Legal

The SEC Gets the Case It’s Been Waiting for in Silicon Valley

Not so long ago, Theranos was flying high, its claims that it was upending the medical diagnostics business largely accepted by the public. Behind the scenes, however, some employees were growing wary of those claims, with at least one eventually reaching out to regulators to report the company’s failure to report its questionable test results.

A stinging series of articles by the Wall Street Journal soon followed, and in recent months, the government agency that oversees U.S. labs has banned founder and CEO Elizabeth Holmes from operating a blood-testing laboratory for two years, and Theranos has shuttered its clinical labs and wellness centers. To make matters worse, the company was last week slapped with a lawsuit by one of its biggest investors, which claims that Theranos knowingly lied to it.

It’s a nearly ideal scenario for the SEC, which is investigating Theranos and widely expected to use a case against it to expand its mandate into Silicon Valley’s startup ecosystem. The truth is while the SEC has long been viewed as a force in the public markets, it also has the authority to chase after private companies that engage in any “act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.” And lately, Wall Street’s top cop is finding Silicon Valley too high-profile a target to resist.

“If you’re only raising couple million bucks, everyone expects your huffing and puffing,” says one San Francisco-based securities attorney. “But if you’re raising hundreds of millions to billions of dollars, why would the SEC ignore that when they’re auditing the financials of some piddly company that’s raising $50 million in an IPO?”

More here.

Image credit: Bryce Durbin

A Strange New Battle Begins Over Who Owns Cruise Automation

A strange new battle over valuable startup equity took another step forward late yesterday afternoon.

Jeremy Guillory, a Bay Area mechanical engineer, has filed a cross-complaint against 2.5-year-old Cruise Automation and its longtime CEO, Kyle Vogt. At issue: Guillory says that the self-driving car company — which developed an autopilot system for existing cars and is being acquired by General Motors for reportedly north of $1 billion — is cheating him out of his rightful 50 percent ownership stake in the business, which he says he helped form. (In legalese, Guillory is accusing Vogt and Cruise of promissory estoppel, conversion, unjust enrichment and accounting.)

You knew this counter-claim was coming Wednesday, when the president of Y Combinator, Sam Altman, tried to get ahead of things publicly in a blog post.

As you may have read then, Altman, who has known Vogt for years and whose accelerator program provided Cruise its first check, acknowledged that Gillory “collaborated with Kyle for a very short period early on in the life of Cruise.”

Some time in the weeks since GM announced it was buying the company in mid March, Guillory requested a percentage of Vogt’s equity in the company, even though, according to Altman, “Kyle and Jeremy parted ways” after roughly one month of working together. “This event happened more than two years ago, and well before the company had achieved much of anything.”

The matter was private at first, with Vogt making what Altman described as an “extremely generous offer to settle this claim,” presumably to keep it from derailing Cruise’s acquisition. When Guillory didn’t accepted Vogt’s offer by a deadline last Friday, Vogt hired the law firm Orrick, Herrington & Sutcliffe to sue Guillory for so-called declaratory relief.

Guillory’s new cross-complaint seems to confirm Altman’s account from yesterday (which itself echoes Vogt’s suit).

The filing acknowledges that Guillory and Vogt first met in mid October 2013 and began working on Cruise. By October 21, 2013, they had submitted an application to Y Combinator, whose deadline that year was October 31. By November 7, 2013, after the duo had been accepted into the accelerator, Vogt told Guillory that he no longer wanted to work together.

Guillory’s attorneys note that on that print application to YC, Guillory and Vogt list themselves as co-founders and 50 percent shareholders of Cruise.

That seems to be the only documentation Guillory has to support his claim, along with this one-minute video, which Guillory and Vogt also submitted as part of their application. Whether it’s enough could determine whether or not Guillory is entitled to up to hundreds of millions of dollars.

More here.

VCs Aren’t the Only Ones Watching Those Mutual Fund Markdowns

VCs have been watching with great interest as mutual funds mark down the value of some of their privately held, illiquid investments, including shares of Dropbox, Zenefits, and Snapchat. Turns out the SEC is watching, too. A new Wall Street Journal report says the agency “has been asking more questions of large fund firms about how they value startups and whether their process ensures an accurate estimate of a company’s worth.”

According to the WSJ, examiners from the agency’s enforcement division are not yet involved in the inquiries. And asked yesterday if the SEC is investigating mutual funds’ pricing of private companies, a spokeswoman responded to us this morning, saying the agency isn’t commenting on its plans.

But some think it’s only a matter of time before a full-fledged investigation is launched into possible violations of federal securities laws, given the difference in prices that some funds have assigned their holdings, how they’ve timed their markdowns, and the opaqueness around both. The whole matter may give pause to other investors who’ve been looking to access the private markets, too.

More here.

Amazon Softens Blow of Times Piece, But Attorneys Warn Against Celebrating Too Soon

In recent days, Amazon has worked to soften the blow of a blistering piece about its culture in Sunday’s New York Times. In the article’s immediate aftermath, Jeff Bezos wrote a memo to employees, saying the account “doesn’t describe the Amazon I know or the caring Amazonians I work with every day.” He further pointed employees to a newer piece by current Amazon engineer Nick Ciubotariu that praises the company’s workplace environment.

The moves helped push the story in a positive direction for the company, as did the Times’s own public editor’s assessment of the story, which, she wrote Tuesday, should have provided more balance and context. (The Times’s executive editor, Dean Banquet, later let her know that he disagreed entirely with her assessment.)

Still, employment attorneys suggest it may be a little soon for Amazon to break out the bubbly. They think there could well be a class-action lawsuit in the many anecdotes cited by the Times of employees who were treated poorly — particularly those who appear to have they lost their jobs owing to health issues and other demands outside of Amazon.

Says Wilma Liebman, a visiting scholar at Rutgers University School of Management and Labor Relations, who spent three terms as a member of the National Labor Relations Board (including, most recently, as its chair): “Being a very tough boss, not being nice, not being sympathetic – that isn’t illegal in itself.” Violating overtime law and discriminating against women because they are pregnant is, however.

More here.

The Venture Math Behind All These Giant Financings

To better understand unicorn valuations, the law firm Fenwick & West recently analyzed the financing terms of 37 U.S.-based venture backed companies that raised money at valuations of $1 billion or more in the 12-month period ending March 31.

Among the firm’s findings about these financings is that only a quarter were led by “traditional” VCs and the rest were led by mutual funds, hedge funds, sovereign wealth funds and corporate investors. The investors also received significant downside protection in case the companies’ value declines. Not last — and not surprisingly — many of these later-stage investors are looking at far less upside than the companies’ earlier investors, which may create issues for some down the road regarding if and when to sell to an acquirer, as well as when to go public.

We talked earlier this week with Barry Kramer, a partner at Fenwick and the author of the firm’s new report, to learn more about the numbers. What follows is a bit of that chat, edited for length.

Were you at all surprised that a full 75 percent of the money that poured into these so-called unicorns came from nontraditional investors?

That’s what I expected. These are the mutual groups and hedge funds that used to invest in IPOs, but IPOs are getting delayed so much that these companies now have the same [risk profile] at the late-stage [as newly public companies].

Also, VCs don’t typically invest at these really high valuations.

Yet traditional VCs, including many early-stage investors, are keeping their board seats at these privately held companies. Did your research touch on the impact of those seats not necessarily turning over? A public offering usually results in some fresh blood on the board.

That’s an interesting point that we didn’t examine, though I think two things could be happening. Because IPOs are being delayed and VCs are serving on these boards longer, it might be impacting their ability to [spend more time] with more junior companies. The other thing I see is that because these [earlier-stage VCs] have, say, 10 to 15 percent of the company, they’re very engaged and attentive because of that economic interest, whereas with public companies, that’s [not always the case].

In your report, you say that roughly 22 percent of the unicorn companies you studied have dual-class common stock structures — which provide founders and management and, in some cases, other shareholders with super voting rights. Was there any type of pattern? For example, were the companies with dual stock structures more often founded by serial entrepreneurs with track records of success?

We’re definitely seeing this much more than 10 years ago, though it’s really all over the map. If you’re two kids out of school without a track record and you get your first venture round, people might look at you funny if you want a dual track structure. You can still do it later, once you have some leverage [because your company is performing well], but it’s often a negotiation. Other times, yes, people are more understanding of founders who have a track record if they ask to [implement a dual stock structure] at an early stage because the founders have proven they know how to run a company.

Your report talks at length about how much downside protection investors are getting in these deals, though you say they have more protections in an acquisition scenario than with an IPO. Can you explain?

In many of these cases, company valuations could fall 80 percent in value, and investors would still get their money back [because of their liquidation preferences]. The typical company will have, let’s say, a $10 billion valuation. And lets say that early-stage investors put in $200 million and later-stage investors invested $800 million [for a total of $1 billion invested]. If the company’s value falls to $2 billion [the price an acquirer is willing to offer for it], all those investors will [be repaid]. But let’s say the company goes public, and you’re a later-stage investor who has acquired preferred shares at $30 per share. If it goes out at $25 a share, you’ll have lost $5 a share.

Of course, companies that go public are typically doing well, so these later-stage investors are investing with the idea that even if they lose a bit at the IPO, the stock will pop up over time.

That’s their only protection?

There are other types of IPO protections. In one common type, the investor puts in a provision that says: If you go public at less than $30, you give me more stock, so I’m effectively paying the [IPO] price. In another scenario, the investor insists that the company can’t go public at less than the price it paid for its shares unless the company gets the investor’s approval first. So there are mechanisms, but [there are less of them appearing in these deals].

For Kramer’s full report, which is very much worth reading, click here.

Did Pinterest Just Change the Game?

In tech, employees often join startups with the idea that they might become millionaires if those companies go public or are sold. But even experienced startup veterans often underestimate the costs involved in exiting one’s stake. Purchasing equity that has appreciated can run into the hundreds of thousands of dollars — if not millions — and most startup documents only give employees 90 days to exercise their fully vested options once they move on.

Pinterest is rejecting that age-old program. According to Fortune, the digital scrapbooking company recently told employees that if they’ve been an employee for at least two years and leave the company — or are let go — they’ll have up to seven years to exercise their vested options.

Presumably, Pinterest is trying to attract the best and brightest by offering them more freedom than a typical startup payment package would allow.

Whether other startups follow suit anytime soon remains to be seen. There are plenty of reasons things work they way they do, including that it’s often in a startup’s best interests to be able to reclaim equity if an employee can’t purchase his or her shares within 90 days of his or her exit. Machiavellian as it may seem, companies might also want to retain their leverage over talented employees to keep them right where they are.

And there are other arguments to preserve the status quo. For example, you could imagine companies’ unwillingness to provide financial information to a lot of former employees who might be entitled to it under the law, yet who might have gone on to work at a competing company.

There are also plenty of secondary buyers capable of providing employees with some liquidity.

Of course, anyone who has been through a secondary sale can attest that they involve plenty of pros and cons. Demand and supply have to align. Many buyers want information rights that can give them assurance about the startups in which they’re investing, yet many companies don’t want to provide that information. Secondary buyers also tend to drive a very hard bargain because they know it’s not a liquid market.

Our bet? As more companies take their time in going public and those golden handcuffs become more onerous for employees, something is going to give. Trying to maintain the same kinds of controls won’t remain feasible forever.

Pinterest employees who wait to exercise their shares may face a much bigger tax bill years from now. But they’ll also have much more time to line up a secondary buyer or otherwise plan to raise the capital to buy their shares and deal with that tax hit.

It’s going to be very hard for other startups to compete with that kind of advantage. Over time, it might prove impossible.

Attorney Jay Gould on the Pros and Cons of a Public Venture Offering

Earlier this week, I wrote that venture capitalists should take advantage of new general solicitation rules that allow them to advertise when they’re in fundraising mode. I was expecting pushback from skeptical VCs; what I heard from them instead was confusion about how they could advertise without breaking the rules.

For help, I phoned Jay Gould, a partner at Pillsbury Winthrop Shaw Pittman who heads up the law firm’s investment funds practice. Gould — who’s in regular communication with the SEC and says those proposed amendments around the new rules will likely be “substantially” adopted — agreed to discuss the pros and cons for VCs interested in advertising.

According to Gould, one of the biggest downsides of advertising is “potentially” drawing more scrutiny from regulators and investors. (It’s already VCs’ biggest fear, seemingly.)

There’s also just a lot more paperwork. First, a firm will have to file a Form D at least 15 days before beginning its general solicitation for the offering. It will then have to elaborate on whatever advertising methods it plans to use. And it will need to file offering materials, like PPMs, with the SEC before it starts handing them out to investors. Not last, a follow-on form has to be filed once the offering is closed.

The solicitation period can also be a little labor intensive, particularly if it drags on and the firm’s performance changes during that time. The reason, says Gould, is Rule 156 of the Securities Act, which states that funds can’t represent information is any way that’s misleading or causes “material” confusion to investors. That means if an existing investment goes south during the marketing of a new fund, the firm needs to alter its advertising to reflect that change in its overall performance to stay in the good graces of the SEC. (Gould says firms should do this “promptly,” and suggests that even minor changes in performance could necessitate these updates.)

What if a venture firm embarks on a public offering, then decides to shifts gears to raise the rest of a new fund privately? It’s not something Gould recommends. Among other challenges: after a public offering closes, a firm has to wait another six months before launching a private offering. (It’s a rule meant to keep the offerings from becoming integrated.)

So what are the advantages for firms interested in availing themselves of the new rules, I ask Gould. He’s quick to point out that the funds that embrace them can post their performance numbers on their Websites, or go on television and talk about their funds without “getting grilled by compliance people.” Both could be effective in bolstering a firm’s brand and making it faster to raise a fund.

In fact, he says, Pillsbury already has “a couple” of fund clients that intend to pursue general solicitation. And he anticipates many more to come — even if it takes a couple of years for firms to grow comfortable with the prospect.

Most venture firms still “view these new rules somewhat suspiciously,” Gould notes. “But someone will do it right,” he says. “And it will be a really professional, polished effort. And people will go, ‘Holy shit. That’s the new standard. I guess I have to do this now.'”

Photo courtesy of Pillsbury Winthrop Shaw Pittman LLP.

The Case for Embracing General Solicitation: VC Edition

Ask VCs whether top venture firms are liable to take advantage of the new general solicitation rules, and the answer is often a barely suppressed laugh.

It’s easy to understand why some might look down their noses at the changes. VCs have been operating like a private club for a long time, and they tend to see their publicity-seeking brethren as trendy and desperate.

But all it takes is a quick skip down memory lane to see how fast some of the most mocked innovations to the VC game have become standard operating procedure for today’s Midas List.

Take secondary investments. As recently as 2004, selling a stake to a secondary buyer was an admission of defeat. But along came SecondMarket followed by a long string of savvy secondary transactions — like those Groupon shares that NEA offloaded to later investors, or Accel’s partial sale of its Facebook stake to Technology Crossover Ventures and Andreessen Horowitz — and suddenly, you were a dummy if you didn’t take some money off the table.

And what about marketing? If you’ve been in the industry for more than a decade, you know that many of the most august firms used to avoid reporters like the plague. Then some prescient venture capitalists like Fred Wilson began to build huge followings, and before you knew it, blogs became de rigueur. Andreessen Horowitz took things to another level when it began aggressively courting press attention in 2009. A lot of the firm’s peers privately complained that the firm was sucking all the air out of Silicon Valley, but today, every top firm has an executive or a team of people focused on communications and content strategy.

The list goes on and on. Seed-stage investing used to be a niche strategy as recently as 2005. Today, there’s a glut of seed-stage investors and seed-funded companies.

Investment documents used to 100 pages long and cost a fortune. Now, many startups use standardized Web templates that they can tweak to their heart’s content.

Successful entrepreneurs were outsiders in VC circles; now many have an easier time raising new venture funds than traditional firms.

Do you see where this is going? Yes, the prospect of advertising may seem outlandish right now, but so did a lot of these other trends.

On the plus side, if advertising can speed up a team’s fundraising process, VCs should have more time to make more money for their partnerships.

And themselves.

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