Final 409A Regulations

A few weeks ago the Final 409A Regulations were released by the IRS. The proposed regulations have been out for over a year, so this is pretty significant development. The final regs can be found here.

Brown University Venture Forum for Enterprise Slide Deck

I recently spoke at a program on valuation and term sheets at Brown University put on by the Brown Forum for Enterprise. I discussed the topic of valuation issues surrounding stock options and 409A. The slide deck can be viewed here.

Study for West Coast VC Deals in Life Sciences

Fenwick publishes a quarterly study of VC deal activity in various areas. The most recent life sciences report can be found here: http://www.fenwick.com/vctrends/LS_VC_Survey_2006.htm?WT.mc_id=LSVCS_032707_e-mail-corp

Indemnification rights in venture deals

While the venture market still seems flush with cash, a number of recent litigations involving venture firms (such as the Hummer Winblad case now in seemingly constant discussion) are driving the market to seek additional protections from their portfolio companies upon investment and afterwards.

In particular, some investors are now asking for indemnification from the company akin to the measures in an acquisition agreement. Companies looking to oppose these provisions should know that they are generally rare. While an indemnity is market where the deal presents some liquidity to the founders or other investors. this is not common in the venture context. The VC investors typically have board seats, observation and information rights and strong covenants, so they are in a position to see how the money is spent. If they don't have then, this presents a bargaining chip for the company in exchange for the indemnity being sought. They also have the right to sue the company for breach of the reps or fraud while there is still money to pay the claim. Unlike an M&A deal, venture round docs usually don't have exclusive remedy clauses.

A later stage financing certainly is more likely to give concern to the investor about the unknown that cannot adequately be tested through due diligence, but it would be unfair to shift that risk to the founders. If I am a VC asking for this provision and getting it regularly, I have to ask kind of company (and founder team) am I investing in if they will accept those terms. The
better the terms for the VC, the more apparently becomes the adverse selection problem.

One way to deal with the issue is to ask the investors their specific concerns. If there is a known problem, such as a litigation, a 409A problem, etc., that can be dealt with through traunches, escrow etc, without personally impinging on the Founders . The NVCA model docs address this issue parenthetically by having certain reps be made by the Founders, where the "Founder's liability for breaches of any provisions of this Section 3 shall be limited to the then current fair market value [as determined in good faith by the board of directors of the Company and such Founder [may, in his sole discretion, discharge such liability by the surrender of such shares or the payment of cash] (note FN1 and FN2 below from the docs). The NVCA docs are intended as a fair starting point for a Series A round, and they do not contemplate an indemnity. Finally, another approach may be to allow the indemnity, but to limit all recourse to the Founder's shares. The risk here, of course, is the precedent for the next round.


[1] Founders' representations are controversial and may elicit significant resistance. They are more common in the Northeast and counsel should be warned that they may not be well received elsewhere.
They are more likely to appear if Founders are receiving liquidity from the transaction or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution
or the Founder was formerly with another Company whose business could be deemed competitive with the Company). Founders' representations are not common in subsequent rounds, even in the Northeast, where risk is viewed as significantly diminished and fairly shared by the investors rather than being disproportionately borne by the Founders.

[2] Investors should consider whether cash is an acceptable remedy; the cash value of the shares is likely to be low, particularly if there has been a breach of a rep or warranty. In addition, if the Investors require the surrender of shares rather than cash, they should also consider whether to include Preferred Stock, as well, if the Founder owns shares of Preferred.

Delaware court comments on "spring loaded" options

This has been an interesting month for stock option decisions. As mentioned in my prior post, a few weeks ago the Delaware Chancery court took a hard line against backdating option practices in Ryan v. Gifford (now available on the Chancery Court's website here).

Another decision issued on the same day (2/6/07)is In re Tyson Foods, an opinion written by Chancellor Chandler. The relevant part of this case is the discussion on "spring loaded" option grants issued by the Company to favor executives. Ok, so what are "spring loaded" options? The court explains that the are options granted right before a company makes an announcement that is expected to have a positive result on the stock price. The converse of this practice are "bullet dodging" grants, where the grants are timed to take place after the impact of an announcement that is anticipated to depress stock price, thereby giving the benefit of a lower strike price.

This theory of liability is interesting because it is different than straight backdating. As the court points out, backdating has the inherent problem of falsifying information about the grant itself. The date of issuance is false, as is the representation to stockholders that the option was granted at fair market value on its grant date. Spring loading, however, does not necessarily face the same ethical issues. As the court notes, a company may be justified in knowing issuing options that are in the money to executives, as a means to retention and providing performance incentives. The problem lies with disclosure.

The court notes that "[t]he touchstone of disloyalty or bad faith in a spring-loaded option remains deception, not simply the fact that they are (in every real sense) 'in the money' at the time of issue. A board of directors might, in an exercise of good faith business judgment, determine that in the money options are an appropriate form of executive compensation.... A company with a volatile share price, or one that expects that its most explosive growth is behind it, might wish to issue options with an exercise price below current market value in order to encourage a manager to work hard in the future while at the same time providing compensation with a greater present market value. One can imagine circumstances in which such a decision, were it made honestly and disclosed in good faith, would be within the rational exercise of business judgment...."

The interesting common thread between both decisions is the overtone relating to good faith/bad faith by directors. Some commentators have already noted that this arises from the Disney decision from 2006 where the Delaware Supreme Court elaborated on what some see as a new duty by the board, one of good faith. This analysis seems to allow for a private right of action under state law against directors, where theories under federal law for insider trading have not gotten much traction with the courts. (“To act in good faith, a director must act at all times with an honesty of purpose and in the best interests and welfare of the corporation.”)

The court also notes in dictum that a director may be absolved of liability if shareholders have expressly empowered the board of directors (or relevant committee) to use backdating, spring-loading, or bullet-dodging as part of employee compensation, and that such actions would not otherwise violate applicable law. It seems like this language could be useful in drafting future plans, although it begs the question as to what impact it would have under 409A, where you may still run into a problem for issuing options below fair market value.

IRS issues tax reprieve for backdated options

Last week the IRS announced an initiative aimed to relieve for rank-and-file employees (as opposed to company executives) affected by backdated and other mispriced stock options. The announcement can be read here.


An employee who exercised a ‘backdated’ stock option in 2006 may owe an additional 20-percent tax, plus an interest tax, under the Federal tax laws governing deferred compensation. If the option had been properly priced, the employee normally would only have owed income tax on the difference between the value at the date of grant and exercise.
The initiative allows companies to step forward and pay the additional 20-percent tax and any interest tax that employees owe.

Employers and employees must both act quickly. Under this initiative, employers must notify the IRS of their intent to participate by Feb. 28, 2007. The employers, in turn, will be required to contact affected employees by Mar. 15, 2007 to inform them that the employer has applied to participate in the Compliance Resolution Program.