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Legal Issues for Accelerators

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Discussing the Legal Issues Accelerators face. This includes compliance, liability, and regulations.

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Legal Issues for Accelerators

  1. 1. Legal Issues for Accelerators Royse Law Firm Silicon Valley, San Francisco, Silicon Beach rroyse@rroyselaw.com www.rroyselaw.com Skype: roger.royse Twitter @rroyse00
  2. 2. Lease vs. License Leases A lease is an agreement in which the landlord agrees to give the tenant the exclusive right to occupy real property, usually for a specific term and, in exchange, the tenant agrees to give the landlord some sort of consideration. A lease transfers to the tenant a leasehold interest in the real property and, unless otherwise provided in the lease, a lease is transferable and irrevocable. Licenses A license gives the permission of the owner to an individual or an entity to use real property for a specific purpose. Unlike a lease, it does not transfer an interest in the real property. It is personal to the licensee and any attempt to transfer the license terminates it. It is (usually) revocable and can be either exclusive or non- exclusive. A facility use agreement (FUA) is a short form license for very limited use of a facility.
  3. 3. Lease vs. License Lease License Characterize Bilateral Unilateral Conveys an interest in real property? Yes No Revocable Usually No Usually Yes Transferable Yes No Exclusive Right Yes Optional
  4. 4. Regulatory Compliance There are countless federal, state, local, and foreign regulations which may impact your business now or in the future. Unsuccessful Precedents: - Coding House - Trump University - ITT Educational Service
  5. 5. Accelerators should consider obtaining insurance to protect the business from unforeseen and expensive accidents or natural disasters Considering Liability Insurance Accelerators should protect themselves against tort liability arising from accelerator licensees and guests using accelerator property and following accelerator advice. Tort Liability Fraudulent & Misrepresentation Breach of Contract Be careful with advertisement materials and representations made to participating companies. Accelerators may be found in breach of contract just like other businesses.
  6. 6. The Core Economics Equity (2-8%) Additional Investments Example Common Stock Preferred Stock Stock Options Convertible Debt Warrants SAFE Instruments
  7. 7. Ancillary Covenants » Information Rights » Anti-Dilution Rights » Approval Rights » Pre-emptive Rights » Investment Rights
  8. 8. (Investment) Convertible Debt v. Warrant
  9. 9. Compensatory Options » Tax of Compensatory Options/Warrants is governed by SEC. 83 » Compensatory: Property received in connection with the performance of services » “No readily ascertainable value” If the option is not actively traded on an established market, the option is not considered to have a readily ascertainable Fair Market Value when granted, unless all of the following conditions exist: – The option is transferrable by the optionee; – The option is exercisable immediately by the optionee; – The option or the property subject to the option is not subject to any restriction or condition that has a significant effect on the FMV of the option; and – The FMV of the option privilege is readily ascertainable, considering whether the value of the property subject to the option can be ascertained, the probability of any ascertainable value of the property increasing and decreasing, and the length of the period during which the option can be exercised Regs. Sec. 1.83-7(b).
  10. 10. Google – Time Warner Dispute Google was disallowed $83 million deduction AOL was issued a $4.6 million IRS notice of deficiency over the same deal Both parties filed petition against the IRS If Sec. 83(a) applies, Compensatory Option is taxed upon on exercise – the excess of FMV over the exercise price. Sec. 83(h) provides that the issuer entitled to a deduction equal to the amount of the income the optionee realized in the tax year that included the year end in which the optionee realized the income. Compensatory Options
  11. 11. Form Agreements Standard agreements provided by accelerators may seem like an easy and cost-effective solution for most startups. But buyer beware: They may not adequately describe your company assets or adequately protect your company from liability. For example, the following provisions will likely need to be modified according to the particulars of each company: - Federal vs. State Choice of Law - 83(b) election - State-Specific Employment Laws, such as non-competes - Shareholder Rights and Liabilities
  12. 12. Security Laws & Regulation  Investment Company Act of 1940 (the “40 Act”) Unlike other federal securities laws, which are designed to protect investors primarily through disclosure, the 40 Act also imposes substantive requirements on the operations of investment vehicles known as Investment companies. If the incubator is required to register as an investment company, it may be forced to comply with many regulatory requirements, including: i. limitations on its ability to borrow; ii. limitations on its capital structure; iii. prohibitions on transactions with affiliates; iv. restrictions on specific investments; v. limitations on the composition of the board of directors; and vi. compliance with reporting, record keeping, voting, proxy disclosure and other rules and regulations.  Broker/Dealer Registration
  13. 13. Security Laws & Regulation A Typical Investment Company: Any issuer (i.e., the incubator) that is or holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities. An Inadvertent Investment Company: The “40% Test” Exceptions: (1) Incubators who are not making and do not presently propose to make a public offering and whose outstanding securities are beneficially owned by not more than 100 persons; or (2) whose outstanding securities are beneficially owned solely be “qualified purchasers;” or (3) Pass the 45% Test
  14. 14. Crowdfunding Jumpstart Our Business Startups (JOBS) Act » Title II General Solicitation o The SEC has extended the exemption for private offerings under Rule 506 to allow for general solicitation providing certain requirements are satisfied o Can only issue securities to accredited investors and there are additional filing requirements » Title III Crowdfunding o Allows companies to raise a limited amount of funds from the general public (Effective as of May 16, 2016) o Investment must be through an intermediary broker or funding portal » Title IV Regulation A+ o Preempts state registration, allow for what some call a “mini-IPO”
  15. 15. Crowdfunding Jumpstart Our Business Startups (JOBS) Act Data of 2016 » As of December 31, 2016, 169 companies had filed a Form C to offer securities under the Title III exemption. » The average minimum raise sought is $100,000 and the average maximum raise is $647,000. » The average time period has been between four and six months. » Among the issuers, Delaware entities accounted for nearly half (81) of all filers, with California (21) and Texas (10) entities a distant second and third, respectively. » Compliance rate is very low - 15%. o By January 9, 2017, only 39 issuers had filed a Form C-U. Among those 39 filings, only 14 were filed within the five business day time period, representing a 15 percent compliance rate. Source: Drinker Biddle Crowdfunding Report
  16. 16. Crowdfunding Jumpstart Our Business Startups (JOBS) Act Data of 2016 Source: Drinker Biddle Crowdfunding Report
  17. 17. General Solicitation » Rule 502(c) of Regulation D provides that neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following: o Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and o Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.” » In general, this means that there will need to be a substantial pre-existing relationship with those to whom an issuing company makes an offer of securities under Rule 506 (now 506(b)).
  18. 18. General Solicitation » Rule 506(b) – The “Old Way” Preserved o If a company is not using general solicitation, they can continue to conduct offerings as they have done in the past in terms of verification of accredited investor status o We may see heightened regulatory scrutiny on the issue of accredited status even for companies conducting Rule 506(b) offerings » Rule 506(c) – The “New” Way Issuers can offer securities through means of general solicitation as long as: o All purchasers are accredited investors; and o The issuer takes “reasonable steps” to verify the purchasers’ accredited investor status » Structuring you event o Demo Days o Pitch Events
  19. 19. Pitch Competitions » Potential problems under Reg D for pitch competitions and demo days o The pitch could be considered a general solicitation and therefore any presentation materials would need to be filed with the SEC o If the pitch is amended after feedback from judges then the new presentation would need to be filed with the SEC before the next pitch » Issuers that break the rules are subject to a one year penalty o Very onerous and essentially a death penalty for early stage companies
  20. 20. Demo Days, Pitch Events and General Solicitation o Open to Public o Public Audience o Financials o The Ask o Standard Disclaimers
  21. 21. Broker dealer registration Any person engaged in the business of effecting transactions in securities must register with Securities Exchange Commission (the “SEC”) as a broker-dealer. Registration is a timely and costly process and requires the broker-dealer to become a member of a self-regulatory organization such as the Financial Industry Regulatory Authority. California has a similar requirement that any person engaged in effecting transactions in securities in California must be licensed with the Department of Corporations.
  22. 22. Broker dealer vs finders » The following activities indicate classification as a broker- dealer: » Negotiating the terms of the financing transaction » Offering or providing advice or recommendations in the financing transaction » Receiving success-based fees (i.e., fees contingent on the success of the financing transaction) » Providing issuing companies with assistance in drafting or distributing sales and financial materials » Soliciting investors » Handling funds involved in the transaction » Previous involvement and the frequency of involvement in the sale of securities
  23. 23. Broker Dealer » In 2013, the SEC released two no-action letters confirming that certain fund- raising websites did not need to register as broker-dealers: o AngelList LLC  Matches investors with companies  Exclusively available to accredited investors  No transaction-based compensation o FundersClub Inc  Posts details of companies to its website after they pass initial due diligence  Exclusively available to accredited investors  No transaction-based compensation » In 2012, the SEC charged some companies operating secondary markets for private stock o SecondMarket escaped unscathed which it puts down to its transparency, rigid accreditation process, and strict adherence to rules on general solicitation
  24. 24. Pooled Investment Vehicles: Investment funds that aggregate funds from many individual investors according to a particular investment strategy. Pooled investment vehicles include investment clubs, partnerships and trusts. Typical investments include stocks, bonds and mutual funds. Typical Fund Accelerator Structure Portfolio Company Pooled Investment Fund Investment Advisory Committee Portfolio Company Portfolio Company General Partner Individual Investors Individual Investors Individual Investors
  25. 25. Royse Law Firm rroyse@rroyselaw.com www.rroyselaw.com Skype: roger.royse Twitter @rroyse00 Thank you!

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