A string of Supreme Court of the United States rulings demonstrate a lack of patent protection for biotech inventions, and SCOTUS efforts to explain its long-held exceptions to Section 101 – laws of nature, physical phenomena, and abstract ideas – have created greater confusion and an increased number of ineligible patents. This article argues that a legislative fix may be the best remedy to the biotech patent issue.
Emerging companies looking to raise capital from outside investors most commonly do so via one of three different structures: preferred stock, convertible debt, or other convertible instruments.
The most common form of financing structure for venture capital investors, especially for larger financing transactions, involves the issuance of preferred stock by startups. Companies typically create a new series of preferred stock for an initial equity financing transaction and for each subsequent equity financing.
Preferred stock typically carries special rights with respect to preferential payments in a liquidity transaction; voting; and protection from dilution. Issuing preferred stock may also require a startup to forgo some degree of control from a corporate governance perspective by allowing the preferred stockholders to elect directors or have special approval rights over certain company actions.
One of the key substantive differences between a preferred stock financing and the alternative structures discussed below is that the parties to a preferred stock financing typically agree on a fixed valuation of the company that is used for determining the price per share and number of shares acquired by the investors.
From a process perspective, drafting and negotiating the legal agreements for a preferred stock financing is more complicated and time consuming than the alternative structures discussed below, but the more comprehensive provisions in these documents leave less work to be done later, and greater predictability for entrepreneurs and investors as they plan for future capital-raising or sale transactions.
Emerging companies may also agree to issue “light” preferred stock to investors, pursuant to a set of streamlined documents with a narrower set of investor rights. In such instances, investors generally receive stock having a liquidation preference, but without the more comprehensive governance rights or investor protections that are ordinarily associated with preferred stock.
Traditional Preferred Stock Financing
“Light” Preferred Stock Financing
Convertible Debt Financing
|Stock Purchase Agreement||Stock Purchase Agreement||Note Purchase Agreement||SAFE|
|Restated Certificate of Incorporation||Restated Certificate of Incorporation||Convertible Promissory Note|
|Investors’ Rights Agreement||Investors’ Rights Agreement|
|Right of First Refusal and Co-Sale Agreement|
|Management Rights Letter|
Figure 1: Representative list of documents required for various types of early-stage financing transactions.
When companies and investors cannot agree on a valuation for the company’s stock, or simply prefer not to issue equity securities for another reason, there are alternative structures by which companies can raise funds.
One such option is for the company to borrow money from lenders. But early-stage companies that have not previously raised capital may find it difficult to find a lender that is willing to extend credit on reasonable terms due to the perceived high degree of credit risk. Those willing to lend money to early-stage companies will seek to be compensated for taking that risk, and the form of compensation frequently sought by such lenders is the ability to participate in the company’s later growth by having the ability to convert the credit extended to the company into equity securities so that the lender becomes a stockholder of the company. In the case of a company that experiences rapid or exponential growth, that equity stake may be worth significantly more than the amount originally lent to the company.
As with traditional loans, convertible debt is typically evidenced by a promissory note, has a maturity date, bears interest at a fixed rate or based on a specified formula, and, in the event of an acquisition, is repaid before any acquisition proceeds are received by stockholders. Unlike traditional loans, however, convertible debt may be converted into equity securities, either automatically upon the occurrence of a specified event (such as an equity financing) or, in some cases, at the lender’s election. When a lender extends convertible debt to an early-stage company, the lender is, in effect, making a prepaid investment in a subsequent equity financing.
To compensate convertible debt investors for investing early and in the absence of a valuation, convertible promissory notes often convert at a discount relative to the price paid by new investors in an equity financing. The discount rate may be calculated in a number of ways, including as a percentage discount (i.e., the notes convert into equity at a price per share that is a certain percentage less than the price paid by new investors) or a valuation cap (i.e., the notes convert into equity based on an assumed pre-money valuation). Convertible promissory notes also often include terms addressing the treatment of the notes in the event of an acquisition. Although these provisions may seem boilerplate, conversion and repayment formulas include important nuances that ought to be discussed and reviewed early in the process with investors to ensure all parties are aligned on how the notes will be treated in the event of a financing or acquisition.
One advantage offered by convertible debt financings is that the documentation can be simpler and less cumbersome to negotiate than the documentation required to complete a preferred stock financing. The simplicity arises in part from the fact that purchasers of convertible debt are willing to invest without agreeing on a fixed valuation and without negotiating complex governance and investor rights. Instead, convertible debt investors rely on later investors to negotiate those terms.
Convertible debt does have a number of corresponding disadvantages. First, issuing convertible debt in lieu of equity merely delays the negotiation of key investment terms, and could make those later negotiations more difficult. This is particularly true if the interests of the terms of the equity investment cause the interests of the new investors and existing noteholders to diverge, in which case the company may end up serving as an intermediary between those two groups. Second, the issuance of convertible debt by an emerging company may raise accounting and legal concerns regarding the company’s solvency, as the issuance may cause a company’s liabilities to exceed its assets. Finally, the accrual of interest and investor-favorable conversion formulas can also dilute founders’ ownership beyond that which founders may have expected at the time notes were originally issued.
Other Convertible Instruments
In addition to preferred stock and convertible debt, a number of alternative forms of convertible securities have gained popularity in recent years. These include the Simple Agreement for Future Equity (SAFE) developed by Y Combinator, Keep It Simple Security (KISS) developed by 500 Startups, and bespoke instruments prepared to address special situations.
The terms of these instruments differ from each other, but all are designed to offer investors some of the key advantages of convertible notes — including discounted conversion rates and the ability to delay agreement on the company’s valuation — without some of the key disadvantages. In particular, because most of these instruments are not styled as debt, they do not accrue interest and do not raise the same solvency concerns as convertible debt.
Properly structured, a successful early-stage financing will set the stage for subsequent financing and strategic transactions, including public offerings or acquisitions. Hastily structured, an early-stage financing transaction can discourage future investment or cause founders to suffer more substantial ownership dilution than expected or desired. Emerging companies, particularly those that have not previously raised outside financing, should therefore carefully evaluate these various options in close consultation with their counsel and other advisers before launching their fundraising efforts.
Avoid These 5 Classic Mistakes Getting Your Startup off the Ground
I have had a unique and rare opportunity to work with hundreds of startup companies from across the globe, from my days as a young associate in Silicon Valley advising the first generation of dot-com darlings and the subsequent Web 2.0 companies that rose from the ashes of Y2K crash, to the new wave of innovators in China and across Asia that have blossomed over the last decade. Despite the diversity of geographies and market opportunities these companies have addressed, I have been consistently awestruck by the energy, passion and commitment of these entrepreneurs across the globe and their determination to succeed.
When it comes to getting Hong Kong and China-based companies properly organized as a platform for future debt and equity financings, strategic alliances and eventual IPO or M&A, however, I have also been frustrated to see so many talented entrepreneurs make costly and avoidable mistakes – particularly since these mistakes tend to recur time and time again. The following list highlights some of the most common mistakes that you are advised to note and avoid.
- Poor Company Structuring
When Hong Kong based startups visit me for the first time, many of them have already incorporated in Hong Kong. There are many reasons why a Hong Kong based entrepreneur should (and must) set up a Hong Kong entity, such as to hire employees or to take advantage of preferential tax treatment for dividends received from a China subsidiary. However, there are advantages of using an offshore holding company as a parent holding company of a Hong Kong subsidiary:
- there are cumbersome procedures for a Hong Kong company to repurchase restricted (i.e., unvested) ordinary shares from founders and to repurchase preferred shares from investors (VCs in Asia often demand a right to have their shares repurchased upon certain events);
- transfers of shares of a Hong Kong company require a payment of a stamp duty (and typically will also require presenting financial statements to the stamp duty office); and
- Hong Kong companies provide less flexibility for listing the company for an US IPO.
While it is possible to restructure the Hong Kong company to be held by a parent company in a more flexible jurisdiction (such as the Cayman Islands), this requires going back to all your existing shareholders to explain why the restructuring is necessary (opening yourself up to new asks from them) and redirecting your scarce funds away from the rock star engineer you were about to hire, to your reliable but decidedly less glamorous solicitor.
At these initial meetings, I often find that founder shares purchase agreements are memorialized on a cocktail napkin, a WeChat/WhatsApp message (or a photo of a napkin sent via WeChat/Whatsapp). Suffice it to say, the actual share registers that evidence such ownership rarely match these founder share purchase agreements. It is true many well-intentioned and passionate founders end up leaving the startup earlier than expected (for reasons best left to another article).
What happens to the departing founders shares in that situation? Can the Company buy them back, and if so, how many shares and at what price? It may be no surprise that these very basic terms are not often clearly set out on these ephemeral contracts. Needless to say, it is critical to have well-constructed and legally binding founder share purchase agreements put in place, not only for the protection of the non-departing founder and the departing co-founder’s successor, but to the professional investors who will insist that the share capital of your startup is deployed to those persons who are needed to drive the Company forward after the departing founder has departed.
- Laws, what Laws?
Your startup is poised to disrupt the rich and complacent incumbent players in your industry, and make life much immeasurably easier for an underserved but worthy market (and if there are some added perks for its founders, be it Teslas or a Necker Island getaway, even better). You lament that the lawmakers did not have the slightest inkling of your business model when the law was drafted that at best exists in a grey area and at worst, appears to be prohibited. How does a startup operate amidst such regulatory uncertainty?
A common refrain these days is to plow ahead and gain influence and market share first. By the time the regulators come knocking, you will have demonstrated the company’s value proposition and have the support of a large and loyal user/customer base, giving you additional leverage in your discussions with regulators.
The other approach is to engage in thorough legal research in all the jurisdictions you plan to operate in at great legal expense, only to realize that there are regulatory landmines around every new product or geography and be stuck in execution paralysis.
The right approach for your company will most likely rest somewhere in the middle of these two extremes and will depend not only your specific business model, but understanding what issue the law states, what it was trying to protect against and how that has evolved, where enforcement is being prioritized, and the position your competitors are taking on this issue. While Hong Kong’s startup community is quite collaborative in sharing their views, the argument that “everyone else is doing it” is unlikely to generate much sympathy from the enforcement authorities if and when your company becomes the target of a data breach or other unfortunate incident.
Consult with a lawyer who has experience in the relevant sector, who can at least give you a baseline survey of the laws in your primary market, who can help you assess whether the activity is clearly prohibited, permitted, or more likely, in a regulatory grey area. A lawyer with the right experience may have encountered similar issues before and may be able to offer operational or structural workarounds. Ultimately you will likely need to take a position that involves some regulatory grey area, but you owe it yourself to actually make an informed assessment of that risk before spending all of your waking hours executing on such a plan.
- Treating China as “just another big market”
As of this article goes to press, 5 of the top 10 unicorns by valuation call China their home. It is no secret that China is an extremely attractive market for manufacturing hardware, as well as distributing the domestic consumer market. It is also no secret that non-Chinese founders have had no shortage of challenges to succeed in China.
There are significant restrictions on foreign investment in Chinese companies, particularly those engaged in the internet, mobile, entertainment and cloud based services. Moreover, the traditional structuring playbooks to address these restrictions, such as using variable interest entity (VIE) structures, are evolving, and new cybersecurity laws are expected to impose stringent requirements on data privacy and localization of data content. While some aspects of foreign investment in China are liberalizing (e.g., in certain areas of e-commerce), you should be realistic about the significant operational, financial, and legal resources you will need to set up meaningful operations in China.
- “Borrowing” T&Cs (a.k.a No thank you, Internet!)
It certainly is tempting. Why pay a lawyer to draft “boilerplate” terms and conditions when you can leverage the hard work of your competitors, who have terms and conditions and privacy policies readily available on their websites/apps? Besides the copyright violations you engage in by plagiarizing your competitor’s T&Cs (and facing the trolls who enforce such violations), it is important to remember that the T&Cs are essential in your binding contract with your entire community – a contract that warrants some thought and attention from you.
Moreover, if the T&Cs were prepared for a company that is incorporated in another jurisdiction, it may not be compatible with the laws under which you are operating (even if you have cleverly replaced the Santa Clara County, California dispute resolution venue to Hong Kong). In the complex and diverse area of privacy law, obtaining user consent is necessary but not sufficient – the purpose for which the consent is granted must often be closely aligned with the company’s specific needs, which is a bespoke exercise that you need to consider.
Finally, do not take it for granted that your competitor hired a competent law firm (if any) to prepare its own T&Cs.
- Nothing is More Expensive than a Cheap Lawyer
Yes, this is a self-serving comment from a lawyer with a healthy billing rate. I cannot emphasize enough that getting attorneys with low hourly rates to work on your project rarely results in the overall cost of a project being lower, and in many cases, putting in a lower-cost inexperienced lawyer on your project may result in a final bill that is higher. For Hong Kong, in particular, law firms tend to serve institutional clients and have less experience serving the needs of startups. You have neither the budget nor the time to wade through over engineered agreements, much less paying your lawyer to spend time working from those forms.
Ask other successful entrepreneurs about their experiences with their counsel. You are looking for counsel experienced in the type of transactions that you will need (e.g., seed financings, licensing and distribution agreements, terms of service, strategic alliance agreements) and who can help you prioritize the critical issues that you need to focus on, issues that present theoretical risks but are practically acceptable and those that are moot for your company.
Will the right lawyer accept shares of the company, cocktails, or a delicious chicken burger in lieu of legal fees? Hopefully not (at least for the latter options). But lawyers who do regularly work with startups may have special discounted or fee deferral arrangements that you can explore.
I fully appreciate that startups must accomplish an extraordinary number of KPIs on a very limited budget, and the idea of spending money on lawyers is suboptimal. But remember, as an entrepreneur, the demand for your time is unrelenting and time lost spent fixing avoidable mistakes can be a death sentence for a startup. I urge you to look at the long view and invest some time upfront to get things done right, which will save you time and unnecessary legal expenses down the road and give you an unfair advantage over your competitors.