Should you provide anti-dilution protection for your equity investors?

Should you provide anti-dilution protection for your equity investors?

Anti-dilution protection is a set of provisions that you can include in your governing document (articles or certificate of incorporation) that are designed to protect equity investors in the case of a reduction in the price of your stock.

Before we talk about anti-dilution protection, we first need to talk about conversion rights.  Conversion rights are the right of your preferred investors to convert their preferred stock to common stock.  Why would they want to do this?  When the company is sold, the buyer generally will want to buy common stock, so at that time, preferred shareholders would convert to common in order to receive their share of the proceeds of the sale of the company.

When you offer preferred stock to investors, they often come with the right to convert the preferred stock to common stock on a 1:1 basis.  So, if an investor has 100,000 shares of preferred stock, they can convert those shares to 100,000 shares of common stock.

Anti-dilution protection is a mechanism that changes that ratio in the case of a decrease in the value of the preferred stock.

There are different formulas that can be used to adjust the ratio.  A very commonly used formula is called the Weighted Average method.  The following formula is used to provide an adjusted number of shares that one share of preferred stock converts into, with the idea that one share of preferred stock will convert into more than one share of common stock as a way to protect the early investors from losing all of the value of their initial investment:

CP2 = CP1 x (A+B) / (A+C)

Where:

CP2    =     Conversion price immediately after new issue

CP1    =     Conversion price immediately before new issue

A        =     Number of shares of common stock outstanding immediately before new issue

B        =     Total consideration received by company with respect to new issue divided by CP1

C        =     Number of new shares of stock issued

Here is an example to illustrate how this works:

When you first start your company, you issue 2 million common shares to the founders.  Then, let’s say you raise $500,000 from investors by offering preferred stock at $1 per share.  One year later, you raise $1,000,000 at $0.80 per share (meaning you sell 1,250,000 shares).

CP1 = $1

A = 2,000,000

B = $1,000,000/$1 = $1,000,000

C = 1,250,000

So, the new conversion price =

1 x (2,000,000 + 1,000,000)/(2,000,000 + 1,250,000) =

1 x (3,000,000/3,250,000) = $0.92

This means that the first preferred stock investors now convert into 1.09 shares of common stock ($1.0 /$0.92 = 1.09).

So, if the company is sold and those investors convert into common, they will get a larger share of the total proceeds from the sale than they would have if there were no anti-dilution protections.

Should you offer this protection to your preferred equity investors?

If you think it is likely that you may sell your company someday and the proceeds from the sale will be an important component of how your investors will be compensated, anti-dilution protection is a nice way to provide some protection to your early investors.  More sophisticated investors might insist on it.

On the other hand, these provisions can be rather complicated and require you to keep track of conversion ratios that might change if you raise more than one round of equity funding.  If you don’t foresee a sale of your company, it could make more sense to leave out provisions related to conversion of preferred stock to common altogether.

If you would like to become an expert on investment terms and other topics related to fundraising for your business, join our Capital on Your Terms Community!  For details, click here: https://www.jennykassan.com/capital-on-your-terms-community/

New rules—New possibilities!

New rules—New possibilities!

The Securities and Exchange Commission has made some changes to the rules governing private offerings of securities.  These are some of the biggest changes we’ve seen in a while and many of them will make fundraising much easier! The new rules are expected to go into effect by February 2021. Note that none of these rules pre-empt state law, so it is always necessary to determine whether applicable state laws may limit the usefulness of these new rules.

Integration

The integration doctrine seeks to prevent an issuer from improperly avoiding registration by artificially dividing a single offering into multiple offerings, such that Securities Act exemptions would apply to the multiple offerings that would not be available for the combined offering.  In practice, the integration doctrine often results in us telling our clients that they must have a six-month quiet period between two types of offerings. The SEC has done away with all of the old integration rules and created a new rule that will make things a bit easier for anyone doing a series of offerings under different rules. The new rule creates some “safe harbors,” which, if you comply with any of them, you don’t have to worry about your offerings being integrated.  Below are two of the more important safe harbors:

  1. If two offerings are separated by 30 days they won’t be integrated, provided that for an exempt offering for which general solicitation is not permitted, the safe harbor would require either: (i) that the purchasers were not solicited through the use of general solicitation, or (ii) that the issuer established a substantive relationship with the purchasers prior to the commencement of the offering.  Where an issuer conducts more than one offering under Rule 506(b), the number of non-accredited investors purchasing in all such offerings within 90 calendar days of each other would be limited to 35.
  2. An offering made in reliance on an exemption for which general solicitation is permitted will not be integrated with a previous terminated or completed offering. 

If none of the safe harbors apply to your situation, there is a general principle that you may be able to use.  The general principle under the new rule is that offers and sales will not be integrated if, based on the particular facts and circumstances, the issuer can establish that each offering complies with an exemption from registration. However, there is a caveat related to whether one of the offerings involves public solicitation.  For example, let’s say you start with a Rule 506(c) offering (which permits public solicitation) and then you stop that offering and switch to an offering under Rule 504 (which does not permit public solicitation).  In that case, you can only avoid integration of the two offerings if you have a reasonable belief, based on the facts and circumstances, that none of the purchasers in the Rule 504 offering were solicited through public solicitation or that you have a substantive relationship with each purchaser that was established before you started the Rule 504 offering.

General Solicitation

Exemption from General Solicitation for “Demo Days” and Similar Events  The new rules provide that certain “demo day” communications will not be deemed general solicitation.  This means that if you are conducting an offering under Rule 506(b) (which prohibits general solicitation) for example, you can go to a demo day that meets the requirements of the new rule and tell the people in attendance that you are raising money without worrying about whether you are violating the rules against general solicitation. The event sponsor must be a college, university, or other institution of higher education; state or local government; a nonprofit organization; or an angel investor group, incubator, or accelerator.  The event sponsor is not permitted to: 

  • Make investment recommendations or provide investment advice to attendees of the event
  • Engage in any investment negotiations between the issuer and investors attending the event
  • Charge attendees of the event any fees, other than reasonable administrative fees
  • Receive any compensation for making introductions between event attendees and issuers, or for investment negotiations between the parties
  • Receive any compensation with respect to the event that would require it to register as a broker or dealer under the Exchange Act, or as an investment adviser under the Advisers Act

Advertising for the event may not reference any specific offering of securities by the issuer, and the information conveyed at the event regarding the offering of securities by or on behalf of the issuer is limited to: 

  • Notification that the issuer is in the process of offering or planning to offer securities 
  • The type and amount of securities being offered
  • The intended use of the proceeds of the offering 
  • The unsubscribed amount in an offering

Online participation in the event is limited to: (a) individuals who are members of, or otherwise associated with the sponsor organization (for example, members of an angel investor group or students, faculty, or alumni of a college or university); (b) individuals that the sponsor reasonably believes are accredited investors; or (c) individuals who have been invited to the event by the sponsor based on industry or investment-related experience reasonably selected by the sponsor in good faith and disclosed in the public communications about the event. 

Testing the Waters:  The new rules create some ways that a business can “test the waters” with potential investors before doing any legal filings.  This means that you can talk to potential investors about your offering and gauge interest and solicit feedback before doing the legal work required to formally launch your offering.  There are two new rules for testing the waters—one applies to the situation where you still don’t know what exemption you plan to use for your offering, and the other one applies when you plan to use Regulation Crowdfunding.

Generic Testing the Waters Exemption—before you know what exemption you want to use

This new rule allows you to tell potential investors that you plan to raise money and ask for their feedback.  You must provide the following disclosures to anyone you talk to: (1) You are considering an offering of securities exempt from registration under the Act, but have not determined a specific exemption from registration you intend to rely on for the subsequent offer and sale of the securities.  (2) No money or other consideration is being solicited, and if sent in response, will not be accepted. (3) No offer to buy the securities can be accepted and no part of the purchase price can be received until it is determined which exemption will be used and, where applicable, the filing, disclosure, or qualification requirements of such exemption are met.  (4) A person’s indication of interest involves no obligation or commitment of any kind.  Under the new integration rules, you will not be able to follow a generic solicitation of interest that constituted a general solicitation with an offering pursuant to an exemption that does not permit general solicitation, unless you have a reasonable belief that the purchasers were not solicited via general solicitation or you have established a substantive relationship with them.

Regulation Crowdfunding Testing the Waters Exemption

Under the current rules, you are not allowed to tell anyone that you are raising money under Regulation Crowdfunding until you have filed your Form C.  Under this new rule, you can talk to potential investors to gauge their interest as soon as you decide that you want to do a Regulation Crowdfunding campaign. You need to provide everyone you talk to with the following disclosures:

  • No money or other consideration is being solicited, and if sent, will not be accepted. 
  • No sales will be made or commitments to purchase accepted until the Form C offering statement is filed with the Commission and only through an intermediary’s platform. 
  • Prospective purchaser’s indications of interest are non-binding.

Regulation Crowdfunding Offering Communications 

The new rules slightly expand what you are allowed to say during your Regulation Crowdfunding campaign.  The rules now explicitly permit oral communications with potential investors and expand the information you can provide outside of the platform to include:

  • A brief description of the planned use of proceeds of the offering
  • Information on the issuer’s progress toward meeting its funding goals

Rule 506(c) Verification Requirements 

This is a very minor change that is helpful for anyone who does more than one offering under Rule 506(c) which requires you to take reasonable steps to verify that all of your investors are accredited.  If you do more than one 506(c) offering in a 5-year period and someone from the first offering wants to invest in the second offering, you don’t have to re-verify their status as accredited as long as they provide a written representation that they continue to qualify as an accredited investor and you are not aware of information to the contrary.  

Harmonization of Disclosure Requirements 

Participation of Unaccredited Investors in a 506(b) Offering:  Under the current rules, you are allowed to have up to 35 unaccredited investors in a Rule 506(b) offering.  In practice, very few businesses allowed any unaccredited investors in these offerings because the disclosure requirements are increased if you make the offering to even a single unaccredited investor and the disclosure requirements include an audited balance sheet which most businesses don’t have.  Under the new rules, if you are raising up to $30 million under Rule 506(b), you will no longer need to provide an audited balance sheet, although the disclosure requirements are still relatively extensive.

Proposed Amendments to Simplify Compliance with Regulation A:  These are a handful of technical rule changes to make Reg A filings easier.  They address things like whether you are allowed to redact sensitive information from contracts included in Reg A filings and simplification of other filing requirements.

Offering and Investment Limits

Reg A:  The maximum offering amount under Tier 2 of Reg A is being increased to $75 mill.  The maximum offering amount for secondary sales under Tier 2 of Regulation A is being increased from $15 million to $22.5 million.

Rule 504:  The offering limit is being increased from $5 million to $10 million. 

Reg CF:  The offering limit is being increased from $1.07 million to $5 million. Investment limits no longer apply to accredited investors—in other words there is no cap on how much an accredited investor can invest in a Regulation Crowdfunding offering. Unaccredited investors may rely on the greater of their income or net worth in calculating their investment limit (under the current rule they had to rely on the lower number). 

Crowdfunding Vehicles

The new rules authorize a new type of entity called a “crowdfunding vehicle.”  This is a special type of entity that can be used when a company conducting a raise under Regulation Crowdfunding wants to avoid having all of its crowdfunding investors having a direct investment in the issuer.  The issuer can form a crowdfunding vehicle and the investors invest in the vehicle rather than the issuer.  The vehicle then becomes the owner of the securities in the issuer.

5-Day Challenge:  Create a Golden Opportunity for Investors

5-Day Challenge: Create a Golden Opportunity for Investors

We just wrapped up a LIVE 5-day challenge—Create a Golden Opportunity for Investors: How to Design a Win-Win Investment Offering.

It was awesome! Hundreds of people joined the challenge where we taught how to design a customized investment offering.  Here’s what they learned:

Day 1—We talked about why it’s so important to design your own offering and how to lay the groundwork to ensure you design the right offering for you.

Day 2—We went over the three basic types of investment offering and how to choose which one you want to offer.

Day 3—We explored how your investors can get paid—spoiler alert: you don’t have to grow fast and hustle for a fast exit!

Day 4—We reviewed the pros and cons of giving investors any control and what that can look like. We also talked about tools to motivate faster and larger investments.

Day 5—We pulled it all together and talked about how designing your offering fits into the larger strategy for raising the right money from the right investors—in a way that lets you stay true to your mission and goals.

It’s not too late to check out the training! The videos and worksheets are still available for FREE for a limited time. Get immediate access to the challenge—start today by signing up here.

How to Make Investing in Your Company a Golden Opportunity

How to Make Investing in Your Company a Golden Opportunity

You’ve built a company with a promising future. You’re ready to start looking for funding. You know there are some folks out there (maybe your customers, suppliers, neighbors, values-aligned supporters, etc.) who will be interested in learning more about the opportunity to invest in your company.

That’s great! But at some point you need to tell them EXACTLY what they will be getting for their investment dollars.

The piece of paper that describes exactly what your investors are entitled to can be called by various names: investment offering, investment instrument, or security. There are many different kinds of offerings, some more commonly known than others. Examples include preferred stock, LLC membership units, convertible notes, revenue-based debt instruments, and SAFEs. Within each category, there are numerous choices to make. For example:

  • Will investors have voting rights and, if so, what specifically can they vote on?
  • How much time can go by before your investors receive payment?
  • How are payments to investors calculated?
  • Are any payments made as the company grows or only when you sell the company?
  • Do all investors have the same rights, or do some have the right to get paid before others?
  • Do you have to set a valuation on the company and, if so, how do you set it?

The options for how your offering can be structured are limitless.

A poorly structured offering can create years of misery when you and your investors butt heads over misaligned expectations, while a well-structured offering can be a win-win for all the stakeholders involved—you, your employees, your investors, your customers, and the long-term success of your business.

So, how do you design a win-win investment offering? We like to break it down into a step-by-step process:

  1. Get clear on the goals, values, and non-negotiables that will inform the design of your offering.
  2. Choose one of the three main categories of offering (equity, debt, or convertible) and make sure it fits with the legal and tax structure of your your business.
  3. Decide on your investors’ rights to get paid—when and how much will they make on their investment.
  4. Decide whether to give your investors any control and, if so, what kind.
  5. Decide whether to offer any perks, in addition to the investment itself, as a way to motivate larger and faster investments.

If you’d like help designing your offering, please watch for our upcoming announcement on a FREE 5-day challenge—Create a Golden Opportunity for Investors: How to Design a Win-Win Investment Offering. During this challenge, we will give you bite-sized lessons and quick daily assignments that will culminate in your having a customized investment offering drafted.

Sign up for our newsletter below to make sure you receive details on how to join the challenge.  

VIDEO: COVID-19 – How has it impacted the world of crowdfunding?

VIDEO: COVID-19 – How has it impacted the world of crowdfunding?

Check out this great video featuring our client Mike Loyd of Dope Coffee who successfully raised funding using Investment Crowdfunding during the pandemic.

Watch the video here: https://youtu.be/tpq1yulOQNg