Buzz

Coping with Poor Corporate Hygiene in the Early Stage Company (Part I)

Dan M. Mahoney, Snell & Wilmer, LLP and Jim Thornton, Managing Director, Guide Ventures


A venture capitalist's portfolio is comprised of many companies, varying in stages of development and value creation. A minority of these companies may unknowingly conceal major deficiencies that can seriously impact the quality and timing of a future financing or liquidity event. From an external perspective, they appear on track-a new CEO with an impressive pedigree, a transformational technology platform and an untapped market. Internally, however, catastrophe lurks due to an early set of bad decisions. The inexperienced VC needs to be operationally involved to detect these "Trojan Horses."

Poor corporate hygiene manifests itself in a number of ways-excessive generosity with equity, unconventional corporate structure and poorly negotiated licensing arrangements, to name just a few. However, these symptoms do not have to sound the death knell for a portfolio company. What follows is a discussion of examples of poor corporate hygiene and the remedies that were employed.

Excessive Generosity with Equity

Equity is the emerging company's staple alternative to traditional consideration or compensation. Despite the continuing controversy over expensing stock options, it remains a primary recruiting tool for early stage companies. Likewise, corporate partners, customers, suppliers, and lenders sometimes seek to obtain equity, usually in the form of warrants, in lieu of traditional cash compensation or as an equity "sweetener." A startup that issues excessive equity equivalents with senior and preferential rights during its formative stages presents a VC with formidable, but not insurmountable, issues.

For example, one recent software startup compensated its lenders, landlord, and suppliers with warrants and restricted stock grants. The warrant recipients were savvy enough to extract very favorable terms: the right to receive new warrants to purchase the securities sold in the startup's first preferred stock financing; registration rights that were on parity with any registration rights granted in the future and that were devoid of any underwriter or company cutback option; preemptive rights on any future equity offerings; and negative covenants.

This was a difficult, if not untenable environment for the VC to operate in. For example, the VC would be pari passu with the warrant holders on liquidation preference as a result of the warrant holders right to receive new warrants to purchase the same securities the VC received in the financing. Additionally, questions arose as to whether the right to receive cumulative dividends inured to the warrant holders prior to actually exercising their warrants. Finally, the warrant holders' excessive registration rights would take seniority over the new preferred stock due to the warrant holders' inability to be cutback. Whatever the outcome, the VC faced a diminution to its anticipated returns.

Additionally, the VC could not be assured that the warrant holders' interests would be aligned with its own or the VC's syndicate of investors. For instance, a majority of the preferred holders would have to approve a sale of the company. The VC was comfortable with this threshold based upon its familiarity with the investing syndicate. However, the warrant holders would have the ability to exercise their warrants and dilute the preferred equity base, thereby requiring a greater number of preferred shares to approve the transaction. More disturbing to the VC was the fact that the warrant holders already possessed certain veto rights owing to their status as warrant holders. The company and its original counsel had not been careful in tying such veto rights directly to the ownership of stock rather than the derivative security itself.

The VC was also concerned about the fact that some warrants had been issued to the company's more promising and larger customers. The company would be receiving its first set of audited financials within six months. The VC was aware that in certain cases the value of a warrant that is issued to a customer might be deemed a rebate to the customer, precluding a company from booking all proceeds from the customer as revenue. The VC was concerned about the potential impact on the income statement and how it would affect the company's ability to obtain additional customers. Moreover, the VC was concerned about the "genuineness" of the revenue from such customers and whether the sales would be recurring in the absence of additional warrants.

The greatest concern to the VC was the fact that the warrant holders, unlike the VC and the other preferred investors, held preferential rights, or at least were assured of such rights, without having to make the current investment. This "call," coupled with the diminution in returns and the cloud created by various novel and unresolved issues, produced a true "deal killer" for the VC.

The VC and its counsel considered a number of solutions. The VC could demand that the warrant holders give up their preferential rights and be content with common stock warrants or the VC could accept the proposed scenario and simply reduce the company's pre-money value. Another approach was to provide the warrant holders with new warrants to acquire a preferential class of common stock that would be junior to the preferred stock but senior to the regular common stock in liquidation.

Ultimately, the warrant holders retained their right to acquire the preferred stock but with a number of "clean ups," as well as a delayed financing. The strike price would be the preferred stock purchase price to avoid any anti-dilution triggers and adverse "cheap stock" accounting issues. Furthermore, all rights attendant to the status of warrant holder (e.g., registration rights, preemptive rights, and veto rights) would be terminated. The warrant holders would have to exercise their warrants to benefit from any preferential rights. This provided an incentive to exercise and make their capital contribution. In a further attempt to mute the objectionable "call" right, the cashless exercise provision was removed from the warrants. These concessions were acceptable to the warrant holders as a result of their ability to ultimately benefit from the liquidation preference and the infusion of much needed capital from a sophisticated new partner.

Another example of a startup being careless with its equity was a genomics startup that structured a "discovery royalty" arrangement with its founder. Under this arrangement, any future discovery that was either created by the founder or was the residue of an earlier discovery of the founder and ultimately used by the startup would generate royalties to the founder that could be taken in either cash or equity at a significant discount to the last round of financing.

The VC in the startup's first institutional round was obviously troubled by the founder's third-party position with respect to his own company, as well as the unpredictable level of dilution that could be created by future discoveries should the founder elect to take his royalties in equity. Moreover, the discount at which the founder would receive his equity was a non-starter for the VC. Finally, the VC did not want to see its investment being used to buy innovation from a company insider who was purportedly "along for the same ride as the VC."

Again, the VC and its counsel discussed a range of solutions. The solutions ran the gamut from requiring the founder to terminate the arrangement altogether and contribute any new discoveries to the company to maintaining the arrangement but deleting some of the more onerous provisions, such as the discount from the last sale price on the equity election or even requiring the equity to be taken at a premium.

In the end, the VC decided that it was uncomfortable with a founder and key innovator having a sweetheart deal. The founder agreed to terminate the arrangement and sign a discovery and inventions assignment agreement that transferred to the company the rights to all past and future discoveries related to the business.

The founder had been reluctant to make this concession in the past due to what he felt was an inadequate ownership stake. As a quid pro quo, the VC agreed to allow a significant option grant to the founder upon the financing and approved a consulting agreement with the founder that provided for periodic formula option grants over the next five years.

A good scrubbing of a potential portfolio company's capitalization will often turn up troubling equity arrangements. It may also produce the existence of derivative securities and other equity deals that may have been previously unaccounted for, whether by former officers or the result of "side letter" arrangements that are quickly forgotten. Once found, an analysis of the impact should be made and a number of remedies considered.

Unconventional Corporate Structure

Emerging companies will too often have unconventional corporate structures. For example, a medical device client formed itself as a limited liability company (LLC). The structure was chosen due to the early angel investors' familiarity with the LLC structure and the flow-through nature of any losses. The VC that was brought in for the initial round of institutional money required a conversion to a traditional C corporation as a prerequisite to funding. From the VC's standpoint, the LLC was a poor investment vehicle for a number of reasons:

  • As a "pass-through" entity for corporate level tax purposes, the LLC presents problems for VC's with ERISA considerations or foreign limited partners that wish to avoid trade or business income;
  • LLC interests or "units" cannot qualify as "small business stock" under Internal Revenue Code Sections 1202 or 1045. Only stock issued by a domestic C corporation qualifies as "small business stock," allowing the investor to exclude from gross income 50% of the gain on a sale or exchange or defer the gain by rolling over the proceeds into replacement small business stock;
  • It is cumbersome to create the complexities of a multi-tiered capital structure involving common stock and preferred stock, as well as the use of options for compensatory purposes; and
  • The LLC structure presents unconventional corporate governance principles, such as a determination as to whether the entity will be member-managed or manager-managed, who the manager will be, where a traditional board or advisory structure fits in, and who has ultimate fiduciary responsibility.

Fortunately, the transition from an LLC to a C corporation is an easy and relatively inexpensive process. For Delaware companies, the process has been simplified by statute. Delaware-domiciled LLCs are authorized to merge into, or consolidate with, a Delaware or foreign corporation with relative ease.

With the client being domiciled outside of Delaware, however, an alternative approach was required. New counsel was introduced to advise the company on the most appropriate method of conversion. They discussed a contribution of the LLC's assets to the newly formed C corporation in exchange for stock or, alternatively, a distribution of the LLC's assets to the LLC members who would then contribute the assets to the C corporation for stock. These approaches, with their focus on a transfer of assets, are often taken in an attempt to leave behind unwanted liabilities or "skeletons." Unfortunately, the new entity is sometimes deemed to succeed to liabilities of the old entity under an amorphous successor liability theory.

On the advice of counsel, the company ultimately formed a new C corporation and merged the LLC into the new entity with the founders receiving shares of stock in exchange for their membership units. With an eye towards prosperity and zeal to oblige new money, the founders were more than willing to forego the pass-through losses from the LLC structure.

This week, Dan and Jim continue the discussion relative to the potential benefits, but more important the likely costs, of short-sighted corporate partnering, bad licensing and how ineffective boards can negatively impact early stage companies.

© 2002 Dan Mahoney and Jim Thornton

Dan Mahoney is an attorney with the Phoenix office of Snell & Wilmer LLP. His practice is concentrated in business and finance, with a focus in securities, venture capital, mergers and acquisitions and corporate compliance. Mr. Mahoney regularly works with clients ranging from small start-ups and emerging growth businesses to large publicly held corporations. He can be contacted at 602-382-6384 or dmahoney@swlaw.com.

Jim Thornton, co-founder and Managing Director at Guide Ventures, is focused upon early stage investing within the Information Technology and Life Sciences sectors for the Western United States. He concentrates on operational issues within startups as well as actively assisting entrepreneurs in team building and strategic partnering. A member of the board for Bocada Corporation and Biopsy Sciences, Jim can be reached at 520-577-0954 or jim@guideventures.com.