Wednesday, November 29, 2017

Fort Worth Magazine Top Attorneys 2017

Thank you to Fort Worth magazine for including me on their annual list of Top Attorneys for the 4th straight year!  I was among those honored in the Corporate Finance/Mergers and Acquisitions category.  Here I am making my way into the reception honoring 2017 Top Attorneys at the Fort Worth Club last night:

Wednesday, November 15, 2017

Blowing the Whistle on Confidentiality Agreements that Restrict Whistleblowers

Recent changes to federal whistleblower protection law have made it necessary to revisit the form of confidentiality agreements (sometimes called non-disclosure agreements or NDAs) used by companies to protect their trade secrets and other confidential information.

Whistleblowers are parties who become aware of illegal or unethical conduct within a company and seek to report such conduct to the proper governmental authorities. In the wake of the collapse of Enron, the Bernie Madoff Ponzi scheme, and other financial and accounting scandals, the government has sought to make it easier for company insiders to report illegal or unethical conduct within a company without fear of retribution from the company. As you might expect, there is often a tension between the company’s desire to protect legitimate trade secrets, often through the use of confidentiality agreements, and the law’s desire to protect and encourage whistleblowers.  

Defend Trade Secrets Act. One example of this recent trend is the federal Defend Trade Secrets Act (DTSA), which was adopted in 2016. Under the DTSA, an individual cannot be held criminally or civilly liable for “blowing the whistle” and confidentially reporting a suspected violation of law to the government or to an attorney. The DTSA also protects a whistleblower who confidentially discloses trade secrets to an attorney or to a court in connection with a lawsuit alleging that an employer retaliated against the whistleblower.

The DTSA requires that any company that enters into a confidentiality agreement with an employee, consultant or independent contractor must include a notice in the confidentiality agreement of the DTSA whistleblower protections described in the previous paragraph. If the company fails to provide the DTSA notice, the company cannot sue the employee, consultant or independent contractor under the DTSA for exemplary damages or for attorneys’ fees as otherwise permitted to be recovered under the DTSA for willful, malicious or bad faith theft of trade secrets.

SEC Rule 21F-17. The Dodd-Frank Wall Street Reform and Consumer Protection Act added a new Section 21F to the Securities and Exchange Act of 1934 (the Exchange Act) which, among other things, prohibits companies from retaliating against whistleblowers who have reported concerns about securities law violations to the Securities and Exchange Commission (SEC) or who have assisted the SEC in any investigation or judicial or administrative action. To further clarify a company’s obligations under Section 21F of the Exchange Act, the SEC adopted Rule 21F-17, which provides that “no person may take any action to impede an individual from communicating directly with the [SEC] staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.”

The SEC has taken administrative action against several companies that have entered into agreements with employees that contain confidentiality provisions that the SEC has alleged to violate SEC Rule 21F-17 by potentially “stifling” whistleblowers. The challenged agreements have included confidentiality agreements, severance agreements, and separation agreements, but any agreement that requires confidentiality obligations for the employee without providing an exception for whistleblowing reports to the SEC would arguably run afoul SEC Rule 21F-17.  In connection with an SEC cease and desist order, the SEC has indicated that including the following language in an agreement with a confidentiality provision would cause the agreement to comply with SEC Rule 21F-17:

“Nothing in this Confidentiality [Agreement] prohibits [the employee] from reporting possible violations of federal law or regulation to any governmental agency or entity, including but not limited to the Department of Justice, the Securities and Exchange Commission, the Congress, and any agency Inspector General, or making other disclosures that are protected under the whistleblower provisions of federal law or regulation.  [The employee does] not need the prior authorization of the [the company] to make any such reports or disclosures and [the employee is] not required to notify the company that [the employee has] made such reports or disclosures.”     

Takeaways. Any company entering into a confidentiality agreement or other agreement with an employee, consultant or independent contractor that includes a confidentiality provision should consider including the DTSA notice described above to ensure that the company will enjoy the full benefit of the trade secret protection and remedies afforded by the DTSA. And companies (especially publicly traded companies) should consider including carve-outs for whistleblowers in their confidentiality agreements, such as the SEC-blessed disclosure described above, to ensure that those confidentiality agreements comply with SEC Rule 21F-17.  

Special thanks to CityBizList-Dallas for publishing this article here. 

Friday, September 8, 2017

What's in a Name (of a Texas company)?

"What's in a name? That which we call a rose
By any other name would smell as sweet."

- Spoken by Juliet in Romeo and Juliet (Act II, Scene II), by William Shakespeare

Sometimes, it seems the hardest part of forming a new company can be picking its name - as if all of the good names have already been taken! And historically, Texas law has done company organizers no favors by preventing companies from using names which are the same as, or "deceptively similar" to, names of existing companies doing business in Texas. At times, the Texas Secretary of State has taken a broad view of names which it considered deceptively similar - further narrowing the field of available names. But thanks to the 85th Texas legislature, picking a name for a Texas company is about to get a little easier.

House Bill 2856, which becomes effective June 1, 2018, will amend the Texas Business Organization Code (TBOC) to permit new filing entities (such as corporations, limited liability companies, limited partnership, etc.) and foreign entities registering to do business in Texas to use any name which is "distinguishable" from the names of all other companies formed, registered, or reserved for use in Texas.

In short, Texas companies will soon be able to have "deceptively similar" names, so long as the names are "distinguishable" from one another.

The change will make Texas law more uniform with the requirements established in other states, including the State of Delaware (see Section 102(a)(ii) of the Delaware General Corporation Law). It is hoped that this change will facilitate the formation of new business entities and expedite the registration of out-of-state business entities to transact business in Texas.

Perhaps all those newly formed or registered Texas companies will soon be humming a Jim Croce tune:

"Like the pine trees lining the winding road
I got a name, I got a name."

Then again, maybe not.

Regardless, I view this change as a positive one for Texas corporate law.

Monday, August 21, 2017

SmartVest Presentation: "Ins and Outs of Term Sheets"

Last week I had the honor of making a presentation as part of SmartVest, a Startup Investor Series sponsored by TECH Fort Worth. I presented "Ins and Outs of Term Sheets," discussing some of the common terms found in Series A investment term sheets. The presentation was a lot of fun to give, primarily because the accredited investors in attendance asked a lot of really great questions.

Thanks to TECH Fort Worth for including me in this valuable educational program for the startup investment community.

Wednesday, August 9, 2017

Takeaways from SEC's Access to Capital and Market Liquidity Report to Congress

Yesterday, the United States Securities and Exchange Commission’s (the SEC's) Division of Economic and Risk Analysis published its Report to Congress on "Access to Capital and Market Liquidity." The Report is available here.

The Report attempts to assess, among other things, the impact of the Dodd-Frank Act, on access to capital for consumers, investors, and businesses.

A few interesting takeaways from the Report:

New Rule 506(c) has been a disappointment.  That's my conclusion, not the SEC's, but the numbers speak for themselves.

Rule 506(c) permits companies to engage in "general solicitation" in connection with private placements of securities strictly to "verified" accredited investors. The traditional Rule 506 (now re-numbered Rule 506(b)) prohibits issuers from engaging in general solicitation, but it permits up to 35 non-accredited investors and has a looser "reasonable belief" standard (as opposed to "verified" under Rule 506(c)) for confirming an investor's accredited investor status.
The premise of Rule 506(c) was that companies would have greater access to capital if they could solicit funds broadly from any accredited investor rather than limiting investment to investors with which the company has a preexisting relationship (those that could be reached without engaging in general solicitation) as required under Rule 506(b).

But overwhelmingly, companies raising capital through Rule 506 have continued to use Rule 506(b) rather than taking advantage of the newly created Rule 506(c).  The Report indicates that during the period from the effectiveness of Rule 506(c) (September 23, 2013) through December 31, 2016, issuers reported raising an aggregate of $108 billion using Rule 506(c) as compared to $4.2 trillion raised through Rule 506(b).

That means less than 3% of all capital raised through Rule 506 took advantage of the new Rule 506(c)!

Regulation Crowdfunding has been a disappointment.  Again, that's my conclusion, not the SEC's, but once gain the numbers speak for themselves.

Regulation Crowdfunding permits issuers to raise up to approximately $1 million over a 12-month period in small amounts from a large number of investors over the Internet. The SEC's sanctioning of equity crowdfunding received a lot of hype and attention in the business press at the time of its adoption.

Unfortunately, during the period from the date Regulation Crowdfunding, went effective on May 16, 2016 through December 31, 2016, only 156 companies have taken advantage of Regulation Crowdfunding, by conducting a total of 163 crowdfunding offerings nationwide. Of those offerings, only 28 issuers successfully met their minimum target capital raise. And of those successful offerings, the median amount of capital raised was only $171,000. 

And the aggregate amount of all capital raised through crowdfunding under Regulation Crowdfunding nationwide during 2016 was only $8.1 million!  I wouldn't be surprised if publishers spent more than that amount on paper and ink writing articles about how significant the crowdfunding revolution was going to be.

Regulation A offering are showing some signs of life.  

Regulation A (Reg A) previously allowed companies to raise up to $5 million in a 12-month period. But issuers virtually never took advantage of the traditional Reg A, in part because the dollar limits under Reg A were so low. The JOBS Act required the SEC to adopt rules increasing the dollar limits on Reg A offerings. Those new rules (dubbed Reg A+) now permit offerings up to $20 million (under Tier 1 of the new Reg A) or up to $50 million (under Tier 2 of the new Reg A) in a 12-month period.

The market has certainly noticed. From 2005-2016 issuers typically conducted only about 14 Reg A offerings per year, raising an aggregate of approximately $163 million per year. During the period from the date Reg A+ went effective on June 19, 2015 through December 31, 2016, there were 97 Reg A offerings seeking to raise an aggregate of $1.8 billion.

Although the SEC does not have access to the precise amount of funds actually raised in such offerings, the SEC estimates that 56 issuers raised an aggregate of approximately $315 million during this period. 


I should caution that all of the trends reported in the Report and summarized above are early, and it is certainly possible that any or all of Rule 506(c), Crowdfunding, and Reg A+ will show gains in popularity as issuers and investors grow more comfortable and more experienced with each of these exemptions from the registration requirements under the Securities Act. But preliminary results certainly have not been encouraging for any of these new or amended exemptions. 


Thursday, August 3, 2017

Surprising Quirks of Texas Nonprofit Corporation Governing Documents

How do the governing documents (certificate of formation and bylaws) of a Texas nonprofit corporation differ from those of a Texas for-profit corporation?

Quite a bit, actually. Below is a non-exclusive list of ways in which the certificate of formation and bylaws of a Texas non-profit corporation often differ from those of a Texas for-profit corporation. Some of these differences may be surprising to those who more frequently deal with for-profit corporations.

1.  Fewer restrictions on the name of a nonprofit corporation.  Section 5.054 of the Texas Business Organizations Code (TBOC) requires that the name of a Texas for-profit corporation include the word “company, corporation, incorporated, or limited” or an abbreviation of one of those words, such as “Inc.” or “Co.” There is no such requirement for a Texas nonprofit corporation.

2.  More restrictions on the purpose of a nonprofit corporation. Section 2.001 of the TBOC provides that a Texas for-profit corporation is generally permitted to have any lawful purpose. Section 2.003 of the TBOC restricts any Texas corporation (whether nonprofit or for-profit) from engaging in certain prohibited purposes, such as unlawful activities or operating as a bank, trust company, savings association, insurance company, cemetery association (with certain exceptions), or abstract or title company. Section 2.002 of the TBOC limits a nonprofit corporation to only one or more of the following purposes:

               a.  Serving charitable, benevolent, religious, eleemosynary, patriotic, civic, missionary,                              educational, scientific, social, fraternal, athletic, aesthetic, agricultural, or purposes;
               b.  Operating or managing a professional, commercial, or trade association or labor union;
               c.  Providing animal husbandry; or 
               d.  Operating on a nonprofit cooperative basis for the benefit of its members.

      Section 2.010 of the TBOC also restricts the permissible activities of a nonprofit corporation.

     Moreover, a nonprofit corporation desiring status as an organization exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code (the Code) must comply with Section 501(c)(3) of the Code, which requires nonprofit corporations to be “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.”

     In its Instructions to Form 1023 (Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code), the Internal Revenue Service (IRS) suggests including the following language as the nonprofit corporation’s purpose to ensure compliance with the purpose requirement in Section 501(c)(3) of the Code: “The organization is organized exclusively for charitable, religious, educational, and scientific purposes under Section 501(c)(3) of the Internal Revenue Code, or corresponding section of any future federal tax code.”

    3.  May have no members or no board of directors. Every for-profit corporation has at least one shareholder and at least one director, but under Section 22.151(a) of the TBOC, a nonprofit corporation need not have any members – it may be managed exclusively by the nonprofit corporation’s board of directors. Alternatively, Section 22.202 of the TBOC provides that a nonprofit corporation may have no board and may instead be managed exclusively by its members. If the nonprofit corporation elects to have no members or no board of directors, Section 3.009(1) of the TBOC requires a statement to that effect in the nonprofit corporation’s certificate of formation. 

4.  Must have at least three directors.  If a Texas nonprofit corporation elects to have a board of directors, it must name at least three people to serve as directors of the corporation under Section 22.204 of the TBOC. For-profit corporations are only required to have at least one director under Section 21.403 of the TBOC.

5.  Action by written consent of less than all directors.  Sections 6.201 and 21.415(b) of the TBOC permit the board of directors of a Texas for-profit corporation to take action by unanimous written consent in lieu of holding a formal meeting of the board, but only if the written consent is signed by all of the directors. On the other hand, Section 22.220 of the TBOC permits the board of a nonprofit corporation to take action by written consent signed by the number of directors necessary to take the action at a meeting in which all of the corporation’s directors are present (typically, a majority), if non-unanimous written consents are authorized in the nonprofit corporation’s certificate of formation or bylaws.

6.  Board committees generally must have at least two members and only a majority of the committee need be directors.  The board of a Texas for-profit corporation may establish a board committee composed of one or more directors under Section 21.416(a) of the TBOC. If a Texas nonprofit corporation wishes to establish a board committee, it must comply with Section 22.218(b) of the TBOC, which requires that the board committee consist of at least two persons. That Section permits persons who are not otherwise directors be named to the committee so long as at least a majority of the committee members are directors of the nonprofit corporation. A nonprofit corporation which is a religious institution may establish committees composed entirely of non-directors.

7.  President and Secretary cannot be the same person. A Texas for-profit corporation is required to have a President and a Secretary under Sections 21.417 of the TBOC, but such offices may be held by the same person under Section 3.103(c) of the TBOC. Conversely, Section 22.231(a) of the TBOC requires that the offices of President and Secretary of a Texas nonprofit corporation be held by different persons.

8.  Directors may vote by proxy.  Section 22.215 of the TBOC permits a director of a Texas nonprofit corporation to permit someone else to vote on the director’s behalf by granting a proxy to the other person, if proxy voting is permitted by the nonprofit corporation’s certificate of formation or bylaws. There is no analogous provision applicable to Texas for-profit corporations.  Directors of a for-profit corporation must vote for themselves - either in person, by written consent, or via electronic means, such as attending a meeting via teleconference.

9.  Liquidating distributions for charitable purposes. A Texas for-profit corporation exists for the financial benefit of its shareholders, and after all of its creditors have been paid or reserved for, liquidating distributions from a for-profit corporation are to be made to the corporation’s shareholders under Section 11.053(c) of the TBOC. On the other hand, nonprofit corporations exist only for one or more of the non-profit purposes described above. Upon liquidation of a nonprofit corporation, Section 22.304(a)(2) of the TBOC generally requires that any assets of the nonprofit corporation remaining after all creditors have been paid must be paid to one or more 501(c)(3) organizations. For the nonprofit corporation itself to qualify as a 501(c)(3) organization, the nonprofit corporation must include a provision in its certificate of formation requiring that liquidating distributions will be made for charitable purposes. 

The IRS’s Instructions to Form 1023 suggest the following language to meet the dissolution clause requirement in Section 501(c)(3) of the Code: “Upon the dissolution of this organization, assets shall be distributed for one or more exempt purposes within the meaning of Section 501(c)(3) of the Internal Revenue Code, or corresponding section of any future federal tax code, or shall be distributed to the federal government, or to a state or local government, for a public purpose.”

Saturday, July 15, 2017

Texas Secretary of State’s Form of Certificate of Formation

Mother, should I trust the government?” – Pink Floyd

That question answers itself, does it not?

I’m pretty sure Pink Floyd did not have form documents promulgated by the Texas Secretary of State’s office in mind when those lyrics were written. Nonetheless, it’s a helpful reminder that you often get what you pay for when it comes to free legal forms. Or perhaps the economic maxim of TANSTAAFL (“There ain't no such thing as a free lunch”) would be a more suitable reference.
Regardless, for those looking to incorporate a Texas for-profit corporation, I do not recommend using the Texas Secretary of State’s form of Certificate of Formation (Form 201), which is available on the Secretary of State’s website here.   

What’s so bad about Form 201?  Well, nothing is horrible about it – you could certainly file it (and pay the related filing fee) and have yourself a functioning Texas for-profit corporation. But an experienced Texas corporate lawyer is likely to suggest a using a form of Certificate of Formation that includes other helpful provisions in addition to the minimum required provisions dictated by the Texas Business Organizations Code (TBOC).

For example, Form 201 does not include any of the following provisions which are common for Texas for-profit corporations:

Director Exculpation.  As a rule, directors do not like to be subject to potential personal liability in connection with their service as a director of a corporation. So Texas corporations often elect to take advantage of Section 7.001 of the TBOC, which permits a Texas corporation to exculpate (relieve from liability) its directors from liability to the corporation or its shareholders. They may achieve director exculpation by adopting a director exculpation provision as part of the corporation’s Certificate of Formation. The basic Form 201 does not include a director exculpation provision, though one could elect to supplement the basic Form 201 by adding such a provision (or any of the other provisions discussed below). Our clients typically elect to include a director exculpation provision in their Certificate of Formation when forming a new Texas corporation.

Mandatory Indemnification of Directors and Advancement of Expenses. Likewise, directors typically think it’s a good idea to have corporations on which they serve indemnify (cover the costs of) directors from potential liability arising from their service as a director. While exculpation relieves directors of liability to the corporation and its shareholders, indemnification protects directors from claims made by third parties. Section 8.101(a) of the TBOC permits Texas corporations to indemnify its directors who gets sued by a third party because of their service as a director so long as the director (1) acted in good faith, (2) reasonably believed that his or her actions taken in an official capacity were in the corporation’s best interest, (3) reasonably believed that his or her actions in all other cases were not opposed to the corporation’s best interests, and (4) in the case of criminal proceedings, did not have reasonable cause to believe his or her conduct was unlawful.

Section 8.103(c) of the TBOC permits a Texas corporation to adopt a provision as part of its Certificate of Formation which makes permissive indemnification mandatory.  That means that once it has been determined that a director has met the 4-part standard described in the previous paragraph for a corporation to be permitted to indemnify a director, then the corporation would be required to provide such indemnification for the benefit of the director.

Of course, sometimes it is unclear at the outset of a suit against a director whether or not the director has met the standard for permissive indemnification. Meanwhile, the director may be incurring substantial expenses in defending himself or herself against third party claims. In cases where it has not yet been determined if the director has met the standard for permissive indemnification, Section 8.104(a) of the TBOC permits Texas corporations to advance expenses to directors in connection with their defense of a claim, so long as the director provides a written statement confirming that (1) the director believes he or she has met the standard for permissive indemnification, and (2) the director will repay any expenses advanced if it is ultimately determined that he or she has failed to meet the standard for permissive indemnification.    

Section 8.104(b) of the TBOC permits corporation to adopt a provision in part as part of its Certificate of Formation requiring the corporation to advance expenses to directors who have provided the written confirmation described in the previous paragraph. As one might expect, directors of Texas corporations typically think it is a good idea to include such an advancement of expenses provision in the corporation’s Certificate of Formation.

Action by Written Consent of less than all Shareholders.   Let’s say you want to amend the corporation’s Certificate of Formation to change the name of the corporation. As with any other amendment to the Certificate of Formation, that change requires the approval of the corporation’s shareholders. If all shareholders are willing and able to sign a written consent approving the name change, then shareholder approval is fairly simple. But let’s further assume that all shareholders fully support the name change, but one of the shareholders, holding only 1% of the corporation’s outstanding shares of stock, is on vacation and is unable to sign a written consent approving the name change. What then? Well, if the name change is important and the corporation does not have a provision in its Certificate of Formation authorizing shareholder action by less than unanimous consent, the only way the corporation may change its name is to call a meeting of the shareholders to approve the name change. Such a meeting must be done in compliance with applicable notice, quorum, proxy, and other provisions of the corporation’s bylaws and relevant provisions of the TBOC. Finding a time and place convenient for an adequate number of shareholders to attend in person or by proxy may be difficult.  On the other hand, a corporation with a Certificate of Formation that includes a provision permitting shareholder action by less than unanimous written consent of its shareholders (as permitted by Section 6.202 of the TBOC) can very easily circulate a written consent to its shareholders requesting approval of the name change.  Once signed by a sufficient number of shareholders, the name change may proceed. 

Section 6.204 of the TBOC provides that a corporation need not provide advance notice to shareholders of shareholder action taken by written consent, so depending upon the advance notice of a shareholder meeting required in the corporation’s bylaws, the right of shareholders to take action by written consent can be important when timing is critical for a matter requiring shareholder approval.

Of course, that’s just of few of the possible Certificate of Formation provisions ignored by the Secretary of State’s Form 201. A Texas corporation might elect to include all sorts of other provisions in its Certificate of Formation, including provisions authorizing preferred stock, providing for preemptive rights, providing for cumulative voting rights, electing status as a “close corporation,” or adopting other provisions which may be appropriate for some Texas corporations.

Bottom line, careful consideration should be given to the options available to a new corporation before just grabbing Form 201 and filing away.

Friday, June 30, 2017

360 West Magazine Top Attorney 2017

I'd like to thank 360 West Magazine for including me in their list of "Top Attorneys 2017"(their annual list of our region's best attorneys)!  This year, I was named in the practice areas of Business Law and Civil Law and Transactional.  

The complete list is available here.  

Monday, April 3, 2017

Regulation Crowdfunding Inflation Adjustments

Limits on the amount of capital that companies can raise through equity crowdfunding just grew a tad.

On March 31, 2017, the Securities and Exchange Commission (SEC) adopted amendments to Regulation Crowdfunding which adjust dollar thresholds and limits to account for inflation.

Specifically, companies that raise capital through equity crowdfunding are now permitted to raise up to $1,070,000 per 12-month period (up from $1 million).

The inflation adjustments also impacted other dollar limits and threshold throughout Regulation Crowdfunding.  For example:

  • The threshold for assessing a crowdfunding investor's annual income or net worth to determine investment limits applicable to such investor increased from $100,000 to $107,000;
  • For a crowdfunding investor whose income or net worth is below the new $107,000 threshold, the maximum amount of securities that can be sold to such investor in a crowdfunding offering has increased from $2,000 to $2,200 [or, if greater, 5% of the lessor of (i) the investor's annual income or (ii) the investor's net worth]; and 
  • The maximum amount that any investor can invest in all crowdfunding offerings in any 12-month period has increased from $100,000 to $107,000.

The SEC was required under the JOBS Act of 2012 to adjust the limits and thresholds under Regulation Crowdfunding to account for the impact of inflation.  Further adjustments are required at least every five years.

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.    

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.