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VCSpotlight
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SPOTLIGHT ON
TERMS AND CONDITIONS
Since the relatively recent release of the
“SAFE” (Simple Agreement for Future
Equity) documents by Y Combinator, we have received frequent inquiries
about the pros and cons of using this
new breed of document over a more traditional form of convertible note. While
the SAFE has the potential to simplify
fundraising for early stage companies,
reducing both the time and costs involved in the process, like any financing
instrument it is complex in its own right
and needs to be deployed with care.
There is one particular feature of the
SAFE that may merit special consideration on a case-by-case basis. More
specifically, the SAFE is designed to
convert at the time of the next preferred
stock financing into a series of preferred
stock commonly referred to as “shadow
preferred stock”. This shadow preferred
stock is a separate and distinct series of
preferred stock from that preferred stock
(the “new investor preferred stock”)
which is issued to the new investors in
the preferred stock financing that triggers the SAFE conversion. Shadow preferred stock is intended to be identical
to the new investor preferred stock in
most respects. While as discussed below
there are good reasons for this approach,
this shadow preferred stock will enjoy
certain protections under §242(b)(2)
of the General Corporation Law of the
State of Delaware (the “DGCL”). The
stockholder rights that are created by
Morse, Barnes-Brown & Pendleton, PC
Morse, Barnes-Brown & Pendleton, PC compiles a comprehensive database of
venture capital transactions that have closed within New England, New York
and New Jersey. VC SpotlightSM periodically features an analysis of first institutional venture capital rounds. This report is a definitive source of information
on emerging companies receiving their first institutional financing and the
venture capital firms that provide it.
Our financing data includes a wealth of detailed information of interest to both
companies and investors alike, including specifics on pre-money valuation, liquidation preferences, dividend rates, participating investors, and distributions
across industries and region. For more information on the data we can provide
contact Joe Martinez at [email protected].
2013 and 2014 First Institutional Rounds
Deal Terms
100%
97%
94%
88%
100%
100%
90%
90%
80%
80%
2013
2014
70%
70%
60%
60%
Percentage
Background
Venture Capital Data
2013 & 2014 First Institutional Rounds – Deal Terms
Percentage
Shadow Preferred Stock:
A Crack In The “SAFE”
Seed Finance Documents?
Q1 2015
50%
50%
54%
49%
40%
40%
30%
30%
20%
13%
20%
20%
30% 28%
25%
20%
10%
10%
0%0%
Dividends
Dividends
Cumulative Dividends
Participating Preferred
Cumulative Participating
Dividends
Preferred
Weighted Average
Antidilution Protection
1X Liquidation
Redemption
Weighted
1x
Redemption
Average
Liquidation
Antidilution
Protection
2013
2014
The information above is the result of an analysis of data gathered from a
variety of publicly available sources for 95 companies that closed their first
institutional round of financing in 2014 and 97 companies that closed their
first institutional round of financing in 2013.
Continued on Page 5.
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virtue of §242(b)(2) should be understood by any company issuing SAFEs
and weighed against the benefits of
creating this shadow preferred stock.
Safe Shadow Preferred and the
Liquidation Preference Premium
Dilemma
SAFEs typically convert into shadow
preferred stock. This shadow preferred
stock is intended to have the same rights
as the series of preferred stock issued to
new investors in the financing round
that gives rise to the SAFE conversion,
except that the liquidation preference,
conversion price, and dividend rate of
the shadow preferred stock are all calculated based on the price per share of
the shadow preferred stock rather than
the price per share of the new investor
preferred stock. The shadow preferred
stock is a rational approach and solution
to one particular asymmetry that would
otherwise result if the SAFE converted
into the new investor preferred stock—
the liquidation preference premium.1
A brief refresher on the economics of
convertible notes helps illustrate the
liquidation preference premium dilemma that SAFEs are designed in part
to address. In a typical convertible note
offering, the company issues promissory notes that are convertible into the
preferred stock issued to investors at the
time of the next round of equity financing. This conversion is typically at some
discount to the price paid per share in
that round to reflect a risk premium.
For example, if an investor invests
$100,000 in seed capital in exchange
for a promissory note for $100,000,
and this note converts at a 20% discount, then when the issuing company
issues preferred stock in its next round
of financing at $1.00, the note will
convert at a price of $0.80 per share.
As a result, the promissory note will
convert into a number of shares equal to
$100,000/$0.80, or 125,000 shares of
preferred stock. This extra 25,000 shares
represents a “stock ownership premium”
inherent in the discount. In addition
to this stock ownership premium, the
noteholder also gets a liquidation preference that is associated with 125,000
shares of preferred stock. Liquidation
preference is the right to be paid a
certain amount per share, typically the
purchase price, in certain exit scenarios.
In the above example, the preferred
stock issued would be entitled to $1.00
of liquidation preference per share for a
total of $125,000 of liquidation preference in the aggregate. So not only has
the above investor received a greater
ownership position for the size of the
investment— an extra 25,000 preferred
shares—the investor has also received
stock with a liquidation preference right
equal to $125,000—an extra $25,000
of liquidation preference. This means
that under certain exit scenarios, the
investor is entitled to receive $125,000
for stock purchased for only $100,000.
This extra $25,000 represents a “liquidation preference premium”. This result
is considered by some to be an inequitable unintended consequence of the
more standard convertible note structure, and the shadow preferred stock
contemplated by the SAFE is intended
to eliminate the liquidation preference
premium.
DGCL §242(b)(2) Risk and
Alternatives
While the shadow preferred stock
reflected in the SAFE is a rational approach to solving the liquidation preference premium dilemma, the creation
of a series of shadow preferred stock
is not without some corporate governance cost and risk. DGCL §242(b)
(2) provides a statutory blocking right
to the stockholders of any class of
stock with respect to any amendment
to the certificate of incorporation
that would “alter or change the powers, preferences or special rights of
the shares of such class so as to affect
them adversely.” Creating the shadow
preferred stock in an effort to solve
the liquidation preference premium
will result in the creation of a separate
class of stock, and the stockholders of
this class—the former holders of the
SAFEs—will have blocking rights pursuant to §242(b)(2). This right might
be implicated, for example, in any
recapitalization in which all series of
preferred stock need to give up certain
rights as a condition to a future financing or M&A transaction.
There are alternatives to the creation
of shadow preferred stock that might
be preferable in view of this §242(b)
(2) risk. One option would be to
simply let the SAFEs convert directly
into the new investor preferred stock
notwithstanding the liquidation
preference premium. Often times
the amount of the liquidation preference premium that would result if
the SAFEs converted into this preferred stock would be relatively small.
Imagine, for example, SAFEs with an
aggregate face value of $500,000 converting into a shadow preferred stock
at a 20% discount to the new investor
preferred stock. The total “savings”
to the company and the other stockholders by converting into shadow
preferred stock at this discount would
be $100,000 in liquidation preference
premium. It might be worth absorbing
this cost in order to avoid potential
pitfalls of §242(b)(2). If the company
is determined to eliminate the liquida-
For a more comprehensive discussion of the liquidation preference premium, see “Seed Convertible Note Discounts: Reconciling ‘Stock’
and ‘Liquidation Preference’ Premiums”, by Jon Gworek, March, 2012.
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tion preference premium, either on
principal or because it is too large a
number to accept in the context of the
transaction, another alternative would
be to allow the SAFEs to convert
into the new investor preferred stock,
but to provide that the liquidation
preference per share, and associated
anti-dilution and dividend rights, with
respect to the preferred stock issued
upon conversion of the SAFEs shall
be determined by reference to the
price per share at which the SAFEs
converted pursuant to their terms.
This would be permitted pursuant to
DGCL §102(d), which provides that
“any provision of the certificate of incorporation may be made dependent
upon facts ascertainable outside such
instrument.” While this approach may
still result in §242(b)(2) risk in certain
circumstances, it might mitigate this
risk to some extent.
Conclusion
Any company issuing SAFEs with
shadow preferred stock should weigh
the benefits of eliminating the liquidation preference premium with the
costs of conferring statutory §242(b)
(2) blocking rights under the DGCL.
Depending on the total cost inherent
in the liquidation preference premium,
the company might decide it is better
to let the liquidation preference premium stand rather than risk the pitfalls of
§242(b)(2). Alternatively the company
might be able to serve both purposes
by issuing one series of preferred stock
to new investors and SAFE holders
alike, but setting up a different set of
rules for the stock issued upon conversion of the SAFEs pursuant to the
flexibility afforded by §102(d).
For further information on this topic,
please contact Jonathan Gworek at
[email protected].
Morse, Barnes-Brown & Pendleton, PC
SPOTLIGHT ON THE LAW
Kind of a Drag:
Recent Delaware Decision
Underscores Importance Of
Following Procedural Rules
Of Contracts
Although the ultimate “home run” for
venture capital investors remains an
IPO of a portfolio company investment, for most investors the primary
method of liquidity is an acquisition
event. Mindful of this typical exit
scenario, investors will often bargain
for “drag-along rights” in their financing documents which contractually
require all (or most) of a company’s
stockholders to vote in favor of an
acquisition event that is approved by a
specified percentage of the company’s
stockholders. A recent Delaware Court
of Chancery decision serves as an
important reminder that the failure to
closely follow the procedural rules of
exercising drag along rights can result
in grave and unintended consequences
for companies and their investors.
In Halpin v. Riverstone National, Inc.,1
five minority stockholders of Riverstone National, Inc. (“Riverstone”)
sought appraisal of their shares of
stock in connection with the June
2014 merger of Riverstone and Greystar Real Estate Partners. The merger
transaction had been approved by the
91% majority stockholder of Riverstone, CAS Capital Limited (“CAS”),
who sought to obtain the minority
stockholders’ approval of the merger
by invoking the drag-along rights contained in a 2009 Stockholders Agreement. The Stockholders Agreement
stated in relevant part:
1
“[I]f at any time any stockholder of
the Company, or group of stockholders,
owning a majority or more of the voting
stock of the Company (hereinafter, collectively the “Transferring Stockholders”)
proposes to enter into any [Change-inControl Transaction], the Company may
require the Minority Stockholders to
participate in such Change-in-Control
Transaction with respect to all or such
number of the Minority Stockholders’
Shares as the Company may specify in
its discretion, by giving the Minority
Stockholders written notice thereof
at least ten days in advance of the
date that tender is required, as the
case may be. Upon receipt of such notice,
the Minority Stockholders shall tender
the specified number of Shares, at the
same price and upon the same terms and
conditions applicable to the Transferring
Stockholders in the transaction or, in the
discretion of the acquirer or successor to
the Company, upon payment of the purchase price to the Minority Stockholders
in immediately available funds. In addition, if at any time the Company and/or
any Transferring Stockholders propose to
enter into any such Change-in-Control
Transaction, the Company may require
the Minority Stockholders to vote in favor of such transaction, where approval
of the shareholders is required by law or
otherwise sought by giving the Minority
Stockholders notice thereof within the
time prescribed by law and the Company’s Certificate of Incorporation and
By-Laws for giving notice of a meeting
of shareholders called for the purpose of
approving such transaction.”
Rather than providing the minority
stockholders with prior notice of the
merger transaction (as required by
the Stockholders Agreement), CAS
informed the minority stockholders
of the closing of the effectiveness of
Halpin v. Riverstone National, Inc., C.A. No. 9796-VCG (Del. Ch. Feb. 26, 2015)
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the merger a week after the closing
of the transaction. In its notice to the
minority stockholders, CAS informed
the minority stockholders that it had
exercised its drag-along rights and
instructed the minority stockholders
to execute a written consent approving the merger. The notice went on to
state that if a minority stockholder executed the written consent, he would
not be entitled to execute appraisal
rights, but that if he did not exercise
the written consent, he would be in
breach of the Stockholders Agreement.
In its counterclaim to the minority
stockholders’ petition for appraisal,
Riverstone sought specific performance of the drag-along provisions
of the Stockholders Agreement. The
court denied this request, finding that
the express language of the Stockholders Agreement required advance notice
of a proposed merger transaction and
as such the drag-along rights were
unambiguously prospective in nature.
Riverstone was limited to the benefit
of its bargain and, by a literal reading
of the Stockholders Agreement, this
did not include the power to require
the minority stockholders to consent
to a transaction that had already taken
place. Riverstone also contended that
the minority stockholders were compelled to consent to the merger due
to the implied covenant of good faith
and fair dealing, arguing that by entering into the Stockholders Agreement
the minority stockholders implicitly
agreed that they would participate
in any merger approved by CAS.
The court similarly dismissed this
argument, finding that the minority
stockholders’ refusal to consent to the
merger transaction was not arbitrary
or unreasonable and that applying the
“gap-filling” function of the implied
covenant was not warranted.
@MorseBarnes
Drag-along rights serve to facilitate
the approval process related to the sale
of a company by preventing stockholder dissent and undue leverage by
minority stockholders. The Court of
Chancery’s decision in Halpin serves
as an important reminder that drag
along rights must not only be carefully
drafted but properly exercised in order
to serve their intended purpose.
For further information on this topic,
please contact Scott Bleier at
[email protected].
CLIENT SPOTLIGHT
MBBP client Brightwurks, Inc. (d/b/a
Help Scout) recently completed a
$6 million Series A equity financing.
The round was led by new investor
Foundry Group, a venture capital
firm focused on early-stage information technology, internet and software
companies. Foundry Group is now
the largest investor in Help Scout and
Ryan McIntyre, a managing director of Foundry Group, has joined
Help Scout’s board of directors. The
round also included participation
from CommonAngels Ventures. David
McFarlane, a venture partner with
CommonAngels and the Chief Operating Officer of Litmus Software, Inc.,
has also joined Help Scout’s board of
directors.
Help Scout offers a help desk invisible
to customers that assists companies in
delivering outstanding customer support. The Series A investment will be
used to further develop the company’s
infrastructure and ecommerce plat-
VCsandStartups.com
forms. This financing follows earlier
seed investments and will help facilitate the continued rapid growth that
Help Scout has experienced over the
last four years. Since publicly launching following participation in the
2011 class of TechStars, Help Scout
now serves over 3,500 businesses in
over 60 countries. Led by its Chief Executive Officer, Nick Francis and his
co-founders Denny Swindle and Jared
McDaniel, the company is based in
Boston, Massachusetts but embraces
a remote culture, with its employees
working out of multiple states and
countries. You can learn more about
Help Scout’s offerings at its website,
www.helpscout.net.
For further information on this topic,
please contact Mary Beth Kerrigan at
[email protected] or Josh French
at [email protected].
The VC Spotlight is a quarterly publication of
Morse, Barnes-Brown & Pendleton, P.C. The
primary purpose of the VC Spotlight is to discuss
terms, conditions and other issues of interest
to investors and venture-backed companies in a
simple, open and unbiased manner so that investors and founders can more efficiently structure and
negotiate financing transactions. The VC Spotlight
also provides updates of interest to the venture and
emerging company business sectors. We invite your
feedback at [email protected].
VC Spotlight is intended as an information source for
clients and friends of MBBP. It should not be construed
as legal advice, and readers should not act upon information in this article without professional counsel.
© 2015 Morse, Barnes-Brown & Pendleton, P.C.
mbbp.com
2013 and 2014 First Institutional Rounds
Number of Deals By Industry
2013 & 2014 First Institutional Rounds – Number of Deals by Industry
3030
2525
28%
24%
22%
19%
2020
19%
2013
18%
2014
1515
13%
13%
10%
1010
10%
8%
8%
55
00
Software
Software
Biopharmaceuticals
Biopharma-
Consumer
Information
Consumer
Services
ceuticals
Other
Other
Internet
& Digital Media
Support Services
Internet
& BusinessBusiness
Information
Services
Digital Media
Support
Services
Software companies and business support services companies had the largest number of transactions in 2014 which continued
the results seen in 2013. Biopharmaceutical companies and internet and digital media companies followed next with each of
2013
2014
First
Institutional Rounds
those industries garnering a few more
dealsand
in 2014
than
in 2013.
Average Investment*
2013 & 2014 First Institutional Rounds – Average Investment by Industry*
$20,000,000.00
$18,000,000.00
$18
$16,000,000.00
$16
$14,000,000.00
$14
2013
Millions
Millions
$12,000,000.00
$12
$10,000,000.00
$10
2014
$8,000,000.00
$8
$6,000,000.00
$6
$4,000,000.00
$4
$2
$2,000,000.00
$0
$0.00
BiopharmaBiopharmaceuticals
ceuticals
Business
Business
Support
Support
Services
Other
Other
Software
Software
Consumer
Internet
&
Consumer
Internet
& Digital
Information
Media
Information
Services Digital
Media
Services
Services
Biopharmaceutical companies had the highest average investments per deal in both 2013 and 2014 with an average of $17.4
million in 2014. The average size of the deals in most of the other industries in 2014 was grouped between $5 million and $6
* Byand
default,
the average
investment
assumes
that all
authorized
shares of
preferred stockamount
have
million. The one exception was the internet
digital
media
spaceamount
which
had the
lowest
average
investment
at $2.8
been issued, but the final data also takes into account information gathered from companies.
million.
* By default, the average investment amount assumes that all authorized shares of preferred stock have been issued, but the final data also takes into
account information gathered from companies.
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