Structuring The Private Placement Or Venture Deal – Part 2

Back in 2013 I wrote a series of blogs about preparing for and then structuring a private placement or venture deal.  In today’s world where public markets are more difficult to access for smaller companies, it is a topic worth revisiting.  There are three primary aspects to the private placement or venture capital arena.  The first is getting dressed for the ball – i.e., preparing a company to be viewed and assessed by investors including the due diligence process; the second is determining valuation or deciding to avoid a determination through convertible instruments; and the third is structuring the deal itself.

In this two-part blog series I am discussing each of these aspects.  This first part addressed pre-deal considerations including valuation considerations and can be read HERE. This part two discusses structuring and documenting the deal.

Structuring The Deal

Although structuring a private placement and negotiating with a venture capital group are very different, the underlying mechanics of investments are universal.  In a venture capital deal, the VC firm generally has all the money and therefore all the power.  In addition, the objectives of the VC fund itself often drive the investment structure.  However, if a pre-packaged private placement is presented to the investment community as a company might present itself to a VC firm, the offering will generally be perceived more favorably.  Also, and importantly, an understanding of the basic components of financial instruments will increase the efficiency of securities counsel and greatly add to the comfort level of all parties involved.

Types of Financial Instruments:

In the broadest sense there are two types of financial instruments used for investment: debt and equity.

An equity instrument can take the form of common stock, preferred stock, securities token, LLC membership interest, limited partnership interest, or warrant or option or any other right, title or interest in a company’s ownership, including its profits or revenue streams.  A debt instrument can take the form of a promissory note, convertible note, or debenture.  A debt instrument can either be convertible into equity or not convertible.

Both debt and equity can have attached financial provisions such as interest or dividend rates, payment preferences, liquidation values, anti-dilution, most favored nations, etc., and non-financial provisions such as the right to appoint or elect board members, board observation rights or negative covenants such as prohibitions against incurring further debt, selling assets or altering business plans without approval of the investor.

Below is a summary of some of the terms and conditions a company can consider in determining what to offer investors or what to expect investors to negotiate for.  Although a company should be careful not to fashion an offering that is overly complicated and that will result in confusion with future financing, from a legal standpoint, the “menu” below is “build-your-own.”

Equity Instruments:

An equity instrument can take the form of common stock, preferred stock, securities token, LLC membership interest, limited partnership interest, or warrant or option or any other right, title or interest in a company’s ownership, including its profits or revenue streams.  Below is a back-to-basics high-level summary of some equity options.

LLC Membership interest or LLC Membership Unit – An LLC Membership Unit is the broad title of equity in a limited liability company.  Through an operating agreement, LLC Members delineate classes of equity and the rights and preferences associated with each class.  The LLC structure is entirely flexible and classes of equity can have any of the rights or preferences, both financial and non-financial, available for common or preferred stock.

Common Stock – Common stock is a general class of stock.  Although there can be different classes of common stock, a single class is the most customary. Although common stock is usually voting, especially in publicly traded equity markets, it can be designated as either voting or non-voting.  Common shareholders fall behind preferred stock holders in the rights to receive dividends and behind both preferred stockholders and creditors in rights to receive payments upon liquidation.  Common stock is the most “common” type of equity security.  Common stock never has a “preferential” financial right.  That is, there is no fixed dividend or other fixed or special rights or preferences associated with common stock.

Preferred Stock – Preferred stock is the most commonly used investment financial instrument due to its flexibility.  Preferred stock can be structured to offer all the characteristics of equity as well as of debt, both in financial and non-financial terms.  Preferred stock can be structured in any way that suits a particular deal – provided, however, that in a bankruptcy or other liquidation, equity, including preferred equity, is behind debt.  The following is an outline of some of the many features that can be included in a preferred stock designation:

1. Dividends – a dividend is a fixed amount agreed to be paid per share based on either the face value of the preferred stock or the price paid for the preferred stock (which is often the same); a dividend can be in the form of a return on investment (such as 8% per annum), the return of investment (25% of all net profits until the principal investment is repaid) or a combination of both.  Although a dividend can be structured substantially similar to a debt instrument, there can be legal impediments to a dividend payment and a creditor generally takes priority over an equity holder.  The ability of a company to pay a dividend is based on state corporate law, the majority of which require that the company be solvent – i.e., have the ability to pay creditors when due – prior to paying a dividend.  Accordingly, even though the company may have the contractual obligation to pay a dividend, it might not have the ability either legally or monetarily to make such payments.

– As a dividend may or may not be paid when promised, a dividend either accrues and cumulates (each missed dividend is owed to the preferred shareholder) or not (we didn’t get the dividend this quarter, but hopefully next);

– Although a dividend payment can be structured to be paid at any interval, payments are commonly structured to be paid no more frequently than quarterly, and often annually;

– Dividends on preferred stock are generally preferential, meaning that any accrued dividends on preferred stock must be fully paid before any dividends can be paid on common stock or other junior securities.

2. Voting Rights – preferred stock can be set up to establish any level of voting rights from no voting rights at all, voting rights only on certain matters – for example, the sole vote on at least one board seat or voting rights as to the disposition of a certain asset – or super voting rights, such as 100 votes for each 1 share of common stock;
3. Liquidation Preferences – a liquidation preference is a right to receive a distribution of funds or assets in the event of a liquidation or sale of the company.  Generally creditors take precedence over equity holders; however, preferred stock can be set up substantially similar to a debt instrument whereby a liquidation preference is secured by certain assets, giving the preferred stockholder priority over general unsecured creditors vis-à-vis that asset.  In addition, a liquidation preference gives the preferred stockholder a priority over common stockholders and holders of other junior equities.  The liquidation preference is usually set as an amount per share and is tied into the investment amount plus accrued and unpaid dividends;

– In addition to a liquidation preference, preferred stockholders can partake in liquidation profits. For example, preferred stockholder might get their entire investment back plus all accrued and unpaid dividends, plus 30% of all profits from the sale of the company or might get their entire investment back plus all accrued and unpaid dividends and then participate pro rata with common stockholders on any remaining proceeds (known as a participating liquidation preference).

4. Conversion or exchange rights – a conversion or exchange right is the right to convert or exchange into a different security, usually common stock;

– Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (80% of the average 7-day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000 or at a discount to the valuation of some future financing);

– Conversion rights are generally at the option of the stockholder, but the company can have such rights as well, generally based on the occurrence of an event such as a firm commitment underwritten public offering (company has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO);

– The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 5 years; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000);

– Conversion rights usually specify whether they are in whole or in part and for public companies limits often have equity blockers such that the shareholder can never own in excess of a set percentage ownership of the company (4.99% – related to Section 13 and the requirement to file a Schedule 13D or 13G; 9.99% related to Section 16 filing requirements and short swing profit prohibitions – see HERE or 19.99% related to the Nasdaq and NYSE 20% rule – see HERE are the most common).

5. Redemption/Put Rights – a redemption right in the form of a put right is the right of the shareholder to require the company to redeem the preferred stock investment (to “put” the preferred stock back to the company); the redemption price is generally a premium to the face value of the preferred stock or investment plus any accrued and unpaid dividends; redemption rights generally kick in after a certain period of time (5 years) and provide an exit strategy for a preferred stock investor.
6. Redemption/Call Rights – a redemption right in favor of the company is a call option (the company can “call” back the preferred stock); generally when the redemption right is in the form of a call a premium is placed on the redemption price (for example, 125% of face value plus any accrued and unpaid dividends or a pro rata share of 2.5 times EBITDA).
7. Anti-dilution protection – anti dilution protection protects the investor from a decline in the value of their investment as a result of future issuances at a lower valuation.  Generally the company agrees to issue additional securities to the shareholder, without additional consideration, in the event that a future issuance is made at a lower valuation such as to maintain the investors overall value of investment; an anti-dilution provision can also be as to a specific percent ownership, for example, such that the shareholder will never own below 10% of the total issued capital of the company.
8. Registration rights – registration rights refer to SEC registration rights and can include demand registration rights whereby the shareholder can demand that the company register their equity securities or piggyback registration rights pursuant to which the company must include all or part of the shareholder’s equity when filing a registration statement.
9. Transfer restrictions – preferred stock can be subject to transfer restrictions, either in the preferred stock instrument itself or separately in a shareholder’s or other contractual agreement; transfer restrictions usually take the form of a right of first refusal in favor of either the company or other security holders, or both.
10. Co-sale or tag along rights – co-sale or tag along rights are rights of shareholders to participate in certain sales of stock by management or other key stockholders.
11. Drag along rights – drag along rights are the rights of the shareholder to require certain management or other key stock holders to participate in a sale of stock by the shareholder.  VC firms or angel investors will often include a drag along provision in an investment to ensure that the company can be sold at a future time as an exit strategy.  These drag along provisions will often be accompanied by a management’s first right of refusal before a third-party sale can be completed.
12. Other non-financial covenants – preferred stock, either through the instrument itself or a separate shareholder or other contractual agreement, can contain a myriad of non-financial covenants.  The most common being the right to appoint one or more persons to the Board of Directors and to otherwise assert control over management and operations.  Other such rights include prohibitions against related party transactions; information delivery requirements; non-compete agreements; confidentiality agreements; limitations on management compensation; limitations on future capital transactions such as reverse or forward splits; or prohibitions against the sale of certain key assets or intellectual property rights.

Options/Warrants – an option or warrant is the right to purchase equity, generally common stock, at a certain price or price formula during a certain period of time.  In the public company setting, options and warrants often have equity blocker provisions as well.

Debt Instruments

A debt instrument can take the form of a promissory note, convertible note, or debenture each having the same general meaning.  A debt instrument can either be convertible into equity or not convertible.  Conversion is simply a form of payment for equity.  That is, instead of cash the creditor is accepting an equity instrument as either whole or partial payment for the debt obligation.

The basic elements of a debt instrument are as follows:

1. Amount – The amount is the face value of the debt instrument.  Loan transactions sometimes involve “original issuance discounts” whereby the face amount of the debt instrument is higher than the actual cash paid by the creditor/investor.
2. Term – The term of a debt instrument is the time in which repayment of the debt is due. A term can be a specified date, upon demand by the creditor, or payable upon the happening of certain events such as the receipt of a firm commitment financing for $xx or the reaching of certain milestones or a combination; for example, a company signs ABC Company as a client, but in no event later than May 1, 2022.
3. Interest rate – all debt instruments should and generally do carry interest.  Interest may be simple or compounded.
4. Transferability or assignability – can one or both parties assign their rights and interests in the debt instrument to a third party.  Debt instruments are usually assignable by the creditor and only assignable by the debtor with the permission of the creditor and generally only when the original debtor remains obligated on the debt either directly or as a guarantor.
5. Secured or unsecured – is the debt instrument secured by collateral generally consisting of real or personal property but can also consist of other financial instruments such as a pledge agreement.  In the public company setting a pledge agreement or security agreement against stock can only tack onto the holding period of the pledgor under Rule 144 if the note is full recourse such that the stock is not the only recourse by the creditor in the event of a default.
6. Guaranty – is a third party, such as a principal of the company guaranteeing the obligations in the debt instrument.
7. Prepayment rights – can the debt be prepaid in whole or in part.  It is common for prepayment provisions to be scaled such that the premium on repayment reduces as the debt maturity date approaches.
8. Payment preferences/subordination/senior debt – the debt instrument can contractually require that it will be paid prior to other debts incurred either before or after the due date.  A right to receive payment in advance of other obligations is a payment preference, which is often referred to as “senior debt,” whereas the debt that is below the senior debt is often referred to as “subordinated debt.”
9. Convertibility – a conversion or exchange right is the right to convert or exchange into a different security, usually common stock;

– Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (80% of the average 7-day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000 or at a discount to the valuation of some future financing);

– Conversion rights are generally at the option of the stockholder, but the company can have such rights as well, generally based on the occurrence of an event such as a firm commitment underwritten public offering (company has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO);

– The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 5 years; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000);

– Conversion rights usually specify whether they are in whole or in part and, for public companies, limits often have equity blockers such that the shareholder can never own in excess of a set percentage ownership of the company (4.99% – related to Section 13 and the requirement to file a Schedule 13D or 13G; 9.99% related to Section 16 filing requirements and short swing profit prohibitions – see HERE or 19.99% related to the Nasdaq and NYSE 20% rule – see HERE are the most common).

10. Default provisions – default may be monetary or non-monetary; in addition to penalties, generally a debt accelerates and becomes due and payable in full upon default.
11. Non-financial covenants – any of the non-financial covenants discussed under preferred stock can be attached to a debt instrument.

Documenting The Deal

Deal documents differ in a private placement vs. a negotiated VC or angel investor transaction.  In a private placement transaction, the documents consist of a private placement memorandum and a subscription agreement.  In addition, the instrument being sold may require an additional document such as a preferred designation, convertible note or warrant agreement.  A private placement memorandum is a disclosure document similar to a combination of a business plan accompanied with the highlights of a registration statement that might be filed with the SEC.  A private placement memorandum generally does not contain either audited or reviewed financial statements, though if available, that information could be provided either as part of the offering package or separately through a due diligence data room.

Generally the first step in a VC or angel investor deal is executing a confidentiality agreement and letter of intent followed by a securities purchase agreement and any needed ancillary documents such as a registration rights agreement, employment agreements, a convertible note, warrants, etc. In addition to requiring that both parties keep information confidential, a confidentiality agreement sets forth important parameters on the use of information, including allowable disclosure both internally and to third parties. Moreover, a confidentiality agreement may contain other provisions unrelated to confidentiality, such as a prohibition against solicitation of customers or employees and other restrictive covenants. Standstill and exclusivity provisions may also be included, especially where the confidentiality agreement is separate from the letter of intent.

A letter of intent (“LOI”) or term sheet is generally non-binding, other than perhaps provisions related to the payment of expenses, exclusivity and confidentiality, and spells out the parameters of the investment transaction. The LOI helps identify and resolve key issues in the negotiation process and hopefully narrows down outstanding issues prior to spending the time and money associated with conducting a deep dive due diligence and drafting the transaction contracts and supporting documents. Among other key points, the LOI will set the amount of investment or investment range for follow on tranches, preconditions to tranches, general use of proceeds, the parameters of due diligence, necessary pre-deal recapitalizations, the payment of transaction related expenses, exclusivity, and time frames for completing each step in the process.  Along with an LOI, the parties’ attorneys prepare a transaction checklist which includes a “to do” list along with the “who do” identification.

Many, if not all, letters of intent contain some sort of exclusivity provision. In deal terminology, these exclusivity provisions are referred to as “no shop” provisions. A “no shop” provision prevents one or both parties from entering into any discussions or negotiations with a third party that could negatively affect the potential investment transaction, for a specific period of time.

A standstill provision prevents a party from making business changes outside of the ordinary course, during the negotiation period. Examples include prohibitions against selling off major assets, incurring extraordinary debts or liabilities, spinning off subsidiaries, hiring or firing management teams and the like. Many companies also protect their interests in the LOI stage by requiring significant stockholders to agree to lock-ups pending a deal closure. Some lock-ups require that the stockholder agree that they will vote their shares in favor of the deal as well as not transfer or divest themselves of such shares.

The securities purchase agreement and ancillary documents are usually prepared by the investors counsel and as such are skewed in favor of the investor.  The securities purchase agreement includes:

• Investment terms – Investment terms include the financial commitment of the investor to purchase securities, the form of securities, amount and timing.
• Representations and warranties – Representations and warranties generally provide the company and the investor with a snapshot of facts as of the closing date. From the company, the facts are generally related to the business itself, such as related to assets and liabilities, that there is no pending litigation or adversarial situation likely to result in litigation, taxes are paid and there are no issues with employees. From the investor, the facts are generally related to legal capacity, authority and ability to enter into a binding contract, and accreditation under the federal securities laws.
• Covenants – Covenants generally govern the parties’ actions for a period prior to and following closing. An example of a covenant is that a company will not change its key employees or board of directors, and must continue to operate the business in the ordinary course and maintain assets pending closing. All covenants require good faith in completion.
• Conditions – Conditions generally refer to pre-closing conditions such the execution of all deal documents and that all representations and covenants remain true at closing. Generally, if all conditions precedent are not met, the parties can cancel the transaction.
• Indemnification/remedies – Indemnification and remedies provide the rights and remedies of the parties in the event of a breach of the agreement, including a material inaccuracy in the representations and warranties or in the event of an unforeseen third-party claim related to either the agreement or the business.
• Miscellaneous legal provisions – These provisions are the legal boilerplate provisions including choices of venue and jurisdiction, assignment rights, the entirety of the agreement, etc.

Ancillary documents include the form of the investment security (preferred stock, debt, warrants, a combination…), registration rights agreements, employment agreements, and any other documents that the provisions of the investment would require as a stand-alone document.

The Author

The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including sitting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

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