Exempt Reporting Advisers: Registration With the SEC or With the State?
Exempt Reporting Advisers: Registration With the SEC or With the State?2 min read
2 min read
Sep 27, 2022 9:51:38 AM | Assure
The deal is closed, you are invested, but what happens next? The fact is the work is not yet done. Any number of events can require your attention, varying in degree from casual company updates to distribution and exit activities. These Post Closing Activities (PCAs) can happen at any time and for any number of reasons. It is difficult to define the limits of what a PCA is, so here we will focus on four of the most common PCAs and some of the implications of those events. The PCAs will specifically be viewed from the perspective of investments made through a Special Purpose Vehicle (SPV), an LLC where investors subscribe to and have ownership of the SPV, not the asset itself.
While the assets owned by the fund are typically illiquid, the membership in the funds themselves have more liquidity. That is not to say that the funds act as a secondary market where old investors can buy or sell their membership interest as a proxy to the shares themselves, but if an investor becomes cash strapped or simply wants to transfer their interest to an entity they own that would receive better tax treatment, transfers are certainly possible. Access to the LLC interest is a contractual right, and with the correct transfer agreements, transferring an LLC interest is a relatively straightforward process.
The trick regarding membership transfers revolves around allocations and tax treatment. Once the transferor and transferee sign the contract transferring the interest, the fund manager must amend the ledger so that the correct investor receives both the correct portion of payout and the right tax documents. Additionally, if the asset the fund holds accrues interest, the value of the members' investment will increase according to the pro rata accrual of interest. That means once an investor transfers their interest, the tax treatment has to reflect the correct day that the new investor entered and the old investor left the fund.
Convertible debt is debt in the form of notes that an investor purchases from the company with the expectation that the value of the debt will convert into equity for the purchaser. There are several benefits to a company issuing convertible debt rather than straight equity, but the largest benefit is that the process is inexpensive and easy for both the investor and company. Many contracts for debt are form in nature, and by purchasing convertible debt the company and investors do not have to spend time and money battling over the valuation of the company. The result is a legally efficient, streamlined means of raising capital. In order for investors to realize the value of their purchase however, the investment will need to convert from debt to equity.
Conversions are usually triggered in two separate ways, either by the maturity date, or by a qualified financing event. A maturity date is a backstop for the debt, a contractual date where the investor can demand that the debt be paid in equity. It is important to note that investors do not have to convert their debt at the time of the maturity date and will often continue to let their debt continue to exist. If they continue to accrue interest on the investment, or force the company to convert the interest, it may actually hurt the company, which in turn hurts their own investment. The more common reason a note may convert is that the company went through a qualified financing event. Qualified financing events are when the company raises money again, subject to the provisions of the debt. For example, the note may specify that the qualified financing amount is $2 million dollars but if the company does a $1 million dollar series round, the note will not convert. However, if the company goes through a $3 million dollar round then the conversion mechanics will be triggered and the investor's debt will convert to equity. Hopefully this equity will continue to gain value until the company goes through an IPO or other positive exit events, and the investor can receive their returns.
Initial Public Offerings (IPOs)
An Initial Public Offering (IPO) is the first time a company will be selling their shares to the general public on one of the commonly known exchanges. To an early stage investor, a company going public is the ultimate sign of success. If the investor participated early in the company's growth, they can expect several hundred percent returns. Professional investors are often judged on how many companies they backed that ended up going public. However, for the investor, there are several steps they will need to take before they are able to cash in on their investment that has had an IPO. This process can last years.
Oftentimes the first step for an investor is to approve the IPO as a shareholder. While this is not controversial, the shareholder will probably be surrendering a number of rights that they have as a preferred shareholder. Part of this will be to convert all of the preferred stock to common stock, sometimes doing a split or reverse split. The investor will then need to sign a Lock-up Agreement, which prohibits the investor from selling their shares immediately after the Initial Public Offering date, typically for a six-month period. The reason for the Lock-up Period is to prohibit investors who invested when the company was private from all selling their shares on the public market immediately after the public listing, causing a massive sell-off of the company, and tanking the value of the shares.
Once the shares have converted to common stock and the Lock-up Period is coming to an end, the investor will need to set up a brokerage account that can trade shares on a public exchange. They will also need to transfer their shares to that brokerage account. Once the Lock-Up Period comes to an end, the shares can be freely sold hopefully at a price that returns strong profits to the investor.
On the other hand, the company may fail, in which case bankruptcy is the most likely outcome. There are several types of bankruptcy options available and the type of bankruptcy being chosen will depend on the circumstances of the company. The most straightforward path for the company is to declare chapter 7 bankruptcy. In chapter 7, the company ceases operations immediately, and the bankruptcy court appoints a Trustee to administer the liquidation of the company. The important factor for the investor to keep in mind is the proof of claim bar date. The court sets a date roughly six months to one year after the filing date to allow creditors to submit their claims to the court for the money they are owed. Shareholders have a claim against the company in chapter 7. If they file proof of claim, they may be able to recoup some of their losses.
In the chapter 7 process, the Trustee will seize any asset of the company that they believe has any value, and auction off the items for the benefit of creditors. Unfortunately, in the hierarchy of bankruptcy creditors, equity shareholders are low on the totem pole. Typically, by the time the creditors above the equity shareholder are paid, there are no funds available to the investor. Once the funds are distributed, the bankruptcy case is closed.
The other primary option for the company is to file for chapter 11. With this option, the company can stay in operation throughout the course of the proceedings, as the primary goal for a company in chapter 11 is to restructure their debt and emerge as a functional going concern once the case is closed. Because the goals and processes of chapter 11 are so different than in chapter 7, the investor may take a more active role in helping the company restructure itself if it chooses. However, proof of claim bar date is still an issue, because if the shareholder does not file their claim in a timely fashion, they may be prohibited from receiving any proceeds from the company even if it is forced into liquidation. If the company enters into chapter 11, the investor should hire a sophisticated attorney who specializes in corporate restructuring.
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