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© MORRISON & FOERSTER LLP 2016 | mofo.com
Late Stage Private Placements
December 2016
Capital-Raising Dynamics
2
• Although the aspect of the JOBS Act that has received the most attention relates to changes to the IPO process, in large measure, the JOBS Act related changes affecting the private market may be more significant.
• Title V and Title VI changes to the Exchange Act Section 12(g) threshold
• Changes to Rule 506
• Legal certainty for matchmaking platforms
• Taken together, these measures have the effect of permitting companies to stay private longer and to rely on exempt offerings (while enabling companies to contact a broader range of potential investors) for their capital-raising.
The JOBS Act and private offerings
3
• Even pre-JOBS Act, based on various studies, it was already the case that more capital was being raised in reliance on Regulation D and Rule 144A (in aggregate) than in SEC-registered offerings—according to the SEC’s Division of Economic Research and Analysis (DERA), in 2014, for example, the total raised in registered offerings was $1.35 trillion whereas the total raised through all private offerings was $2.1 trillion
• Amounts raised in private offerings are likely to be understated given that many issuers fail to file Form Ds and amounts raised in 4(a)(2) offerings are not reported
• The amounts raised in registered offerings include debt offerings, whereas the majority of Reg D offerings involve equity or “new capital”
Reliance on private or exempt offerings
4
• These trends became more pronounced in 2015 and 2016
• Companies are choosing to defer their IPOs and rely on private financing for much longer than in the past
• This is evident from various IPO reports
• For example, based on statistics for the period from 1/1/12 through 11/17/16, the median market cap for IPO issuers was approximately $386.5 million, and the average was $1.3 billion
• Fewer than 2.3% of IPO issuers have a market cap of $50 million or less
Reliance on private or exempt
offerings, cont’d. 5
• According to various reports, including the Wall Street Journal, there are now at least 169 private companies valued by venture capital firms at $1 billion or more
• Uber has been able to raise significant amounts (reportedly $5 billion) in private financings, giving it a value of close to $62.5 billion
• Many privately held companies have been able to raise capital from “cross over investors” (as we will discuss later) that traditionally invested only in IPOs and in publicly held companies
• These companies, often referred to as “unicorns,” have a median valuation after their most recent investment in 2015 of $2 billion (CB Insights)
• However, various sources report that the pace of unicorn formation has slowed and the pace of investment in unicorns has subsided
• 2016 has proven challenging for venture-backed technology IPOs. In the third quarter, 14 venture-backed companies went public, raising $1.04 billion, and creating over $5.7 billion in public company market value (National Venture Capital Association and PitchBook)
Venture-backed companies delaying IPOs
6
• Venture-backed companies raised more in the private market ($8.8B) than the public market ($894M) in the second quarter of 2016 (National Venture Capital Association & Thomson Reuters)
• Venture-backed tech companies’ total average funding ($182M) and median funding ($105M) are up 64% and 42% from last year (CB Insights 2016)
• 56% of startups eyed acquisition by a larger company as the long-term goal compared to just 17% that still want to go public (Newsweek/Silicon Valley Bank 2016 Survey)
Venture-backed companies
delaying IPOs, cont’d. 7
Market Trends
8
U.S. LATE STAGE ACTIVITY BY QUARTER
Market Trends
9
Market Trends, cont’d. 10
Recent high profile pre-IPO private placements
11
$500M $1.5B $526M
$1.0B
$367M
$350M
$275M $300M
$366M
$1.81B
$794M
$5.6B
• There are a number of dedicated late-stage investors, some of which were once only IPO investors. These investors believe that by investing in a late-stage or pre-IPO private placement, they will be able to benefit from an “IPO bump” in valuation and have secured a significant position in the stock.
Frequent investors in late-stage private placements
12
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Why undertake a
late-stage financing
13
• There may be a variety of different motivations for a late stage or pre-IPO private placement
• Company may want to defer IPO and need to raise additional capital prior to the IPO
• Company may want to take out early friends & family and angel investors and “clean up” balance sheet or provide partial liquidity for longstanding holders
• Company may want to bring in strategic investors
• Company may be advised that it should prepare itself for the IPO by gaining support and validation from key sector investors that are opinion leaders
Rationale
14
• Company and bankers may want to “de-risk” the IPO by bringing in cross-over investors that will also invest in the IPO
• Company may be advised that an up round will make higher IPO pricing easier for IPO investors to accept
• May be quite sector dependent
Rationale, cont’d 15
Late Stage Investments
16
• Typically made into existing, relatively mature companies
• Proven product viability
• Exhibits signs of increasing adoption and revenue growth
• Cash flow is dependable
• Past initial hyper-growth period and reasonable to expect sale or IPO within 12 – 24 months
Late stage investment characteristics
17
• Larger and more diverse groups of existing shareholders
• Founders, current/former management, employees, seed, family, high net-worth, early stage institutional venture and professional angels
• Each group has different levels of involvement, varying rights and protections tied to equity and divergent objectives for investment
• Founders/management may be significantly diluted by investment — need to create alternative incentives for them
• Start-up, seed investors may desire quicker exit at lower valuation
Late stage investment
characteristics, cont’d. 18
• Late stage equity
• Typically equity deals based on the previous A-D series of preferred
• However, later stage deal can depart greatly from venture
• Can be greater upside depending on liquidation preference
• Key is calculation of preference, whether there is participation and whether/how many additional rounds to exit
Types of securities
19
• Alternative is to take debt that looks like equity and includes:
• Interest payments to match PIK dividends
• Mandatory prepayment on trigger events to match redemption rights
• More financial control in terms of covenants
• Possible security interest in assets of issuer
• Convertibility features and warrant coverage
• Complications involve intercreditor/subordination issues with other lenders, particularly financial institutions
• Less up-side, particularly in IPO, and therefore utilized more in pre-sale transaction
Types of securities, cont’d. 20
• Common stock versus preferred stock
• “Growth equity” almost always preferred stock with preference on liquidation
•Basis for preferred stock is previous series with departures in later stages for:
• Conversion rights
• Liquidation and participation with common stock in remainder (usually capped)
• Dividend rights more often accrued and cumulative
• Board representation and approval is also critical (look for over-representation of early series with lower preference trigger for returns)
• Control of triggers for drags and tags
Types of securities, cont’d. 21
• Common stock used for companies with simplified cap structures and if very close to exit (particularly IPO)
•Depending on valuation and prior preferences, can give investor larger % and return
•Can be used to “top up” ownership percentage after purchase of company issued securities (particularly through secondary)
Types of securities, cont’d.
22
• Liquidation preference of the investor’s preferred stock
• Typically senior to all other outstanding classes or series of common stock and preferred stock
• Sometimes pari passu to an existing series of preferred stock, particularly if the investment is priced as a flat or up round (using the same or higher pre-money valuation as the previous financing round)
• Typically includes all accrued and accumulated dividends in the liquidation value of the preferred stock
• Usually participating (sharing in any residual liquidation value of the common stock on an as-converted basis)
• If participating, is generally not capped in a down round investment, but usually capped (by dollar amount or multiple of return on investment) in a flat or up round investment
Liquidation preference
23
• Dividend terms for preferred stock:
• Typically accrue a fixed dividend on the original liquidation value, with the dividend rate typically higher than in early stage deals (which typically have lower fixed dividend rates if they accrue a dividend at all)
• Are more likely than those in an early stage deal to be payable periodically in cash and, if not, are usually cumulative, unlike those in early stage deals, which are usually non cumulative even when they do accrue a dividend. In addition, the cumulative dividend is often compounding (earning a dividend on the accrued dividends) on a quarterly or annual basis (whether or not declared by the board)
Dividend rights
24
• Often allow accumulated dividends to be convertible into common stock or, in some cases, are payable in cash on conversion (rather than forfeited on conversion as with many early stage deals that have cumulative dividends)
• Participating, with the right to share pro rata on an as converted basis in any dividends paid on the common stock
Dividend rights, cont’d. 25
• Specific issues for late stage private placements include:
• Price for late stage investor that triggers rights — particularly if have to pay a much higher valuation
• Full ratchet versus weighted average — can negotiate full ratchet if high valuation; however, this is very unusual; previous investors usually require weighted average using same formula as previous rounds
• “Pay to play” — much less common in later stage rounds (unless down-round) but may be required as condition to consent from early investors; if don’t participate, then lose anti-dilution protection: late stage investor more likely to receive anti-dilution rights in such cases
Anti-dilution rights
26
• Exempt securities — issuances that trigger anti-dilution; much more heavily negotiated in late stage; issuer often desires to use equity in acquisitions and third-party partnerships without triggering anti-dilution
Anti-dilution rights, cont’d 27
• High valuations at later stage yield minority investments and therefore protective provisions are usually stronger
• Negotiate to include strong affirmative covenants
• Financial and other information delivery rights
• Registration rights and rights in M&A
• Redemption rights
• Negotiate to include strong negative covenants
• Specify the actions that the company may or may not take without specific vote of the class
Protective provisions — charter/contractual
28
• Usually include all of the “ordinary course” provisions from venture – related to sales of company or assets, bankruptcy, expansion of option pool, IPO or sale
• Expanded to include financial covenants, addition of debt, acquisition strategy, partnerships, management changes, etc.
• Contractual remedies for failure particularly with affirmative covenants – e.g., right to take over board if fail to redeem
Protective provisions —
charter/contractual, cont’d 29
• Right of first refusal (“ROFR”)
• Mirrors rights of previous investors to have the right to buy when designated stockholders sell
• Issues around percentage trigger for stockholders who are subject to the right
• Usual threshold is 1-5%; however, if retain same threshold, (a) aggregation of sales can have material impact and (b) may exclude senior management (if you don’t want them to sell out) because of dilution in round
• Late stage investors typically not subject to ROFR
Participation rights and restrictions
30
• Right of first offer
• Typical right to have securities offered by the issuer first to investors prior to third parties
• With later stage, because of lower % and higher valuation, can also include a right to buy-up to maintain ownership percentage in all securities issuances (including those that would previously be exempt)
• Particularly important because of use of equity in M&A and partnerships and for employee/management consideration
• Pricing is the key given typically high valuation for late stage (i.e., do the purchases outside of financings need to be at the investment valuation)
• Also make sure to add “evergreen” true-up provision to provide flexibility in terms of timing and deal terms
Participation rights and
restrictions, cont’d 31
• Right of first refusal
• Somewhat unusual for late stage investor to be subject to ROFR (and offer first to company and other investors)
• Investor does not want to limit liquidity options
• Will push for rights to purchase when others sell to maintain % ownership
• Tag-along
• Almost always secure tag-along rights in M&A
• Drag-along
• Almost always negotiate for rights to drag other investors
Transfer restrictions
32
• Late stage investor will not want to be subject to the drag except under certain conditions; negotiate for control to approve the transaction that triggers the drag rights
• Alternative is protective provision - blanket right to approve sale (or more likely sale below dollar threshold to return liquidation preference)
• Consider who else is required to trigger drag (what stockholders groups/classes are required – effectively a block on sale)
Transfer restrictions, cont’d. 33
Involvement by Strategics
34
• Transfer to “competitors”
• More heavily negotiated definition of competitors to whom investor may not transfer—current and future competitors
• Negotiated “update” rights to list of competitors
• Related – negotiation of the right for strategic investor to make investment in competitors of company
• Particularly important to issuer if investment is coupled with strategic partnership
• Key is definition of competitor – by type of product and/or by name – and update rights over time
• Also negotiation regarding steps to be taken if investor buys into a competitor either directly or indirectly
Transfer and investment restrictions
35
• Stand-still provisions more common in M&A transactions
• Sometimes asked of investors in late stage deals, particularly of strategics
• Investor is obligated to refrain from actions that relate to acquisition of control of the issuer including making proposals to acquire the issuer, buying shares, or launching a proxy contest
• Exceptions
•Negotiated sale
•Agreed-to-limits
•Other investor action
Stand-still provisions
36
Other Considerations
37
• How much to rely on work of previous investors in diligence
• Careful to distinguish between strategic and financial investors given risk profile and desired outcomes
• Timing of last investment and composition of investors
• Usually include more detailed representations and warranties and disclosure schedules
• Longer operating histories
• More “material” agreements, partnerships, joint ventures
• More complex balance sheets
Representations & warranties
38
• U.S. regulatory compliance – issues like privacy and environmental matters
• International compliance – issues like FCPA
• Intellectual property issues
• Indemnification
• Unusual in early stage because issuer has few assets and founders would need to guarantee indemnification obligations
• Much more common in late stage; protects against the downside and provides increased incentives for full disclosure
Representations & warranties,
cont’d 39
• Typical conditions — differences from traditional VC deal
• Early stage has fewer “outs” while closing conditions for late stage may more closely resemble M&A
• Regulatory compliance (e.g., anti-trust waiting period)
• Preemptive rights waivers (separate from consents)
• Material adverse change/effect on issuer
• Bring-down of reps and which ones will provide “out” if there is a change
•Depends on company and industry
• Legal opinion issues
Closing conditions
40
• Termination provisions/termination fees
• More likely to include fees to cover expenses and to serve as deterrent to sale of issuer during interim closing period
• Particularly important if combined with strategic deal
Closing conditions, cont’d 41
• NDA subject to public company disclosure requirements
• NDA for strategic partnership vs. investment
• Carve-outs for:
• Confidential information provided to Board representative
• Related information learned from other parties (particularly other Portcos)
• Residuals
•Ability to use residuals to develop competing products
• “Residuals” defined as in material in the “unaided” memories of employees who have access to the confidential information
• “Unaided” if employee does not intentionally memorize or retain
Confidentiality issues
42
• Info Rights/Access = back-door standstill
• Insider trading considerations
• Back-door standstill in M&A
• Section 16
• 5-10% ownership (13G)
Confidentiality issues, cont’d 43
• Private company issues
• Board seat or observation rights?
• May have confidentiality issues with board seat if equity investment is combined with strategic partnership
• Need to carefully consider composition of board – particularly given approval of M&A – and incentives of early investors, particularly in event of liquidation event
• Often necessary to push for removal of certain board members so early investors do not have too much control in M&A
Board seat
• Secondary purchases — often combine investment directly in issuer with purchase in secondary directly from existing stockholders
• “Cross-purchase” structure
• Less cash from investment available for company
• Typically purchase of common stock from management and employees to provide liquidity
• Can also purchase preferred from previous investors particularly those that need exit given LP demands
•Note issues particularly with liquidation preferences and other terms not desirable to late stage investor
Secondary purchases
45
•Can’t change charter rights of class but can change contractual rights
• In contract rights, particularly important to ensure that you can bundle secondary shares with primary securities for co-sale, tag and registration rights
Secondary purchases, cont’d 46
• Disclosure and process issues under the tender offer
• Use of third-party platform (e.g., Nasdaq Private Market) but administrative hassle
• Not subject to tender offer rules but important that it be “fair” particularly if insiders are selling
• Information prepared by the issuer and included in OTP but investor effecting the purchase and taking
• Note issues with options (net exercise feature)
• Issues with international stockholders/employees — tender offer rules in different countries
Tender offers
47
• Mitigate risk through indemnification
• Also need true-up in company issued securities recommended as opposed to allowing a “double dip” by participants
• Risks mitigated further by purchasing directly from issuer and requiring issuer to effect tender
Tender offers, cont’d. 48
Material Non-Public Information
and Valuation Issues
49
• Generally, most market participants associate concepts of “insider trading” with publicly traded securities
• However, the prohibition on insider trading stems from Rule 10b-5, which, by its terms, is not limited to “public” companies
• How should private companies think about insider trading and the information that they make public or that they are required (contractually) to share with certain parties?
• Information requirements?
• “Regulation FD” parallels?
Insider trading
50
• What constitutes “current information”?
• What can we learn from information requirements applicable to other exempt offerings?
• Should private companies implement trading windows?
Insider trading, cont’d 51
• How are the shares of privately held companies valued and who is responsible for valuations?
• The IPO prices for many companies that have gone public have been lower than the prices at which these companies had last raised capital privately and lower than the prices at which secondary private transactions were completed
• Private companies also have been able to raise money at higher premiums than their direct competitors who are public
• What does this suggest, if anything?
• Are investors no longer applying a “liquidity discount”?
• Is the premium associated with the liquidation preference that typically accompanies preferred stock rounds only?
Valuation
52
• In IPOs, investment banks in pricing the IPOs and IPO investors demand an “IPO discount” (“IPO underpricing”)
•When VCs or “cross over investors” participate in successive private financing rounds, often they can negotiate for themselves downside protection, including protection should the company go public at a lower valuation—but what about participants in secondary private markets?
Valuation, cont’d. 53
Valuation, cont’d. 54
• Many analysts also have noted that the fact that few unicorns are being purchased in M&A transactions suggests some skepticism regarding valuation levels
• There have been approximately 20 over $1 bn acquisitions of private tech companies this year, but only 2 involved unicorns
Valuation, cont’d 55
• Can the late stage investor/fund face any liability in connection with valuation issues?
• Is the investor buying newly issued shares or shares from an existing holder?
• Is the existing holder selling to the late stage investor sophisticated? Can s/he evaluate the company and its value as well as the late stage investor?
• What information is available to the existing holder? Does the late stage investor have more information? Better information?
• Will the late stage investor be shaping the IPO? Influencing the IPO price?
Valuation, cont’d. 56
IPO Dynamics
57
• Timing between the private placement and the IPO
• Are expectations aligned between the late stage investors and the company?
• What if the timeline for the IPO is extended?
• Will the late stage investors need liquidity? Will other existing stockholders of the company or employees require liquidity?
• Valuation issues
• As discussed, most late stage private placements include provisions providing for IPO price protection
• How will this work in a volatile market? What if IPO price is almost certainly less than the private price?
• How is the new valuation determined?
Preparing for the IPO
58
• Well recognized cross-over investors may be helpful in promoting the issuer’s interests when dealing with the IPO bankers
• Will cross-over investors participate in the IPO?
• Ideally, the pre-IPO round investors will be the “anchor orders” in the IPO
• No ability in the U.S. to obtain and secure cornerstone investors
• Only two options: either obtain an indication of interest from the cross-over investor that can be disclosed in the IPO prospectus, or do a concurrent private placement to the cross-over investor at the IPO price concurrent with the IPO
• Maybe more uncertainty with the indication of interest option if the market remains volatile and IPOs price below stated ranges
Preparing for the IPO, cont’d. 59
• Did the cross-over investors receive confidential information during the pre-IPO process? Has that information been disclosed in the IPO prospectus? Are they cleansed of material nonpublic information?
Preparing for the IPO, cont’d. 60
