VCSpotlight
SM
Venture Capital Data
Q3 2015 First Institutional Rounds – Deal Terms
SPOTLIGHT ON THE LAW
For further information about either
this article or the NVCA model documents, please contact Jon Gworek at
jgworek@mbbp.com or Scott Bleier at
sbleier@mbbp.com.
Morse, Barnes-Brown & Pendleton, PC
Our financing data includes a wealth of detailed information of interest
to both companies and investors alike, including specifics on pre-money
valuation, liquidation preferences, dividend rates, participating investors,
and distributions across industries and region. For more information on
the data we can provide contact Joe Martinez at jmartinez@mbbp.com.
Q3 2015 First Institutional Rounds
Deal Terms
100%
100%
100%
91%
90%
90%
80%
80%
70%
70%
60%
60%
Percentage
Regardless of whether practitioners
agree with the modifications that
have been made over the 10 plus
years of their existence, the deliberate process the National Venture
Capital Association’s model venture
capital forms committee has gone
through in updating and modifying
these documents has resulted in a
product that is a must-have resource
to any venture capital practitioner. A
careful review of the changes reveals
just how deliberate and exacting an
effort this has been. The forms are
the byproduct of a unique, cooperative effort undertaken by many of
the most experienced and sophisticated venture capital practitioners in
the country. The full length article
traces and categorizes the key changes
that have been made to these documents over the years. Changes have
been grouped based on one of three
underlying purposes - changes made
to clarify without changing the underlying intent; changes that reflect
shifts in venture capital practice; and
changes that simply reflect efforts
to generally refine and improve the
documents.
Morse, Barnes-Brown & Pendleton, PC compiles a comprehensive database of venture capital transactions that have closed within New England,
New York and New Jersey. VC SpotlightSM periodically features an analysis
of first institutional venture capital rounds. This report is a definitive
source of information on emerging companies receiving their first institutional financing and the venture capital firms that provide it.
Percentage
The Evolution of the
NVCA Documents: A Brief
Description of Changes Since
Inception
Q4 2015
50%
50%
48%
40%
40%
30%
30%
26%
22%
20%
20%
9%
10%
10%
0%0%
Dividends
Dividends
Cumulative Dividends
Participating Preferred
Weighted Average
1X Liquidation
Redemption
Cumulative Participating Antidilution
Weighted
1x
Redemption
Protection
Dividends
Preferred
Average
Liquidation
Antidilution
Protection
The information reported above is the result of an analysis of data gathered
from a variety of publicly available sources for 23 companies that closed
their first institutional round of financing in the third quarter of 2015.
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Continued on Page 8.
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S P O T L I G H T O N TA X
Explaining Profits Interests
and Their Tax Consequences
Equity incentives are an important
form of compensation in many types of
businesses and are especially important
at the start-up phase when only limited
funds may be available to pay cash
compensation. Entrepreneurs familiar
with the corporate form of business
likely have received equity incentives
themselves, possibly in the form of
restricted stock, stock options or stock
appreciation rights (SARs). Now that
LLCs have become a popular choice
of entity, more service providers are
receiving LLC equity incentives. One
such LLC equity incentive is a “profits
interest.” This article answers two questions of importance to the recipient of
a profits interest: (1) what exactly is a
“profits interest” and (2) what are the
tax pros and cons to the recipient?
Q: My employer, an LLC,
promised me equity incentives.
I just received documentation
indicating I have a “profits
interest.” I was expecting restricted
stock, stock options or, perhaps,
stock appreciation rights. What is a
“profits interest?”
A: There are two types of equity
in an LLC taxed as a partnership
– “capital interests” and “profits
interests.” A capital interest, like a
share of stock in an entity taxed as
a corporation, represents a slice of
existing company value; this means
that if the LLC were to liquidate
right after grant, the recipient of a
capital interest would receive a share
of the liquidation proceeds or capital.
On the other hand, a profits interest
Morse, Barnes-Brown & Pendleton, PC
represents only a right to share in
the future growth of the entity; that
is, income and/or appreciation that
is generated after the date of grant.
Existing value is attributed to the
current LLC equity holders. If the
LLC were to liquidate right after
grant of a profits interest, the current
LLC equity holders would receive all
LLC value and the recipient of the
profits interest would receive nothing.
While an LLC could issue restricted
capital interests in the LLC, options
to buy interests, or interest appreciation rights (akin to restricted stock,
stock options and stock appreciation
rights, respectively, in a corporation), profits interests are unique to
tax partnerships and carry some tax
advantages over these other forms of
equity incentive.
Q: What are the possible tax consequences of a profits interest?
A: From a tax perspective, the primary reason employers issue profits
interests is that a profits interest does
not result in taxable income to the
recipient upon grant. Since a profits
interest represents a right to a share of
future value of the LLC, it is worth
nothing upon receipt. Thus, there is
no tax liability to the recipient associated with the grant of a profits interest. This treatment is different from
the grant of restricted stock/restricted
capital interest where, upon the grant
of restricted stock/restricted capital
interest, the recipient is subject to tax,
at ordinary income rates, upon the
difference between the price she paid
for the equity and the value of the
equity. The grant of restricted stock/
restricted capital interests, depending
on the value of the stock/capital interest and the price paid for it, may cause
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a liquidity issue for the grantee who
must come up with the funds to pay
the purchase price and/or the taxes.
A second reason employers issue
profits interest is that a profits interest represents equity in the LLC and
upon its later sale or redemption it
will generate capital gain income subject to certain partnership tax rules,
applicable also to capital interests,
which may re-characterize some of
the capital gain income as ordinary
income. Until the options are exercised for stock, appreciation rights
and options do not represent equity,
and any value that is attributable to
these forms of equity incentives is
treated as ordinary income, taxed at
higher ordinary income tax rates, and
may also be subject to Social Security
and Medicare taxes.
A third important difference is that
upon receipt of a profits interest, the
grantee becomes a partner for tax
purposes. Because the grantee is now
a partner, she should not be treated
as an employee for tax purposes.
Thus, the grantee will receive Forms
K-1, reporting her share of the LLC’s
fiscal year profit and loss (if any) in
accordance with the LLC’s Operating Agreement and payments for
services (i.e., formerly “salary”). The
grantee will be solely responsible for
paying periodically estimated taxes
and self-employment taxes. The LLC
should no longer report payments
for services on a Form W-2 or withhold income and Social Security and
Medicare taxes or pay the employer’s
share of such taxes.
In summary, if the change in employment status and added tax reporting
burden are not deal-killers, the receipt
of a profits interest has the distinct
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advantages over other types of equity
incentives of both no current taxation
and a potential for capital gains treatment. Nonetheless, a grantee must
be comfortable that the terms of the
profits interest represent a meaningful
incentive. Careful review of the terms
governing the profits interest, which
are typically contained in a Grant
Agreement and the LLC’s Operating
Agreement, is necessary.
Important questions the recipient
of a profits interest should ask to
ensure she understands what she is
getting include:
xIs
x the class or series entitled to
distributions to pay taxes on
its allocable share of LLC
income each year?
xDoes
x
the class or series carry
voting rights?
xIs
x the class or series subject
to other restrictions which
do not apply to other LLC
interests, such as transfer
restrictions or restrictions on
access to information about
the LLC?
•• What value has been set for the
LLC upon grant of the profits
interest? This value will be attributed to the existing LLC equity holders. If the value is too
high, the profits interest may
never share if the value cannot
be reached and surpassed; if it
is too low, the intended profits
interest may instead be a capital
interest, causing the recipient to
have taxable income upon grant.
For further information on this topic,
please contact Diana Española at
despañola@mbbp.com.
•• Is the profits interest subject to
vesting? If so, what is the vesting schedule and what will happen if the vesting is not met?
A company with a bright future but
a temporary cash shortage might be
tempted to compensate employees
with an ownership interest in the
company (stock or equity) instead of
with cash.
•• What are the rights of the class
or series of equity on which the
profits interest has been granted? For example,
xWill
x
the class or series
share in distributions of
operating income, as well as
liquidating distributions?
Morse, Barnes-Brown & Pendleton, PC
SPOTLIGHT ON
EMPLOYMENT
Wage & Hour Tip:
Employers Cannot Pay
Employees With Stock or
Equity In Lieu of Cash
But, is this practice legal? Generally,
the answer to this question is
no. Under state and federal law,
employees must be paid at least the
minimum wage in cash. Providing
equity, no matter how much the
equity is worth, does not fulfill this
requirement.
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An exception to this rule is made,
however, if the employee comes
within the exemption for executivebusiness owners provided for in the
federal Fair Labor Standards Act
(“FLSA”). An individual who comes
within this exemption is exempt
from the FLSA’s minimum wage and
overtime requirements.
To be exempt as an executive-business
owner under the FLSA, an individual
must (1) be employed in a bona
fide executive capacity, (2) own at
least a 20% bona fide interest in the
business and (3) be actively engaged
in the management of the business.
Unless an employee meets each of
these requirements, paying in equity
alone will run afoul of wage laws, and
could result in significant liability
for the employer, as well as possible
individual liability for the president,
treasurer, and individual “officers and
agents” of the employer’s corporate
entity.
For further help in determining
whether your employee comes
within the executive-business owner
exemption or questions about paying
employees with equity, please contact
Sandy Kahn at skahn@mbbp.com.
The VC Spotlight is a quarterly publication of
Morse, Barnes-Brown & Pendleton, P.C. The
primary purpose of the VC Spotlight is to discuss
terms, conditions and other issues of interest
to investors and venture-backed companies in a
simple, open and unbiased manner so that investors and founders can more efficiently structure and
negotiate financing transactions. The VC Spotlight
also provides updates of interest to the venture and
emerging company business sectors. We invite your
feedback at vcspotlight@mbbp.com.
VC Spotlight is intended as an information source for
clients and friends of MBBP. It should not be construed
as legal advice, and readers should not act upon information in this article without professional counsel.
© 2015 Morse, Barnes-Brown & Pendleton, P.C.
Cambridge, MA
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Q3 2015 First
Institutional
Roundsof Deals by Industry
Q3 2015 First Institutional
Rounds
– Number
Number of Deals By Industry
BIOPHARMA
22%
OTHER
26%
MEDIA / CONTENT
9%
CONSUMER
INFORMATION
SERVICES
8% ELECTRONICS
/ HARDWARE
13%
SOFTWARE
22%
Biopharmaceutical and software companies had the largest number of deals with in the third quarter of 2015 with 5 deals
each. Electronics/hardware companies were next with 3 deals followed by companies in the consumer information services and
media/content industries with 2 deals each.
Q3 2015 First Institutional Rounds
Q3 2015 First Institutional
Rounds
– Average Investment by Industry*
Average
Investment*
$18,000,000.00
$18
$16,000,000.00
$16
$14,000,000.00
$14
Millions
Millions
$12,000,000.00
$12
$10,000,000.00
$10
$8,000,000.00
$8
$6,000,000.00
$6
$4,000,000.00
$4
$2,000,000.00
$2
Other
Other
Media/
Content
Media/Content
Software
Software
Electronics/
Hardware
Elec./Hardware
Consumer
Info
Services
Cons. Info Serv.
Biopharmaceuticals
Biopharmaceuticals
$$0
In the third quarter of 2015, biopharmaceutical companies had the highest average investment amount per deal by a wide
margin with an average investment of $15.8 million
the five
dealsamount
in that
space.
Companies
focused
on
consumer
* By default,for
the average
investment
assumes
that all
authorized shares
of preferred
stock
have
been issued, but the final data also takes into account information gathered from companies.
information services, electronics/hardware, software
and media/content were grouped at a lower level and ranged from averages
of $4.4 million to $2.5 million.
* By default, the average investment amount assumes that all authorized shares of preferred stock have been issued, but the final data also takes into
account information gathered from companies.
@MorseBarnes
VCsandStartups.com
mbbp.com