion with industry insiders during the American Bar Association Business Law Section’s annual meeting in Chicago.

Cannabis leafThe Angel Venture Capital Subcommittee, which Yukich and Kittay co-chair, will present an in-depth 360-degree examination of venture capital investing in cannabis companies, featuring:

Panelists:

  • Jeremy Unruh, general counsel and director of external communications at PharmaCann, a medical cannabis provider based in Oak Park, Illinois.
  • Charlie Bachtell, founder and CEO of Cresco Labs, LLC, a Chicago-based medical cannabis cultivating and manufacturing company.
  • William Bogot, co-chair of the Cannabis Practice Group at Fox Rothschild LLP.

Date: Thursday, Sept. 14

Time: 10 a.m. to 11 a.m.

Venue: Chicago Ballroom VIII, Ballroom Level, Sheraton Grand, Chicago, Illinois.

Quick quiz:

  • If your startup is seeking investors, will you have more success with private equity or venture capital firms?
  • How about when you’re looking to sell that company?

Businessman giving Vulcan greeting from Star TrekThe answers are (1) venture capital and (2) private equity.  If you weren’t sure, you’re not alone; the terms are often confused or used interchangeably.  However, PE and VC firms generally have very different investment strategies.  Understanding the distinctions may help save time and money and…perhaps…save face (i.e., not everyone will judge you for confusing Star Wars and Star Trek, but others will never forget).

Like most either/or categorizations, the distinctions blur in the middle, making generalization dangerous.  But in basic terms, here is what you need to know to avoid that awkward Han Sulu moment.

Characteristics of a PE investment (or, investing by Vulcan rationality)

PE firms typically invest in existing companies with a quantifiable track record (including proven cash flow), existing products or services, and potential for value creation.  PE investors may also consider businesses that complement their existing constellation of portfolio companies.  Therefore, whether or not PE firms invest in a company is a highly data-driven decision.  PE firms purchase a majority stake (often 100%) in their target investments.  This permits them to take an active role in their portfolio companies and to create value through financial engineering and restructuring.  In broad brush terms, this investment strategy focuses on value.  PE firms purchase underperforming or undervalued companies intending to guide them to optimal performance, increase their value, and sell them for a profit.  In other words, PE firms help existing companies realize their potential and boldly go where they have not gone before.  Because this strategy applies in many circumstances, PE investments are made across a wide set of industries.

Characteristics of a VC investment (or, investing by Dagobah ecosystem)

VC firms typically invest in emerging companies, which may have no or a limited operating history, but potential for light speed growth.  Therefore, whether or not VCs invest in a company is a holistic decision involving analyzing ideas and people (i.e., the business plan and the founders’ and management team’s ability to execute it).  To mitigate risk, VCs diversify their investments by making minority investments across a universe of startups.  Because they purchase smaller stakes, VCs have less control than PE firms over the day-to-day operations of their portfolio companies; however, VC’s often retain veto rights over certain major decisions.  In broad brush terms, this investment strategy focuses on growth.  VC firms invest early in the hopes of sharing in the upside upon exit or IPO.  These criteria keeps many VC investments industry-specific (e.g. technology and life sciences).  Although startups often fail, VCs can earn attractive returns if even one rebellious company blows up and disrupts an existing empire.

Of course, PE and VC investments have similarities, not the least of which is seeking above market returns.  The primary difference is how they arrive there.  From a company’s perspective, VC and PE firms serve distinct purposes and are appropriate at different stages of a company’s life cycle.  Entrepreneurs must understand the differences between VC and PE firms and their investing philosophies to ensure they’re approaching the appropriate investors at the right time.  Of course, there is much more to consider.  This is just a high level overview intended to demonstrate that there is a difference.  In a critical moment, remembering that PE firms invest like Vulcans and VCs invest like Jedis might remind you of the key distinctions.

An abbreviated version of this article will appear in the American Bar Association’s Business Law Today, Fall 2017 Edition.

Is your startup brand so strong that consumers tattoo the logo on their arm? Or so hard to pronounce that investors, vendors and customers are disinclined to do business with you?

"Hello, my name is..." nametagAccording to a study published in the peer-reviewed academic journal Venture Capital, your company name matters even more than you think.  The study, entitled “The Effect of Company Name Fluency on Venture Investment Decisions and IPO Underpricing,” found that a startup’s name can seriously affect how a company is perceived by investors and customers alike.

Names that are easily pronounced, such as Uber and Lyft, are preferred by both early and late-stage investors. They tend to be offered more money, whether its through crowd funders, angel investors, VCs or IPO investors.  The study also found that “uniqueness” is virtue, but only with early-stage investors.  According to the study, since very little is known about a company in the early stages, unique names give the impression there is something special about the company.

On the other hand, difficult names “evoke cues of unfamiliarity and create a perception of high novelty, which is valued by these pre-venture stage investors,” according to the study. The study cautions, however, that novelty wears off by later stages, when unique names can make more risk-adverse investors feel uncomfortable.

This study adds to the list of impacts that name can have on a venture, including:

  • An easy to pronounce and remember company name could get you more funding and customers as you grow
  • Company names and logos which are “unique”, “unobvious” and/or “novel” when associated with your services get stronger trademark protections faster with the USPTO
  • Securing 360-branding including a web domain, Instagram and Twitter handle, and an issued trademark on the name and logo early in the process with the help of an IP attorney saves cost and time as you roll out your product

Often founders launch or pivot on a name only to realize the Instagram account or web domain is taken, causing confusion in the market and requiring expensive litigation or licensing deals to consolidate your brand.  A strategic approach to choosing your company name ensures a consistent and easy brand association across digital and print media as well as adding to your successes with investors and customers, saving you time and money as you go to market.

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!

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.

For investors and founders of emerging tech companies, leaving money on the table is a tragedy which can never be remedied once it occurs. An exit sale to or investment from a large strategic buyer is for many young tech companies a once-in-a-lifetime event with enormous economic consequences impacting both the company’s founders and investors. They must “get it right” with respect to the enterprise value of the emerging tech company.

For reasons explained in a 2014 article by Fox Rothschild partner Mark V. Santo, the failure by the emerging tech company to conduct ‘reverse due diligence,” and undertake a deep dive into the operations and management of the acquirer, is tantamount to leaving money on the table.

On April 5, the Division of Corporate Finance of the Securities and Exchange Commission released two new compliance and disclosure interpretations (“C&DIs”) regarding Regulation Crowdfunding.  Regulation Crowdfunding was adopted in 2015 in order to implement the provisions of Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 that exempt certain crowdfunding transactions from registration under the Securities Act of 1933.

Crowdfunding
Copyright: yupiramos / 123RF Stock Photo

The first new C&DI addresses the disclosure requirements of Rule 201, and specifically the related party disclosure requirements of Rule 201(r).  Rule 201(r) requires that in connection with a crowdfunding offering, a crowdfunding issuer must disclose and describe any related party transactions that are currently proposed or that occurred since the beginning of the issuer’s last fiscal year in which the amount involved is greater than 5% of the total amount that the issuer raised under the crowdfunding exemption over the previous 12 months, including the amount proposed to be raised in the current offering.

C&DI Question 201.02 clarified that for purposes of this requirement, crowdfunding issuers should calculate the 5% threshold for disclosure of related party transactions based on the target offering amount plus the amount already raised during the previous 12 months, even if the issuer indicates that it will accept offering proceeds in excess of the target offering amount. In other words, the possibility of accepting additional offering proceeds in excess of the target offering amount should be disregarded for purposes of calculating the 5% threshold for disclosure.

The second C&DI released by the Division of Corporate Finance clarifies Rule 202(b)(2), which provides that an issuer is no longer required to comply with the ongoing reporting requirements of Rule 202 once the issuer has filed at least one annual report pursuant to Rule 202 and has fewer than 300 shareholders of record.

C&DI Question 202.01 provides that, when calculating the number of shareholders of record for purposes of Rule 202(b)(2), the issuer is required to count all shareholders of the same class of securities issued in the crowdfunding offering, even if some of those shareholders did not obtain such securities in connection with the crowdfunding offering.

The full text of the two new C&DIs described above, along with all previously released C&DIs regarding Regulation Crowfunding, can be found on the SEC’s website.  In addition, an overview of the Regulation Crowdfunding rules can be found in this earlier Emerging Companies Insider post.

The U.S. Citizenship and Immigration Services recently published the International Entrepreneur Rule (the “Rule”), which finalizes regulations intended to increase and enhance entrepreneurship, innovation and job creation in the U.S.  The Rule becomes effective on July 17, 2017.  In a prior blog, we analyzed the Rule when it was first proposed in August 2016.  Since then, the Rule has been through a period of public comment.  The resulting amendments generally make it easier for foreign entrepreneurs to establish startup companies in the U.S.  However, the Rule was spearheaded by President Obama, and its future is reportedly uncertain under the new administration.

Statue of Liberty
Copyright: dvrcan / 123RF Stock Photo

The Rule establishes criteria for granting “parole” (temporary permission to be in the U.S.) to certain foreign entrepreneurs to facilitate their ability to oversee and grow their stateside startups.  These entrepreneurs must show that their startup has potential to grow rapidly, create jobs and provide a significant public benefit to the United States. Startups will be judged by, among other things, how much venture, angel or accelerator capital and/or government grants they’ve received.

Applicant entrepreneurs must have a substantial ownership interest in the startup entity and an active and central role in its operations.  They must show they would substantially further the entity’s ability to engage in R&D or otherwise conduct and grow its U.S. business.

In response to public comments, the final Rule is generally more entrepreneur-friendly than the proposed rule that we described in our original blog.  Some key changes are listed below.

  • Startup Formation: To apply, startup entities must be “recently” formed.  Under the original Rule, this meant that the startup entity must have been formed within three years of the parole application.  Under the final Rule, the timeframe is extended to five years.  Since the entire potential parole period is five years (discussed below), startups could be 8-10 years old during their re-parole period, a ripe time for exits.
  • Definition of Entrepreneur: Under the original Rule, a person was only an eligible entrepreneur if he or she owned at least 15% of the startup at the time of the initial parole application, and 10% at the time of re-parole.  Under the final Rule, the ownership thresholds are reduced to 10% and 5% respectively.  The change benefits teams of founders who split equity among themselves and accounts for dilution during future financing rounds.
  • Minimum Investment Amount: Under the original Rule, entrepreneurs were only eligible if their startup had received at least $345,000 from one or more “qualified investors” (discussed below).  These investments had to be received in the 12 months prior to applying.  Under the final Rule, the investment threshold is reduced to $250,000, reflecting analysis of median seed investments of firms graduating from accelerator programs.  The timeframe is extended to 18 months.
  • Qualified Investor Definition: Under the original Rule, an investor was considered “qualified” if it made investments in startups in at least three different years in the preceding five year period of no less than $1 million and if at least two of these investments created at least five qualified jobs or generated at least $500,000 in revenue, with annualized revenue growth of at least 20%.  Under the final Rule, the investment threshold is reduced to $600,000, again to reflect median seed investments for firms successfully exiting accelerators.  The three year requirement is eliminated, but the investment performance criteria remains the same.
  • Re-Parole: Under the original Rule, the initial parole period was two years and entrepreneurs could apply for a re-parole period of up to three years.  Under the final Rule, the initial parole period has been extended to 30 months, but the re-parole period has been reduced to 30 months.  The net result is that, despite the changes, the entire parole period remains five years.  The increase in the initial parole period will give entrepreneurs additional time to qualify for re-parole (receive qualified investments or government funding, increase revenue or achieve job creation).

Generally, the final Rule is responsive to issues raised during public comment, and the changes largely make it easier for foreign entrepreneurs to build their businesses in the U.S.  Despite the apparent benefits to the U.S. startup ecosystem, the Rule may be in jeopardy under the new administration.  Emerging Companies Insider will stay on top of the story as it develops.