Nice Convertible...a few words on Convertible Notes

Marianne Hudson (Executive Director of the Angel Capital Association) did a quick survey of angel investors on convertible notes recently, and summarized the responses in an article for Forbes.  It was interesting to see that 82% of the angels she talked to preferred not to use convertible notes, but that 78% had done a convertible note financing in the prior 18 months.  Which means there are a lot of angels doing note deals who would rather be buying shares.

I'm always surprised when a new entrepreneur or angel comes into our offices with a very strong opinion on convertible notes, either very intent on only doing a convertible note round or insistent that they would never use convertible notes.  Usually, their reasons come from things they've read online, which are often incomplete or inaccurate.

I would agree with the few angels in Marianne's survey who are fine doing either priced rounds or convertible notes, depending on the situation.  As the article says, convertible notes are just another tool that can be used to finance startups.  And in some situations, they are the best option.

Priced Round
— A financing in which a price-per-share (and therefore the Company's valuation) is negotiated and set at the time of the financing. A convertible note financing is not a priced round; in fact that's one of its chief advantages in some situations.


Background: Bridge Financings

In the late 90s and early 2000s, we really only used convertible notes in true "bridge financing" situations -- meaning a situation where a company was in the process of getting together a larger financing round, but needed some money quickly (e.g., to make payroll and pay rent) while the deal was closing.  In these cases, the company's current investors and/or the new investors in the new financing would put a little money together for a 'bridge' to get the company through to the bigger closing, and this interim financing would be structured as a convertible note (often with a warrant sweetener), basically as an advance against the upcoming financing.  This way it could automatically convert into the new shares once the bigger financing was closed but, if for some reason, the company couldn't get the round closed, it would remain as a debt on the company's books, and the investors advancing the funds would have a good claim to repayment.

Bridge to Nowhere
— A term investors use for a bridge financing in which the follow-on financing (into which the bridge was intended to convert) seems to never occur. Sometimes called "a bridge that turned into a dock."

Expanding Use of Convertible Notes

As the 2000s wore on, however, it became more common to use convertible note financings in situations even in "non-bridge situations" - i.e., when a specific larger round of financing was not in the works.  In fact, in many cases, a company will use a convertible note financing even when the company never intends to raise another round of financing.

The advantages that convertible notes have even in non-bridge situations are due to:

  • the relatively simple terms of a bridge financing (as opposed to, for example, a preferred stock financing), which saves on time and legal fees, and
  • the fact that there is no need to set a valuation for the company in order to close the round and put the money to work.  

Some terms of convertible notes have evolved to better fit the situations in which they're used now.  Primarily, the "Cap" used in the notes has become far more important than it was in the bridge scenarios.  The "Cap" is included to protect the angel investors from the so-called "runaway success problem"  which has become a much bigger likelihood now that startups can achieve massive valuations without having to raise bigger rounds of money.

But more on the the Runaway Success Problem, the Cap and other key terms of Convertible Notes in a later post...

No More Premiums: Penalties for Paying Employees' Individual Health Insurance Premiums Begin in July

Beginning in July, penalties under the Affordable Care Act will apply to employers who provide payments to employees to cover premiums on individual health insurance policies.  This is true whether the payments are considered before-tax or after-tax.

In the past, some small businesses have reimbursed their employees or covered their costs of obtaining individual health insurance policies, rather than going through the process of obtaining a group policy for the company and its employees.

Directives from the Department of Labor, Department of Health and Human Services and the Department of the Treasury have clarified that this practice is incompatible with certain requirements of the Affordable Care Act and will result in penalties (up to $100/day per affected employee, with a maximum of $36,500/year per employee). 

Certain transition relief has allowed small businesses to continue the practice through this month, but the relief period is coming to  an end.

If you have been providing your employees with reimbursement or payments to cover their individual health insurance policies, you should stop the practice this month.  Businesses may provide employees with a stipend or pay increase that the employees may, if they choose, use for purchasing individual health insurance policies.  But there can be no requirement or agreement that the increase or stipend  must be used for health insurance, and the employer cannot require the employee to provide documentation that health insurance has been obtained.

Virginia Tech Revises Its IP Policy

Virginia Tech's Board of Visitors adopted a new IP Policy as of June 1, with two primary revisions - one focused on student entrepreneurs and one focused on when the University may "give back" IP to the Inventor.

Student IP

The change in the policy language relating to student inventors clarified that, in general, the University does not claim ownership of student-developed intellectual property - including IP that may be developed in connection with coursework.  Generally speaking, the three exceptions to this are:*

  • If the student is an employee of the university (or otherwise paid by the university for the work) and the IP is developed as part of their work.
  • If the IP is developed under a sponsored research or other program under which third parties (including government agencies) may have rights to the IP by virtue of agreements with the university and/or the faculty researchers running the project.
  • If, in developing the IP, the student uses university resources not generally available to others (in the context of IP developed as part of a course, the test is whether the university resources were made available to all other students taking the course for credit). 

This overarching policy has always been in place, and this change is more of a clarification.  There has been a fear among student groups that the university will take IP developed by students in general, though this is not the case.  Virginia Tech Intellectual Properties (VTIP: the organization that manages the University's IP) has tried to combat this fear, but the paranoia has lingered.  At one point there were policies put in place with dollar amount thresholds in an attempt to provide some clarity (e.g., if the student develops IP without using $10,000 or more in university resources, then it belongs to the student).  But the difficulty in putting a value on use of resources made that difficult to apply in practice, so these didn't really provide the desired clarity.

Giving IP Back to the Inventor

The other change is a new section of the IP policy stating that the University may decide to release IP back to the Inventor in cases where the University and VTIP decide not to pursue protection or commercialization.   This has also always been an option, whether or not stated in the policy itself, and VTIP has released some IP back to Inventors in the past.  Under the revised policy, VTIP and the University still hold a lot of discretion on whether or not to release the IP back to the Inventor, and there aren't yet formal guidelines or procedures on how VTIP may make this decision.  Perhaps adding this section to the IP policy will at least give rise to a discussion  on what policies and practices make sense here.  

We work with a lot of faculty inventors and many of them feel that the University should adopt a free agency approach posited by the Kauffman Foundation (an approach which, as you can probably imagine, is strongly opposed by AUTM, the Association of University Technology Managers).  Many universities are currently experimenting with different approaches to this question of if and when to release IP to the Inventors.  Every university has different philosophies on its goals and purpose with respect to its IP and the potential for economic return from it (and these philosophies change even within a university over time), so this is not an easy question to answer.

Because of university politics ("What?!" you exclaim. "There are politics within the university?!  I'll not believe it!"), the potential for economic return, the risk of missed opportunities and feelings that naturally attach to someone's inventions, this question is a particularly sensitive one among faculty inventors, tech transfer organizations (e.g., VTIP), the university administration and the administration of individual departments and institutes within the university.  

Because of its role, VTIP can be put in a troublesome position when pressured to release IP back to the Inventors, but at the same time is required to meet budgets, produce revenue, meet patenting and/or licensing goals, etc.  Not to mention the tongue-lashing some would give VTIP if Virginia Tech IP is released to an Inventor who goes on to make billions of dollars with it, without having to pay Virginia Tech any royalties (some would feel the opposite, but I think the voices of criticism would be loudest or most influential here, at least in the near future).  In other words, I would not expect VTIP to freely begin giving away IP to Inventors unless the University clearly and unequivocally states that it has a strong policy in favor of this, and adopts economic and political structures for VTIP which support this.  The risk to VTIP of a misstep is just too strong.  However, I have spoken with the head of VTIP on this topic and he is completely in favor of generating thoughtful discussion and developing guidelines on IP release which make sense and protect both the interests of the University and the faculty Inventors.

In the end, these revisions themselves probably do not change the game that much.  But the change does indicate that the University's leadership is keenly aware of the importance of its policies on entrepreneurship within its classrooms and laboratories.   And if these changes generate more discussion, which generate more clarification, which generate more changes, and so on, this is a very good thing. 


* Note that these are general summaries of the IP Policy and should not be relied on as legal advice.  You should review the exact language  of the IP Policy to determine your rights in any particular instance.

Is Virginia's New Crowdfunding Exemption A Good Option for Tech Startups?

          Photo (c) STEPHANIE KLEIN-DAVIS/The Roanoke Times

          Photo (c) STEPHANIE KLEIN-DAVIS/The Roanoke Times

Thursday, Virginia joined 19 other States which have enacted Crowdfunding legislation, allowing businesses to raise funding by selling shares through public advertising - or 'general solicitation' as it is known to us securities-lawyer-types.  What is never mentioned in the press releases and reporting are the many limitations and requirements on these state-level Crowdfunding exemptions, which make them much less useful for the types of technology startups I tend to work with.  This is a run-down of some of those limitations as a way of cautioning startups to consider other alternatives before using this new law.

Background: Securities Law, Fundraising & The Federal/State Mashup

As most of you know, Crowdfunding in various forms is already alive and well.  Companies have raised millions on platforms like Kickstarter and IndieGoGo to fund new projects.  But, in the U.S., securities laws make it generally illegal for companies to use these public sites to raise money for the sale of shares, convertible notes or other securities.  In other words, you can promise products, sell services and accept donations to raise money through public advertising but, unless you've done an IPO, you can't sell stock that way.*

It has been this way since the 1930s when the securities laws we know and love were passed.  The laws included a general ban on selling shares publicly unless a company went through the IPO process first.  Then, in 2012, came the Jumpstart Our Business Startups Act (JOBS Act), in which Congress ordered the Securities Exchange Commission (SEC) to enact rules creating a new Crowdfunding exemption to the general ban.  So that was in 2012.  "Where are the new rules?" you're asking.  "Surely the SEC has written these by now!  I can't wait to start selling shares online!"

Unfortunately, due to its institutional fear of allowing companies to sell stock to unprepared, unsophisticated types (the SEC was created in the 1930s as a result of rampant fraud in selling shares of fraudulent and fictional companies to the unsuspecting public), the SEC is taking its sweet time in getting these rules finalized and into effect.

So here come the States.

One thing you need to know is that there are two overlapping layers of securities laws in the U.S. - the federal level and the state level (also called "blue sky laws").  When you sell shares in the U.S., you have to comply with both levels of securities laws.  If you sell shares in multiple states, as is often the case, you will need to comply with the federal securities laws and the blue sky laws of each state involved.  The federal level has become much more important since 1996 when Congress passed a law that sort of overrides a lot of state regulation for certain types of securities offerings (a specific exemption upon which I rely heavily in the vast majority of tech company fundraising I work on).

The Intrastate Exemption

BUT, at the federal level, there is one small exemption in which the SEC said to the States, "Hey States, for certain small offerings completely within your borders, you guys get to control the rules."  That federal exemption is known as the Intrastate Exemption.  In securities law class in law school, I remember being told by my favorite professor: "Do not use this exemption, it is dangerous."  And in 18 years of helping tech companies raise funds, I haven't ever used it and don't know of anyone who has.  The requirements which must be met in order to safely keep your offering within this exemption are tricky and make it useless for most tech startups. 

It is within this small, not-often-used, "dangerous" federal exemption that the States have created the new State-level Crowdfunding laws.

Virginia's New Crowdfunding Exemption

Against that backdrop, the first thing you should know about the Crowdfunding exemption is that, as an Intrastate exemption, it is purely for Virginia companies raising money solely from Virginia investors.  You are not allowed to offer shares to anyone outside of the Commonwealth. You will also need to be sure that shares aren't transferred to persons outside the Commonwealth within a certain period of time after the offering.  There are other requirements designed to keep this exemption purely a state affair.

The potential to fall outside of the Intrastate exemption once you have started an offering creates a lot of risk.  You will be in violation of securities laws with potential fines, penalties and actions by the SEC.  You may have to offer investors the chance  to sell their shares back.  It can cause trouble for future offerings.

And once you start down the road of offering shares under this Intrastate exemption, it would be very difficult to change your mind and go another route if it wasn't working.  For example, if you started advertising online in a Crowdfunding offering under the new Virginia exemption, but found you were getting interest from  someone out-of-state and wanted to take their money, you wouldn't be able to simply shut down your website offering and switch over to a more traditional private offering to raise the funds from investors elsewhere.  The fact that you had already conducted this online 'general solicitation' would make the traditional securities laws exemptions unavailable to you.   (And you also couldn't just declare that the original online Crowdfunding offering was now "over" and you are starting a new, different offering - securities laws would mostly like integrate the two offerings, meaning essentially that they'd be treated as part of one offering.)

This could mean that you'd have to shut down your fundraising efforts for a period of time and wait for six months or more before trying to start a traditional private offering.  This is a lifetime for most tech startups in need of cash.  This alone makes the new Crowdfunding exemption such a risky prospect that I wouldn't advise it in most cases.


As with the federal Crowdfunding exemption, the Virginia exemption now awaits the passage of the specific rules from a regulatory agency - in this case Virginia's State Corporation Commission (SCC) - before the law can be used.  Unlike the SEC, the SCC is expected to finalize and enact the rules for the Crowdfunding exemption relatively quickly.  The Securities Division of the SCC has already put forth the proposed rules, which are in a waiting period for public comment and final consideration by the SCC.  The discussion below is a summary of just some of the requirements of the proposed rules, which remain subject to change before final passage.


The Virginia Crowdfunding exemption permits companies to raise up to $2,000,000 in the aggregate, and up to $10,000 from each investor, except that you can accept more than $10,000 from investors who are "accredited."  The term "accredited investor" under securities laws has a very specific meaning - for individuals, it generally means someone who has over $1,000,000 in net worth (not including the value of their principal residence) or has made $200,000 in income each of the past 2 years and expects to do so again this year ($300,000 if investing as a couple).  There are other categories of accredited investors, but for individual investors, this is the most common category.

If you want to use the exemption to raise the full $2,000,000, you will need to have audited financials from your most recent fiscal year.  Having a CPA audit your financials can be quite an expense for a true startup, so many will not be able to raise up to the full amount.  Without audited financials, the most you can raise under this exemption is $500,000, and that requires a "review" of the financials by a CPA which, will not as expensive as a full audit, does require an expense up front if you haven't already had your financials reviewed.  Without audited or reviewed financials, the most a company can raise is $100,000.

Limitation on Type of Securities Offered

The exemption is also limited to equity securities - meaning, generally: shares.  It is not available for debt offerings.  Presumably, this means that you would not be able to conduct a Convertible Debt offering through this exemption.  In lieu of Convertible Debt (which is often used as a placeholder when the Company and the investors don't feel ready to yet put a value on the company and its shares), Companies could utilize one of the new convertible securities like yCombinator's SAFE securities which are treated as shares but which aren't fully priced at the time of offering.  However, using Crowdfunding to sell these more complicated securities to unsophisticated investors presents its own risk.

Filing Requirements

The new exemption rules will require  that a Company first file with the SCC a "Disclosure Statement" or use a new form called Form ICE (cool name, boring form) at least 20 days before starting the Crowdfunding offering.  That form will require some information about the Company, the securities being sold, the Company's officers, shareholders holding more than 10% of any class of shares, the Company's intended use of the funds and  each website on which it will offer shares.  The rules also discuss the need to identify a bank to which the investor's money would go, and require that the Company provide a copy of the escrow agreement with the bank (if there is a minimum threshold for the offering).

The Disclosure Form will also contain information on any lawsuits, anticipated future offerings that might dilute current investors and financial statements of the Company for the past 3 years (or as long as the Company has been in existence if shorter).

Reporting Requirements

Additionally, once a Company raises any money through this exemption, it will be required to provide quarterly reports to its investors as long as any of the shares sold in the offering are outstanding.  This quarterly report will also have to be filed with the SCC and I believe will be publicly available.  Along with a discussion by management of the Company's operations and financial condition, it will include a listing of the compensation of every director and executive officer of the Company (or its affiliates), including all cash,  stock, options, etc., received by each.

Most startups I have worked with would strongly prefer that this information not be made public.  Many VCs do not like this kind of information about their portfolio companies to be made public. 

Increased Risk of Lawsuits?

In addition to the limitations and requirements listed above, there is also a general fear (shared by me) that raising money from so many people who don't have experience with startup investing, who may not have a lot of money to spare and who have no connection to the Company or its founders other than clicking "BUY" on a website will lead to far more lawsuits when things go poorly.  Generally speaking, VCs and experienced angels understand the risk they're taking and understand that tech startups fail and run out of money all of the time.  Lawsuits from these kinds of investors over failed startups are remarkably rare and generally only occur when there has been true fraud by the founders.  However, the risk of lawsuits go way up when taking money from less-experienced investors.  

These lawsuits can occur when the company goes under or when investors feel like the founders or executives are siphoning money out of the company, but they also tend to occur at a particularly inopportune moment: when the company is being acquired.  When the company is being acquired, there is almost always a shareholder vote required and a lot of information to be provided to the shareholders ahead of that vote.  If a shareholder feels that the deal is no good, or that the management or later investors are coming out ahead in the deal at the expense of early shareholders, they can take certain actions which put the deal  at risk.  Having a large number of shareholders who don't have experience in this realm or and don't have a real connection with the company heightens the risk that there is a threatened lawsuit at the time of an exit event.  And acquirers are very afraid of these threats - "We're not buying a lawsuit" is a common refrain when there is a vocal disgruntled shareholder.  This may require negotiation with the grousing shareholders, giving them more than their fair share, just to get the deal done for everyone else.

Impact on Future Activities

If your company wants to have the option of raising additional rounds of capital, either from experienced angel investors or from VCs, this large pool of small, unsophisticated shareholders is likely to cause hesitancy, at the very least.  The combination of heightened litigation risk from other shareholders, public reporting requirements, and risk of the Intrastate exemption in general will be negatives when later investors are considering putting money into your company.  If they do invest, because they will perceive your crowd investors as unsophisticated, they will require terms which ensure that these investors have no control over the company.  Taking the investment and putting these terms in place are likely to create some ire among your crowdfunders, many of whom will believe that you should just continue crowdfunding no matter how much you need to raise.


* With a couple of limited exceptions.