Tuesday, March 14, 2017

Cracking the SAFE: Financing Option for Start-ups

What the heck is a SAFE start-up investment and is it right for you?

SAFE stands for Simple Agreement for Future Equity.  The investment approach and the acronym itself were developed and coined by Y Combinator, a Silicon Valley-based start-up accelerator and seed investor. SAFEs have been getting quite a bit of buzz in the start-up community.

A SAFE is a convertible equity instrument used by start-up companies. The investor invests cash today in exchange for the company’s promise to issue equity in the future. What type of equity and upon what terms?  Exactly.  SAFE’s are convertible into the next round of equity issued by the company (typically a Series A preferred stock financing round) - whatever that financing round ends up looking like. SAFEs typically convert at a price discount to the Series A round and/or with a valuation cap applicable to the Series A round so that the early stage SAFE investor gets some benefit from taking on more risk by investing in the company at an earlier stage.

Here’s how it works.  Say you have a start-up company that has a great idea but urgently needs funding (sound familiar?).  You have some friends and family or angel investors that have bought into the concept and your vision, but because the company is early-stage, pre-revenue, there are no obviously appropriate valuation metrics.  The company needs equity financing sooner rather than later, but how do you price the equity at such an early stage? Whatever valuation you pick is likely to be unfair to the founders or the investors. And what other equity terms will apply (common or preferred equity, liquidation preference, dividend rate, registration rights, tag-along rights, board membership rights, voting rights, etc.)? As you can see, when you start funding a start-up, a lot of questions arise quickly.  Does it really make sense to spend a start-up’s limited time and money negotiating valuation and other deal terms at such an early stage? The parties could spend thousands of dollars and countless hours putting deal terms in place for a concept that never gets off the ground.

The SAFE investment instrument allows you to kick these sorts of issues down the road to a more appropriate stage of the start-up’s life cycle. When the start-up engages in a true Series A financing round, perhaps the financing round led by more sophisticated professional investors, such as a venture capital firm. Often the Series A investor is better able to take on the task of valuing the company and structuring the terms of the Series A investment. And perhaps the company has a revenue stream to value or at least a clearer path to defining and measuring a potential revenue stream at that point. When things go as planned, the SAFE investors can piggy-back off the added time, information and expertise of the Series A investors to hopefully achieve more equitable deal terms. The SAFE converts into the same (or substantially similar) security purchased by the Series A investors at the same time the Series A round closes.

If SAFEs sound familiar, it’s because SAFEs are in many ways similar to convertible notes, which have long been a tool used by early-stage start-up investors. SAFEs, like convertible notes, involve a cash investment today with an expectation of conversion in an equity security in the future.
Advocates for SAFE, such as Y Combinator, argue that SAFEs are superior to convertible notes because, among other things (1) SAFEs accrue no interest, (2) SAFEs have no maturity dates, and thus, no potential solvency issues for the start-ups, (3) SAFEs have fewer terms to negotiate, and thus are less expensive to implement (a SAFE is typically only about 5 pages long), and (4) SAFEs are more reflective of economic reality – investors in convertible notes rarely really intended to be a lender to the company (the convertible note is just a placeholder until conversion, typically when the Series A terms are known).

There is much positive to be said for SAFEs as a quick-and-dirty mechanism to bridge a start-up to a more formal round of equity financing. From the company’s perspective, there is much to love about SAFEs.

From the investor’s perspective, on the other hand, SAFE is a misnomer. The instrument isn’t “safe,” or at least not as safe as a convertible note or a priced equity financing round. If the start-up never issues it’s “next” round of equity, the SAFE exists in investment purgatory as neither an equity investment nor a loan. SAFEs typically provide that SAFE investors get a liquidation preference or get converted into equity upon a sale or liquidation of the company – but that could be many years down the road – or never!  Of course, no start-up equity investment is truly safe. If the company fails spectacularly, a convertible note holder is likely to be every bit as “wiped-out” as a SAFE holder. Still, there are advantages to an investor having the status and rights of a lender or a true equity holder.

That said, a SAFE investor could reasonably conclude that the cost savings to the investor (and to the company) of investing in a SAFE might outweigh the added investor protections of negotiating to acquire convertible notes or a full-blown common or preferred equity investment.     

While the SAFE investment vehicle is not for everyone, it is certainly a worthy addition to a start-up’s financing tool-box.

SAFE form documents proposed by Y Combinator are available on their website here.

Friday, March 10, 2017

J.R. Ewing -Types Continue to Vex Courts and Corporate Law

Since the dawn of our legal system, courts have had to deal with the problem of the sneaky contracting party (think: J.R. Ewing from tv's "Dallas" - or to cite a more recent example, Rumpelstiltskin from tv's "Once Upon a Time").  You know the type - someone who tricks another party into signing a contract - only after signing the contract does the other party learn further information which, had it been disclosed at the time, the other party never would have agreed to the deal terms in the contract.

On the one hand, courts like to uphold contracts freely entered into by parties which are otherwise legally enforceable.

On the other hand, courts hate to permit contracting parties to get away with fraud or otherwise sneaky behavior.

I've blogged about this issue before here when the Texas Supreme Court tackled the case of the stinky restaurant. In that case, the court came out on the side of the duped tenant whose landlord failed to disclose that the space they were renting smelled like sewer gas.

Two recent corporate law cases decided in Delaware Chancery Court highlight this ongoing tension.

In Prairie Capital III, L.P. v. Double E Holding Corp., the court considered a case in which a company was sold based in large part upon falsified monthly sales information created by the seller. Unfortunately for the buyer, the stock purchase agreement included two key provisions: (1) one in which the buyer confirmed that it was relying exclusively on its own due diligence and the seller's representations and warranties in the agreement itself, and (2) a standard integration provision in which the parties agreed that the stock purchase agreement was the entire agreement of the parties (i.e., there were no oral agreements, side deals, etc.). Fortunately for the buyer, the seller also breached some expressed representations and warranties in the agreement itself, so the buyer's case was able to proceed against the seller on other legal theories.  Nonetheless, the court concluded that so-called extra-contractual misrepresentations by the seller could not be the basis of a fraud claim by the buyer. In the court's view, the buyer had adequately disclaimed reliance on any such extra-contractual statements, even though the buyer did not use any particular "magic words" to do so.

In FdG Logistics LLC, v. A&R Logistics Holdings, Inc. the court considered a case with almost identical facts as the Prairie Capital case but reached the opposite result - the buyer was permitted to pursue fraud claims against the seller. In that case, the seller was alleged to have made extra-contractual misrepresentations (i.e., misrepresentations other than those explicitly set forth in the representations and warranties section of the purchase agreement) in documents provided to the buyer during the due diligence period before the merger agreement was signed. Even though the merger agreement in question included a statement from the seller that it was not making any representations or warranties other than those explicitly set forth in the agreement itself and there was a standard integration (entire agreement) provision, the court ruled that there was not a clear disclaimer of reliance by the buyer in the merger agreement. Without such a clear disclaimer of reliance by the buyer, the buyer's fraud claims could proceed. The court admitted that it was splitting hairs, noting that statement by the seller that it is exclusively making certain representations and a statement by the buyer that it is exclusively relying on such representations seem "like two sides of the same coin." Nonetheless, because courts hate to permit parties to get away with fraud, it will only find an adequate disclaimer of reliance by a victim when such disclaimer is crystal clear.

It is easy to see the tension at work in these types of case. Courts want to allow sophisticated and well represented parties to set the terms of their own deals - and tailor the scope of the relevant representations and warranties upon which the parties relied. That sort of flexibility keeps parties from endlessly claiming to have relied upon all sorts of statements made outside of the contract itself. On the other hand, courts don't like the idea of rewarding those who commit fraud for their dishonesty and underhanded tactics, such as failing to disclose material facts that fall outside the scope of the representations and warranties in the agreement itself but are nonetheless important to the other party.    
                
Takeaways:

The takeaways here are fairly obvious:

  • If you are a buyer and you relied upon a particular piece of information received from the seller in making a decision to enter into a transaction, you'll want to have the agreement say so explicitly in the seller's representations and warranties in the agreement itself. Then, you won't have to worry about whether or not the court will tolerate extra-contractual misrepresentation or fraud by the other party in your particular case.
  • If you are a seller, and wish to minimize your exposure for alleged extra-contractual misrepresentations, you'll want to include an explicit disclaimer from the buyer of reliance on any other statements from the seller other than those in the agreement itself. And after FdG Logistics, we now know that such disclaimer should be written such that it reads as a statement from the buyer's perspective disclaiming reliance, not just a statement from the seller that it is not making any other representations or warranties.  And even though courts often claim they aren't looking for any particular "magic words," sellers should seek to include the magic words "disclaim reliance" on other statements of the seller or seller's representatives. PUTTING THE DISCLAIMER OF RELIANCE IN BOLD AND ALL CAPS IS ALSO A GOOD IDEA. 
But regardless of how carefully contracts are drafted by the parties, society will always have parties seeking to game the system by complying with the letter but not the spirit of agreements, and courts will have to decide whether to let them get away with those games or not.

Friday, February 17, 2017

Texas Bar Today - Top 10 Blog Post

My last blog post, "The Divisive Merger: A Powerful Tool in Texas," was named one of the Top 10 legal blog posts of last week by Texas Bar Today.  What do I win, you might ask?  This cool seal:


Wednesday, February 15, 2017

The Divisive Merger: A Powerful Tool in Texas

What the heck is a divisive merger?

A divisive merger is a merger involving splitting up one company up into two or more new companies.

It's a potentially powerful tool available to Texas companies under the Texas Business Organizations Code (TBOC).  And it's a tool that is not available in most other states, including Delaware.

The concept of the divisive merger is baked into the definition of the word "Merger" in Section 1.002(55)(A) of the TBOC, which defines "Merger" to include, among other transactions, "the division of a domestic entity [such as a Texas LLC or Texas corporation] into two or more new domestic entities or other organizations or into a surviving domestic entity and one or more new domestic or foreign entities or non-code organizations."

So why is a divisive merger so powerful?

Let's say you and another person own Texas Widgets, Inc., a Texas corporation that does business in two Texas cities - Dallas and Fort Worth.  Now say you wish to split the business in half, with one shareholder taking the Fort Worth operations (which will continue in business as Cowtown Widgets, Inc.) and the other partner taking the Dallas operations (which will continue in business as Big D Widgets, Inc.).  You'll just assign half of the company's assets to one shareholder or the other, right? But wait - what if one or more of the company's leases, permits, licenses, contracts or other instruments setting forth the company's legal rights include non-assignment provisions that prohibit the company from conveying rights from Texas Widgets to Cowtown Widgets or Big D Widgets?  Is the split-off transaction doomed without getting the consent of the company's landlord(s) or other parties?  Maybe not.  Depending upon the exact language prohibiting assignment in the contract or other document, the company may be able to enter into a divisive merger to split up the company's assets without triggering the anti-assignment provisions which would otherwise require the company to obtain another party's consent. If a company merges, technically no assignment has taken place - legally, it is as if the surviving company always owed the asset or other legal rights.

Even if your company is not a Texas entity, you might be able to convert or merge your company into a Texas entity, then take advantage of the divisive merger statute to complete a transaction with similar hurdles to overcome.

And there may be other situations where a divisive merger makes sense - perhaps where taking the time, effort, and expense of conveying individual assets might be unduly costly (such as conveying dozens of working interests in oil and gas properties in numerous counties throughout Texas). A merger might be able to immediately vest title to assets to a newly merged company as a short-cut to individually conveying a series of individual assets.    

Although the divisive merger can be a valuable tool, it can also be a sword used against you by savvy operators.  So when drafting anti-assignment provisions in business contracts, you might consider if the other party might be able to use a divisive merger as an end-run to a anti-assignment provision that permits mergers but not assignments by the other party.

Saturday, January 21, 2017

Trump Tweet Suggestions

I'd like to thank the Fort Worth Business Press for publishing an article I wrote titled "Hail to the Tweet: 5 Tweets I'd like Trump to send out to make America great again."  The article is available here.

Wednesday, January 18, 2017

U.S. Supreme Court Clarifies Insider Trading Rules

The U.S. Supreme Court recently ruled in the case of Salman v. United States, 137 S.Ct. 420 (2016), that an insider may not avoid securities liability for insider trading by tipping inside information to the insider's family member or friend who trade shares of stock rather than the insider trading in the shares directly.

This result seems obvious - why should an insider who is prohibited from trading on insider information under federal securities laws - who is also restricted from selling the information by those same laws - nonetheless be permitted to gift that same information to the insider's family member or friend and permit that relative or friend to be unjustly enriched by trading on that same inside information?

The U.S. Supreme Court was forced to weigh in on this issue because the Second Circuit Court of Appeals had previously ruled that a jury could not infer that the tipper received a personal benefit from tipping confidential information to a family member or friend without proof of a gain to the tipper of a "pecuniary or similar valuable nature." And if the tipper did not receive any personal benefit from the tip, the tipper could not be guilty of insider trading.    

Insider Trading Law Background:

Insider trading is prohibited by Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated by the Securities and Exchange Commission (SEC) thereunder. Rule 10b-5 makes it unlawful for anyone to, among other things, "engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security."

The U.S. Supreme Court had previously interpreted that language of Rule 10b-5 to prohibit any person in a position of trust and confidence with regard to a public company (such as an officer, director, attorney, accountant, or other insider)(an "insider") from trading on confidential information for the benefit of the insider. Importantly, an insider could not be liable for tipping inside information unless the tipper breached a fiduciary duty by disclosing confidential information for a personal benefit. Supreme Court case law precedent had asked courts to consider "whether the insider receives a direct or indirect personal benefit from the disclosure." Without such personal benefit,there was no breach of fiduciary duty, and thus no fraud or deceit within the meaning of Rule 10b-5, and no liability for insider trading. If the tipper has a duty not to trade on inside information, a person who knowingly receives such information in violation of the tipper's duty of confidentiality (a "tippee") has the same duty as the tipper to refrain from trading on that inside information.

So the key issue in the Salman case was whether or not is would be appropriate for a jury to just assume that an insider is receiving a personal benefit when the insider tips confidential inside information to the insider's family member or friend - or must the party alleging insider trading bring forth further evidence demonstrating such personal benefit - such as the tipper's receipt of cash, property, or other item of tangible value as a result of the tip?

As the Salman Court explained, a tip by an insider as a gift to a family member or friend is no different than an insider trade by the insider followed by a gift of the proceeds of the trade. Accordingly, once it is established that the tippee is a relative or a close friend, it is unnecessary to show any tangible reward to the tipper to find the tipper guilty of insider trading.

This result was so obvious that the Court unanimously agreed with the opinion.

Wednesday, December 28, 2016

So long, Rule 505, We Barely Knew Ya'

The Securities and Exchange Commission (SEC) has repealed Rule 505 under Regulation D, effective May 22, 2017.

What is Rule 505, you might ask?  Exactly.  Rule 505 has been an exemption from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act") upon which virtually nobody has relied. And now it will soon be gone.

Overwhelmingly, issuers conducting private placements of securities have relied upon Rule 506 as the preferred exemption from the registration requirements under the Securities Act. Why? Because there are no dollar limits on the amounts that can be raised under Rule 506.  And because relying on Rule 506 has meant that state-level securities registration requirements were preempted. And if the issuer sold securities exclusively to accredited investors, there were no information disclosure requirements necessitating the preparation of a detailed private placement memorandum. Hence, Rule 506 offerings are generally quicker, easier, and less costly than a Rule 505 offering.

According to the SEC's final rule release abolishing Rule 505 (SEC Release 33-10238), less than 3% of the 132,091 Form Ds filed from 2009 to 2015 reporting private placements conducted under Regulation D were made in reliance on Rule 505.  And only 1.2% of the Form Ds in the study reported offerings exclusively under Rule 505 (as opposed to 1.7% of the offerings relying upon Rule 505 in addition to other rules under Regulation D).

In fact, in 2015, less than 1% of all new Regulation D offerings claimed an exemption under Rule 505.

And because Regulation 505 offerings are required by rule to be no more than $5 million in any 12 month period, the offerings have been smaller dollar-sized offerings, and thus Rule's 505 overall impact on our capital markets has been quite minor.  Securities offerings under Rule 504 and Rule 505 collectively accounted for less than 0.1% of all capital raised in Regulation D offerings from 2009 to 2015, according to the SEC release.  

In the same SEC final rule release, the SEC expanded the dollar limit for private placements made in reliance on Rule 504 in any 12 month period from $1 million to $5 million.  With that change, the SEC felt reliance on Rule 505 had become even less attractive to potential issuers of securities - so much so that Rule 505 had become obsolete.  

So Rule 505 will soon be abolished.  So long, Rule 505 - we barely knew ya'!