Mergers & Acquisitions
The Danger of Pre-Closing Coordination in Merger Transactions
By Barry M. Block, Michael W. Jahnke, Daniel F. McInnis and Rachel G. Talay
When negotiating provisions in a merger agreement, conducting due diligence and engaging in transition planning, parties to a merger or acquisition need to consider carefully whether their coordinated actions might be alleged to violate antitrust laws. The Federal Trade Commission (FTC) and the Antitrust Division of the U.S. Department of Justice (DOJ) have a long history of bringing lawsuits against parties that engage in what the regulators view as excessive coordination prior to closing. While these antitrust agencies understand and acknowledge that many forms of premerger coordination are reasonable and even necessary, they also contend that certain coordinated actions in the context of an unconsummated deal may violate the antitrust laws. This type of behavior is colorfully termed “gun jumping.”
Two Theories of Gun-Jumping Violations
The government’s general position with respect to gun jumping is that merging parties must remain effective competitors until closing and cannot lessen competition between them to facilitate a merger that has not been consummated. Balanced against these positions is the recognition that some form of cooperation is necessary in coming to an agreement, engaging in standard due diligence, and ultimately preparing both the acquirer and the target to operate the combined businesses effectively upon closing.
In balancing these two sets of goals, the antitrust agencies have developed two theories of gun-jumping liability.
The first deals with the issue of parties that prematurely act as one firm prior to the government completing its review of a deal for competitive concerns. Because the Hart-Scott-Rodino Act (HSR), 15 U.S.C. § 18a, requires that merging parties observe a waiting period following notification of certain mergers and acquisitions (an HSR filing), if the parties explicitly or in practice transfer control – often termed beneficial
The Danger of Pre-Closing Coordination
in Merger Transactions................................................... 1
Cashing In Your Chips: Negotiating
Letters of Intent From the Seller’s Perspective.............. 5
Be Careful What You Wish For: Government Contracting
and the Unwary Contractor – Current Ethics Issues & Obligations 7
The Capital Dilemma: Should an
Early-Stage Company Issue Equity Interests or Convertible Debt in
Pursuit of Capital?........................................................... 9
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For more details on any of the topics covered in this Business Law Update, please contact the authors via the links at the end of each article or David R. Valz, editor-in-chief. For information on our Corporate Transactions & Securities practice, please contact Frank D. Chaiken, practice group leader.
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ownership – prior to completing this process, they can be accused of jumping the gun. Importantly, this theory does not require any finding that the merging firms are competitors. Thus, even though most mergers and acquisitions – including those reviewed under the HSR process – present no competitive concerns, the agencies will still bring gun-jumping actions against parties that do not follow the letter of the law in the premerger notification process.
The second theory requires that parties to a merger or acquisition remain competitors even if they have agreed to combine. In general, for example, under
Section 1 of the Sherman Act or Section 5 of the FTC Act, competitors are not permitted to engage in collective actions that adversely
Loyola Antitrust Colloquium, Institute for Consumer Antitrust Studies, April 25, 2014.
A particularly difficult set of issues is raised by the exchange of competitively sensitive information. Competitors are prohibited from agreeing to fix prices or even sharing sensitive data, such as pricing plans, if they know that the access to such data will reduce rivalry between them. These limits do not change because of an announced merger. Deal negotiations and due diligence, however, often require
merging parties (or at least the buyer) to analyze a host of nonpublic information that normally would not be shared with a competitor, requiring the parties to tread
affect overall competition. Thus, in transactions where the parties are competitors, coordination that is not “ancillary” to the merger transaction – i.e., not reasonably necessary to protect the integrity of the transaction itself – is considered risky behavior. In this situation, extra care should be given to preventing pre-closing collective actions that adversely affect competition, especially when there
are no legitimate business reasons for taking
such actions. Importantly, Sections 1 and 5 apply even if a specific deal is “non- reportable” under the HSR Act, i.e., no HSR filing has to be made. Moreover, even for reportable deals, the applicability of
must remain effective
competitors until closing and cannot lessen competition between them to facilitate a merger that has not been consummated.
carefully between limiting exchange of
sensitive information and allowing the
buyer to complete the necessary due diligence regarding the acquisition target. Generally speaking, it is helpful to consider “who, what and when” factors – i.e., limiting who receives competitively sensitive information to a “clean team” of persons not involved in pricing/marketing/production decisions, limiting disclosure to only what is necessary to enable the buyer to make its valuation and purchase decision (and aggregating sensitive information when possible), and revealing information only when necessary (i.e., staging information flow so as to
Sections 1 and 5 extends beyond the HSR waiting period to the actual consummation of the merger or acquisition.
Non-Reportable Deals May Be Increasingly Risky
The second gun-jumping theory may become a greater focus for the enforcers, because the DOJ has recently acknowledged that “non-reportable” deals now are being investigated regularly. On April 25, 2014, Leslie Overton, a Deputy Assistant Attorney General in the DOJ’s Antitrust Division, devoted an entire speech to the issue of non- reportable deals. Her relevant key points were that there is no “safe harbor” for non-reportable deals; investigations of these deals are not isolated occurrences – from 2009 to 2013, the DOJ investigated 73 non-reportable deals (far more than previously identified publicly), representing 20 percent of all merger investigations during that period; and the investigations are serious – more than one in four resulted in a challenge. “Non-reportable Transactions and Antitrust Enforcement,” speech before the 14th Annual
disclose sensitive information later in the process). This issue
will be explored in more detail in an upcoming publication.
Gun-jumping violations can result in the imposition of civil penalties, temporary restraining orders, injunctions and other equitable remedies, including prohibitions on future conduct and affirmative obligations. However, the most typical remedies are prohibitions against further gun- jumping behavior coupled with monetary penalties, which must be imposed by the DOJ because the FTC Act does not permit the FTC to seek civil penalties for HSR Act violations. Under the HSR Act, those who fail to observe the waiting period are liable for a civil penalty of not more than $16,000 for each day during which such person was in violation of the HSR Act. The DOJ has obtained civil penalties from both the acquiring and acquired person, and could potentially go after natural persons as well. In addition, the DOJ could
potentially prosecute a gun-jumping case criminally under Section 1 of the Sherman Act, but has never done so.
Engaging in conduct that might be viewed as gun jumping by the regulators may also have additional practical impacts if a merger review is ongoing. The agencies would likely move some of their resources away from the merger review and on to the gun-jumping investigation. This would delay the merger review and potentially harm the reputation that the merger parties have with the agencies. A gun-jumping investigation could also be damaging to the business and public reputations of the merging parties if information about the investigation is released.
The antitrust agencies continue to look for and bring cases against parties that have allegedly jumped the gun. In the past 10 years, there have been three gun-jumping cases brought by the DOJ. As discussed below, the final judgments in these cases included equitable relief and monetary civil penalties. The DOJ’s contentions in these settlements are restated below.
United States v. Smithfield Foods, Inc., No. 1:10-cv-00120
- an. 21, 2010)
- The target stopped exercising independent business judgment in its ordinary business operations after entering into a merger agreement. The target submitted for the buyer’s consent supply contracts, including one accounting for a very small percentage of the target’s annual capacity. These procurement contracts were necessary to the target’s ongoing business, entered into in the ordinary course and included sensitive information including price. The parties agreed to pay a civil penalty of $900,000.
United States v. Qualcomm, No. 1:06CV00672 (D.D.C. Apr. 13, 2006)
- Under a merger agreement, the parties stipulated that the target would not, without the buyer’s consent, license its intellectual property to third parties; enter into agreements involving the obligation to pay or receive $75,000 or more in a year or $200,000 or more in the aggregate; enter into agreements relating to the purchase or sale of intellectual property rights (with a few exceptions); or present business proposals to customers or prospective customers. The target ceded control of
its management and operations by agreeing to these and other similar provisions in the merger agreement. The parties agreed to pay a civil penalty in the amount of $1,800,000.
United States v. Gemstar-TV Guide Int’l, Inc., No. 03-0198, 2003 WL 21799949 (D.D.C. July 11, 2003)
- The parties entered into agreements eliminating or reducing competition between them during the period that the parties were negotiating the merger agreement and during the premerger period. The parties agreed to delay ongoing contract negotiations with customers, allocate markets, customers and other responsibilities, and to fix the prices and material contract terms offered to customers. They also prematurely combined some of their operations. The parties failed to remain separate and independent economic actors prior to expiration of the HSR Act waiting period and prior to consummation of the merger. The parties agreed to pay a civil penalty of $5,676,000 and allow customers to terminate their contracts if they were entered into during the period that the parties were in violation of the antitrust laws. The parties also agreed to certain prohibited and required conduct, and to maintain an antitrust compliance program for a period of 10 years.
The Need for Careful Counseling
Parties should establish certain guidelines and restrictions when entering into a pre-closing phase of coordination for any merger or acquisition, especially in those cases where the parties could be viewed by the agencies as competitors. The following issues should be considered when establishing guidelines and restrictions:
- Educate business personnel on the risks of gun- jumping liability
- Restrict the flow of competitively sensitive information through nondisclosure agreements, “clean” rooms and policies
- Consider exchanging historical and/or aggregated information when planning certain post-merger business activities like pricing, marketing, assigning customers and accounts among the sales department, branding, strategy and capital decisions
Assign different personnel to handle the post- merger planning activities than those who handle the day-to-day operations in that particular part of the business
- Outsource the post-merger planning activities to third-party consulting and accounting firms that offer integration services, if necessary
- Postpone, as practical, post-merger planning (such as of significant capital projects) until near to or after consummation of the transaction
- Carefully consider discussions of any post-closing matters that require premerger attention
- Closely monitor joint communications to customers (for example, to highlight the benefits of the
merger) to ensure that the topics do not spill over into ordinary course selling
In cases where the parties are not competitors, the transaction is less likely to raise concerns under Section 1 of the Sherman Act or Section 5 of the FTC Act. Similarly, this type of transaction could potentially receive early termination of the waiting period under the HSR Act, thereby shortening the period during which a HSR Act violation could occur. However, every transaction is different, and the line between lawful premerger coordination and unlawful gun jumping is narrow and ever- changing. Parties to a merger or acquisition should consider consulting with legal counsel if they have concerns regarding their premerger coordination and related activities.
Thompson Hine Again Recognized by Corporate Counsel as Innovation Leader
Thompson Hine has been honored in every category for game-changing innovation in The BTI Brand Elite: Client Perceptions of the Best-Branded Law Firms. Our firm was ranked in the top 1% of law firms nationwide in the category “Innovation: Client Service Strategists” – firms making changes to improve the client experience. In addition, we were ranked as one of 11 leading firms nationwide in the category “Innovation: Value Leader” – firms making changes in processes to add value, and one of 18 leading firms nationwide in the category “Innovation: Movers & Shakers”
– firms delivering new services that others are not.
“Thompson Hine again earns its top spot in Innovation in Client Service,” said Michael B. Rynowecer, president of the BTI Consulting Group. “Corporate counsel report the firm is embracing approaches to improving predictability and cost containment and adding more value. These efforts play directly into corporate counsel goals.”
“We have invested in changing the way we do business to align our service delivery with client needs for efficiency, predictability and adherence to budget. We are pleased to see our commitment to legal project management, value-based billing and process improvement, among other measures, recognized by clients in ranking our firm as an innovator,” said Deborah Z. Read, the firm’s managing partner. “We work hard to exceed our clients’ expectations for service delivery, and we appreciate our recognition as one of the top seven firms in the country for making changes to improve the client experience.”
Cashing In Your Chips: Negotiating Letters of Intent From the Seller’s Perspective
By William M. Henry and Todd M. Schild
To a potential seller of a business, receiving a proposed letter of intent (LOI) from a prospective buyer represents some level of success – real validation to the seller that all the hard work put into building and growing its business has finally paid off. Upon receiving that LOI, a seller’s first impulse may be to simply accept the terms as presented, fearing that rejecting or asking for clarification on terms will be deemed ungrateful, hard-charging or otherwise met with disfavor by the buyer. This impulse, however, can be shortsighted, as there are many terms in an LOI that can influence how favorable a deal the seller will get. Instead, the seller should – and the buyer often expects that the seller will – consider and negotiate the material transaction terms in the LOI.
Generally, the LOI’s purpose is to set forth certain key terms of the transaction, including the purchase price. Although many of the terms in the LOI are, by design, nonbinding, the LOI usually includes one essential (from the buyer’s perspective) binding term: exclusivity, which mandates that for a period of time following the date of the LOI (usually until some fixed date or the closing, whichever occurs first) the seller will negotiate only with that buyer and no others. The buyer desires exclusivity since it will incur costs conducting due diligence, negotiating transaction documents and moving toward closing, and it does not want to incur these costs if another buyer can swoop in and steal the transaction or be used by the seller as leverage to negotiate a better deal.
The seller can use the proverbial trade chip of granting exclusivity to require specificity on certain of the nonbinding terms. While the nonbinding terms – including price – are nothing more than a handshake in terms of enforceability, they do offer a very strong starting point for any negotiations. Any substantial deviation from this roadmap by the buyer can be viewed by the seller as a “retrade,” which can provide the seller with leverage concerning other points to be negotiated during the course of the transaction. Therefore, when representing a seller of a business, we often recommend that the seller consider addressing the following points in the LOI:
- Purchase price. The LOI should clearly articulate the purchase price the seller will receive at closing, the amount of the purchase price that is to be paid
post-closing (i.e., in the form of a note, earn-out or other post-closing adjustment), the amount of any
escrow or hold-back of the purchase price, and whether there will be any post-closing adjustments to the purchase price (including a working capital adjustment, as addressed below). If the buyer contemplates that any portion of the purchase price will not be paid at closing, the seller should be sure that the LOI is clear in terms of when, and under what conditions, such portion will (or may) be paid to the seller.
- Working capital adjustments. Depending on the nature of the business (and whether there are large month-to-month fluctuations in working capital), a seller may wish to request a working capital adjustment be expressly contemplated in the LOI as a “must-have” item in the ultimate purchase agreement, or alternatively, if it believes a decline in working capital is possible, the seller may wish to state that no working capital adjustment will be required to avoid any ambiguity post-LOI.
- Indemnification limits. It is in the seller’s interest to establish in the LOI its maximum liability for post- closing claims. Often, a buyer will resist agreeing in the LOI to cap the seller’s potential liability until it has seen enough diligence to better appreciate the potential issues or risks in the seller’s business. This resistance does not mean the seller should not attempt to do so.
- Representations and warranties – scope and survival. While somewhat less common, some LOIs will state what types of representations and warranties the purchase agreement will include. The seller may not often go into this level of detail, but with a sophisticated buyer, having these negotiations up front may provide useful context to the negotiation of the purchase agreement (and what the buyer truly cares about). Here, the buyer
may wish to be as broad as possible and attempt to include a variety of representations and warranties. In this case, the seller should look to use the leverage it gains from agreeing to exclusivity to limit these representations and warranties, as well as to expressly exclude certain others (e.g., “the definitive agreement will not include a 10b-5 warranty”). Further, the seller may wish to limit the period of time during which it might be liable for breaches of representations and warranties by setting forth a specific survival period (e.g., 12, 18 or 24 months).
Until the LOI is signed, exclusivity is not in place, and the seller is free to talk with as many potential buyers as it likes. When the LOI is signed, the seller loses this freedom and the buyer stands to gain significant leverage in negotiations, an advantage the seller should consider carefully. First, the
seller should not rush to sign an LOI simply to have something signed. Second – and more importantly – the seller should not hesitate to use the exclusivity trade chip to leverage specificity on some of the above provisions in the context of the LOI negotiations. A detailed LOI can serve as an excellent basis for future negotiations as the transaction moves forward.
Ultimately, a well-negotiated and detailed LOI can significantly improve the quality (especially in terms of protecting the seller) of the definitive purchase agreement that is finally executed. Accordingly, it is prudent for a seller to consider engaging sophisticated M&A counsel to ensure that the LOI satisfactorily protects its interests.
For more information about LOIs, contact William M. Henry
Thompson Hine LLP has been recognized for the 12th year in a row as a leading law firm in the 2014 issue of Chambers USA: America’s Leading Lawyers for Business, which ranks lawyers based on interviews with both clients and peers according to technical
legal ability, professional conduct, customer service, commercial awareness, diligence
were among those recognized.
Be Careful What You Wish For: Government Contracting and the Unwary Contractor – Current Ethics Issues & Obligations
By Lawrence M. Prosen & Daniel P. Broderick
Does your business transact business with or for the federal government? If so, is your firm compliant with the numerous ethics and business practices requirements associated with such
contracts unique to the federal government? Over the next several months, Thompson Hine’s Government Contracts group will publish a multiple-part series on government contracts ethics issues (the series). To highlight this subject matter and provide our readers with the most current and accurate information, the following summary provides some of the topics and background we will cover. The series will be issued through Thompson Hine’s Government Contracts Update email and will also be available on our website.
To fully understand and determine whether your company is subject to the heightened requirements associated with ethics and business practices under the auspices of government contracts, one only must determine whether your company is directly or indirectly obtaining federal monies from, or performing under, a federal government contract. If the answer is “yes” or even “maybe,” then you must be cognizant of the very real likelihood that your business is subject to heightened scrutiny and requirements. As we will discuss in more detail in our series, these requirements are pervasive and significant regardless of the type or size of your business. More critical is that under the current presidential administration, we have generally observed a decided uptick in the oversight, investigation and prosecution of government contractors for ethics-related issues. The number of stories in the news about False Claims Act violations, allegations of fraud, kickbacks, bribes and the like appears, from an empirical perspective, to have increased exponentially.
Did You Know?
If you directly or indirectly contract with the government (via prime contract, subcontract, purchase order or other vehicle), there are many laws, regulations and standards unlike anything in the private commercial realm that may very well apply to your work, labor and accounting. To fully
understand and address these unique ethics and business issues, it is key that you understand how these laws, regulations and standards become applicable to your contract.
Where Are the Laws & Regulations?
Almost all of the laws, regulations and contract clauses dealing with these ethics issues and relating to federal procurement can be found in Federal Acquisition Regulations (FAR) (Title 48 of the Code of Federal Regulations) Part 3. FAR Part 3, entitled “Improper Business Practices and Personal Conflicts of Interest” (48 C.F.R. Part 3), covers various issues, including gratuities, price fixing/collusion, antitrust issues, kickbacks, lobbying, whistleblowers, codes of conduct/ethics and other issues. Important to note is that even if not expressly referenced in a given contract, they may still be incorporated as a matter of law into your contract.
As a result, the real question becomes a two-part inquiry:
(1) Is my contract or subcontract subject to or part of a federal government procurement and, if the answer is “yes,” then (2) What ethics- and business conduct-related requirements and statutes apply?
Why Should I Care?
Rare is the day that goes by without opening a national or major newspaper to find that a contractor or employee is being pursued under the Civil or Criminal False Claims Act (FCAs) or that a whistleblower is pursuing such an action via a qui tam action. Under the FCAs, the government or a private party has the right to pursue contractors and subcontractors for fraudulent conduct, waste and false invoicing for payment of federal monies. This extends as well to federally funded local and state contracts often. Damages can range from criminal sanctions and jail time (Criminal FCA) to financial damages, including treble (triple) damages based on each occurrence of a false claim under the Civil FCA. Debarment or suspension, in which the contractor is barred from pursuing federal (or state) government contracts, can also occur.
This liability can also extend to improper/false certifications of a business as “small,” knowingly submitting nominal or
intentionally and artificially low bids to get work, and bribery/bid rigging, among other things. These and other issues directly covered by FAR Part 3, among other laws and statutes, call for the full and substantial attention of any business or person transacting business directly or indirectly with the federal government.
With this background, the following are but a few highlights of the requirements that may impact your business, which we will discuss in more detail in the pending series.
Code of Government Contracts Business Ethics & Conduct
One of the more recent additions to FAR Part 3 is the requirement that most government contractors and certain subcontractors have in place a Contractor’s Code of Business Ethics and Conduct. While many contractors already have codes of conduct in place as part of a “standard” employee manual, the FAR-required standards are more involved and typically are prepared as an adjunct or amendment to the nongovernment contracts-specific manual. As we will discuss in the series in detail, there are extensive requirements for what a contractor must include in such a Contractor’s Code and to whom it applies.
Whistleblower Protections & Poster
As called for in the FCAs, whistleblowers have significant protections from termination, discrimination and the like. The intention is that whistleblowers must be allowed to pursue and report any offenses they claim to be aware of without fear of reprisal. Toward this end, along with the Code of Business Ethics, the FAR was amended to require that any contractor with a contract exceeding $5 million or less as established by an agency, or if it is for disaster assistance, display the applicable Inspector General Hotline Poster containing the fraud hotline number and other relevant information. Does your business do this? If not, you should determine whether it should be doing so.
This poster is not unlike those required to notify employees of the mandatory minimum wage and other Fair Labor Standards Act requirements. It is applicable only to employees working on federal government contracts, but generally from an administrative perspective, it is best to post it for all employees.
Another area of concern that has arisen is when an employee of a procuring agency is provided with gratuities, gifts or other favors by a proposed contractor in return for favorable treatment (e.g., award of a contract). Such
conduct is disallowed and with good reason. Not only does this undermine one of the basic tenets of government contracts, namely full and open competition on a level playing field, but it often can result in a waste of taxpayer funds by not awarding to the best or lowest-priced contractor. Upon a determination of improper gratuities, the agency may (a) terminate the contractor’s right to proceed;
- initiate debarment or suspension proceedings; and
- assess exemplary damages if the monies were appropriated to the Department of Defense. These are serious issues with serious potential damages/exposure.
It is likewise illegal under the Anti-Kickback Act of 1986 for a subcontractor to make payments or kickbacks to a prime contractor (and for the contractor to accept such payments) for the “purpose of improperly obtaining or rewarding favorable treatment in connection with a prime contract or a subcontract relating to a prime contract.” FAR 3.502-2. It is also illegal to even offer or solicit such kickbacks. Exposure includes civil and criminal penalties.
Conclusion: What Should You Do?
The foregoing is but a small sampling of the types of business ethics issues that are relatively, if not exclusively, unique to the government contracting realm. As mentioned above, our Government Contracts group will be publishing a three-part series on government contracts ethics- and conduct-related issues. While not exhaustive, this thorough, plain English series will provide a solid footing from which to determine what, if any, next steps may be warranted and what obligations may apply. We invite you to forward your contact information or notify us if you have interest in being sent links to and/or copies of the publications as they are issued.
What is apparent is that often contractors (or subcontractors) lack awareness, or even the applicability, of these critical requirements to their projects and contracts. Thompson Hine also offers government contracts-specific code/manual development and training for employees. Working with our labor and employment attorneys, we can also perform a full audit of your in-place employment and government contracts policies, procedures and needs. Please do not hesitate to contact us to discuss any concerns or issues you may have.
The Capital Dilemma: Should an Early-Stage Company Issue Equity Interests or Convertible Debt in Pursuit of Capital?
By Paige S. Connelly
Reasons for Raising Capital
An early-stage company might raise capital for numerous reasons depending on its business operations, the industry in which it operates and its growth stage. The company might need funding to support product development, research, day-to-day business operations or myriad expenses including employee payroll and equipment purchases. Issuing convertible promissory notes to investors can be a fast and relatively inexpensive way to raise capital, but the company should assess the effects of convertible debt on its capitalization down the road.
Raising capital by issuing Series A preferred stock to investors provides certainty of pricing and specificity of the security’s other terms, but a Series A transaction often involves more time and expense than a convertible note round. This article focuses on the factors that an early-stage company (and the investors considering investing capital in one) should consider when raising capital through an investment transaction.
Convertible Debt Advantages
A convertible promissory note is a debt instrument that is convertible into equity interests in the company at a later time. A convertible note’s terms may provide that the note converts into equity upon a trigger event (a “conversion event”), including the next round of financing above a certain amount, an exit transaction or at the investor’s election after a certain date. As an incentive for the investment, the investor often receives a discount on the price at which the debt will convert to equity in the next equity issuance (the “conversion price”).
Some early-stage companies choose to raise capital through a convertible note round because a convertible note can enable the company to obtain financing from investors and defer in-depth negotiations about the company’s valuation until the next round of financing (likely a Series A round in which the security will have to be priced). Convertible debt provides advantages for the noteholder as well. If the company fails and liquidates before it can raise additional financing, an investor holding a debt instrument is generally entitled to the company’s remaining cash or assets in the dissolution process, up to the amount of principal and
The decision whether to issue Series A preferred stock or convertible notes to secure capital for an early-stage company is a fact-sensitive inquiry.
interest outstanding under his or her note, before the equity holders receive anything. Alternatively, if the company is successful in securing investors for a Series A round, a noteholder can convert the note into the same security that the first institutional venture capital investors receive in the Series A financing (typically Series A preferred stock) with the same rights, preferences and privileges of holders of that stock, and often with a discount.
As the terms of convertible notes have developed, it has become more difficult for an emerging company to put off the valuation conversation. Many early-stage investors are negotiating a conversion price cap in a convertible note to limit the price at which the note will convert (a “conversion cap”). It has become customary in the market to include a conversion cap, which requires the parties to agree on the prospective valuation of the company, and which may be even more difficult than determining the valuation at the time of issuing a security. Many investors request a conversion cap because it shifts some risk to the company in the event of a significant valuation increase.
Convertible notes also afford early-stage investors the protections discussed above with less “pay to play” pressure than often comes with an equity investment in a Series A financing. When an investor purchases Series A preferred stock in an emerging company, subsequent funding rounds will surely follow to infuse additional capital into the business to help it grow. If the investor cannot afford to invest additional funds in each subsequent round (Series B,
Series C, etc.) to retain his or her equity position in the company, the investor’s equity stake gets more diluted in each round. Although a noteholder may be in a similar position if his note automatically converts to shares of Series A preferred stock in a Series A financing and a Series B round looms ahead, the noteholder receives a bigger chunk of Series A equity at conversion relative to his initial investment if he benefited from a discounted conversion price and/or a conversion cap on valuation.
Convertible Debt Disadvantages
From the emerging company’s perspective, if a convertible note matures before a conversion event, the company must repay the principal and interest accrued on the note unless the noteholder agrees to extend the maturity date. If the company is not in a financial position to repay the noteholder, the noteholder might have bargaining power to revise the investment’s economic terms to his or her benefit.
From the noteholder’s perspective, in contrast with holders of common stock, the company’s directors and officers do not owe any fiduciary duties to noteholders, so the investors’ ability to impact the management’s decision making is limited to the investors’ contractual rights under the note. Noteholders also face the risk that later-stage investors may negotiate changes to the terms of the convertible notes that may adversely impact the early investors. However, if the company secures the next round of financing prior to the notes’ maturity, the convertible note can offer more robust protections than common stock at a lower cost than that associated with a Series A transaction.
Issuing Preferred Stock
When deciding which method to use to raise capital, an early-stage company might look to its investors to determine what type of investment security or instrument they prefer. Venture capital investors might demand more clarity on pricing the security issued and will only invest in equity. The
company should also take into account the amount of capital to be raised in the seed round. Generally, if the company is raising less than $500,000, convertible notes would likely be preferred to a Series A transaction because of the cost associated with a Series A round. On the other hand, if the company seeks to raise capital in excess of $1 million, the higher transaction costs of a Series A financing might be justified to gain greater certainty of pricing the stock.
A Series A financing transaction typically calls for a suite of investment agreements that set out certain rights to help protect investors’ purchase of a minority, noncontrolling
interest in the company. These agreements include a Stock Purchase Agreement, Investors’ Rights Agreement, Voting Agreement, Right of First Refusal and Co-Sale Agreement, as well as an Amended and Restated Certificate of Incorporation of the company to authorize the creation of the new preferred security. Under these documents, Series A preferred stock holders are generally entitled to a preferred dividend and a liquidation preference, meaning they receive their initial investment plus any accrued but unpaid dividends before common stock holders receive any distributions when distributions are made in connection with a company sale. Shares of Series A preferred stock are typically convertible into shares of common stock on a 1:1 basis, and such shares frequently carry both the right to a liquidation preference and the right to participate with common stock holders on a pro rata basis in the distribution of any remaining cash or proceeds. Series A preferred stock holders often have approval rights with respect to certain company actions, meaning their consent is required for the company to authorize or issue additional equity interests; incur indebtedness, subject to certain exceptions; enter into a change of control transaction or other liquidation of the company; pay dividends; or redeem shares of capital stock. Large investors may receive preemptive rights to purchase additional shares of stock in future funding rounds, if they wish to retain their respective ownership percentages in the company. As referenced above, preemptive rights are beneficial for VC investors to maintain their pro rata ownership interest, but smaller early-stage investors may not be able to take advantage of their preemptive rights if they cannot afford to participate in the next round by purchasing additional equity. Finally, the lead VC investor often is entitled to designate a seat on the board of directors, and the approval of the Series A director may be required for the company to engage in material transactions or issue debt or equity under certain circumstances.
The decision whether to issue Series A preferred stock or convertible notes to secure capital for an early-stage company is a fact-sensitive inquiry. The company should consider:
- The potential investors – angel funds, VC institutional investors or individuals – and what terms they require for their investment vehicle
- How much money the company needs and whether the costs of a Series A financing are justified
- The company’s current stage of operations and how difficult is it to determine the company’s valuation
- The urgency of the company’s need for capital and what the company’s goals are for future financing transactions
These factors influence the type of investment security and its terms, specifically the security holders’ rights and the allocation of risk among the company and the investors. Given the numerous financial demands on an early-stage company, both methods for raising capital are common in the market and can be appropriate in the VC space.
For more information about raising capital for an early-stage company, contact Paige S. Connelly.
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