Austin, Texas, downtown skyline at sunsetThe American Bar Association is holding its upcoming 2018 Business Law Section Annual Meeting at the Austin Convention Center in Austin, TX, from September 13 to 15.

Fox partners Emily Yukich and Matt Kittay are organizing a panel discussion entitled “Austin’s Startup Community Global Impact: Featuring SXSW and Central Texas Angel Network.

The panel will feature Claire England (Executive Director of the Central Texas Angel Network (CTAN)) and Chris Valentine (SXSW Pitch Event Producer). It will provide unique insights regarding Austin’s early stage investment community gleaned from CTAN’s 160+ angel investment deals and SXSW’s tenured status as an annual gathering for the world’s startup community.

The event will take place on Friday, September 14 from 10:00 AM to 11:00 AM at the Angel Venture Capital Subcommittee Meeting of the Private Equity and Venture Capital Committee.

For more information and to register to attend the section’s Annual Meeting, please visit the ABA website.

Startups represented by seedling growthFor early-stage companies in need of capital, finding potential investors can be difficult and time-consuming, especially when conditions in the capital markets are tight. For many companies, using a “finder,” an individual or entity that identifies, introduces and negotiates with potential investors, to help locate potential investors may seem to be a promising solution to this problem. However, there are risks involved in using finders, including those arising from potential violations of the SEC’s broker-dealer registration requirements. These risks are significant and, as investors become increasingly wary of the potential consequences, could threaten a company’s ability to raise capital in the future and its prospects for long-term growth and success. Finders operating as unregistered broker-dealers also face significant risks, including the possibility of severe SEC sanctions.

On April 12 at the ABA Business Law Section Spring 2018 Meeting in Orlando, Fox partner Emily Yukich and associate Matt Kittay, as well as Martin Hewitt, prominent New Jersey attorney and chair of the ABA’s Committee on State Regulation of Securities, will provide an in-depth CLE presentation on these risks. They will discuss the main risks finders face when acting as an unregistered broker-dealer, cover a critical SEC No Action Letter on the topic (the M&A Broker Letter), and will look at certain state regimes in applying the general prohibitions and restrictions in place.

The program will take place from 9:00 AM to 10:00 AM at the Rosen Shingle Creek in Orlando.  If you’d like to attend, please register for the Spring Meeting on the ABA’s website.

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

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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).

Whether it is expanding into a new market or moving out of the proverbial garage, it is common for a startup company to sign a commercial lease agreement in its early stages. In negotiating the lease, the company’s legal counsel will rely heavily on the owner to advise on the “business terms” of the lease.  In fact, in many cases, the attorney is brought into the process after a letter of intent has been signed and the key business terms have been agreed upon.  These business terms are important and can be difficult to re-trade once they have been established with the landlord.  This post offers the following 5 tips for an owner negotiating the business terms of his or her first office lease:

  1. Personal Guaranty: The landlord may require a personal guaranty, particularly if the company has a limited operating history.  This can be a difficult pill to swallow, particularly for a business owner that has taken the proper steps to incorporate and shield himself or herself from individual liability.  If a personal guaranty can’t be avoided, try to limit the guaranty to a specified monetary amount (for example, the monthly rent multiplied by a certain number of months).  You could also propose eliminating the guaranty as of a future, specified date (provided that the tenant does not default under the lease prior to that date).
  2. Understand Your Additional Rent Obligations: A tenant’s “base rent” obligation is usually outlined clearly in the lease.  However, in many commercial leases, the tenant will owe additional amounts in excess of the base rent.  For example, taxes, insurance and/or maintenance expenses can be passed through to the tenant as an additional rent obligation in some leases.  While historical figures can provide a useful estimate of these expenses, they are not necessarily indicative of future charges.  Pay careful attention to how large capital expenses or major renovations can be passed on to your company.  Negotiating a cap on controllable operating expenses can be a useful way to limit the tenant’s exposure in this area.
  3. Permitted Use/Exclusive Use: Contact the local municipality to make sure that your contemplated use of the leased premises is permitted by applicable laws and zoning ordinances.  If you sign the lease and later learn that your desired use is not permitted, you may still be responsible for the entire lease obligation despite not being able to use the space for your business.  Also, if you are renting in a building or complex, consider requesting an exclusive use provision that limits the landlord’s ability to lease space to your competitors.
  4. Improvements/Alterations: If you need to make alterations or improvements to the space in order for it to meet your company’s needs, it can be helpful to negotiate and obtain approval for this work at the outset of the lease.  Often, a landlord will offer an allowance or free-rent period to assist a tenant with the initial fitout, but it is better to negotiate these concessions upfront than after the lease is signed.  In addition, the lease should clearly specify who owns the improvements and whether the tenant is required to restore the space to its original condition at the expiration of the lease.
  5. Have a Plan for Reducing or Expanding Space: It can be difficult for an early stage company to predict how much space it will need over a 3-5 year period (or longer).  Negotiating favorable parameters for assigning or subleasing the space can be extremely valuable if you ever need to downsize or exit the space.  Conversely, if you feel the space may eventually be too small, consider seeking a right of first option/refusal to lease other space at your building or complex.  This offers flexibility without requiring you to take on too much space before it is needed.
For lease sign
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Once you have made the decision to incorporate your business, and gone through the formation process, it can feel like your company is ready to take on the world. However, there is one important item that cannot be neglected: the minute book. A minute book is the living official record of a business and contains all of the important documents to reflect the business’ history.

Checklist
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Maintaining organized records in a minute book is critical for any business.  For example, when a company seeks a new loan, raises funds via new investors, or becomes the target of an acquisition, it must undergo due diligence and produce its minutes to prove it has complied with both regulatory and its own self-governing documents such as its charter and bylaws.

The minute book begins with a business’ incorporation documents, including its articles of incorporation and bylaws (or articles of organization and operating agreement, if it’s an LLC). As time passes, and if the minute book is properly maintained, it will contain the documents that, among other things: authenticate compliance with governing documents via board and equity holder consents; confirm the company’s officers, directors and/or managers, who may resign or be replaced from time-to-time; and substantiate the capitalization of the company by memorializing changes in equity ownership.  Having a complete and current record streamlines any due diligence process and increases the company’s credibility from the very beginning.

Furthermore, the minute book will contain the “minutes” from the company’s annual and special board and equity holder meetings. The minutes are a written description of what took place at the meetings and serve to memorialize the actions taken by those in attendance during the meeting.  These records are valuable for preserving institutional memory, ensuring compliance with the company’s constitutional documents, and substantiating board or shareholder actions and processes if challenged later.

A corporation that commits to maintaining its minute book can save substantial time, money, and stress when it is called for review. On the other hand, neglecting to document the corporation’s history as it occurs can leave the company stuck trying to piece together years, if not decades, of information when the pressure is on to produce the records.

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.”

Most successful startup companies will eventually mature to the point where they need to raise a round of institutional venture capital. Such companies face an important decision: whether to seek VC from an east coast or west coast firm. Although the answer will often depend upon the startup’s geographic location and industry, emerging growth companies need to understand that there are many key differences between west coast and east coast investors.

Copyright: ar130405 / 123RF Stock Photo
Copyright: ar130405 / 123RF Stock Photo

One important distinction lies in the concept of participating preferred stock, a deal term more commonly found on the east coast. Participating preferred refers to preferred stock with a special liquidation preference. In a deal with participating preferred stock, investors will receive full return of their investment before any other money is paid out, and then also ‘participate’ in the distribution of the remaining proceeds, up to an agreed upon multiple (often 2x or 3x) of the investment.

As an example, consider a VC with a 3x participating preferred invests $10 million in your company for a 50% stake. If you later sell the Company for $50 million, a common, but misplaced, expectation would be that the VC would receive $25 million, equal to their 50% equity stake in the company. In reality, the VC will get their $10 million investment back, and will then receive an additional $20 million (50% of the remaining $40 million). This gives the VC a total of $30 million, or 60% of the sale proceeds.

As you can see from this simplified example, participating preferred stock effectively reduces the amount of money left for the founders and executive team. As such, emerging companies should recognize that participating preferred is an important deal term that requires careful negotiation. Failure to do so will often result in investors receiving a far greater share of sale proceeds than the founders intended.

Copyright: / 123RF Stock Photo
Copyright: / 123RF Stock Photo

When negotiating the terms of their investment in a startup, angel investors should consider requiring the following covenants from founders.   These covenants help preserve the value of the angel’s investment  by protecting the company from potentially adverse actions of the founders.

  • Vesting of Equity: The founders’ equity should be subject to forfeiture in decreasing percentages over several years (commonly referred to as “vesting”).  Vesting prevents a founder who leaves the startup after working for only a short period of time from retaining all the equity in the startup originally granted to him or her. Note, however, that if founders receive equity that is subject to vesting (often referred to as “restricted stock”), they should consider making an election under Section 83(b) of the Internal Revenue Code within 30 days after issuance in order to avoid adverse tax consequences once the equity vests.
  • Repurchase Rights:  The startup should have the right to repurchase a founder’s vested equity upon certain “triggering events.”  Triggering events may include: (i) death, (ii) disability, (iii) bankruptcy, (iv) taking action materially adverse to the startup’s interest, or (v) becoming disassociated or expelled from the startup.  Depending upon the particular triggering event, the purchase price is often the fair market value of the equity determined by an independent appraiser, which amount is often paid out over several years.
  • Restrictive Covenants:  Departing founders should be prohibited from (i) divulging or using the startup’s confidential information, (ii) competing with the startup (whether by starting his or her own company or working for an existing competitor), or (iii) soliciting the startup’s employees, contractors, or customers away from the startup.  These types of restrictions are usually found in standard company documents such as a Stockholders’ Agreement or Operating Agreement, or in a separate written agreement between the startup and the founder directly.
  • Assignment of Inventions:  Founders (as well as employees, developers, and other contractors of a startup) should be bound by a written agreement that assigns to the startup all intellectual property created in connection with the services performed for the startup.  Absent a written agreement, the individual or entity providing the services will generally have ownership rights in such intellectual property, and this can cause problems for a startup when it seeks to assert ownership rights, raise capital or sell to a third party.

Philadelphia Magazine just published an article I wrote examining common legal issues for startups. In it, I provide a checklist for founders looking to establish their businesses while minimizing or avoiding common legal headaches later on. Here’s an excerpt:

Checklist
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Startup founders make countless decisions about their businesses. Here’s a list of 10 legal issues that can make-or-break their businesses:

1. Choice of Entity. Although many factors go into determining whether to form a startup as a corporation or an LLC, two important factors are the startup’s funding and hiring plans. A startup will typically form as a corporation if founders expect to raise venture capital (generally $1 million or more), as VC firms often prefer to invest in a corporation to avoid the pass-through profits and losses of the LLC being attributable to the individual partners of the VC firm. Further, if founders intend to incentivize employees through the issuance of stock options, a startup will typically form as a corporation, as a stock option plan of a corporation is typically less expensive to put in place and easier to administer than a profits interest plan of an LLC.

To continue reading, please visit the full article on the Philadelphia Magazine website.

As chairs of the American Bar Association Business Law Section’s subcommittee on Angel Venture Capital, Fox Rothschild is undertaking an ongoing analysis of early stage convertible notes and their current market terms. Over a series of blog installments, we will analyze the state of the market and present results of the subcommittee’s informal national survey of convertible note term trends.

As Fox Rothschild attorney Alexander Radus noted in our first entry in this series, convertible notes offer advantages to priced equity rounds for early stage companies- faster and cheaper to close, fewer terms to negotiate, and the ability to delay the ultimate question on the valuation of the company.  But once a Founder has resolved to raise capital on convertible debt, the inevitable question they face is “what are the market terms on the economics for a convertible note round?”

In September 2015, Fox Rothschild conducted an informal national survey of 24 attorneys leading private equity and venture capital practices.  Respondents included lawyers from the west coast (3), the southwest (1), the midwest (3), the southeast (2), and the northeast (15).  One goal of this survey was to quantify market economic terms on several of the most common features of convertible notes.

Like traditional loans, convertible notes accrue interest and have a maturity date.  However, unlike traditional loans, convertible note capital raises assume that a priced round of equity financing will follow the convertible note financing, typically termed the “Qualified Financing” (e.g., a new money Series A investment of $1 million).  When the company closes the Qualified Financing, the note debt converts into preferred stock along with the purchase of Series A by the new money investors.  Although there’s variation among structures, convertible note investors have, over time, established a market set of mechanisms to compensate them for their earlier and riskier investment- the “Discount” and the “Cap”.

  • Discount. Notes typically convert at a discount (e.g., 10-30%) to the price paid by the new Series A investors. This results in investors converting the principal and interest of their notes at a lower price than the purchase price paid by the other Series A investors, thus receiving additional “bonus” shares in the Series A round.  Founders want to negotiate the lowest Discount possible.
  • Cap.  Although the Discount is a great feature for “juicing” the number of shares a noteholder receives in the Qualified Financing, investors often also negotiate a valuation “cap” on the pre-money valuation at which the notes will convert. Caps provide a backstop on runaway increase in value of the company for the purposes of calculating the conversion price of the notes.  The Cap ensures that if the company’s pre-money valuation in the Series A round is higher than the Cap, the note converts at Capped valuation.  In effect, this guarantees the minimum number of shares the noteholder will get on conversion in the Qualified Financing.  Founders want to negotiate the highest Cap possible, or even better, no Cap at all.

Typically, noteholders have the right to convert their note at the lower of (a) the conversion price determined by applying the Discount and accumulated interest to the pre-money valuation or (b) the conversion price determined by applying the Cap. For example, on convertible notes with a 20% discount and a $4 million valuation cap, the noteholder would receive a 20% discount on the Series A price up to a valuation of $5 million, and if the Series A investors are paying a price per share based upon a valuation higher than $5 million, the convertible notes will convert at a discounted price per share based upon the $4 million valuation cap.

Cap and Discount, therefore, are two of the main economic terms Founders and investors negotiate when offering notes.  So, what’s market?  Each of our survey respondents confirmed the Discounts and Caps on their five most recent convertible note financings.

Blog 1 Blog 2

A few interesting points based on these survey results:

  • While Discount shows strong center at the “standard” 20% (28% of deals), a surprising number of deals (16%) reported no Discount on the offering.
  • Nearly a third (30%) of note deals indicated “uncapped notes”, highlighting a market deviation from what most would consider as a “standard” feature; perhaps the growing number of “unicorn” companies (private emerging tech companies achieving a +$1B valuation) has given Founders leverage to eliminate the Cap feature from note offerings.
  • For those note offerings that include a Cap, almost all Caps are at or above $3mm- a good sign for Founders typically raising their first round on convertible notes.

In addition to these economic terms, the survey produced insights related to timing of the offerings, alternative “convertible equity” offerings, and other unique features, which will be discussed in our next installment in the series.