Startups in a Down Economy: Legal Strategies for Raising Capital

© 2020 Haynes and Boone, LLP
Idea to IPO
Startups in a Down Economy:
Legal, Business, and Financing
Strategies
#startup #ideatoipo
Roger Royse
@rroyse00

© 2020 Haynes and Boone, LLP© 2020 Haynes and Boone, LLP
Disclaimer
No information contained in this presentation is to be construed as legal
advice. No information contained in this presentation is intended or
related to any particular factual situation. Nothing herein forms an
attorney-client relationship. If legal advice or other expert assistance is
required, the services of a competent professional should be sought.
2

Summary
 Planning for a downturn
 Federal aid and tax credits
 Tax aspects of debt forgiveness
 Personal investment and guarantees
 Force majeure, impracticality and impossibility
 Business interruption insurance
 Fraudulent conveyances and avoidable transfers
 Personal liability: sales taxes, employment taxes and veil piercing
 Employment claims
 Fiduciary claims - creditors
 Venture capital terms
 Exiting: fire sales and management carveouts and the Trados litigation
 Bankruptcy and Insolvency
3

Planning for a Downturn
 Sequoia Black Swan memo of 2008
 Sources of follow on capital
 Bain & Company recommends organizing around 6 urgent priorities
 Protect employees and customers
 Financial Modelling
 Defend revenue
 Stabilize operations
 Reduce costs
 Play offense
4

Are we in a downturn?
 CNN: July 31, 2020 “US economy posts its worst drop on record”
 33% annual rate decline from April through June
 FITS News: Sept 22, 2020 “Economy Poised for Massive expansion in Q3”
 28.7% Q-3 bounce
 Brookings: September 17, 2020
 Small busines revenue down 20% in 2020
 Ch 11 bankruptcies increased over last year
 New business formations down in Q2 but still high
 Venture financings strong
5

Businesses that are doing well
 Ecommerce
 Online services
 Food safety
 Telemedicine
 Insurance tech
 Housing
 Supply Chain
6

7

8

9

10

Paycheck Protection Program Loans
 Overview of Available Relief under CARES Act
 Loan Programs
o Paycheck Protection Program
o SBA EIDL Loans
o Main Street Lending Program
 Tax Credits and Deferrals
o Employee Retention Tax Credit
o Opportunity Tax Credit
o Employer Social Security Tax Deferral
11

PPP – Loan Forgiveness
 Intent to is to incentivize the use the proceeds for 24 weeks of payroll
 Based on retaining or rehiring and maintaining salary levels
 60% PPP must be used towards payroll costs (even though you are
closed)
 Forgiveness not taxable as income
12

SBA Economic Injury Disaster Loans
 Eligibility
 Companies that can show an injury
 In operation since 1/31/2020
 Small business, most nonprofits, sole proprietors, small ag coops
 Operates primarily in the US
 Independently owned and operated
 Not dominant in its field on a national basis
 Not available for cannabis and other federally restricted activities
13

SBA EIDL Terms
 Up to $2,000,000 (up to $200k with no personal guarantee)
 3.75% Interest Rate, up to 30 years term
 Loans under $25,000 require no collateral
 Up to 30 Year term – case by case
 Up to $10,000 injury advance have been fully allocated
14

SBA Economic Injury Disaster Loans
 Eligibility:
 Business employs 500 or fewer people likely considered a small
business and eligible, including the loan advance.
 Number of employees is higher for businesses in some industries
 In addition to the PPP loans but cannot be used for same purpose
15

Other Loans
 Express Bridge Loan-small businesses who currently have a business
relationship with an SBA Express Lender may access up to $25,000
 Debt Deferment on existing 7(a) loans
 California Statewide Certified Development Corporation (CDC) –
working capital loans up to $250,000 for 5 to 10 years at prime plus
6.25 – 9.25%
 CDC Small Business Finance loans up to $500,000 between 7.25%
and 14.5%
 SBA 7(a) loans – up to $5 million for short or long term working capital
 504 Loans up to $5.4 million long term fixed rate loans
 SBA micro loans
 https://calstatewide.com/community-advantage-lending/
16

Payroll Tax Credit
 Refundable payroll tax credit for 50% of certain wages paid through 12/31/2020
 Available if operations have been
 fully or partially suspended as a result of government order limiting travel or meetings, or
 significant decline in gross receipts
 Covers wages of furloughed employees or all employee wages for employers with 100
or fewer employees whether or not furloughed
 Covers wages and comp including health benefits
 Excludes wages used for credits for required paid sick leave or paid family leave
 If employment tax deposits do cover the credit, employer may receive advance
payment from the IRS on Form 7200
 FY 2020 employer payroll tax deposits delayed to end of 2021 and 2022
 payroll deposits delayed - 50% of 12/31/2021 and 50% on 12/31/22 unless PPP forgiveness
 Not available for employers receiving PPP assistance
17

PPP vs. Tax Credit
 If any portion of PPP is forgiven, no social security tax deferral
 Credit is 50% up to $10,000 per employee
 Reduced by sick and FMLA credit
 Forgiveness is up to $100,000 annualized comp per employee
 Forgiveness is tax free
 Payment is deductible
18

Workouts
Convert debt to equity
Settle debt at discount
Convert preferred to common
19

Cancellation of Indebtedness
 Cancellation of indebtedness (“COD”) income
 Debt forgiven or satisfied for less than adjusted issue price
 Debt modified or exchanged for other debt
 Conversion of debt to equity
 Target is treated as satisfying the debt with an amount of money equal
to the fair market value of the stock issued. Code Section 108(e)(8).
 Debt Purchased by related party
 Creditor forbearance
20

 Generally, COD income is realized at the time the debt is satisfied for
less than its principal amount.
 COD income is equal to the difference between the amount due under
the obligation and the amount paid by the debtor.
Measuring Target’s COD
21

Can COD Income be Excluded?
COD can be excluded from income in certain cases:
 Discharge in bankruptcy (regardless of the extent of Borrower’s insolvency).
 Code Sections 108(a)(1)(A) and 108(d)(2).
 Discharge when Borrower is insolvent (but only to the extent of insolvency).
Code Sections 108(a)(1)(B) and 108(a)(3).
 “Qualified farm indebtedness.” Code Sections 108(a)(1)(C) and 108(g).
 For borrower other than a C corporation, “qualified real property business
indebtedness” (QRPBI). Code Sections 108(a)(1)(D) and 108(c).
 Qualified principal residence indebtedness (QPRI) discharged before 2017 (or
subject to an arrangement entered into and evidenced in writing before Jan.
1, 2017). Code Sections 108(a)(1)(E) and 108(h).
22

When Is COD Excluded from Income?
 The insolvency and bankruptcy exceptions are the exceptions most
often used in a debt workout.
 The bankruptcy exception applies to all COD income.
 The insolvency exception applies only to the extent of target’s
insolvency.
 If the insolvency and bankruptcy exceptions don’t help, the exception
for qualified real property business indebtedness (QRPBI) may be
useful (for taxpayers other than C corporations).
23

Insolvency and Bankruptcy Exceptions
 If target is not in bankruptcy, it could only exclude some or all of the
COD from income if it were insolvent.
 Insolvency is defined as the excess of liabilities over the fair market
value of assets, as determined immediately before the COD. Code
Section 108(d)(3).
 In a bankruptcy, the COD income is excluded regardless of the
debtor’s solvency.
24

Reduction of “Tax Attributes”
 If target could avoid COD income through the insolvency or bankruptcy
exceptions, then it must reduce valuable “tax attributes” to the extent of
excluded COD. Section 108(b).
 Recall that if target is in bankruptcy and avoids the loss limitation rules, then
it must reduce its NOLs under the “toll charge” provision. Avoiding COD
income would require a further reduction of target’s tax attributes.
 Tax attributes include NOLs, credits, capital losses, carryovers of losses, and
basis.
25

Reduction of “Tax Attributes”
 Complex rules on the order in which attributes are reduced, but Borrower
does have a limited amount of choice about the order in which attributes are
reduced.
 If the taxpayer chooses, it may elect to forgo the standard reduction
 provisions and reduce the basis in its depreciable assets first.
 This election may be made, for instance, if the taxpayer has assets it expects
to maintain for a period of time and if its NOLs may soon expire and it could
potentially utilize them.
26

Personal Investment and Guarantees
 Springing recourse guaranties - default by the borrower.
 Bad boy guaranties
 filing of a bankruptcy case by the borrower;
 diverting cash generated by the borrower from payment of the borrower’s
obligations while the borrower is in payment default to the lender;
 lies on the loan application; and
 transfer of the borrower’s assets to non-creditors
 Limited guaranties:
 only a certain dollar amount of the debt, a percentage of the debt, a portion of the
lease term, or any other fraction of the obligation created by the guaranteed
contract.
 Personal guaranty defenses
 Fraudulent inducement
 Revocation - Cal Civ Code 2815
 Increase in guarantor's risk of loss
 Defense of debtors
27

Force Majeure
The parties’ performance under this Agreement is subject to acts of God,
war, government regulation, terrorism, disaster, civil disorder, curtailment
of transportation facilities, or any other emergency beyond the parties’
control, making it impossible to perform their obligations under this
Agreement. Either party may cancel this Agreement for any one or more
of such reasons upon written notice to the other.
28

Impracticality
 Impracticability means the excuse in performance of a duty. Under the
common law of contract, impracticability is a defense that can be
relied on when the duty to be performed becomes unfeasibly difficult
or expensive for a party who was to perform.
 UCC - Delay in delivery or non-delivery in whole or in part by a seller
who complies with divisions (B) and (C) of this section is not a breach
of his duty under a contract for sale if performance as agreed has
been made impracticable by the occurrence of a contingency the non-
occurrence of which was a basic assumption on which the contract
was made or by compliance in good faith with any applicable foreign
or domestic governmental regulation or order whether or not it later
proves to be invalid.
29

Frustration of Purpose
An unforeseen event undermines a party's principal purpose for entering
into a contract such that the performance of the contract is radically
different from performance of the contract that was originally
contemplated by both parties.
California law: Performance remains possible but:
 the fundamental reason of both parties for entering into the contract
has been frustrated by an unanticipated supervening circumstance;
and
 it destroys substantially the value of performance by the party
standing on the contract.
 the frustration must be so severe or substantial that it is not fairly to be
regarded as within the risks that were assumed under the contract.
30

Business Interruption Insurance
 Business interruption insurance is insurance coverage that replaces
income lost in the event that business is halted for some reason, such
as a fire or a natural disaster. This type of insurance also covers
operating expenses, a move to a temporary location if necessary,
payroll, taxes, and loan payments.
 Lost revenue, rent, employee expenses, relocation etc.
 Restoration period
 Mitigation
31

D&O Insurance
 Directors and officers (D&O) liability insurance
 Protects personal assets of directors and officers
 Suits by shareholders, employees, creditors, competitors, investors,
customers, or other parties
 Willfulness carveouts
32

Fraudulent Transactions
 The Uniform Voidable Transactions Act (UVTA), formerly named the Uniform
Fraudulent Transfer Act (UFTA).
 Creditors can avoid transfers
 Constructive fraud:
 Did not receive a reasonably equivalent value in exchange for the transfer; and
 The debtor was insolvent
 Actual intent to hinder, delay, or defraud
 California crime to fraudulently sell, convey, assign, or conceal property with
the intent to defraud, hinder, or delay a creditor of its rights, claims, or
demands.
 Bankruptcy fraudulent conveyance:
 Intent to hinder, delay, or defraud a creditor or subsequent creditor;
 Receive less than a reasonably equivalent value in exchange;
 Insolvent or became insolvent as a result of the transfer
33

Personal Liability - Contract
 Contractual
 Personal guarantees
 Co-Obligor
 Pledges and security interests
34

Personal Liability - Willful Failure To
Pay Payroll Taxes
 Federal:
 "responsible persons" who were required to pay over the money or who
controlled the funds that should have been deposited. Many people
associated with a business may be found to be a responsible person,
including corporate officers, treasurers, managers, and even
bookkeepers, in certain circumstances.
 trust fund recovery penalty up to 100% of the unpaid withheld tax.
 IRS will assess the penalty against any person who it believes was
responsible for the nonpayment of the taxes
 State: Employment Development Department (EDD) in California
 EDD can assess 100% of the tax due to anyone deemed a responsible
person
 Criminal liability: Justice Department can pursue criminal prosecution
if employer willfully fails to pay over employment taxes
35

Personal Liability – Other State Taxes
 Most states have personal liability laws
 California Sales tax
 Any person of the entity that is responsible for the filing of returns,
payment of tax, or who is charged with the duty to act on behalf of the
business for sales and use tax purposes may be held personally
responsible
 California Unemployment, Workers’ Compensation and Disability
Taxes/Contributions
 personal liability on any officer, major stockholder or other person having
charge of the affairs of a corporate employer who willfully fails to pay any
contribution (employer portion) or withholding (employee portion) for
unemployment, workers’ compensation or disability taxes
36

Personal Liability – Bad Checks And
Credit Cards
Section 476(a) of the California Penal Code imposes criminal liability on
an officer of a company who willfully issues a check with knowledge that
at the time of issuance, the company does not have sufficient funds or
credit with the bank on which the check is drawn to pay the check and
other checks then outstanding. The officer can be sentenced to up to one
year in jail, although restitution is the more common remedy.
 Corporate Credit Card Liability. Employees who use “corporate” credit
cards may be held responsible for charges which they signed.
37

Personal Liability - Improper Distributions
and Loans
Improper Distribution to Shareholders. Section 316 of the California
Corporations Code imposes personal liability on a shareholder for a
distribution which would render the corporation insolvent.
 Once corporate dissolution proceedings have commenced, there cannot
be a distribution to shareholders unless the payment or adequate
provision for payment of all known liabilities of the corporation.
Improper Loans or Guaranties. Section 315 prohibits the making of
loans to officers or directors or guaranteeing their obligations without
prior disclosure and approval of a majority of shareholders.
38

Personal Liability - Wages
 Section 215 of the CA Labor Code:
 Misdemeanor for any agent or officer of a company to violate those
provisions of the California Labor Code which require that (i) wages to be
paid accordingly to the weekly or bi-weekly payroll schedule and (ii) any
check issued for wages to be for good funds.
 Labor Commissioner may proceed against officers
 Section 216 of the CA Labor Code:
 If company has ability to pay and does not, officers may be liable
 Fraud claims
 Employees work after the company does not have sufficient funds to pay
accrued wages.
39

Personal Liability - ERISA
 U.S. Department of Labor (DOL) enforcement
 Failure to timely segregate employees’ 401(k) plan deferrals:
 Become ERISA fiduciaries
 Personally liable to make good the losses to the plan.
40

Personal Liability - CERCLA
 CERCLA allows the EPA to investigate and clean up hazardous waste
sites and to recoup clean-up costs from “potentially responsible
parties.” The definition of a “potentially responsible party” is broad and
may include corporate officers and directors.
41

Personal Liability - Fraudulent Failure to Pay
 In order to make a case for fraud or intentional misrepresentation, the
creditor has to prove four elements:
 a knowing or intentional misstatement;
 the misstatement is material;
 the creditor reasonably relies on the misstatement; and
 the creditor is damaged as a result.
42

Statutory Claims
 Bank Fraud 18 USC 1344
 Wire Fraud 18 USC 1343
 Section 10(b) of the Securities Exchange Act of 1934 makes it
unlawful to “use or employ, in connection with the purchase or sale of
any security” a “manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the [SEC] may
prescribe.
 State anti fraud and blue sky laws
 Federal and state rescission rights
 Unregistered broker dealer
 Unaccredited investors
 State law sophisticated investor requirements
43

Alter Ego Claims
 Corporate entity may be disregarded and officers and directors may
held personally liable for corporate debts and obligations
 Factors:
 failure to complete formation of the company;
 failure to properly capitalize the company;
 use of company assets for personal use; and/or
 commingling of company funds with personal funds.
 Follow the money
 Reverse veil piercing
44

Fiduciary Claims
 Business judgement rule
 Entire fairness standard
 Loyalty
 Care
 Good faith
 Obedience
 Disclosure
 Confidentiality
 Duties to common and preferred stockholders
 Duties to creditors
45

Fiduciary Claims by Creditors
 Trust fund doctrine
 Directors owe a duty to act in the creditors' interests when corporation
is insolvent (not just the zone of insolvency)
 Zone of insolvency vs insolvency may not be clear
 North American Catholic Educational Programming v. Gheewalla (Del.
Supr. 2007))
46

Troubled Company Terms-
Reset The Cap Table
 Forced conversion to common
 Optional conversion clause can be triggered on a stated vote
 Pull Up
 New money pulls up some prior preference
 Reverse split
 Reduce number of shares
47

Pay to Play
 Pay to play
 requires existing investors to invest on a pro rata basis in subsequent
rounds or they lose preferential rights (anti-dilution, liquidation
preferences, voting rights)
 Applies to future rounds but can be added in current financing
48

Troubled Company Terms - Full Ratchet
 Down rounds
 Trigger anti dilution protection unless waived
 Three types of anti dilution:
 Broad based weighted average
 Narrow weighted average
 Full ratchet
 Full ratchet
 adjusts the conversion price of the preferred stock to common stock to
reflect the new down round price.
 Foreign anti dilution terms can be worse
49

Option Repricing
 Option exercise price may be above value
 Repricing reduces the exercise price
 ISOs are treated as regranted
 Securities law issues under Rule 701
 Tender offer rules
 Accounting charges
50

Troubled Company Terms – Carveout Plans,
Capped Participation
 Good Technology sale to Blackberry opposed by common
stockholders
 Good turned down better offers, including one for $825 million, nearly
double BlackBerry’s offer.
 Investors claimed that instead of pushing a deal that maximized value
for common stockholders, mgmt pushed for a deal with a sweet
“retention plan”
51

Troubled Company Terms – Insider rounds
 Low valuations
 Penny warrant coverage
 Anti dilution
 Redemption rights
 Pay to play
52

Successful Exits
 IPO
 Sale or Acquisition
53

Unsuccessful Exits
 Zombie Companies
 In re Trados Inc. Shareholder Litigation
 Bankruptcy or Insolvency Reorganizations
 Fire Sales
 Management carveouts
 Fiduciary duties: shareholders, optionees, preferred and creditors?
54

In re Trados Inc. Shareholder Litigation
 Board adopted a management incentive plan (MIP) that was
structured so that once an offered sale price for Trados exceeded the
venture capitalists’ liquidation preference, compensation to the
preferred stockholders would increase substantially at the expense of
common stockholders.
 Preferred received most of their preferences, MIP got $7.8 million,
common got nothing
 Interested director transaction
 Fair process
 Fair price
55

Best Practices
 Duties to common and preferred
 Independent boards
 Good process and minutes
 Bankers
 Separate votes
56

Other Unsuccessful Exit Issues
 Tax Liability
 Personal Liability
 Tax
 Employment
 Fiduciary Claims
 Securities Law Claims
 Contractual
 Pierce the veil and creditor claims
 Serial Entrepreneurs and failed companies
57

Section 382 – In General
 The U.S. has rules that prevent trafficking in losses.
 Section 382 restricts the ability of a “loss corporation” to claim NOLs
generated before the sale against income earned after the sale if
there has been an “ownership change.”
 An ownership change occurs if the percentage of stock owned by 1 or
more 5 percent shareholders increases by more than 50 percent
during a 3 year period.
 The NOL limitation for any year after an ownership change is equal to
the value of target immediately prior to the change, multiplied by the
long-term tax-exempt rate
58

WARN Act
 Federal Worker Adjustment and Retraining Notification Act of 1988
(the "WARN Act") requires most employers with 100 or more
employees to provide 60 calendar-day advance notification of plant
closings and mass layoffs of employees
 California WARN Act modeled after the federal WARN Act. But the
California WARN Act extends protection to a wider range of laid-off
employees
59

Winding Up
 WARN Act
 Payments to creditors
 Distributions to stockholders
 After found assets
 Post dissolution claims
 Zombie companies and the California Franchise Tax Board
60

AUSTIN
600 Congress Avenue
Suite 1300
Austin, TX 78701
United States of America
T +1 512.867.8400
F +1 512.867.8470
CHARLOTTE
101 S. Tryon Street
Suite 2250
Charlotte, NC 28280
T +1 980.771.8200
F +1 980.771.8201
CHICAGO
180 N. LaSalle Street
Suite 2215
Chicago, IL 60601
T +1 312.216.1620
F +1 312.216.1621
DALLAS
2323 Victory Avenue
Suite 700
Dallas, TX 75219
T +1 214.651.5000
F +1 214.651.5940
DALLAS - NORTH
2505 North Plano Road
Suite 4000
Richardson, TX 75082
T +1 972.739.6900
F +1 972.680.7551
DENVER
1050 17th Street
Suite 1800
Denver, CO 80265
T +1 303.382.6200
F +1 303.382.6210
FORT WORTH
301 Commerce Street
Suite 2600
Fort Worth, TX 76102
T +1 817.347.6600
F +1 817.347.6650
HOUSTON
1221 McKinney Street
Suite 2100
Houston, TX 77010
T +1 713.547.2000
F +1 713.547.2600
LONDON
1 New Fetter Lane
London, EC4A 1AN
United Kingdom
T +44 (020) 8734 2800
F +44 (020) 8734 2820
MEXICO CITY
Torre Esmeralda I, Blvd.
Manuel Ávila Camacho #40
Despacho 1601
Col. Lomas de Chapultepec,
DF 11000
Mexico City, Mexico
T +52.55.5249.1800
F +52.55.5249.1801
NEW YORK
30 Rockefeller Plaza
26th Floor
New York, NY 10112
T +1 212.659.7300
F +1 212.918.8989
ORANGE COUNTY
600 Anton Boulevard
Suite 700
Costa Mesa, CA 92626
T +1 949.202.3000
F +1 949.202.3001
PALO ALTO
525 University Avenue
Suite 400
Palo Alto, CA 94301
T +1 650.687.8800
F +1 650.687.8801
SAN ANTONIO
112 East Pecan Street
Suite 1200
San Antonio, TX 78205
T +1 210.978.7000
F +1 210.978.7450
SHANGHAI
Shanghai International
Finance Center, Tower 2
Unit 3620, Level 36
8 Century Avenue, Pudong
Shanghai 200120, P.R. China
T +86.21.6062.6179
F +86.21.6062.6347
THE WOODLANDS
10001 Woodloch Forest Drive
Suite 200
The Woodlands, TX 77380
T +1 713.547.2100
F +1 713.547.2101
WASHINGTON, D.C.
800 17th Street NW
Suite 500
Washington, D.C. 20006
T +1 202.654.4500
F +1 202.654.4501
61

Startups in a Down Economy: Legal Strategies for Raising Capital

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