What Startups Should Know about Series B Financings When Negotiating Series A
Raising a Series B financing is a major milestone in the life of a company. However, from the negotiation of the term sheet to the closing process, you will face a set of issues that is unlike what you experienced in the Series A financing. Here are some issues to keep in mind about Series B financings, some of which are important to know when negotiating your Series A:
- Starting Point for Negotiation of Terms. By the time you raise a Series B financing, there is already at least one investor at the table who has received a set of rights in the prior financing, and these rights will need to be taken into account when negotiating the terms of Series B. This means that the appropriate starting point for negotiating the Series B term sheet is typically the Series A term sheet. You should understand that Series B investors will typically require at least all of the rights that Series A received. So, if you make significant concessions on terms in a Series A financing, you may be in effect conceding these terms to future investors as well.
- Specific Deal Terms. The general principle of having to account for both existing and new investors has implications for many of the specific Series B terms. To take one important example, a venture-backed company’s certificate of incorporation will usually include provisions requiring a vote of the investors before the company can take certain major actions, such as selling the company or raising a new round of financing. One of the important questions in a Series B financing is whether these actions will now require a single combined vote of the Series A and Series B investors, or if the Series A and Series B investors must each approve these matters separately. It’s typically to your advantage to have a single combined vote because this reduces the number of corporate hoops you need to jump through before taking action, but the Series A and Series B investors may want separate votes to ensure that they can protect their respective interests.
- Negotiation Process. Series A investment documents typically provide that you cannot raise a Series B financing without the consent of the Series A investors. This means that, even if the Series A investors aren’t directly involved in the negotiations between you and the Series B investor, they may still want to review the Series B terms and documentation before approving the deal (or have their lawyers review them), which can lead to additional rounds of negotiation. Typically, the lead Series A investor will have a director on your board and would therefore be aware of the Series B terms, at least at a high level, well in advance of closing. However, if the Series A director has not been closely involved in the deal, or if there are multiple Series A investors who each need to approve the deal, then the financing could turn into a three (or more) ring circus, with you, the Series A investors, and the Series B investors trying to ensure their respective interests are protected. While every situation is different, it’s generally advisable for you to figure out early which of the Series A investors will need to approve the Series B financing and get in front of this process, so as to avoid the prospect of a last-minute review and negotiation of documents by Series A investors. You should also factor the Series A investors’ review and negotiation into your deal timeline and therefore into your planning as to when you need to start the Series B process to ensure you have enough runway to get to closing.
- Down Rounds. If you are raising a Series B financing at a lower valuation than the Series A, this raises an additional set of issues. While all the potential complexities of down rounds are beyond the scope of this article, a key point to be aware of is that Series A documents typically contain antidilution protections, which give the Series A investors the economic equivalent of additional shares if the company subsequently does a down round. This creates additional dilution for the founders on top of the direct dilution from the Series B investment, and is part of the true cost to the founders of doing a down round.
The above issues are relevant not only for your second round of funding, but also for preparing for Series A, since decisions made at the time of Series A may well have ramifications into Series B and beyond. By keeping the above issues in mind and planning accordingly, you can set yourself up for a successful Series A and Series B, and so position yourself for bigger and better achievements in the future.
Gwen Edwards, Succeed with Investors, October 8, 2013
THE RISKS OF USING “FINDERS” TO RAISE CAPITAL
Raising investment capital for a busi‐ ness isn’t easy in this climate and most entrepreneurs are willing to take any help they can get. Few entre‐ preneurs have sufficient personal con‐ tacts to fund an offering and when they are not an attractive candidate for the venture capital market, they enlist the services of well‐connected individuals who make introductions and open up their contact lists. These individuals who act as intermediaries in the capital raising process are called “finders.” The problem is these “finders” may be acting as unregistered broker‐dealers. The Securities and Exchange Commis‐ sion (SEC), the Financial Industry Regulatory Authority (FINRA), as well as state regulatory agencies highly regulate the activities of broker‐ dealers. In the past, private place‐ ments involving unregistered finders ran little risk to the finder or the is‐ suer. The SEC rarely investigated or pursued finder arrangements, and sought enforcement only when the unlicensed match‐making occurred in connection with much more signifi‐ cant wrongdoing. This has changed. Over the past 18 months, the SEC has actively pursued investigation and enforcement actions for violation of the broker‐dealer laws as they relate to unregistered finders. In addition, in this current economic climate where investors in private placements have seen their invest‐ ments sour, or at best their path to liquidity shut down, investors are bringing private actions against issu‐ ers to rescind their investments. California Corporations Code Section 25501.5 gives investors the right to rescind a transaction when an unreg‐ istered broker‐dealer procures their investment. If the investor no longer holds the securities, he or she may sue for damages. Pursuant to its authority under an amendment to Code of Civil Procedure Section 1029.8, the court may award attorney’s fees, costs and treble damages up to $10,000. As a result of the civil and regulatory exposure, companies seeking to at‐ tract private capital have wisely re‐ considered their use of finders. If not doing away with finder arrangements entirely, they have tailored their ar‐ rangements to ensure their finders fit within a very narrowly‐tailored ex‐ emption from registration. The “Finder’s Exemption” From BrokerDealer Registration Section 15 of the Securities Exchange Act of 1934, as amended, defines a “broker” as any person engaged in the business of effecting transactions in securities. Section 15(c)(6) makes it unlawful for a person not registered as a broker‐dealer to effect any trans‐ action in securities. California’s “blue sky” securities laws essentially restate the federal law. Corporations Code Section 25004 defines a broker‐dealer as any person engaged in the business of effecting transactions in securities in California. Under Section 25210, any person acting as a broker‐dealer must be licensed by the Department of Corporations unless they are oth‐ erwise exempt. Finders argue they are not “effecting transactions” in securities, and there‐ fore are not acting as broker‐dealers, when they facilitate investments. Finders and issuers have historically relied on a 1991 SEC no‐action letter (Paul Anka, July 24, 1991) to support this position. In the Anka no‐action letter, the SEC blessed a “finder’s ex‐ emption” for persons that merely open up their contact lists or make introductions to potential investors. The SEC found it important that the finder merely furnished his contact list of accredited investors and did not negotiate or offer advice in the financ‐ ing. Although the SEC looked askance at the compensation arrangement where the finder was paid a percent‐ age of the money he raised, it noted he had not previously arranged invest‐ ments and agreed he would not do so in the future. JUNE 2009 JOHN P. CLEARY John P. Cleary is a nominee for the North County Bar Association’s 2010 Writer’s Award for the following article which appeared in the November 2009 edition of North County Lawyer Magazine. Copyright @2009 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com │ 2 California case law and interpretive guidance from the Commissioner of Corporations also address the issue of finders. In each instance, the finder’s exemption has been narrowly con‐ strued to exclude most capital raising efforts by unregistered finders. Based on available authority, several issues must be examined before en‐ gaging a finder. Each issue is relevant to whether a finder will be deemed an unregistered broker‐dealer for pur‐ poses of regulatory action or liability under Section 25501.5. The determi‐ nation is not a balancing test of these factors. Rather, violation of one of these factors will render the finder arrangement illegal. 1. Is the Finder Providing Services Other Than Simple Introductions? Black’s Law Dictionary, Sixth Edition, defines a finder as “an intermediary who contracts to find, introduce and bring together parties to a business opportunity, leaving ultimate negotia‐ tions and consummation of business transactions to the principals.” A per‐ son loses his or her finder status by taking any role, however minor, in the ultimate sale of the securities. The finder’s involvement must start and stop with making introductions. Issuers must ensure the finder is not involved in presentations to investors, negotiation of transactions, structur‐ ing of deal terms and similar activi‐ ties. Other activities that will render a finder non‐exempt include: • providing advice or recommenda‐ tions about the merits of a par‐ ticular transaction. • providing assistance to investors in completing the purchase agreement, subscription agree‐ ment or other documentation. • providing financing to any inves‐ tor for purchase of the securities. • providing assistance to the issuer in drafting or distributing any material including financial data or sales materials. • introducing the issuer to com‐ mercial banks, lawyers or other professionals to facilitate the fi‐ nancing. • handling the funds or securities involved in the transaction. The more information and assistance the finder gives to investors or the issuer, the less likely he or she will maintain exempt status. Even arrang‐ ing meetings between the issuer and prospective investor will jeopardize the exemption. Both issuers and find‐ ers are well‐advised to ensure the scope of engagement is clearly and conspicuously committed to writing and followed in practice. 2. Does the Finder Regularly Engage in the Business of Facilitating Investments? As the SEC first made clear in the Anka no‐action letter, the regularity of a finder’s activity is crucial to the de‐ termination of whether he is acting as a broker‐dealer. Nothing is more cer‐ tain to blow the finder’s exemption than engaging a person who regularly acts as a finder. Individuals who profess to be “profes‐ sional finders” may be successful in raising money, but they will put that money at risk and expose the com‐ pany to the potential of regulatory action, fines, penalties, litigation and a myriad of other consequences. If an issuer is looking for a proven finder, the only safe action is to employ a registered broker‐dealer or placement agent. 3. Is the Finder’s Compensation Dependent on Success in Raising Capital? It is a common misperception among entrepreneurs and finders that the payment of a fee in cash or equity is acceptable if the finder merely makes introductions. This is wrong. It is a myth perpetuated by entrepreneurs and finders who have not been caught. It is verboten to pay a finder a fee based on the amount of capital he or she is responsible for bringing to the company. SEC no‐action letters post‐ Anka and recent guidance from the SEC could not be clearer that success‐ based compensation is the primary characteristic of broker‐dealer activ‐ ity. Whenever the finder will be com‐ pensated based on success in raising capital, he or she has the “salesman’s stake” characteristic of a broker. In the SEC’s view, it is this “salesman’s stake” that creates the risk of unscru‐ pulous activity and the need for the regulation and oversight that broker‐ dealer registration provides. I have heard countless proposals from entrepreneurs and consultants seek‐ ing to avoid the success‐based com‐ pensation prohibition. The most common would involve hiring the finder as a “consultant” and paying him a “consulting fee” for unspecific business purposes, payable if and when the company achieves a certain funding threshold. No matter how the arrangement is structured, if the fee is tied to the finder’s activity in raising investment capital, and he would not have received the fee absent his suc‐ cess in doing so, then it is not permis‐ sible. The safest course is to pay the finder a fixed fee regardless of the outcome of his or her efforts (for example, the finder receives a $10,000 fee for mak‐ ing the introduction regardless of whether the investor purchases shares). This of course requires the assumption of some risk on the part of the entrepreneur in the event the in‐ troduction does not lead to an in‐ vestment. If practicality requires a success‐based compensation ar‐ rangement, the only solution is to have the finder affiliate with a regis‐ tered broker‐dealer, essentially be‐ coming a “back office” entity. For smaller transactions, this is not a real‐ istic solution because the finder would have to pass the relevant li‐ censing exams, find a firm willing to undertake supervisory duties over his activities and he certainly would have to share a portion of the fee with the supervising firm. The Consequences of Using an Un Copyright @2009 Procopio, Cory, Hargreaves & Savitch LLP. All rights reserved. www.procopio.com │ 3 registered Finder Using an unregistered finder to help fund a deal poses significant risks to both parties involved. The issuer will face regulatory action by the SEC and state authorities, and may face private actions by investors for damages or to rescind their investments. Using an unregistered finder will call into ques‐ tion reliance on the Regulation D pri‐ vate placement exemption and be‐ cause Section 25501.5 allows inves‐ tors to rescind investments procured through the use of unregistered find‐ ers, the funds raised will be at risk during the statute of limitations pe‐ riod. The contingency created through the rescission right also causes accounting troubles. Finally, if the investors demand a legal opinion to close the transaction, the issuer will also have a hard time convincing counsel to issue one. Using an unregistered finder will also jeopardize future efforts to raise capi‐ tal. A common sanction sought by the SEC against issuers utilizing unregis‐ tered finders is to bar the issuer from conducting Regulation D offerings in the future. This, of course, could have a lethal effect on a start‐up company dependent on private capital. In addi‐ tion, some regulators have at least informally advised issuers that the use of non‐exempt finders will render the company liable as aiders and abet‐ tors of securities law violations under Section 20(e) of the Securities Ex‐ change Act of 1934. For emerging growth companies planning to tap the public markets in the future, these issues will at best be spoilers during the road show presentations to large banks. The consequences to the finder also are severe. If a finder’s activities do not fall within the exemption from registration, his or her agreement with the issuer will be wholly unen‐ forceable in court. As a result, the finder has no way to enforce payment by the issuing company and may not be compensated for his or her ser‐ vices. In addition, non‐exempt finders are susceptible to civil and criminal penalties under both federal and state law.