Executives Can Still Buy Shares With a Company Loan

As many of you know, Sarbanes Oxley prevents public companies from loaning money to officers and directors. In the past, this was commonly done for stock purchases. Since Sarbanes Oxley applies only to public companies, it is still possible to buy private company stock via a company loan. The loan however needs to be repaid prior to IPO. As the IPO market opens, we may see more executives buying their stock or exercising options via loans. The principal advantage is starting the one-year holding period for long term capital gains purposes.

The company loan is not without risk. It is a real obligation (that accrues interest) and it must be repaid on maturity. In the dot.com bust we saw many companies (particularly those assigned to a bankruptcy trustee) collect on such loans. The goal is to minimize personal liability by maximizing the portion of the loan that is non-recourse. A typical structure is to have the note be non-recourse and secured only by the underlying shares. However, if the fair market value of the shares at the time of the loan is not significantly greater than the loan amount, then the full loan amount will be deemed ordinary income to the executive. The fix is to have a portion of the loan be full-recourse (meaning the executive is personally responsible for repayment), but the remainder to be non-recourse. To be safe, it is best to follow broker margin rules, which provide for 50 percent loan to value, and thus 50 percent full recourse. There is no IRS direct guidance on this but I think the broker rules are a good place to start.

The executive can view the full recourse portion of the note as a down payment, except they don't need to pay cash, rather they are personally responsible for repayment if liquidity of the underlying shares doesn't materialize. Using the above guidelines, the loan amount should be no greater than 2X the full recourse portion. Of course, it is possible to secure the loan with other collateral, but most people don't want to pledge their car as security.

Remember that these loans do not have a cash impact on the company, they are cash neutral - the money is loaned to the executive and it goes right back to the company.

These loans are not for everyone and most companies and board of directors are disinclined to entertain them. However, for top executives, they may be a useful technique to retain and attract top talent.

There are many more details and considerations than I've outlined here. You should consult your tax and legal advisors before proceeding.

A Convertible Bridge is better than Equity for your Seed Round

For most seed rounds, a convertible bridge structure is better than Series A Preferred Stock. Convertible notes have the following advantages:

• Faster time to close. There are simply fewer terms to negotiate (less than 10 actually) versus Preferred Stock (closer to 50). As a result, the term sheet can be a page a long.

• You don't need a lead investor. Because of the simplicity of the terms, the Company can lead the process and close on multiple closings with investors over time.

•Investors can lock in the pre-money valuation. A convertible note doesn't mean investors need to give up locking in a pre-money valuation - the principal argument raised in favor of equity. The convertible note can provide that on the next equity round, the notes convert at the lower of the next round valuation or the locked-in valuation stated in the note. In this way, investors are assured the percentage ownership of the Company they've negotiated and the Company has avoided the costly and time consuming process of selling equity in its seed round.

•Less Expensive. Faster time to close and simplicity means fewer transaction expenses. In our experience, convertible note rounds cost a Company less than $5k (investors also usually don't use legal counsel), whereas equity rounds can cost up to $50k ($25-$35k for Company fees plus investor legal fees which are usually reimbursed to the lead investor).

•Investors get Venture Capital terms. When the notes convert, they will convert into the same Series A Preferred Stock (with all its bells and whistles) that the lead VC investor will negotiate at that time. Bridge investors will get all the same terms as the venture investor (except perhaps a better valuation!) and can piggyback off of that investor's negotiation skills.

•One Series of Stock. Converting all notes in the future into the same preferred stock that a future VC investor buys is best for the Company as well. It means all investors will hold the same series of preferred stock. This is more manageable for the Company going forward.

Convertible Bridge Terms are as follows:

•Size of round - usually a range or target.

•Multiple closings over time - you close each time an investor wires money to your account.

•Maturity Date - usually 12 or 18 months from first close.

•Conversion - automatic conversion on Series A of a certain threshhold size.

•Valuation or Discount. The notes will either convert at the pre-money valuation terms as described above or at a discount (usually 15-25%) to the Series A price.

•Interest Rate - the minimum applicable federal rate - which is now less than 1%.

•Legal Expenses - each investor pays its own legal counsel if they decide to use one.

•Amendments - the note terms can be amended by a majority of the noteholders. This is important for future flexibility.

Your Private Fundraising Round is Now Public

The SEC has changed, effective as of March 2009, the disclosure requirements for private companies selling stock. The new Reg D rules now require electronic filings for each financing that a company completes. This means you will need to disclose the amount and timing of your financing and the executive officers and directors of your company. While this information was previously required for the Reg D safe harbor, it is now instantly publicly available. It is critical that the information filed be accurate. The new filing requirements however no longer make you disclose the name of each purchaser, although if your purchasers are serving on your board of directors, the public will now know this information. Please note that there are other exemptions from the securities laws that you may be able to rely on to avoid this public disclosure requirement that we can advise on.