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VCSpotlight SM 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. • Waltham, MA • Cambridge, MA • mbbp.com 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. 1 Morse, Barnes-Brown & Pendleton, PC • Waltham, MA • Cambridge, MA • mbbp.com 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) • Waltham, MA • Cambridge, MA • mbbp.com 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. Morse, Barnes-Brown & Pendleton, PC • Waltham, MA • Cambridge, MA • mbbp.com