Beware the Cap Table

So you founded your own company, congratulations! You came up with a great idea, built a team, and built a product. You are going to take over the world! But there is one thing standing in your way: money.

Startups can live and die by financing. The good news is that there are many different ways to raise money. One of the most popular/prestigious is to get an investment from an Angel or Venture Capital investor. Of course, whenever you raise money (even if it is convertible debt) you need to be aware that you are giving up a portion of your company. You may need the money, but equity is valuable, and you should protect it fiercely.

Equity is visualized/kept track of on something called a Capitalization Table (Cap Table for short). They are usually on an Excel spreadsheet, but more and more they are moving to online platforms like eShares.

Numbers and Excel spreadsheets can be super intimidating. But, founders, I encourage you to embrace the challenge and really understand your cap table. You should know it inside and out, and how different types and amounts of financing will change it. How well you understand your cap table will have far reaching consequences for the health of your company and your personal finances.

Unfortunately at the Clinic we see too many startups who take money from inexperienced investors and end up selling too much of their company too soon. While every company is different, here are some ballpark figures you should keep in mind:

  • Accelerators/incubators usually take somewhere between 5-10% of equity their portfolio companies for a combination of cash and services.
  • Angel/Series Seed investors should get somewhere between 15-33% of your company. The exact numbers depend on a number of factors, but if an investor is asking for more than 1/3 of your company at this early stage, that should raise red flags.

One of the best things you can do for your company and yourself is raise as little outside capital as possible. This means that you should bootstrap for as long as possible, and once you do raise money, be very diligent about how you use that cash so you can wait as long as possible before you raise more (if you raise more at all).

Companies that give up too much too early are in danger of scaring off future investors. When founders don’t own enough of their own company investors fear that founders, who are the heart and soul of the company, will no longer have incentives to work hard. We have seen this in several companies.

On the flip side, there are some recent success stories from the Ann Arbor ecosystem. While I won’t give away too many details for confidentiality reasons, there are some common threads. Each company raised a relatively small amount of capital (only a few million dollars, which I know sounds like a lot, but is tiny in this world). In every case the founders kept close track of their cap table and made sure they didn’t give up too much. When these companies sold, the majority of the purchase price went right to the founders, who still owned sizable (sometimes close to half) of the equity in their companies. When you are talking about acquisitions in the tens or hundreds of millions of dollars, every percentage point on the cap table is important. Many of those founders can now go on to be VCs, found another company, or never work again if they so choose.

So founders, don’t skimp on learning the ins and outs of your cap table, it will pay off in the long run!


A Primer on Bank Financing for Small Business

Small businesses may be financed in a variety of ways. Two of the most basic are through the investments of founders and key backers, and through loans provided by banks. Although bank loans are not appropriate for all small businesses, they can be a valuable lifeline for many. In order to receive such bank financing, the borrower will undergo a process called underwriting, which will rely on a few key considerations.


Underwriting A Loan

The primary task of a bank that performs commercial credit functions (loans for business purposes) is the underwriting of loans. Although this process varies from bank to bank, and may sound intimidating, it can be boiled down to a broad description helpful to entrepreneurs and small business owners. At its most basic, underwriting commercial credit is the process by which the bank will determine whether not to extend a loan to any particular party who requests it. What the bank is doing is making the decision of whether or not the requested loan is an appropriate risk for it to take on. This decision reflects a judgment about a few core criteria.

First, a small-business owner seeking bank credit should understand the goals of the bank, or other financial institution, from which they have requested a loan. A bank makes its profits primarily through something called its net interest margin. This metric is a simple calculation that attempts to quantify the difference between what a bank pays out to its depositors as interest on their accounts, and the amount that a bank receives from its borrowers on their loans. As common sense would suggest, a bank will only make money if it is able to charge its borrowers a rate of interest higher than it is paying to its depositors. This is not, however, the end of the story.

In addition to charging borrowers a greater rate of interest than it pays depositors, the bank will also need to account for the possibility that its borrowers do not pay back their loans at all — and therefore reducing the total amount it receives from borrowers as a group. This is the primary consideration a bank undertakes in its underwriting process. Put simply, if the bank does not believe that a small-business will be able to repay the loan, it will not enter into the transaction. This is why it is sometimes difficult for new start-ups and small businesses to get bank financing. Because the risk in a new venture is often hard to quantify, the bank will require extra assurances that it will be paid back, including with interest. These assurances come in a variety of forms, but the two below usuallyrepresent the most important considerations to a lender.


What A Bank Looks For

Cash Flow

A primary consideration in the underwriting process is the cash flow of the proposed borrower. There are a number of ways to calculate this figure, but one of the simplest is a measure called EBITDA (earnings before interest, taxes, depreciation, and amortization). What this accounting figure attempts to reflect is the actual amount of cash coming into and going out of a business. A bank will want this figure to be large enough that when loan payments are taken into account, the business will not struggle to fund its necessary operations.

This presents a challenge for start-ups in particular because they often do not have a history of cash flows at all, let alone a history of positive cash flows. Entrepreneurs often start businesses which will take months or even years to show profitability. Further exacerbating this problem, a bank will often require a borrower to be able to show at least a few years of positive cash flow, to reassure the bank that it will be paid back. Although this is often a disqualifying factor for many small businesses, as will be seen below, it may not foreclose the possibility of funding a business with bank loans.



Collateral means something specific in the context of banking. It refers to some other property the borrower commits to the lender as way of guaranteeing repayment. For example, in a simple transaction a borrower may grant the lender a lien or security interest on the business’s tangible property. Perhaps on the building in which the business operates, or on valuable equipment the borrower uses to create its goods. From the bank’s perspective good collateral is often essential in that it represents a kind of back-stop against possible losses in the event the business is unable to pay back its loan through cash flows.

From this description, it may already be apparent that good collateral may represent another way for a small business to gain bank financing, even in the absence of a history of positive cash flows. If the bank is satisfied that the collateral it holds against a loan will be sufficient to satisfy the debt, they are more likely to lend to a new-and-unproven enterprise. Examples of strong collateral include property whose value greatly exceeds the size of the loan requested, and such property as may be easily sold by the bank. The gold standard would be cash held at the bank financing the loan, because it has a readily-ascertainable value, and can be easily converted to satisfy the borrower’s debt. Therefore, even in the absence of positive cash flows, a small-business may be able to reassure the bank of repayment by committing adequate collateral.



For many new and emerging start-ups, bank financing may not be a realistic goal. However, for a business that has a history of positive cash flows, or one that has access to high-quality collateral, it remains a potentially valuable source of funding. It has the benefit of allowing the entrepreneur to retain ownership of their business (rather than selling part ownership to investors), and can provide a ready source of funds for the entrepreneur to invest back into the business. Through the process of underwriting, a bank will look at a number of factors to determine whether it wants to take the risk of extending a loan. Cash flow and collateral are only two considerations, but are often the most important to the lender.


The Basics of Debt-Based Crowdfunding



Attaining funds is a critical step for many entrepreneurs. Fortunately, innovative concepts like crowdfunding, where funds are collected from a large, dispersed pool of investors, have provided entrepreneurs with alternatives to traditional funding sources like financial institutions and venture capitalists. According to an industry report, in 2015, the global crowdfunding industry surpassed $34 billion in estimated fundraising volume. In conjunction with the increase in crowdfunding transactions, crowdfunding sites have multiplied. These sites come in a variety of different forms and provide entrepreneurs the ability to customize their funding campaigns. Common types of crowdfunding sites, in their simplest form, include:

Equity-Based – investors receive a portion of the company in exchange for funds

Reward-Based – investors receive goods or services in exchange for funds

Donation-Based – individuals provide contributions


While these three types comprise a large sector of the crowdfunding market, entrepreneurs and investors also commonly use debt-based sites, which accounted for $25 billion in estimated fundraising volume in 2015. In a debt-based crowdfunding transaction, rather than receiving equity in exchange for capital, investors receive a debt instrument, often in the form of a note or bond, with a fixed repayment term and a specified rate of interest. Most debt-based sites are free to register and require borrowers to submit financial information before receiving a customized interest rate and credit risk. Entrepreneurs favor these sites because the interest rates are often lower than or competitive with interest rates at traditional financial institutions. It is important to keep in mind that this type of crowdfunding campaign is not for every entrepreneur. Rather, it is particularly advantageous for entrepreneurs who have difficulty meeting market demand for their service or product.

Debt-based crowdfunding has been described as a “win-win” because it provides investors with a relatively low-risk return and entrepreneurs with the ability to retain equity. However, one inherent risk to investors is the fact that these loans are often unsecured and leave little recourse in the event of default. The growth of the crowdfunding industry has alleviated some of these investor concerns, as several debt-based platforms boast impressive track records. Three examples of such sites include:


Lending Club:

  • Founded: 2006
  • Total Amount of Loans (individual loans and business loans): Over $20 billion
  • Interest Rate Range: 5.32–30.99%

Funding Circle:

  • Founded: 2010
  • Total Amount of Loans: Over $2 billion
  • Interest Rate Range: 5.49–27.79%


  • Founded: 2006
  • Total Amount of Loans (individual loans and business loans): Over $6 billion
  • Interest Rate Range: 6.88–31.10%

It is undeniable that debt-based crowdfunding has experienced a dramatic growth over the past decade. Yet, citing a limited pool of investors and an influx of loan applications, critics warn that perhaps the “novelty” of debt-based crowdfunding is coming to an end. It remains to be seen whether this is the case.

For now, because the laws concerning crowdfunding remain in flux, entrepreneurs should stay informed. Visit the following links to learn more about crowdfunding:

CrowdFund Intermediary Regulatory Advocates

Crowdfund Insider


Crowdfund CPA


A Quick Primer on Title III Equity Crowdfunding: Drafting Your Term Sheet (Part 3 of 3)

Now that the SEC has passed its equity crowdfunding rules, it will be interesting to see if "market" terms emerge.

Now that the SEC has passed its equity crowdfunding rules, it will be interesting to see if “market” terms emerge.

While it remains to be seen how and to what extent crowdfunding will take off, here are a few things to keep in mind as you start thinking about possible deal terms on your first crowdfunding operation. I should note that ultimately, I anticipate that entrepreneurs will gravitate toward terms suggested by the most popular funding portals, and that these terms will become the market standard. Nonetheless, you’ll still have to come up with the economic and control terms of the deal yourself, and I hope this article helps you think critically about such terms as you do.

  • Valuation – Valuation is a function of the amount being raised and the percentage of the company being purchased. Current practices involve a negotiation between the investors and the entrepreneur, whereas crowdfunding will let the entrepreneur set the terms. In Venture Deals, Brad Feld and Jason Mendelson warn of setting your valuation too high due to the risk of not achieving a higher valuation at the time of your next round, causing dilution of your original supporters. While crowdfunding investors might not have the same anti-dilution protections as VC investors, there still might be risks from a subsequent down round due to the investors’ expectations going unmet. The takeaway here is to be reasonable in your valuation and have a solid plan on how you’re going to use your funds to build and create value in the business.
  • Number of Shares – Angel investing in seed rounds typically acquire between 20%-35% of the company—any more than that could hurt your ability to raise future rounds. Of course, with new types of companies entering the mix, common practices may not hold. Consider having your CFO use a <a href=””>pro forma cap table</a> to run through a few hypothetical future financing scenarios, and let where you hope to end up inform where you might start.
  • Protective Provisions – Freedman and Nutting anticipate a future in which funding portals may opt to allow investors to pool their funds into a single entity that could serve as an agent of the “CF class” and possibly negotiate a board seat. Until that becomes a reality in the U.S., you can expect investors to pay special attention to the veto rights they are given.In negotiated transactions, investors almost always have the right to vote when an issuer (1) alters the rights of the issued shares, (2) changes the authorized shares of common or preferred stock, (3) creates a new class of shares having rights, preferences or privileges senior to the issued shares, and (4) wants to merge or be acquired. I can’t imagine many investors signing up to invest without (1)–(3), but we’ll have to see how investors respond in a system in which the terms are set by entrepreneurs.Note that Section 4A(b)(1)(H) requires “a description of how the exercise of the rights held by the principal shareholders of the issuer could negatively impact the purchasers of the securities being offered,” so failing to treat your investors fairly will likely negatively impact the economic terms of your offering.
  • Drag-Along/Tag-Along Rights – Drag-along rights ensure that if you want to sell the company, you can compel other shareholders to sell their shares on the same terms. Tag-along rights provide corresponding rights for investors and ensure that they have the option to sell their shares on the same terms if you sell the company.Drag-alongs tend to be more controversial when they are being requested by investors in a new round, in which case they could force an entrepreneur to sell her company even if she didn’t want to. When being imposed on crowdfunded investors, they simply allow you to capture the full value of your equity in the event of a sale. You’ll almost certainly want them given the large number of shareholders inherent in crowdfunding transactions. It’s tough to think of a reason why you wouldn’t want to offer investors tag-along rights—which is likely why both drag-alongs and tag-alongs appear in the suggested term sheet on UK crowdfunding site Seedrs.

Of course, no deal is the same, and you should always work with an attorney experienced in this field when creating a financial offering.

Part 1 of this series is here and Part 2 of this series is here.


A Quick Primer on Title III Equity Crowdfunding: Is Equity Crowdfunding Right For Your Startup? (Part 2 of 3)

Even though equity-based crowdfunding is now legal, it might not be right for you.

Even though equity-based crowdfunding is now legal, it might not be right for you.

This is part 2 of our series on equity based crowdfunding.  Let’s take a step back from the brave new world of equity crowdfunding and think back to the existing model of getting early stage funding through networks of angels and VC’s. Hasn’t this system worked until now, and will startups be missing out if they stray from the beaten path?

We’d be remiss to forget that angels and VC’s provide more value than just capital. Experienced investors will challenge your assumptions and send you back to the whiteboard a few times before providing capital, which can ultimately improve your business outlook in the long run. Post-financing, these investors also serve as valuable mentors and advisors, providing expertise and a rolodex of people that can help your business blossom. And even though these investors are loathe to sign confidentiality agreements, you’re generally safe to meet with these folks with the understanding that your financials won’t wind up in the hands of a competitor. All this is to suggest that simply because you might no longer need the traditional conduits for seed capital, it doesn’t follow that they won’t be one of your better options.

But rather than compare crowdfunding to the traditional early-stage/seed model on the merits, it may be more accurate to think of it as opening up entrepreneurial finance to businesses that didn’t have much access before. In Equity Crowdfunding for Investors, David Freedman and Matthew Nutting predict that while crowdfunding will eventually attract all types of businesses, early adopters may be limited to certain types, such as consumer products businesses with a devoted fanbase, for-profit businesses supporting a social cause, community-based retailers with investors that have a direct connection to the business, and creative projects such as films, music, and games. Many of these might not quite qualify as a “homerun” to an angel or VC, but could still attract investment for a variety of reasons.

Here are a few questions to ask as you grapple with the question of whether to seek a Reg CF round:

  • How many rounds do you plan on raising in the future? Ideally, your first Reg CF round should be enough to get your project off the ground, and subsequent rounds will also be crowdfunded. I have personally heard one VC state that as of now, he would refuse to invest in a company with a large number of unaccredited investors. That’s not to say that this is a widely-held belief of VC’s or that the industry doesn’t stand to change; but if you anticipate seeking VC funding in the future, a crowdfunding round may be too much of a hindrance in the long term.
  • How competitive is your industry? Are you developing tech that will be the next big thing in virtual reality? The next cure for a heavily-researched disease? If confidentiality, trade secrets or other IP are a major concern, or the industry in which you operate is extremely fast-paced, you may want your investor profile to be as lean as your startup. While drag-along rights (discussed in Part 3) coupled with the founders maintaining control over the company may make receiving stockholder approval for major transactions less of an issue, you’ll want to think about how the disclosures mandated by Reg CF will affect your financing strategy.
  • How big do you plan on getting? Reg CF is overall, less burdensome. But if your company will someday be the size of Facebook (which it will be, of course), then the costs associated with other exemptions may not be a huge concern, all things considered. Of course, if the $1 million cap on Reg CF rounds simply won’t meet your needs, then you should certainly seek alternative exemptions rather than impede your business early on.

You can find Part 1 of this series here.


A Quick Primer on Title III Equity Crowdfunding: Starting-Up as a VC (Part 1 of 3)

The SEC's equity-based crowdfunding rules went into effect on May 16, 2016.

The SEC’s equity-based crowdfunding rules went into effect on May 16, 2016.

In the same way technology empowered anyone to become an entrepreneur, so too will it enable anyone to step into the shoes of a venture capitalist. April 5 marked the 4th anniversary of the JOBS Act’s signing by President Obama, but the final rules which implement Title III, which pertains to equity crowdfunding, went into effect on May 16, 2016.

While the creation of a more legitimate crowdfunding industry can be seen as a major step in the democratization of capital markets, it’s not as if the barriers to entry are being completely leveled—entrepreneurs and investors alike will still have to be conscientious of the investment restrictions, disclosure requirements, and other limitations before determining whether equity crowdfunding is suited to finance their ventures.

In this first part of this three-part series, we clarify some terminology for those completely new to the concept of equity crowdfunding and give a quick overview of the regulations themselves. In Parts 2 and 3, we’ll help you use some of this information to determine whether crowdfunding is right for your business and some things to think about when you raise your first round.


If you’re confused by the foregoing because you’ve been funding new ventures through Kickstarter for years, don’t feel bad; people often speak of “crowdfunding” generally without distinguishing between equity crowdfunding and other types.

Crowdfunding simply refers to the practice of funding a project through a large number of donors. In the past, people have initiated crowdfunding campaigns through platforms like IndieGoGo and Kickstarter in which donors typically receive certain perks or rewards for early presales or donations.

Equity crowdfunding involves the offering of equity securities to investors online. Investors purchase an actual ownership stake in the business entity with an intent to share in its financial returns and profits. It’s a close cousin of debt crowdfunding or peer-to-peer lending, which involves the offering of debt securities to groups of lenders online.  Debt crowdfunding sites like Lending Club and Upstart have already taken off.

In the U.S., the sale of securities implicates federal securities laws, as well as state “blue sky” laws. Issuers must either register their securities with the SEC or find an exemption (…or, face serious penalties).  Until recently, startups nearly always structured early stage offerings to fall under Reg D, a set of three rules—504, 505, and 506—which carve out exemptions to the registration requirements of the Securities Act of 1933, which we described in great detail in an earlier post. Because Reg D fails to provide startups a way to reach larger pools of investors, the SEC created another avenue by amending Regulation A (now referred to as Reg A+), as described in our prior post. Reg A+ allows companies to file a single, less costly registration with the SEC as opposed to one under each state’s blue sky laws, but given the need for audited financials (and a track record of legal, audit, and underwriting fees sometimes exceeding $1M), Reg A+ is not always suited to early/seed stage companies.

Enter Regulation CF

To fill the vacuum of ways for startups to raise seed capital from a large number of investors, Title III added Section 4(a)(6) to the Securities Act to create an exemption from registration for certain crowdfunding transactions.

Amounts Raised

Section 4(a)(6) sets a hard cap of $1M per 12-month period for any entity raising funds. This may seem low, considering that the median convertible note round last year was $1M, on the rise from years prior. However, it’s possible that the sort of crowdfunding enabled by Reg CF will itself change the way startups raise money by eliminating the need to pull together a syndicate of interested accredited investors and gather funding in a single transaction.

Investment Limits

The SEC doesn’t want you to get carried away as you start channeling your inner Mark Cuban. If you make less than $100,000, you can invest the greater of $2,000 or 5 percent of your annual income or net worth in a 12-month period. If you make over $100,000, you can invest up to 10% of your annual income or net worth (but in no cases greater than a total of $100,000) per 12-month period. Transactions must be done through an intermediary registered as a broker-dealer or a funding portal.

Entrepreneurs Who Can Stop Reading Now

Some companies aren’t eligible to use the Reg CF exemptions. These include:

  • Non-U.S. companies
  • Exchange Act reporting companies
  • Certain investment companies
  • Companies that are disqualified under Reg CF’s disqualification events (which include the conviction of crimes, court orders against engaging in the sale of securities, and other regulatory actions against the issuer)
  • Companies that have failed to comply with the annual reporting requirements under Reg CF during the two years immediately preceding the filing of the offering statement, and
  • Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Resale Restrictions

Securities purchased in a crowdfunding transaction generally cannot be resold for a period of one year. Investors should consider themselves in it for the long haul.


How will investors know what they’re investing in? Issuers are going to have to disclose in their offering documents information that includes:

  • Information about officers, directors, and owners of 20 percent or more of the issuer
  • A description of the issuer’s business and the use of proceeds from the offering
  • The price to the public of the securities or the method for determining the price
  • The target offering amount
  • The deadline to reach the target offering amount
  • Whether the issuer will accept investments in excess of the target offering amount
  • Certain related-party transactions
  • A discussion of the issuer’s financial condition
  • Financial statements of the issuer that are accompanied by information from the issuer’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor.

An issuer relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless they’ve already had their financial statements audited. Issuers are also required to file an annual report with the SEC and provide it to investors.

Check out Part 2 of our series here.


Pitching Investors: Watch for General Solicitation Rules

Securities laws may restrict how you discuss how your startup plans to raise money.

Securities laws may restrict how you discuss how your startup plans to raise money.

Many people think securities laws are only relevant to big companies in their billion dollar public offerings. Securities laws, however, are also relevant to your startup.

The general rule in the Securities Act of 1933 prohibits selling securities other than by means of a registration statement. Fortunately, the statue also provides certain registration exemptions for transactions that are not public offerings.

One critical concept under Regulation D is the general solicitation rule. Failing to comply with the general solicitation rule may cause a start-up to lose the exemption status. Under some circumstances, pitching your company could be deemed a general solicitation. Therefore, it’s critical for founders to pay attention to the Regulation D and the general solicitation requirements before pitching your company.

Safe harbors in Regulation D

Most startups rely on Regulation D, promulgated by the SEC as the exemption from the registration requirements of the securities laws. There are three main safe harbors in Regulation D – Rule 504, 505, and 506. Rule 504 and Rule 505 are less popular because the issuers have to comply with the securities laws in each state where they are selling securities (see previous post for more information of Rule 504 and 505).

The most commonly used exemption is Rule 506, which allows a company to raise an unlimited amount of capital from an unlimited number of accredited investors (see previous post for information of accredited investors). Rule 506 has two separate but related exemptions—Rule 506(b) and Rule 506(c). Rule 506(b) prohibits general solicitation while the new Rule 506(c), subject to a variety of conditions, allows offering through public advertising and general solicitation.

What is General Solicitation?

Regulation D doesn’t define general solicitation, but gives some examples of prohibited solicitations, including any advertisement published in any media (e.g., television, newspapers, magazines, Internet, radio, public seminars, or cold calls), and any meeting whose attendees have been invited by a general advertising.

When is a solicitation not general? The SEC interpreted the prohibition as requiring that the issuer (or a person acting on its behalf) has a “pre-existing relationship” with each offeree. Examples of pre-existing relationship including:

  • Use an outside agent, such as a broker, to serve as an intermediary
  • Use questionnaire to request investors providing self-verification regarding their financial status
  • Use password protection to prevent general public from accessing investment information on the website

The New Rule 506(c) Under the JOBS Act

On July 10, 2013, the SEC revised Regulation D to remove prohibition on general solicitation and general advertising in offerings and sales under Rule 506(c), provided that all purchasers of the securities sold in these offerings are accredited investors. The major differences between Rule 506(b) and Rule 506(c) are summarized in the chart below.

Rule 506(b) Rule 506(c)
Limitation on amount of capital raising Unlimited Unlimited
Type of investors Accredited investors and up to 35 non-accredited sophisticated investors Only accredited investors.
General solicitation Prohibited Allowed
Accreditation process Allow Self-certification Take reasonable steps to verify accredited investor status

Although Rule 506(c) allows general solicitation, which seems to be a huge advantage, there are several reasons an issuer may prefer to rely on Rule 506(b).

First, Rule 506(c) requires an issuer to take “reasonable steps” to verify that all investors in the offering are accredited investors. According to the SEC guidance, self-certification by investors, for instance questionnaires in which investors self-report their income or net worth, does not satisfy Rule 506(c)’s standard. Instead, issuers must generally request investors to provide tax returns, bank statements, or credit reports to demonstrate their income or net worth. Not only will this requirement add an additional administrative burden on an issuer, it may also alienate some investors.

More importantly, Rule 506(b) is a non-exclusive safe harbor. This means that an issuer can still use the general Section 4(a)(2) exemption under the Security Act if the offering fails to satisfy Rule 506(b)’s requirements. However, an issuer using general solicitation in reliance on Rule 506(c) does not have this fall-back option as general solicitation is prohibited by the Section 4(a)(2) exemption.

Finally, the SEC has also proposed to add new disclosure requirements to Rule 506 and Form D, which may offset Rule 506(c)’s Advantages. For example, the proposed rule requires a Rule 506(c) issuer to file an advance Form D at least 15 days before any general solicitation (instead of the current requirement, 15 days after the first sale). The proposed rule also requires an issuer to file the general solicitation materials, which must have specific mandated legends, with the SEC on or before the date of the general solicitation. These requirements may be difficult or impossible to comply with in practice.

If you do decide to rely on Rule 506(b), here are some tips to help avoid running into the general solicitation trap.

  • Limit offers and solicitations to persons with whom you have a “preexisting substantive relationship.”
    • When attending a pitch event, make sure the attendees are limited to persons with whom the event organizer has a pre-existing relationship or who have been contacted through a network that the event organizer can rely upon to create that relationship.
  • Avoid making “offer” to people you do not have a preexisting relationship.
    • To avoid making offer, only provide factual business information and do not include projections.
  • Monitor the activities of any agents or representatives to ensure that they are not performing general solicitations.
  • Prepare a list of likely investor targets as early in the process as possible and stick to it.
  • Be very circumspect in any interactions with the press.
  • Keep strict control over the dissemination of offering materials.
  • Use password protection and online questionnaires to prevent nonaccredited investors from accessing investment information on a website.
  • Review your website content.







Revisiting Regulation A+: A Few Considerations

Entrepreneurs should consider the risks and rewards of a Reg A+ offering. Image by Andrew Magil on Flicker. CC By 2.0 License.

Entrepreneurs should consider the risks and rewards of a Reg A+ offering. Image by Andrew Magil on Flickr. CC By 2.0 License.

The ability to successfully fundraise is typically a significant factor in an early technology venture’s success. While most seek to raise capital from a small number of wealthy individuals or institutions, such as angel investors or venture capital firms, entrepreneurs are increasingly seeking the ability to raise capital through larger groups of investors, each offering a smaller financial contribution. Until recently, startup financings have typically fallen under Regulation D, a set of three rules – 504, 505, and 506 – which carve out exemptions to the registration requirements of the Securities Act of 1933, as described in this prior post. However, “Reg D offerings” are not without limitations – offerings conducted under Rule 504 are capped at a modest $1M, while offerings under 505 and 506 significantly limit the number of unaccredited investors. Although still a popular option, Reg D offerings often do not give capital-starved ventures the ability to sell to a much larger pool of interested investors, especially one including unaccredited investors..

It is not surprising then that there was significant excitement within the entrepreneurial community when the SEC finalized amendments to Regulation A in June 2015. Similar to Regulation D, the existing Regulation A provided an alternative set of exemptions to the Security Act of 1933, but these exemptions did not include limitations on the number of unaccredited investors. However, prior to this recent amendment, due to the fact that Reg A offerings were capped to $5M per sale and subject to burdensome “blue sky” security laws of individual states where securities would be sold, Reg A offerings have failed to take off. The new amendments to Regulation A, dubbed “Regulation A+,” created buzz by raising the dollar limit from $5M to $20M and $50M for each of the respective Tier 1 and Tier 2 offerings. Combined with a new coordinated review process for Tier 1 offerings and blue sky law exemptions for Tier 2 offerings, Regulation A+ gives entrepreneurs the ability to raise much more per sale while bypassing the time and financial costs associated with blue sky law compliance.

Since June 2015, the SEC has received many filings and have qualified around a dozen sales to date. A few examples of recently qualified offerings include:

  • Sun Dental Holdings, LLC – A traditional dental device manufacturing company that also focuses on digital scanning, cloud-based data management system and 3D printing to produce dental devices.
    • Sun Dental filed and qualified a Tier 2 offering for $20 million (9/3/15 – 12/1/15).
    • Disclosed costs include $330K in legal fees, $380K in audit fees, and $950K in underwriting fees.
  • Groundfloor Finance Inc – An online investment platform designed to source financing for real estate development projects.
    • Groundfloor has had two Tier 1 offerings qualified, the first for $545K (3/23/15 – 8/31/15) and the most recent for $1.5M (10/7/15 – 10/29/15).
    • Disclosed costs for the first offering included $458K in legal fees, $30K in audit fees.
  • Elio Motors – An automobile company planning on manufacturing low-price, compact cars for a fraction of the price.
    • Elio filed and qualified a Tier 2 offering for $25M (8/28/15 – 11/20/15).
    • Disclosed costs include $110K in legal fees, $25K in audit fees.

While Reg A+ offerings have been gaining some traction, there are still significant obstacles in pursuing this financing option. Some issues entrepreneurs should consider before proceeding include:

  1. Cost. The first obstacle to Reg A+ has been the fees associated with completing and filing the application. While not as costly as an actual IPO, Regulation A+ still requires a dedicated team of lawyers and accountants to produce the offering circular and the financial statements (audited, if conducting the more lucrative Tier 2 offering). Recent filings have put legal fees anywhere from the low thousands up to $485K, and auditing fees typically add on another $20K to $30K. Due to the complexity of securities law and filing requirements, experienced counsel and the associated fees are essential to the process.
  2. Administrative Burden. In addition, the venture must be prepared to handle the administrative aspect of filing and selling securities under Regulation A+. Developing the substance of the offering circular will be time consuming, and companies conducting a Tier 2 offering will be on the hook for ongoing reporting requirements. For a leanly staffed team, the administrative burden might be a significant worry.
  3. Liability. Sellers of Regulation A+ securities are liable for any material misleading statement or omission made in an offering circular or oral communications, and anything said in the offering circular could be used in litigation down the road. As such, entrepreneurs must be careful to engage with experienced counsel in developing their circular.
  4. Impact on Future Investors. Experienced attorneys have brought up concerns surrounding the impact of introducing many unaccredited investors into a company’s cap table. There appears to be a consensus that VCs and other institutional investors tend to shy away from companies that have “crowded cap tables” because it can be difficult and risky to invest in a early-stage company with such a composition.
  5. Public Disclosure. Entrepreneurs will need to provide significant disclosures about their business and financials in its offering circular. This can sometimes be an issue for a venture that prefers to keep certain facts about its technology or financials internal until a more appropriate time.

While brimming with potential, Regulation A+ offerings can hardly be considered “easy money.” These very real obstacles are substantial, and should give any prudent entrepreneur pause to entertain other, more traditional financing methods. Those who do decide that they have the appetite to pursue a Regulation A+ offering should do so with ample resources, experience counsel, and a clear understanding of the difficulties involved in the process.


Convertible Equity – A New Hope?

YCombinator's SAFE documents are a popular mechanism for implementing a convertible equity financing arrangement.

YCombinator’s SAFE documents are a popular mechanism for implementing a convertible equity financing arrangement.

Over the past few years, financing for early stage companies has increasingly taken the form of convertible debt. Some estimates suggest that these notes are used in more than 2/3rds of startup seed rounds. Moreover, these notes may be collectively responsible for saddling thousands of startups with billions of dollars of debt. Ironically, very few players in the startup world anticipate these notes being repaid, but a number of founders and investors have expressed concern that these securities can potentially trigger significant consequences for a startup. Yet despite these shortcomings, convertible debt continues to enjoy prominence as a financing instrument primarily due to its expedient and affordable nature. Frustrated with the failure of the startup community to address this ailment, Adeo Ressi of the Founder Institute contacted Yokum Taku at Wilson Sonsini Goodrich & Rosati to try to create an alternative to convertible debt. In 2012, they proposed convertible equity as an alternative to debt financing. This alternative offers startups a new way to finance their company with the benefits of a convertible note while simultaneously eschewing some of its key drawbacks.

What is Convertible Debt?

Before exploring the benefits of convertible equity, it’s critical to understand why convertible debt is an attractive financing option for startups. Convertible debt is structured as a loan to the company by an investor that converts to equity in the company upon some future triggering event. Usually, this conversion occurs upon a “qualified financing,” in which the company raises a minimum, predetermined amount of cash in a Series financing. Sometimes convertible noteholders will negotiate valuation caps or discount rates to reward the investor for their risk in investing at such early stages. In this sense, convertible debt is meant to mirror traditional equity financing in many ways.

The allure of convertible debt primarily rests in how quickly these notes can be consummated without significant attendant legal fees. The entirety of a convertible note and its accompanying terms may be encompassed in a mere few pages. Moreover, convertible notes do not set a valuation on a company and can be negotiated independently with individual investors (i.e. a “rolling round”). As such, the legal costs are a fraction of the costs associated with a full equity financing.

What’s Wrong with Debt?

There are at least four issues with convertible debt that should give both founders and investors pause:

  • Maturation: First, convertible notes have a maturity date. Notes generally mature within one or two years of the loan’s issuance. In the best cases, when a startup fails to meet the note terms and cannot raise adequate funds in a qualified financing, the entrepreneurs must return to investors in order to renegotiate the loan terms. In a worst-case scenario however, investors can demand repayment of the loan. If even one investor demands repayment, it can trigger catastrophic effects for the startup that has to use much-needed funds to repay an investor. Finally, certain state laws require individuals to register as lenders if they extend loans for more than a year, imposing potential greater costs on the investors as well.
  • Interest: As a debt instrument, convertible notes also have an interest rate. While the interest is generally converted to equity upon a qualified financing, some have questioned whether levying interest rates on startups are appropriate from an optics perspective if the investors are genuinely acting as investors and not lenders. Additionally, managing various interest rates across different investors can be challenging and take away valuable product development time.
  • Insolvency: Former lawyer turned investor, Jason Mendelson, also highlights a potential consequence of convertible debt that has not received much attention in the media. Since convertible notes are debt, companies should recognize them as liabilities. Yet, because convertible debt usually converts to equity, few people actually recognize it as a liability on their balance sheets and financials. When properly recognized as a liability however, convertible debt may incidentally put many startups into insolvency immediately upon receipt, since few seed stage companies have any assets of significant value to offset these liabilities. In some states, courts impose additional duties and personal liability on directors towards creditors when a company is insolvent.
  • Creditworthiness: Finally, closely related to the insolvency issue is how convertible debt may impact startups creditworthiness. Again, because convertible debt is a liability, startups may have problems receiving credit lines or borrowing from traditional institutions if their balance sheets appear to be saddled with significant liabilities.

Convertible Equity

 Convertible equity is a type of security that seeks to remedy the aforementioned issues attendant with convertible notes. Generally speaking, convertible equity is a contractual arrangement wherein the investor agrees to contribute money to the startup in exchange for some future equity upon a qualified financing. Convertible equity functions similarly to convertible notes but eliminates two critical features of convertible debt: maturity dates and interest rates. The effect of eliminating these two aspects of convertible debt are best seen by considering the same factors that hamstring convertible debt:

  • Maturation: By eliminating the repayment feature, the threat of an investor demanding repayment and derailing the startup disappears. Investors no longer risk becoming lenders under most state law regimes, and founders can focus on developing products and services.
  • Interest: Without interest, startups don’t have to spend time managing complex financials and cap tables to keep track of various interest rates across noteholders. Philosophically, eliminating interest aligns these securities more closely with traditional equity financing as well, an initial inspiration for the creation of convertible debt.
  • Insolvency: Convertible equity can likely be recognized as equity on a company’s balance sheet, eliminating the risk of insolvency and unintentionally heightened duties owed to creditors. According to its creators, there may even be tax benefits if the securities can be qualified as qualified small business stock.
  • Creditworthiness: Finally, while it is unlikely that convertible equity can be used to significantly enhance a startups credit profile, it does not pose the same threat of harming a startup’s creditworthiness by saddling its balance sheets with liabilities.

Convertible equity can also be outfitted with most, if not all of the additional characteristics and rights of convertible debt such as valuation caps and discount rates. It can also include many of the rights offered in equity financing rounds, although negotiating these extensively would run up legal costs and mitigate any potential benefits for using convertible equity. Most importantly, because convertible equity is modeled after convertible debt, the deals can be completed just as quickly and cost effectively.

Is it right for you?

Despite emerging only three years ago, convertible equity shows signs of promise for many early stage ventures. There is at least one estimate that nearly 25% of recent early stage deals have used convertible equity, and in 2013 Y Combinator promulgated a set of convertible equity documents they dubbed the SAFE agreement (simple agreement for future equity). Yet, despite the increasing prominence of convertible equity, founders should still question whether pursuing this type of financing will be beneficial.

In making this choice, the considerations should be similar to those that arise when choosing between conventional equity financings and convertible debt. Is limiting the time expended raising funds important? Are you trying to minimize your legal fees? How sophisticated are your investors, and will they insist on negotiating for extensive rights as part of the financing? If expedience and cost are significant factors, convertible equity poses an attractive alternative to convertible debt for all of the above reasons.

The last hurdle startups may face is in convincing investors that are inexperienced with this form of financing that it’s a safe, viable alternative. As accelerators like Y Combinator move towards this model, more startups will find it easier to have this conversation with their investors, but convertible equity is still nascent. For this reason, startups in communities with more developed legal and VC practices such as those in Silicon Valley may find it easier to make the shift to convertible equity. With time however, I believe this form of financing will be more appropriate than convertible debt in many, if not most instances for early stage financings.


Venture Capital Firms and Non-Disclosure Agreements

Many VC's will refuse to sign non-disclosure agreements.  Should this concern you?

Many VC’s will refuse to sign non-disclosure agreements. Should this concern you?

Traditionally venture capital firms looking to add potential portfolio companies have been unwilling to sign non-disclosure agreements (“NDA”) during initial discussions with entrepreneurs about their technologies and execution strategies. This unwillingness from VC firms to sign NDA’s stems from a number of reasons, including: (1) minimizing their susceptibility to legal action, (2) avoiding restricting their investments in a particular industry sector, (3) avoiding conflicts of interest, (4) avoiding wasting their time and resources, and (5) VC firms deem NDA’s unnecessary because VC’s realize the negative consequences to their firm’s reputation should they improperly use proprietary information provided to them by entrepreneurs.

Potential Investor Liability

A large reason VC firms have been hesitant to sign NDA’s with any potential portfolio companies is because of the fear that such NDA’s would expose them to potential lawsuits over disclosed information. Investors at VC firms typically look at a number of similar pitches and similar technologies from different startups all within the same industry. Thus, investors fear that signing NDA’s with any one startup will limit the investors’ ability to fund any startup company without exposing the investors to legal action. Additionally, because of the sheer amount of pitches heard by investors from the multitude of startups within the same industry, investors lack the internal resources to adequately monitor compliance with multiple NDA’s signed with these multiple startups. Thus, most VC firms have opted out of signing NDA’s with startup companies because of the risk that doing so could open their firm to a breach of contract due to the large amount of similar technologies looked at in certain industries.

Building a Portfolio

Closely tied to this issue of minimizing legal liability VC firms in the past have stayed away from signing NDA’s out of the fear that signing such agreements would restrict investors’ ability to make informed and strategic investments in multiple startups within the same industry. The strategy used by VC firms is to build a portfolio by investing in multiple startup companies within a certain number of industries (normally high-tech). VC firms build these portfolios in the hope that a few of the many startups invested in will be successful and bring a rate of return high enough to compensate for the many startups invested in by the VC firm that will fail. Investors fear that signing NDA’s would hinder their ability to build portfolios and realize returns on their investments, and because of this they generally refuse to sign such agreements. If VC firms were forced to sign such NDA’s there would likely be a lot less cash available to entrepreneurs, and the startup climate in the United States would suffer.

Potential Conflicts of Interest

VC firms have also been reluctant to sign NDA’s in the past because of the potential conflicts of interest posed by these agreements. Investors in VC firms many times serve as advisory roles or are on the boards of directors of their portfolio companies. In such a capacity these investors may have a fiduciary duty to disclose information and opportunities to these portfolio companies, but could be prohibited by the NDA from disclosing such information to other portfolio companies.

Reducing Transaction Costs

Along with potential conflicts of interest, NDA’s require a good amount of time and money to negotiate the terms that will go into these agreements. Because investors in VC firms meet with a large number of potential portfolio companies, the amount of time and money needed to draft and specifically tailor NDA’s for each startup would be overwhelming. Thus, investors have traditionally felt that it would not be feasible for them to sign NDA’s for potential portfolio companies because the time and money put into doing this would outweigh any benefit derived from them. And lastly, a side argument posed by VC firms is that if the firms’ investors ever did steal confidential information from a potential portfolio company, such an act would damage the firm’s valuable reputation to the point that any benefit derived from the confidential information would be negligible.

Some Exceptions to No NDA’s

Despite all the reasons for why VC firms generally do not sign NDA’s when sifting through potential portfolio companies, there is commentary suggesting that VC firms are increasingly open to targeted use of NDA’s.  NDA’s are more common for VC firms investing in life sciences or material sciences companies where disclosure of highly sensitive, yet discrete, formulas, compositions, and clinical data is necessary. A few years ago, many VC firms increased their focus in later-stage portfolio companies.  This is likely a result of VC firms attempting to avoid risk in building their portfolios. This trend has resulted in VC firms being more willing to sign NDA’s with these later stage companies. This is because VC firms are dealing with sophisticated companies who have developed detailed trade secrets that are more reasonably subjected to confidentiality obligations. These later stage companies are more sensitive about disclosure of their proprietary information and may not want to proceed with talks prior to execution of an NDA. It is likely these later stage companies have more bargaining power when shopping for VC funds. Thus, VC firms are more willing to sign NDA’s with these later stage companies in an attempt to get them to the table.

Additionally, there has emerged a heightened competition between VC firms for the hottest and most profitable deals. As a result, investors are more willing to deviate from traditional practices and sign an NDA in order to attract sought after startup companies. Also, newer VC firms who are less likely to rely on their firms’ fledgling reputations have been more willing to open up and sign NDA’s as a way to garner the trust and support of potential portfolio companies.


Now it’s more likely because of the changing VC landscape both externally, in the form of increased competition, and internally, in the form of later stage investments in potential portfolio companies for investors in VC firms to be more willing to sign NDA’s when looking for companies to invest in. Overall though, it is still standard practice for VC firms to not sign NDA’s when looking for potential portfolio companies to invest in. This in the long run will create value for both entrepreneurs and investors alike because (1) the transaction costs avoided by not having to negotiate NDA’s likely results in savings being passed on from VC firms to entrepreneurs, (2) the decreased legal liability for VC firms who need to build a portfolio of startup companies to stay in business and be profitable, and (3) the increased availability of funds available for entrepreneurs because of such VC firms decreased legal liability. Therefore, VC firms not signing NDA’s pose benefits for entrepreneurs and investors alike. However, every VC firm and investor varies in their personal preference and practice. It would be best to do independent research on any potential investors to find out what their personal policy is about signing NDA’s before beginning talks with a startup.