New England Biz Law Update
The last few months have taught us a few things about financing and selling companies. Below are some current developments.
Single purpose entities
Many lenders attempt to prevent business borrowers from seeking bankruptcy relief, thus protecting their contractual collection provisions. The use of single purpose entities to achieve this result is standard for certain loans, including syndications.
As a matter of public policy, federal law does not permit a borrower’s waiver of the right to seek bankruptcy. However, it does require proper internal debtor procedures to authorize bankruptcy. The history of SPEs involves the use of state procedural law to insure that a borrower cannot declare bankruptcy.
The simplest method establishes a board including a lender representative, or a director independent of borrower, and requires unanimous authorization. The risks include the independent director voting in favor of bankruptcy as his fiduciary duty, a problem sometimes circumvented by procedures to replace recalcitrant independent directors.
Another method requires unanimous consent of all equityholders, including an equityholder designated by the lender. In the Lake Michigan Beach case (North Dakota Bankruptcy Court in April of this year), the borrower’s LLC operating agreement expressly absolved everyone from any fiduciary duties. The court ruled that the waiver of fiduciary responsibility violated Michigan law stating that LLC members owe fiduciary duties to the entity. A bankruptcy vote that did not include the vote of the lender-designated member was held effective.
In Delaware, parties are permitted to negate fiduciary duties by contract. In June, the Bankruptcy Court (Intervention Energy Holdings) considered a Delaware LLC that specifically waived fiduciary duties, as permitted by state law. If the learning of the Lake Michigan Beach case were applied, the refusal to consent to a bankruptcy filing on the part of a single Delaware unit holder might block bankruptcy under state law.
The court expressly declined to consider the Delaware statute, ruling broadly that any governance scheme permitting creditors to prevent a bankruptcy filing is “tantamount to an absolute waiver of that right” and is thus void as contrary to federal public policy.
Given the force of Delaware decisions, it is difficult to anticipate how a lender can create a truly bankruptcy-remote Delaware entity again.
Financing startups
Financing startups ought to be getting easier. The SEC, under pressure from Congress, recently facilitated capital formation.
SEC Rule 506(c) allows general solicitation of accredited (wealthy) investors; SEC rules effective this year permit crowdfunding from retail investors; offerings under an easier “registration” scheme now known as Regulation A+ has theoretically opened up larger flows of capital.
For successful startups, a robust private securities market for purchase, and resale, of equities also has developed; some larger tech enterprises do not even bother with going public but rather continue to raise funds (and permit exits) in this unregulated environment.
In December 2015, Congress passed the PATH Act, which made permanent significant tax breaks for small business stock profits under IRC §1202, excluding from tax, AMT and the Obamacare 3.8 percent override all profits on the sale of small business stock held at least five years.
It has always been true that enterprises must raise capital based on their own business merits. However, companies remain impacted by marketplace forces. Two potential sleeper developments that may have unexpected an impact on capital formation are:
- Historically, payment for health care was based on services (fees for seeing patients, providing pharmaceuticals, running tests). The health care industry is now moving toward a “value-based” model whereby payment is based on net treatment outcomes. Against this revised screen, companies are being met with different investor questions. The emphasis no longer is whether there is a reimbursement code for particular deliverables, but rather on demonstrated likelihood of improved overall patient outcomes.
- According to the Association for Capital Growth, capital-intensive businesses must consider the risk of changes in the federal tax code eliminating corporate interest deductions. Such action could materially alter projections for profit, and underlying cash needs, of an emerging enterprise.
Finally, emerging companies must deal with their “pre-money valuation,” utilized by investors to calculate their equity percentage. There are numerous stories of absurdly high valuation for companies with no sales in a hot vertical but, outside of these few high-flying companies, enterprises must defend their pre-money valuation to control dilution of existing shareholders.
In this ongoing debate, commercially available valuation matrices are wielded to justify specific valuations, which valuations are objectively unknowable absent market-established value. Nor can the value ascribed to an enterprise in prior financings be dispositive, as new investors may claim they should not be burdened with the lack of financial judgment of their predecessors.
These valuation models address potential size of marketplace, value added by a company’s product or service, a projection of market penetration, benefit to customers, robustness of marketing plans, projected revenues, gross margins and competition. There are often questions concerning protection of intellectual property, entrepreneurial experience, prior investment in sweat and money, and outside professional advisors.
What was startling about the Dell decision, which by the way could cost Michael Dell and his take-private group many millions, was that the court did not even consider the deal price.
About notes and SAFEs
Because valuation is so elusive, startups recently have utilized mechanisms that do not require a present valuation. These mechanisms are convertible notes or SAFEs.
A convertible note is an unsecured, interest-bearing promissory note made by an issuer, convertible into equity upon a subsequent capital investment (when theoretically investors will have a better idea of value).
As a reward for making capital available at an early time, convertible notes are granted a discount, 10 to 30 percent, from the new pre-money valuation. This discount is dilutive of the equity. It is the founders or early “friends and family” investors who absorb this dilution; the new money will invest based on its own pre-money valuation, and all the other equity interest will share the dilutive effect.
There are only two possibilities: The emerging company is successful or it is not. If the company is not successful, collection of the note is dubious. So the convertible note effectively is equity that has not yet been priced. On the plus side, since the note is debt, it has a liquidation preference ahead of the equityholders.
Although convertible notes enjoy a discount in the next financing, investors should insist on a “valuation cap,” a ceiling on the future pre-money valuation at which the notes may convert. Otherwise, noteholders run the risk of having their equity numerically swamped by a very large subsequent round of financing at high valuation.
Some startup companies are fearful of issuing convertible notes that mature before the next financing round. The SAFE is, in effect, a contract that converts into equity in much the same circumstances as a convertible note, and has a priority in liquidation, but there is no interest and no maturity date and SAFEs can last indefinitely. (There may be tax issues relative to SAFEs, a subject beyond this article’s scope.)
Pricing a sale
In May, the Delaware Chancery Court ruled on the acquisition of Dell’s stock in a going private transaction. Setting the stage: the Delaware corporate statute, as do corporate statutes in virtually all states, creates a right of “appraisal” for shareholders who do not vote in favor. By refusing to assent, equityholders have statutory rights to have fair value set by the court (even if the transaction attracted the assent of the vast majority of other equityholders).
What was startling about the Dell decision, which by the way could cost Michael Dell and his take-private group many millions, was that the court did not even consider the deal price, at which the vast majority of Dell shareholders had agreed to sell their stock. The court itself went through its own process of valuation de novo and reached its own much-higher judgment as to fair value.
While Delaware courts approach management-related transactions such as Dell with heightened scrutiny, nonetheless this was the first Delaware decision in a long time to upset deal price as not representing fair market value.
The court noted that there was no breach of fiduciary duty by Michael Dell or other management, stating that the deal price would “sail through” the court if application of fiduciary standards alone were the only criterion.
In future sales transactions, the question remains as to the shape of Delaware law. To what extent will a de novo analysis, such as performed by the Chancery Court in Dell, be undertaken in an ordinary case? Or, what if, for example, existing insiders do not lead an acquisition, or are given a carried interest in the new enterprise, or senior executive positions, or robust noncompetition agreements or employment agreements, or stock options, or an opportunity to buy back into the deal at the same price as the acquiror?
The degree to which the Dell opinion is encapsulated in unique facts (the valuation failing to reflect the transition of Dell’s core business into smart phones and tablets while Dell’s historical market in personal computers was shrinking) remains to be seen.
Conclusion
The first half of 2016 was one of great flux. Court-driven, market-driven and legislative changes significantly affected lending practices, capital formation, and risks in pricing company sales. Stayed tuned.
Stephen M. Honig practices at Duane Morris.
