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Board Representation
When companies raise capital there are a number of rights that the investors (typically through the lead investor) will seek, such as a preference on liquidation (the right to be repaid their investment before the founders receive distributions), tag-along rights (the right, if the founders sell their stock to a third party, to participate in the sale), approval rights (the right to approve certain actions the company wishes to take) and pre-emptive rights (the right to purchase their pro-rata share of equity in future company financings.
An additional right a lead investor will often seek is to be granted a seat on the governing board of the issuer. Having a board seat gives the investor the ability to have a voice in crucial decisions, as well as access to information regarding the company the investor might not otherwise be privy to. However, sitting on a board also carries with it certain obligations, such as (i) making due inquiry into matters the board is voting on, and (ii) voting in the best interests of the company. Thus, if the company is considering signing a contract with a competitor of a board member, the board member may be obligated to approve the contract if favorable to the company, even if it is disadvantageous to the interests of the director. Further, board members are obligated to bring corporate opportunities to the companies whose boards they sit on, and sitting on a board may expose a board member to lawsuits brought by unhappy investors. Given the foregoing risks, investors might instead consider asking for the right to sit in on board meetings without actually being a board member (so called “observer rights”). Observer rights give the investor access to company information and the ability to participate in a board’s decision process, without the risks attendant to being a board member.
If you would like to know more about board representation please contact Stephen Goldstein at sgoldstein@sgoldlaw.com, or at (212) 586-5555.
Commercial Lease Guarantees
On Tuesday, May 26, 2020, Mayor DeBlasio signed Local Law 1932-A, which provides that personal guarantees of commercial New York City leases for non-essential businesses (which includes retail stores and restaurants) are unenforceable with respect to lease defaults which occur from March 7, 2020 through September 30, 2020.
Often when a business entity (such as a corporation) signs a lease for commercial space, the landlord will require that the individual owner(s) of the business personally guarantee the lease obligations. Thus, if the tenant defaults on rent or other payments due under the lease, the landlord can sue the individual owners personally for the moneys owed. Under Local Law 1932-A landlords will not be able to enforce personal lease guarantees if the lease default occurs during the period March 7 through September 30, 2020. While the new law will provide relief to business owners, its constitutionality has been called into question as it impairs validly executed agreements. It is therefore likely that the enforceability of Local Law 1932-A will be challenged, and it is an open issue as to whether the courts will uphold it.
If you have particular questions regarding commercial leases and lease guarantees please contact Stephen Goldstein at sgoldstein@sgoldlaw.com, or at (646) 259-5024.
Force Majeure
Contracts often contain what are known as “Force Majeure” clauses, which excuse a party’s performance under the contract where performance becomes impossible due to an event beyond the control of the non-performing party. For instance, a manufacturer might be excused from having to deliver construction equipment by a particular date if its factory were damaged by an earthquake. Typically the Force Majeure clause will list the types of events which excuse performance, such as “war, floods, epidemics, and other events beyond a party’s control.” In addition, the clause might provide that, if the event delays performance for more than say 60 consecutive days, the other party has a right to terminate the contract. In light of the current COVID-19 virus many parties are looking to Force Majeure clauses to excuse performance under agreements they are parties to. One question clients have recently asked is whether the pandemic excuses performance where the contract can still be carried out, but there is no value in carrying out performance. For instance, if someone agreed to rent a house in August in another state, but now cannot travel to that state due to the pandemic, can the rental be terminated by the lessee? For such a question, careful consideration must be given to the precise language of the agreement, as the typical Force Majeure language would not cover such a situation.
If you have particular questions regarding events of Force Majeure please contact Stephen Goldstein at sgoldstein@sgoldlaw.com, or at (212) 586-5555.
Profits Interests
As mentioned in an earlier post, companies sometimes issue stock to employees as compensation for services rendered. However, as was pointed out in that post, if the employee does not pay for the stock she will have to pay taxes on the value of the stock, with the value determined as of the time of issuance. In order to avoid that result, a company might instead issue a stock option to the employee, giving her the right to purchase stock at a price based on the value of the stock when the option was granted. Thus, if the value of the company’s stock rises, the employee could choose to exercise the option (particularly if the company is being sold) and benefit from the gain in value. Of course, in order to exercise the option the employee will have to pay for the stock, paying what the stock was worth at the time the option was issued.
An alternative to the grant of an option is for an employer to issue a “profits interest” to its employee. Under the Internal Revenue Code, limited liability companies (though not corporations) can grant an employee or other service provider a “profits interest” in the LLC. In certain fundamental ways a profits interest is similar to ownership of equity in a company, in that the holder shares in profits distributed by the LLC just as an equity owner would. For instance, if an employee owns 10 units of a profits interest, and the other LLC members own 90 units representing equity interests, the holder of the economic interest will receive 10% of distributed profits which are generated from day to day operations of the LLC. Where economic interests differ is that, on a sale of the LLC, that same holder of the 10 units of profit interests will receive 10% of the amount the value of the LLC increased from the time the profits interest was issued until the LLC is sold. For instance, if at the time of the grant of the profits interest the LLC was worth $5,000,000, and the LLC sells for $9,000,000, the holder of the profits interest will receive 10% of the $4,000,000 increase in value, rather than 10% of the total $9,000,000 sales price. On the plus side, unlike the issuance of stock, the issuance of a profits interest is not taxable to the recipient, and unlike a stock option the recipient need not pay the LLC anything in order to receive the benefit of the profits interest. Thus, profits interests are often favored over options. However, as noted above, profits interests are not available to corporations, and thus corporations usually turn to stock options as an alternative to an outright equity grant.
If you would like to know more about profits interests and other means of compensating employees or other service providers please contact Stephen Goldstein at sgoldstein@sgoldlaw.com, or at (212) 586-5555.
Safes
A prior-post described the use of convertible notes as a means by which companies raise capital prior to having a valuation upon which to calculate a per share price. An alternative to a convertible note is a Safe, which is an acronym for “Simple Agreement for Future Equity”. Like a convertible note, per a Safe an investor pays an agreed to amount to the issuing company, and on the occurrence of the company’s next financing round the Safe converts into the stock sold in the financing. Usually interest will accrue on the Safe, and when the Safe converts the holder of the Safe will typically receive a discount on the price being paid for the stock being issued. For instance, assume an investor pays $100,000 for a Safe, it accrues interest of 4% per year and carries a 20% discount. If in one year the Safe issuer sells $1,000,000 of preferred stock at $10.00 per share, the Safe will convert and the holder will receive $104,000 of preferred stock at a price of $8.00 per share.
One important thing to note is that Safes were originally written for corporations, and not for use by limited liability companies. Thus, the terms of the Safe (such as conversion into preferred stock) will likely not apply to LLCs. However this is not to say they cannot be used by LLCs. Rather, the typical Safe will have to be revised such that its terms apply to limited liability companies (for instance, that it converts into units of interests in the LLC).
If you wish to learn more about Safes please contact Stephen Goldstein at Sgoldstein@sgoldlaw.com, or at (212) 586-5555.
Preemptive Rights
When purchasing stock in a corporation an investor will typically ask for a representation in the purchase agreement setting forth the percentage of stock in the corporation the investor will own immediately following the closing. For instance, if an investor purchases 100,000 shares of stock for $100,000 she will want to know that the 100,000 shares represents say 5% of the stock of the corporation. Thus, if the corporation is later sold for $5,000,000 then, provided no further shares have been issued, the investor knows she will receive $250,000 of the sales proceeds. However it is a rare corporation that does not subsequently issue stock after a capital raise, as the corporation will typically need to sell additional shares of stock to fund operations. It is for this reason that investors often ask for preemptive rights with respect to subsequent capital raises. Pursuant to preemptive rights, if a corporation sells stock to raise capital the existing shareholders will have the right to purchase their pro-rata share of stock being sold on the same terms being offered to new investors. Thus, a shareholder who owns 5% of the stock of a corporation would have the right to purchase 5% (or such lesser amount as the shareholder may elect) of the shares being offered for sale. Please note, preemptive rights will typically not apply to all issuances of stock. For instance, there are almost always carve outs with respect to stock issued pursuant to the exercise of stock options, in connection with mergers or in furtherance of a strategic partnership.
If you would like to know more about preemptive or other shareholder rights please contact Stephen Goldstein at sgoldstein@sgoldlaw.com, or at (212) 586-5555.
Drag-Along Rights
When investors purchase equity in a corporation or limited liability company they often ask for tag-along rights, which provide that if one of the founders sells stock in the company to a third party, the investor can participate in the sale. Conversely, as a condition to the sale of the stock to the investor the company and the founders may insist that they be granted drag-along rights. Per a typical drag-along rights provision, if the founders elect to sell at least a majority of the outstanding stock in the company, all other shareholders must sell the same percentage of their stock as is being sold by the founders. Thus, if the founders sell 75% of their stock to a third party, all investors must sell 75% of their company stock on the same terms, regardless of the purchase price paid. Since this can result in an investor having to sell her stock for less than she paid, the investor will often seek to require that the price must exceed some agreed to threshold before the drag-along rights can be invoked.
If you wish to learn more about drag-along rights please contact Stephen Goldstein at Sgoldstein@sgoldlaw.com, or at (212) 586-5555.
Tag-Along Rights
When investors purchase equity in a corporation or limited liability company the primary purpose of the transaction is to obtain an ownership interest in the corporation or LLC, with the hope if not the expectation that the equity will increase in value and ultimately be sold at a profit. Further, there may be periodic distributions of profits in respect of the equity. However investors also will typically negotiate for various rights when purchasing equity in a company, such as the right to information regarding the company or to attend board meetings. Among the more important rights to seek are “tag-along” rights, which provide that if one of the founders sells stock in the company to a third party, the investor can participate in the sale. For instance, if a founder were to sell 50% of her stock in the company, the investor would have the right to include up to 50% of the investor’s stock in the sale upon the same terms (and for each share of stock the investor includes in the sale, there would be a corresponding reduction in the amount of stock the founder would include, unless the buyer were willing to increase the number of shares being purchased).
The tag-along rights are important, as without them an investor in a company may have little opportunity to sell his or her stock in the company unless it were to go public or be sold as a whole.
If you wish to learn more about tag-along or other investors rights please contact Stephen Goldstein at Sgoldstein@sgoldlaw.com , or at (212) 586-5555.
Preferred Stock
Unlike S corporations which, per the Internal Revenue Code, can only issue one class of stock, C corporations can issue multiple classes of stock, with the classes typically comprised of Common Stock (voting and non-voting) and Preferred Stock. The classes of stock authorized, and the rights of the classes, are set forth in a corporation’s Certificate of Incorporation, though additional rights can be granted contractually.
As indicated by its name, holders of Preferred Stock are typically granted rights and priorities not attendant to Common Stock. For instance (i) Preferred Stock usually receives some defined dividend before Common Stock can receive any dividends, (ii) on a sale or dissolution of the corporation Preferred Stockholders will receive payment of some specified amount (often the price paid for the Preferred Stock, or perhaps some multiple of that price) before the holders of the Common Stock receive any distributions, and (iii) the Preferred shareholders will have the right, voting together as a class, to approve certain corporate actions, such as the issuance of stock with rights greater than theirs.
Over the course of time a C corporation may (and usually will) issue different classes of Preferred Stock (for instance, Class A, Class B, Class C), with each succeeding class usually having rights somewhat different from and perhaps greater than those granted the prior class. For instance, the purchase price for each class may be different, and typically a subsequent class will have a priority over liquidating distributions, such that the holders of the last class in the Series must receive their priority return in full before a prior class is paid, with the Common Stockholders standing last in line.
If you would like to know more about Preferred Stock please contact Stephen Goldstein at Sgoldstein@sgoldlaw.com, or at (212) 586-5555.
Security Interests
Loan Agreements and Notes are executed when loans are advanced in order to evidence the fact a loan was made and to set forth the loan terms, including the remedies the lender has on default. While a well drafted Loan Agreement can afford a good deal of protection to a lender, those remedies provide little comfort if, when the loan becomes due, the borrower has insufficient funds to repay the loan. Should that occur the borrower’s various creditors will typically find themselves fighting to recover payment, and the lender may receive only pennies for each dollar loaned. One of the best ways to avoid this scenario is for the lender to require that the borrower grant the lender a security interest in particular property of the borrow as a condition to the loan being made. Per the security interest (which must be set forth in a written agreement), the borrower agrees that if she/he/it does not repay the loan as required the lender can sell a particular asset of the borrower, with the proceeds of the sale used to repay the loan and to reimburse the lender for related costs incurred (such as legal fees). The assets used to secure the loan can run the gamut from real estate (in which case the security interest takes the form of a mortgage) to bank accounts, contract rights and intellectual property.
If you would like to know more about security interests please contact Stephen Goldstein at sgoldstein@sgoldlaw.com, or at (212) 586-5555.
