Venture Capital Finance

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
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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
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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
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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
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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.

On January 10, 2017, the U.S. House of Representatives passed a bill commonly known at the “HALOS Act”, which directs the Securities and Exchange Commission (SEC) to revise Regulation D.  Prior to the proposed amendment, Regulation D exempts certain offerings from SEC registration requirements but prohibits “general solicitation” with respect to such offerings.  The proposed amendment states that the prohibition shall not apply to events with specified kinds of sponsors — including “angel investor groups” unconnected to broker-dealers or investment advisers — where presentations or communications are made by or on behalf of an issuer, but:

  • the advertising does not refer to any specific offering of securities by the issuer;
  • the sponsor does not provide investment recommendation or advice to attendees, engage in investment negotiations with attendees, charge certain fees, or receive certain compensation; and
  • no specific information regarding a securities offering is communicated beyond the type and amount of securities being offered, the amount of securities already subscribed for, and the intended use of proceeds from the offering.

If the bill becomes law, early stage companies which present at demo days and other “pitch events” will have clear guidance that such actions are exempt from violating the SEC’s prohibition on “general solicitation”, avoiding the need to verify investors as “accredited” as a result of their pitches.  Investors likewise would have better assurances that companies have not tripped the general solicitation trigger.


Matthew R. Kittay is a corporate attorney in Fox Rothschild’s New York office and Co-Chair of the American Bar Association’s Angel Venture Capital Subcommittee.

Founding a company is an exciting moment in an entrepreneur’s career.  But even on Day 1, there are steps entrepreneurs should take to avoid major financial and diligence issues in the future.  In this series of posts, we’ll cover some basics that often trip up founders to help guide you through those early steps.

Entrepreneurs often assume they own their company de facto (i.e., by virtue of the fact that they formed it, without any other required action)- a proposition that seems so logical and fundamental, it’s hard to believe its not true.

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Later in their company’s lifecycle (typically, when there’s pressure on due diligence because the founders either consult an attorney knowledgeable in the space or there’s an interested incubator, accelerator or angel investor), many founders are surprised to learn that after forming their company, they must take another critical step to become shareholders in the company they founded – purchasing their company’s stock.

This often overlooked step works to the founder’s benefit, when it’s done correctly.  In fact, we often tell founders that the ability to purchase their company’s stock on Day 1 is one of the core economic upsides to founding a business in the first place.  While this seems backwards (why should you have to buy stock in a company founded by you- isn’t that the investor’s role?), it makes sense considering the price the founders pay for that stock, as long as the stock is purchased at or near the time of formation of the company.  Because at formation of the company, there’s typically no assets or value associated with the company other than the nominal par value of the stock, allowing a founder to purchase their shares at a fraction of a penny per share (whatever the par value is set to).

Of course, there’s nuances and unique circumstances to each company formation that need to be discussed with your lawyer and financial advisor.  Sometimes, there is real value associated with the stock, even on Day 1 (for example, if the company is a spinout with assets).  And there are other steps that a prudent founder or founding team may need to take at inception along with the purchase of their stock (e.g., consider imposing vesting restrictions on the stock and filing an 83(b) election).

But first things first, make sure you purchase your stock on Day 1, before that hockey stick growth you’re projecting becomes a reality…

Fox Rothschild’s Emerging Company Resource Center includes formation document checklists developed by our nationally recognized emerging companies attorneys; information on relevant intellectual property issues (trademarks, patents, licenses); data room portals for investor due diligence; and other resources for emerging companies.  We encourage our entrepreneurs to reach out to us with questions as they grow their company with these resources. 

A new rule proposed by the U.S. Citizenship and Immigration Services (USCIS) grants limited entrée to entrepreneurs establishing stateside startups.  The “International Entrepreneur Rule” would permit the Secretary of Homeland Security to offer parole (temporary permission to be in the U.S.) to individuals whose businesses provide “significant public benefit.”

Who Qualifies?

Statue of Liberty
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So what is a “significant public benefit”?  According to the proposed rule, an entrepreneur can meet this standard by demonstrating that the startup has substantial potential for rapid growth and job creation, and that the entrepreneur’s parole would significantly help the startup conduct and grow its business in the US.

These are still abstract concepts, so the rule proposes benchmarks to evaluate entrepreneurs and their businesses. To qualify:

  1. The startup must be recently formed in the U.S. (i.e., generally within 3 years of its application).
  2. The individual must possess a substantial ownership interest in the entity (i.e., generally 15% or more) and have an active and central role in the business.
  3. The entity must have:
    1. received substantial investment from qualified investors (at least $345,000) with established records of successful investments; or
    2. received substantial awards or grants from certain governmental entities (at least $100,000); or
    3. partially satisfied one or both of the above criteria and must submit additional evidence of potential public benefit (e.g., acceptance into a startup accelerator, creation of new technologies or focus on cutting-edge research).

Notably, “qualified investors” are not determined based on the traditional definition of “accredited investors.”  Instead, the proposed rule focuses on investors’ track records.  Specifically, a startup must show that its investors have a history of making startup investments on a regular basis over a five-year period and that at least two of their investments have experienced significant growth in revenue or job creation.

For How Long?

Initial parole terms are for up to two years, and grantees have the opportunity to apply for an additional term of up to three years.  Renewal applications are determined on similar criteria as above, but thresholds differ.  For example, renewal applicants only need to own 10% of the startup, to account for dilution due to financing rounds during the initial parole period.

Join the Debate

The DHS is currently seeking public comments on the proposed rule, including with respect to the definition of “entrepreneur” and investment thresholds.  The proposed rule is a step in the right direction, but will generate comment and criticism, especially regarding its balancing act of encouraging innovation, promoting the public benefit and preventing fraud.  While investment thresholds are intended to weed out lifestyle businesses, they may also eliminate endeavors that serve the public good but are not scalable or otherwise likely to provide market venture returns.  The five-year maximum parole term seems a close shave given the time it can take from founding to exit (even the proposed rule recognizes that from 2009-2012 the average age of a company at public exit was 7.9 years).  Finally, focusing on investor track records instead of traditional accreditation concepts may discourage bad faith parole-for-cash investments, but it is likely to generate uncertainty.

These issues are likely to be addressed during public comment, and perhaps resolved before final publication.  The effort is certainly praiseworthy and may permit one or more foreign entrepreneurs to build their “New Colossus.”

High-growth cybersecurity startups have received a total of $9 billion in venture capital funding in the past six years, according to the National Venture Capital Association.  The private sector has rapidly adopted the cybersecurity solutions developed by these emerging companies; however, the federal government has been missing out on these innovations due to its cumbersome and confusing procurement process.

Cybersecurity
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Two bills recently approved by the House Committee on Homeland Security aim to jumpstart a prohibitively slow and complex procurement process for innovative cybersecurity technologies.  According to industry insiders, by the time innovators win government contracts, cybersecurity needs have often evolved, requiring products to be adjusted to stay effective.

Texas Rep. John Ratcliffe, chairman of the Subcommittee on Cybersecurity, Infrastructure Protection and Security Technologies, introduced the Leveraging Emerging Technologies Act of 2016 and the Support for Rapid Innovation Act of 2016. House Majority Leader Kevin McCarthy recently indicated that the House may soon consider them.

  • The Leveraging Emerging Technologies Act of 2016 directs the Department of Homeland Security (“DHS”) to address homeland security needs by engaging with “innovative and emerging technology developers and firms, including technology-based small businesses and startup ventures.” Specifically, the bill requires the DHS to develop a strategy to engage small businesses and startup ventures developing new security technologies, including by:
    • ensuring that innovative and emerging technologies can be included in current and future federal procurement contracts;
    • coordinating with venture investors, particularly those funding small businesses and startup ventures, to assist with commercializing innovative and emerging technologies; and
    • addressing existing barriers to small businesses and startup ventures in the federal government’s acquisition process.
  • The Support for Rapid Innovation Act of 2016 expands the Homeland Security Act’s rudimentary framework that already encourages joint federal-private sector efforts to develop and acquire cybersecurity technology. Specifically, the DHS, through oversight from the Under Secretary for Science and Technology, would be required to engage in partnerships and commercialization that “introduce new cybersecurity technologies throughout the homeland security enterprise.”

Nimble startups are well-positioned to address the ever-changing cybersecurity landscape.  And the rapid deployment of venture funding into this space attests to the demand for innovative solutions.  It remains to be seen whether these bills, if ultimately signed into law, can make the federal government faster on its feet and able to benefit from (and provide support to) private sector innovation.