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.

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.

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.

Rule 506(b)'s Merit - and Is there Merit to Merit Review?

An overwhelming majority of private placements of securities in America are done by means of sales strictly to accredited investors in reliance upon the exemption from the registration requirements under the Securities Act of 1933 afforded by Rule 506 under Regulation D (now known as Rule 506(b)).

So what so great about Rule 506(b)?  Some of the key benefits are as follows:

1. No Uncertainty.  Rule 506(b) provides a tremendous amount of clarity for issuers of securities seeking to ensure that they have a valid private placement exemption. So long as an issuer has a reasonable belief that all of its investors are accredited and the issuer refrains from engaging in public solicitation activities, the issuer will generally have a valid private placement. Outside of the "safe harbor" of Rule 506(b), other factors (some of which are identified below) can complicate the analysis and/or limit an issuer's freedom when offering securities. For example, if an issuer wishes to rely upon the exemption afforded by Section 4(2) of the Securities Act, it better get ready to sort through decades of case law and SEC releases on what exactly it means to have a "transaction by an issuer not involving any public offering." 
2. No Dollars Limits.  This benefit speaks for itself.  Rule 506(b) puts no limits on the dollar size of a private placement.  Contrast that with Rule 504 which limits issuers to raising $1 million or Rule 505 which limits issuers to raising $5 million.
3. No Investor Limits.  Rule 506(b) permits sales to an unlimited number of accredited investors. Contrast that with the Section 4(2) exemption which provides no statutory guidance regarding how many investors may invest before a private placement turns into a public offering. 
4. No Blue Sky Compliance.  Securities sold in reliance on Rule 506(b) are deemed to be "covered securities," thereby preempting most state level blue sky regulation. States may require issuers to make a notice filing, pay a small filing fee, and consent to service of process in any state where it sells securities, but issuers who sell "covered securities" need not register or find a valid exemption from registration in up to 50 different states.
5. No Disclosure Requirement.  While Rule 506(b) permits sales to up to 35 unaccredited investors, issuers rarely permit unaccredited investors to participate in Rule 506(b) private placements because doing so requires issuers to provide a detailed private placement memorandum to every investor, which is generally cost prohibitive. By limiting sales exclusively to accredited investors, there is no information disclosure obligation upon the issuer (though it is generally advisable to provide at least some disclosure document to each investor to insulate the issuer from potential securities fraud claims).  
6. No Verification Requirement. The SEC recently adopted Rule 506(c) which permits issuers to engage in public solicitation in connection with private placements so long as the issuer "verifies" that all investors are accredited. But since the steps that an issuer must take to "verify" an investor's status are somewhat vague (and/or are somewhat intrusive on the investor) at this point, most issuers engaging in private placements continue to rely upon Rule 506(b) and its lower standard that the issuer have a "reasonable belief" that its investors are accredited. 

Today I want to focus on Item 4 above - the preemption of potential multi-state blue sky registration and/or review by state level securities regulators (such as the Texas State Securities Board).  How valuable is it to avoid such review and regulation?  Very.  Even if every individual state securities regulatory body was a marvel of efficiency and reasonableness, merely getting familiar with the registration requirements and/or exemptions from registration in up to 50 states would be a challenging task for issuers. 

But consider states that require so-called "merit review" of a securities offering. That's when a state-level blue sky regulator takes it upon themselves to look beyond whether or not the issuer has fully disclosed the material information about the issuer and the offering to determine if a particular investment is "fair" to potential investors.

I have serious doubts that the twin goals of investor protection and facilitating capital formation for the US economy are advanced by merit review by state blue sky securities regulators.  For example, according to an article by Samual S. Guzik in a recent issue of the Texas Journal of Business Law, in 1980 securities regulators in the Commonwealth of Massachusetts and other states prohibited "ordinary investors" from participating in an IPO for Apple Computer, reasoning that the offering price was too high relative to the company's book value!  

Fort Worth Business Press Article

Thank you to the Fort Worth Business Press for publishing my article titled "New SEC rules to permit general solicitation in private placements," which is available here.

As noted in previous blog posts, these new rules are a huge deal in the private capital markets.

CityBizList Article on New Rule 506

One of the biggest changes ever in the world of private placements is coming September 23, 2013.  That's when the SEC's new Rule 506 becomes effective, permitting "general solicitation" in connection with private placements in which the purchasers are exclusively "verified" accredited investors.

I wrote an article for CityBizList - Dallas about this topic.  The article is available here.

Rule 506 Amendments - The SEC Giveth and Taketh Away

On July 10, 2013, the SEC adopted long-awaited final rules eliminating the prohibition against general solicitation and general advertising in Rule 506 offerings if the issuer of the securities takes reasonable steps to verify that all purchasers of securities in the offering are accredited investors.

Congress instructed the SEC amend to Rule 506 to permit general solicitation in Rule 506 offerings as part of the Jumpstart Our Business Startups (JOBS) Act.  The JOBS Act was enacted on April 5, 2012, and required the changes to be made within 90 days (or by July 4, 2012).  On July 10, 2013, the SEC announced its final rules implementing the change permitting general solicitation in Rule 506 offerings.  The amendment becomes effective September 23, 2013.  So by my calculations, the amendment becomes effective only 446 days after the deadline set by Congress in the JOBS Act!

In any event, the amendment to Rule 506 should come as good news for small and mid-sized businesses seeking to raise capital in private placements.  Beginning September 23, 2013, there are no longer restrictions on advertising and other means of general solicitation to conduct a valid private placement under Rule 506 if the issuer is careful to verify the accredited investor status of its investors.

On the other hand, the same day that the SEC released its final rule permitting general solicitation, the SEC also adopted or proposed related rules which may restrict the ability of issuers to take advantage of the new general solicitation rules, including:

1. adopting so-called "bad-boy" disqualifications from Rule 506, which will restrict issuers who are affiliated with felons and other bad actors from participating in Rule 506 offerings;
2. proposing new rules which will require additional filings with the SEC in connection with any Rule 506 offering in which the issuer engages in general solicitation, including filing a Form D 15 days before any such general solicitation; and
3. adopting strict standards for adequate verification of the accredited investor status of potential purchasers in Rule 506 offerings using general solicitation.

SEC Releases adopting the final rules are available here (regarding general solicitation) and here (regarding "bad boy" disqualifications).  The SEC Release proposing the new rules regarding additional Form D filing requirements is available here.  

North Texas Private Investment in Q2

"It's all ball bearings nowadays." - Irwin M. "Fletch" Fletcher as airplane technician, Gordon Liddy.

"It's all energy nowadays." - Me.

I couldn't hep but think of Chevy Chase's classic movie line when I reviewed the Dallas Business Journal's Private Investment Survey for the second fiscal quarter of 2012.  The survey shows total private investment in North Texas of $1.24 billion for Q2, of which $1.13 billion was raised by Venari Resources LLC, an oil exploration firm.  Of the remaining $120 million of private investment, $53.7 million went to other energy-related companies.  

So by my calculations, 95% of the private equity raised in North Texas in Q2 went to into the energy sector.  So maybe it's not all energy nowadays, but it's pretty darn close.   

By the way, I learned last week that Burton "Bubba" Gilliam, the actor that played Bud opposite Chevy Chase in the scene quoted above, is a fellow resident of North Texas.  Since he's one of my favorite actors, I thought that was pretty cool.

The Incredible Shrinking Accredited Investor Status

Is it time for the SEC to consider adjusting the thresholds for individual accredited investor status?

The term "accredited investor" is defined in Rule 501(a) of Regulation D.  Status as an accredited investor is important because companies that issue securities to accredited investors may be able to qualify for one or more exemptions from registration and disclosure requirements under the securities laws.  Under Rule 501(a), an investor who is a natural person may qualify as an accredited investor if the investor has either:
(1) an individual net worth, or joint net worth with that person's spouse, in excess of $1,000,000, excluding the value of any equity in their primary residence; or
(2) individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

Regulation D was adopted in March of 1982.  For context, that's also the year Eddie Murphy made his film debut in 48 Hrs.  The $1,000,000 and $200,000/$300,000 thresholds have not changed since then.  Adjusted for 30 years of inflation to today, the thresholds for individual accredited investor status would now be $2,424,381 for net worth, $484,876 for individual income, and $727,314 for joint income with the investor's spouse.  That's based on my calculations from the U.S. Department of Labor Bureau of Labor Statistics' Consumer Price Index for All Urban Consumers from March 1982 to July 2012 available here.

Or to flip that analysis around, the $1 million net worth requirement today would have been the equivalent of a $412,476 net worth requirement in 1982.  As Seinfeld's George Costanza might say, that is significant shrinkage!

SEC: "Verify Means Verify"

As I have blogged about previously, the JOBS Act required the SEC to adopt rules which would permit general solicitation in connection with a Rule 506 private offering made strictly to accredited investors if the issuers "take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the [SEC]."

So, of course, securities law practitioners have been anxiously waiting for the SEC to adopt those new rules and clarify what actions an issuer must take to "verify" the accredited investor status of purchasers of its securities in Rule 506 offerings.  

On August 29, the SEC proposed amendments to Rule 506 to implement the changes required by the JOBS Act.  Those proposed amendments are available here.  Under the proposed amendments, the SEC addressed the question of what is required to "verify" accredited investor status by stating that the issuer must "take reasonable steps to verify that purchasers of securities sold in any offering under this § 230.506(c) are accredited investors."  The SEC's proposing Release explains that "reasonableness" "would be an objective determination, based on the particular facts and circumstances of each transaction."  The determination would include the following factors:

• the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
• the amount and type of information that the issuer has about the purchaser; and
• the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

In short, the SEC is saying "verify means verify."

Fortunately, the Release goes on to provide quite a bit of helpful commentary describing different types of accredited investors and how an issuer might verify their status.  For example, an issuer could verify the status of an investor who claims to be an accredited by virtue of the fact that he is a registered broker-dealer by going to FINRA's BrokerCheck website.  The Release acknowledges that verifying the status of a natural person who claims to meet the net worth or annual income test for accredited investor might be more challenging.  Among other possible verification methods, the Release suggests that one or more private companies might get into the business of providing accredited investor certifications upon which an issuer might be able to reasonably rely for more difficult determinations.

DFW Private Investments Q1 2012

It seems the market for private capital in Dallas-Fort Worth is a little top-heavy this year. According to a survey conducted by the Dallas Business Journal, DFW area companies raised $574 million from private equity, venture capital and angel investments during the first quarter of 2012.  However, two deals (Ennis-Flint and Lucid Energy) accounted for $480 million, or 84% of the total private investment in DFW during that fiscal quarter.

JOBS Act Article

Yesterday, CityBizList Dallas published an article I wrote about the JOBS Act which is available here.

As you can tell from the article, I think the JOBS Act is very good news for growing businesses seeking capital from either the private or public markets.  I suspect private offerings will be especially aided by the relaxation of restrictions on general solicitation with regard to Rule 506 offerings.  Of course, we'll have to see what the final SEC implementing regulation look like, but I think growing businesses will be pleased with the results.

JOBS Act becomes law

On April 5, President Obama signed into law the Jumpstart Our Business Startups Act (the "JOBS Act").  The JOBS Act represents the most significant change to the law governing securities offerings since the Securities Act of 1933.  I'm sure I will be blogging about the JOBS Act quite a bit in the coming months as the SEC rolls out its new rules implementing the JOBS Act, but I thought I'd mention an aspect of the law I found most interesting today.

Many private offerings will soon no longer be private!  Let me explain.  Most private offerings of securities rely upon Rule 506 for its exemption from the registration requirements of the Securities Act.  Usually, Rule 506 offerings are made exclusively to accredited investors (investors with high incomes, high net worths, or both).  Rule 506 currently prohibits general solicitation (such as advertisements on television, radio, newspaper, etc.) to publicize the offering.  The JOBS Act requires the SEC to adopt rules permitting general solicitation connection with 506 offerings on so long as all of the purchasers of securities in the offering are accredited investors.  Hence, companies seeking capital will soon be able to publicly offer securities in a "private" offering!  These are interesting times to be a securities lawyer.

SEC Proposes Changes to Accredited Investor Definition

On January 25, 2011, the SEC proposed amendments to the definition of "accrdited investor" for the purposes of private placements under Regulation D and Section 4(5) (f/k/a Section 4(6)) of the Securities Act of 1933. 

As readers of this blog surely know, accredited investors are those more affluent investors who are deemed by the SEC to be sophisticated enough able to make investment decisions in private placements without the benefit of many of the issuer disclosure and registration requirments otherwise required by the Securities Act. 

For many years, among the parties who could claim accredited investor status was an investor who was a natural person with an invidual net worth, or joint net worth with that investor's spouse, in excess of $1,000,000.  Until the adioption of the Dodd-Frank Act in July of 2010, an investor could include the value of his or her home in determining whether or not the $1,000,000 threshold had been met.

As required by the Dodd-Frank Act, the definition of accredited investor now excludes the value of the primary residence of a natural person.  The SEC's proposed rules go on to clarify that the statutorily required phrase "excluding the value of the primary residence of such natural person" should be interpreted to mean that the natural person's net worth should be "calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property."

The purpose of the proposed rule changes are to (1) implement the definition change otherwise required by the Dodd-Frank Act, and (2) clarify that the investor's net worth will be calculated by excluding only the investor's net equity in the primary residence (not the entire value of the investor's home).

New Accredited Investor Definition

The impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act is far reaching and in many respects unknowable until regulatory rule making fleshes out the particulars of the new law.  One item that is clear is that it just got a lot harder to qualify as an "accredited investor" for the purposes of a so-called Reg D private placement.

A quick background on the term "accredited investor" is probably in order.  Those are folks that federal securities regulators (the SEC) have determined are sophisticated enough to make their own financial decisions.  Usually a person's accredited investor status is based upon such person's financial net worth.  Sales of securities to accredited investors are often exempt from the strict disclosure obligations and registration otherwise applicable to securities sales. 

There are several types of accredited investors, such as banks, insurance companies, investment companies and high net worth individuals.  It is this final category of accredited investors that has received the most attention from securities regulators.  Previously, "any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000."  That definition may have made perfect sense at the time such definition was originally adopted, but with inflation and sky-rocketing home values in the last decade, many people who met the technical definition of accredited investor were no longer especially sophisticated.

The Dodd-Frank Act attempts to deal with this issue by excluding the value of a natural person's home from the calculation of the $1,000,000 threshold for accredited investor status.  The act also empowers the SEC to further adjust the definition of accredited investor to reflect the impact of inflation or other factors that the SEC determines relevant.

I expect this change in the law will have a profound impact on private companies' access to capital as many former accredited investors will no longer meet the definition and will thus be unlikely participants in private placement transactions.