Our colleague Kristen Howell has published an alert reporting on an important development in the cryptocurrency industry. The U.S. Securities and Exchange Commission has declared that Bitcoin, Ethereum and other coins operating on truly decentralized platforms are not securities. The agency’s reasoning was revealed in remarks by William Hinman, Director of the SEC’s Division of Corporate Finance, at the Yahoo Finance “All Markets Summit: Crypto” on June 14. Hinman explained that since the value of cryptocurrency is not based on the expectation of profits resulting from the success or failure of the issuer, it does not compare to a typical security. You can read Kristen’s alert on the Fox Rothschild website.
The National Venture Capital Association (NVCA) publishes model legal documents for venture capital financings, including a Certificate of Incorporation, Preferred Stock Purchase Agreement and Investors Rights Agreement. These documents enjoy wide industry acceptance as baseline agreements that parties and their counsel can tailor for each deal. They also include commentary on East and West Coast practice and bracketed alternative provisions to insert/omit depending on the deal terms. Perhaps most attractive to the parties, starting from a standardized form can decrease legal hours (and, more importantly, fees) from term sheet to closing.
Recently, NVCA updated the model legal documents for the first time since 2014. Considering the wide use of these documents, these revisions are likely to impact future VC financings. Here are some of the key changes:
Certificate of Incorporation
- Protective Provision for Cryptocurrency/Blockchain Issuances: VCs typically negotiate for veto rights over a company issuing additional equity and debt securities. Now, the model Certificate includes a protective provision giving investors the right to veto token, cryptocurrency and blockchain-related offerings.
- Redemption Rights: VCs might negotiate for a redemption right, which requires the company to repurchase their preferred stock under certain conditions. If the company does not fulfill a redemption request, the model Certificate now includes a high rate of interest on the redemption price of any shares not redeemed “for any reason”. Recent case law suggests that a board may be protected by the business judgment rule if it determines not to use funds to redeem preferred stock despite an obligation to do so. (See e.g., TCV VI, L.P. Trading Screen, Inc., Case No. C.A. 10164-VCN (Del Ch. Ct. Feb. 26, 2015); SV Investment Partners, LLC v. Thoughtworks, Inc., Case No. C.A. 2724 (Del. Ch. Ct. Nov. 10, 2010). Triggering an interest payment “for any reason” gives investors increased leverage and some compensation.
Stock Purchase Agreement
- Provisions for Life Science Transactions: Life science companies are attractive to VCs due to their potential for rapid growth and significant ROI. The updated Stock Purchase Agreement includes provisions specific to life science transactions. These include more robust treatment of milestone closings, including undersubscription procedures and penalties for an investor’s failure to close, and new reps and warranties related to government and university sponsored research, clinical trials and FDA approvals.
Investors Rights Agreement
- Anti-Harassment Covenant: In a timely addition, the Investor Rights Agreement now includes a covenant requiring the company to adopt an anti-harassment policy and a code of conduct governing appropriate workplace behavior. NVCA recently published a set of model documents and resources addressing harassment and discrimination.
- Drag Along Rights: A drag along provision can permit VCs to “drag” the junior preferred and common holders into a sale of the company. Under certain circumstances, dragged shareholders can receive little or no compensation in a drag sale, which may prompt a legal challenge. The updated drag provision is intended to more effectively implement drag transactions and reduce the likelihood of a minority stockholder claim.
Users already familiar with NVCA’s model documents will be glad to see the revisions are not extensive. However, given the wide acceptance of these forms, it’s safe to say that the updates will be impactful. This is especially true with respect to anti-harassment policies, which is both a high-profile issue and has obvious benefits for all parties. Stay tuned to Emerging Companies Insider for a follow-up blog addressing NVCA’s new model documents addressing harassment and discrimination.
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.
Although 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.