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Is A 180 Day Lockup Typical When A Company Goes Public?

Question: A company I used to work for has registered to IPO. Apparently I have to wait 180 days until after the company goes public to sell. Is this typical? When do investors get to sell? What happens when everyone gets to sell at that 180 day point? Does the stock usually tank? Or is there a provision to spread out the sales?

The answer is “yes, it’s standard.”  In fact, it is so typical that most financing documents of private companies lay out the restriction and get investor approval even in the earliest days of a company’s life.

There are exceptions, but when you see different provisions, it’s always driven by the investment bankers, not the company or investors.

As for what happens when the 180 day lockup comes off – it really depends on the company.  More times than not, the price goes down as investors and others speed to sell some / all of their stock to take risk off the table.  There are usually no provisions to spread out the selling.

 

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Convertible Debt – Conversion Mechanics

We continue our convertible debt series today with a discussion about conversion mechanics. This is a very important term, but usually one that everyone can be happy with at the end if they concentrate on it.

In general, debt holders have traditionally enjoyed superior control rights over companies with the ability to force nasty things like bankruptcy and involuntary liquidations. Therefore, having outstanding debt (that doesn’t convert) can be a bad thing if an entrepreneur ever gets “sideways” with one of the debt holders. While it’s not talked about that much, it happens often and we’ve seen it many times leaving the debt holder in a great position of leverage in negotiations.

Here is typical conversion language:

“In the event that Payor issues and sells shares of its Equity Securities to investors (the “Investors”) on or before [180] days from the date herewith (the “Maturity Date”) in an equity financing with total proceeds to the Payor of not less than $1,000,000 (excluding the conversion of the Notes or other debt) (a “Qualified Financing”), then the outstanding principal balance of this Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”

Let’s take a look at what matters in this paragraph. Notice that in order for the note to convert automatically, all of the conditions must be met. If not, there is no automatic conversion.

Term: Here, the company must sell equity within six months (180 days) for the debt to automatically convert. Consider whether or not this is enough time. If we were entrepreneurs, we’d try to get this to be as long as possible. Many venture firms are not allowed (by their agreements with their investors) to issue debt that has a maturity date longer than a year, so don’t be surprised if one year is the maximum that you can negotiate if you are dealing with a VC investor.

Amount: In this case the company must raise $1,000,000 of new money, because the conversion of the outstanding debt is excluded, for the debt to convert. Again, its the entrepreneur’s decision on how much is a reasonable number, but think about how long you have (here 180 days) and how much you think you can reasonably raise in that time period.

So what happens if the company does not achieve the milestones to automatically convert the debt? The debt stays outstanding unless the debt holders agree to convert their holdings. This is when voting control comes into play. It is key to pay attention to the amendment provision in the notes.

“Any term of this Note may be amended or waived with the written consent of Payor and the Majority Holders. Upon the effectuation of such waiver or amendment in conformance with this Section 11, the Payor shall promptly give written notice thereof to the record Holders of the Notes who have not previously consented thereto in writing.”

While one will never see anything less than a majority of holders needing to consent to an amendment (and thus a different standard for conversion), make sure the standard doesn’t get too high. For instance, if you had two parties splitting $1,000,000 in debt with a 60 / 40 percentage split, you only need one party to consent if the majority rules, but both parties would need to consent if a super majority must approve. Little things like this can make a big difference if the 40% holder is the one you aren’t getting along with at the present moment.

Convertible Debt – Valuation Caps

Today, in our series on convertible debt, we examine the conversion valuation cap.

The cap is an investor-favorable term that puts a ceiling on the conversion price of the debt. The valuation cap is typically only seen in seed rounds where the investors are concerned that the next round of financing will be at a price that is at a valuation that wouldn’t reward them appropriately for taking a risk by investing early in the seed round.

For example, an investor wants to invest $100,000 in a company  and thinks that the pre-money valuation of the company is somewhere in the $2 to $4 million dollar range. The entrepreneurs thinks their valuation should be higher. Either way, the investor and entrepreneurs agree to not deal with a valuation negotiation and consummate a convertible debt deal with a 20% discount to the next round.

Nine months pass and the company is doing well. The entrepreneurs are happy and the investor is happy. The company goes to raise a round of financing in the form of preferred stock. They receive a term sheet at $20 million pre-money valuation. In this case, the discount of 20% would result in the investor having an effective valuation of $16 million for his investment nine months ago.

One on hand the investor is happy for the entrepreneurs but is shocked by the relatively high valuation for his investment. He realized he made a bad decision by not pricing the deal initially as anything below $16 million would have been better for him. Of course, this is nowhere near the $2 to $4 million the investor was contemplating the company was worth at the time he made his convertible debt investment.

The valuation cap addresses this situation. By agreeing on a cap, the entrepreneur and investor can still defer the price discussion, but set a ceiling at which point the conversion price “caps”.

In our previous example, let’s assume that the entrepreneurs and investor agree on a $4 million cap. Since the deal has a 20% discount, any valuation up to $5 million will result in the investor getting a discount of 20%. Once the “discounted value” goes above the cap, then the cap will apply. So, in the case of the $20 million pre-money valuation, the investor will get shares at an effective price of $4 million.

In some cases, caps can impact the valuation of the next round. Some VCs will look at the cap and view it as a price ceiling to the next round price, assuming that it was the high point negotiated between the seed investors and the entrepreneurs. To mitigate this, entrepreneurs should never disclose the seed round terms until a price has been agreed to with a new VC investor.

Clearly, entrepreneurs would prefer not to have valuation caps. However, many seed investors recognize that an uncapped note has the potential to create a big risk / return disparity especially in frothy markets for early stage deals. We believe that – over the long term – caps create more alignment between entrepreneurs and seed investors as long as the price cap is thoughtfully negotiated based on the stage of the company.

Convertible Debt – The Discount

As we start our convertible debt series, we’ll focus on the discount. Remember that a convertible debt deal doesn’t purchase equity in your company. Instead, it’s simply a loan that has the ability to convert to equity based on some future financing event (we’ll tackle the conversion mechanics in a later post.)

Until recently, we had never seen a convertible debt deal that didn’t convert at a discount to the next financing round. Given some of the excited market conditions at the seed stage, we’ve heard of convertible deals with no discount, but view this as irregular and not sustainable over the long term.

The idea behind the discount is that investors should get, or require, more upside than just the interest rate associated with the debt for the risk that they are taking by investing early. These investors aren’t banks – they are planning to own equity in the company, but are simply deferring the price discussion to the next financing.

So how does the discount work? There are two approaches – the “discounted price to the next round” or “warrants.” We are only going to focus on the discounted price to the next round approach, as it’s much simpler and better oriented for a seed round investment. We’ll cover warrants in a later post in the series.

For the discounted price to the next round, you might see something like this in the legal documents:

“This Note shall automatically convert in whole without any further action by the Holders into such Equity Securities at a conversion price equal to eighty percent (80%) of the price per share paid by the Investors purchasing the Equity Securities on the same terms and conditions as given to the Investors.”

This means that if your next round investors are paying $1.00 per share, then the note will convert into the same shares at a 20% discount, or $0.80 per share. For example, if you have a $100,000 convertible note, it’ll purchase 125,000 shares ($100,000 / $0.80) whereas the new equity investor will get 100,000 shares for his investment of $100,000 ($100,000 / $1.00).

The range of discounts we typically see is 10-30% with 20% being the most common. While occasionally you’ll see a discount that increases over time (e.g. 10% if the round closes in 90 days, 20% if it takes longer), we generally recommend entrepreneurs (and investors) keep this simple – it is the seed round, after all.

Convertible Debt Series

We’ve been overwhelmed by the support for our book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. As part of the experience of releasing the book, we’ve gotten the chance to interact with many new people interested in the venture capital and angel financing process.

The most often requested additional topic that we don’t cover extensively in our book is the use convertible debt in early stage – especially seed stage – financings. While we generally don’t use convertible debt at Foundry Group, we’ve had plenty of experiences with it over the years and strong opinions about what entrepreneurs should pay attention to when consummating a convertible debt transaction.

This series won’t be a discussion about the pros and cons about raising a traditional preferred equity round versus a convertible debt round. Plenty of discussion about this can already be found on the web about this. For a primer, take a look at articles by Jason Mendelson, our partner Seth Levine, and our friends Mark Suster and Fred Wilson.

This series will be about the terms that matter and how to best approach thinking about how them, much like we did in our Term Sheet series which went on to inspire the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.

We’ll be publishing posts on Tuesday and Thursday for the next few weeks so as not to compete with Fred Wilson’s awesome MBA Mondays series and Brad’s “just getting started” Finance Fridays series.

We hope you like the new series and as always, please comment freely, tell us what you think, and help us clarify stuff we don’t explain well.

Do You Need To Be A Corporation To Raise VC Funding?

Question: Does one need to switch an LLC to a corporation to raise VC funding? Would you recommend starting out as a corporation pre-money or as an LLC?

The short answer is yes, you have to be a corporation to raise VC funding

VCs will want you to be a C-Corp for a few specific reasons. The main advantage of an LLC over a C-Corp is that the taxes are not flow through.  In other words, your company’s tax situation will not hit the bottom line of the VC.  As VCs are generally structured to be flow through tax entities, if your company was a LLC, your tax situation would flow through the VC and directly to their investors.  This is not a good place to be and VC investors demand that we only invest in C-corps to stop this problem.

And you should be happy, because if this wasn’t the case you’d get nagging phone calls every year from every investor in a VC fund looking for that tax documents.  :)

The second issue is issuing stock to employees.  Since stock options are the chief motivator of employees at a startup, you need have a stock option plan.  In a LLC, there is no concept of stock ownership.  It’s about “unit” ownership and it’s nearly impossible to mimic a standard stock option plan in the world of “units.”

Before raising money, you should feel free to start off as a LLC.  In the “old days” (ten years ago, it was time consuming and costly to convert from a LLC to a C-corp, but these days it’s much much easier.

GREAT New Blog – IP Law for Startups

Today, I learned that former classmate of mine at the University of Michigan has started a blog for startups dealing with intellectual property issues.

Jill Bowman is a great person and her blog is not only informative, but is also written in her voice, not legalese.  (Her husband says it’s too “girly” but I totally disagree). 

Jill promises to dish on IP “train wrecks” (her words) that she’s seen over the past decade and hopefully her wisdom can save some folks future headaches.

She also promises to talk about costs savings in IP controversies and expose how some big firms are ripping off their clients. 

Her first post is Ten Smart Reasons to Learn About IP Law.  Jill, welcome to the blogosphere.  We are happy to have you. 

Why Don’t Venture Capitalists Tell You Why They Won’t Invest?

Today, we were asked the following question:

‘”Why don’t VCs tell you the reason why they don’t invest? Any feedback would be useful. It’s just plain rude.”

I (Jason) figured that this is really a personal question, so I thought that I’d post on my personal blog, as I certainly can’t speak (or even guess) the response for the entire VC industry.

You can see Jason’s thoughts here

Preparing to Wind Down a Business: What information do you need?

We continue to work our way through wind downs in the third part of the series from Roger Glovsky.  Roger, you have the floor…

The primary responsibility for shutting down operations and liquidating assets falls on the managers and/or owners of the business, at least until or unless the creditors or court system takes over.  This could come as a nasty shock to some investors.  Many angel investors or even venture capitalists enter a transaction with the intent of just contributing money.  They may be surprised to learn some day that the management team for the company they invested in have all resigned and that no one is remaining to wind down the business, sell off the assets, or pay down the liabilities.  Suddenly, one  day the investor or owner receives a call (most likely from a creditor) asking what they plan to do with their company and how they plan to address the outstanding liabilities.  Not a happy call for the investor or owner.

Whether you are a manager or an owner faced with winding down a business, the goal of the person winding down the company is to fulfill his or her fiduciary obligations and preserve the management’s or owner’s business reputation.   The first step is to assess the financial situation of the business.  The second step is to take note that time is of the essence and the longer it takes to do the first step, the more time, money and reputation it will cost the management or owners.   

When you buy an existing business, you typically do what is referred to as "due diligence" to make sure you know what you are buying.  Similarly, when you are winding down a business, you must do your due diligence to make sure you know what assets and liabilities the company still has and how best to handle them.  This is what I call "reverse due diligence".  Reverse due diligence involves all of the same information that a buyer or investor might request for a growing business, but for a different purpose: the purpose is for marshaling assets and managing liabilities  to maximize value on the downside.  In normal due diligence, a buyer will scrutinize financial information and disclosure schedules looking for hidden liabilities that may detract from the value of the acquired company.  In reverse due diligence, the person winding down a business is looking for hidden assets that can maximize value and facilitate the settlement of the company’s obligations.

So, what information do you need?

1. Financial Information.  Most importantly, you need to get a good handle on the financial situation.  Are there current financial statements (e.g., P&L, balance sheet, cash flow) prepared by an outside accounting firm?  If not, start with the most recent tax return and review all information relating to income, balance sheet, assets, liabilities, and capital structure.  Are there internal financial statements prepared by the company?  Is there a Quickbooks file (or other accounting software) that can print a transaction report for the current or prior years?  What might be the "off-balance-sheet" assets?  Seek help from the company’s accountant and financial advisors to make sure that the financial information is accurate and up to date.

2. Taxes.  Make a list of all states in which the company is obligated to pay taxes.  What is the process in each state for submitting final tax returns?   What tax good standing certificates are required for dissolution?  What are the outstanding tax obligations (e.g., payroll taxes, estimated taxes, annual taxes, sales taxes)?  What obligations are coming up in the near future?  What tax obligations or tax filings will be required after the company ceases operations?  What money will you need to reserve for payment of taxes after dissolution?

3. Hard Assets.  List all assets, including both "hard" assets and intangible assets.  Hard assets include computers, equipment, furniture, products, and inventory.  Are the assets leased or owned?  Are the assets worth more sold separately or combined with other assets (such as a product line or customer contract)? You may want to start with the most recent balance sheet to identify major assets that have been capitalized.  Which assets are most valuable?  Which assets can be sold easily (e.g., using brokers, auctioneers, eBay, or Craigslist)?  Are there any strategic assets that may be desired by vendors, partners or competitors?

4. Soft Assets.  Soft assets are intangibles that  include securities, accounts receivable, contract rights, bank accounts and cash.  Intangibles also include intellectual property such as patents, copyrights, trademarks, websites, blogs, and domain registrations.  Is there technical information or process know-how that employees (or former employees) could document and make available for sale?  What is the value of the brand and how can it be transferred?  Is there software or technology (or other IP) that could be licensed?  Can customer lists be sold?

5. Potential Buyers.  Can you identify a specific list of potential buyers?   Who might have a strategic or competitive business interest in some or all of the assets?   Consider vendors, contractors, customers, strategic partners and affiliated entities.  Would business brokers or investment bankers be able to find potential buyers?   If not, are there auctioneers or liquidators who would help fire sale the assets?

6.  Lenders.  What loans or financings has the company entered into?  Are there other credit arrangements?  Make sure that you review executed (i.e., final) drafts of all documents.  What do the documents require?  Which creditors or obligations take precedence?  What happens in the event of default?  Are there any personal guarantees?  Can the loan or financing arrangements be renegotiated?

7. Employees.  What are the current payroll obligations?  How should they be managed during the wind down process?  What bonuses, vacation pay [Ed. Note: and sales commissions] and accrued expenses are owed?  What payroll taxes will be due? What employee benefit plans need to be cancelled or terminated?   How will this affect employees on COBRA?  Can you save money by switching to a Professional Employer Organization (PEO)?  Are there any other forms of compensation (stock, deferred compensation or other incentives) that have not been documented or paid?  What employment contracts exist and what restrictions will remain enforce?  Can you or a potential buyer solicit employees?  Are you treating all employees fairly and equally?  How will your actions affect employees that you might want to hire again for a future venture? 

8. Customers.  Make a list of all current customers, past customers, and prospective customers.  Which customers have outstanding receivables?  Are there open orders?  Should open orders be cancelled or delivered?  Which customers have you collected money from but won’t be able to deliver products or services?  What prepayments from customers should be refunded?   How much of the receivables can be collected after the company ceases operation?   Which receivables should be written off as uncollectable?  At what point should you notify customers that you intend to cease operations?  How long can you hold out for a bu
yer to take over a product line or business?  Are there any long term agreements for services?   What goodwill can be salvaged or business reputation maintained by transferring unfinished projects to another service provider?

9. Vendors.  Make a list of all suppliers and contractors.  Be sure to review current versions of all agreements, including any addendums or renewals.  Which vendors do you owe money?   What leases are there for real estate or equipment?   Are there any long term contracts?  Can you negotiate an earlier termination or buy-out of the contracts?   Can you get the contract modifications in writing?  What are the notice requirements and other obligations upon termination?  How many days in advance must notice be given?  Are some notice requirements sooner than others?   Are there any security deposits or prepayments (e.g., insurance) that will be repaid to the company?

10. Records; Compliance.  Review all corporate records, paying particular attention to obligations upon dissolution or liquidation of the company’s assets.  Make sure that you have current copies of all corporate (or LLC) records including charter, bylaws, stockholder agreements (or in the case of an LLC, the Operating Agreement).  Are there any security, investment or other financing documents that affect the owners’ rights or the distribution of assets?   Are there any documents that assign responsibility or indemnification upon default of obligations?  Are there regulatory filings or other compliance obligations?  What licenses or registrations does the company have and how should they be withdrawn or terminated?  Are there any environmental issues or other compliance obligations that will continue after operations cease?

Review all of the assets and liabilities carefully.  Are the assets worth more or less than the company paid for them?  Are there any assets with hidden value (such as websites with significant traffic or popular domain names)?  We have had some clients sell domain names alone for more than $500K.  Some of these assets may have more value to competitors than they do to the failed business. 

After you have gathered the information above, you should be able to make a preliminary assessment as to whether the company’s net worth is positive or negative.  Be sure to review the assessment with the company’s accountant, attorney and other professional advisors in order to determine when to cease operations and to plan for the orderly liquidation of assets.  The professionals can help to structure and guide the wind down strategy.  There are many financial and legal pitfalls for the unwary.   It does not have to be time consuming or expensive, but the assessment does require a trained eye to avoid potential issues that might arise later after the assets have been liquidated and the proceeds disbursed.

The above list is just a sample of the most common items to consider before winding down a business.  There are many more items that would be included on a typical due diligence checklist.  The financial information and due diligence should be performed with the utmost care and accuracy to make sure valuable assets or significant liabilities are not overlooked.   Are there may major items that we have failed to mention?  What information did you find the most useful in winding down a business?

Roger Glovsky is a founding partner of Indigo Venture Law Offices, a business law firm based in Massachusetts, which provides legal counsel to entrepreneurs and high-tech businesses. Mr. Glovsky is also founder of LEXpertise.com, a collaboration and networking site for lawyers, and writes blogs for iLaw2.com and The Virtual Lawyer.

Related Posts:

Part 1:  How to Wind Down Your Company

Part 2:  When to Shut Down Your Company

The above content is intended to serve as a general discussion of the subject matter and is provided for informational purposes only. It is not legal advice and should not be construed as such. Do not act upon this information without seeking professional advice or rely on this website or use the content as a substitute for consultation with professional advisors.

When to Shut Down Your Company

Last week we started the blog series (written by Roger Glovsky), How to Wind Down Your Company.  The response and comments were great!  Keep them coming.  This week we tackle the hardest problem of all: deciding when to shut down your company.

It is not easy an easy decision, especially for entrepreneurs.  Starting a company is about creating a vision, persuading others to believe in the vision, turning an idea into reality, and pursuing a dream.  The last thing an entrepreneur wants to do is to shut down his or her dream.

So, how do you make the decision to shut down your company?  When do you decide to shut down your company?  The short answer is: When the company has no other alternatives.

What are the alternatives?

Financing.  If the company burns through the Series D funding, why not just raise Series E, F or G?  There are plenty of letters in the alphabet, aren’t there?  No.  Not every business problem can be solved with money.  The business model may have changed.  Competition may be too great.  Technology may have failed to perform.  Or the customer just didn’t buy enough of the products.  And the Series A, B, C, and D investors may already have been burnt by prior down rounds, cram downs, or failed expectations.

Sale or Merger.  This may be the best option for an entrepreneur, if it is available.  The sale or merger of a business is often regarded as a success even if the sale price is well below the amount contributed by investors.  Why?  Because the sale price may not be disclosed.  The typical press release of a failed business simply states that a small company was acquired by a big company and that together the new combined company plans to do great things.  The big company may get strategic assets (often technology or intellectual property) at a discount and the small company preserves its reputation.  Win-win.  The public may not ever know that the business failed.

Bankruptcy.  The company could file for bankruptcy and leave it to the courts to handle it.  This can be an expensive and inefficient process.  Why? Because the courts have required procedures to ensure fairness to those with potential claims including lenders, suppliers, customers, tax authorities, employees, investors, shareholders, and others.  The process of sorting out potential claims takes time and the resulting delays may reduce or destroy the value of certain business assets.  Often, the disposition of business assets can be handled better outside of bankruptcy through private settlement processes.

Crash and Burn.  You could simply leave the company on "autopilot" and let the business hit the wall at 200 mph.  As I mentioned in my first post, the end result is "crash and burn". Complete loss of life.  No one walks away.  It isn’t pretty.  The business dies and no one takes responsibility for its failure.  No regard for any of the trust relationships created during the visionary, start-up and operating phases.  Just "oh well, we tried."  The problem is personal assets could be at risk and the law may hold directors, officers, and stockholders (or other business representatives and owners) responsible long after the business entity ceases to exist.

Deciding "there is no alternative," should not be a last minute determination.  In most companies, you can see the end coming well in advance.  Either the company is gaining customers or losing them.  The energy is either flowing into the management team or out of it.  The products are either shipping with fewer bugs or more bugs.  The cash flow is either improving or getting worse.  If you are paying any attention to the business at all, you know what’s happening.

Shutting down a business is really a process, not a decision.  You don’t just wake up one morning, look at your to do items and then write "wind down company" at the top of the list.  It’s a process.  You have to go through the painful, possibly agonizing process of evaluating your alternatives.  You should consider carefully who will be affected by the shut down and seek advice from trusted and knowledgeable sources.  You should consult with your board of directors (or other governing body) as well as your legal counsel and financial advisors.  In the end, you need to make a thoughtful, well-reasoned decision and then take the necessary actions.  The earlier you deal with the issues, the more alternatives you will have and the easier it will be to transition to the next venture.

During the mid 1990′s, I was President of a software development company faced with the decision of shutting down its business.  We were selling Mac software to enterprise customers at a time when almost every major corporation in America stopped using the Mac in the workplace.  And we were competing against other vendors, including Apple, that were literally giving away a similar product for free.  We had some good years and were profitable, but we were selling into a legacy systems market and saw the end coming well in advance.  We reviewed various options with our board of directors and made several attempts to develop new products and pursue other opportunities, but in the final analysis, we decided that the various options did not match our talents or resources. Instead, we wound down the business and simply distributed the remaining assets to the stockholders.

You don’t have to "pull the trigger" right away, but you do need to begin planning well in advance.  Whatever you do, don’t wait too long to start the process; it gets messy.  What do I mean by "too long"?  The company can’t meet this week’s payroll.  The Company doesn’t have enough money to pay its taxes.  The company already missed a loan payment.  You are wondering what happens to your personal guarantees when the business fails.

What is the likelihood of business failure?  I can’t vouch for the information, but here are some interesting statistics.  We would like to hear your war story about winding down a business.  What made you decide to cease operations?  What actions did you take?  What alternatives did you consider?

Roger Glovsky is a founding partner of Indigo Venture Law Offices, a business law firm based in Massachusetts, which provides legal counsel to entrepreneurs and high-tech businesses. Mr. Glovsky is also founder of LEXpertise.com, a collaboration and networking site for lawyers, and writes blogs for iLaw2.com and The Virtual Lawyer.

The above content is intended to serve as a general discussion of the subject matter and is provided for informational purposes only. It is not legal advice and should not be construed as such. Do not act upon this information without seeking professional advice or rely on this website or use the content as a substitute for consultation with professional advisors.