I recently discovered an innovative financing arrangement for young companies called the Standby Equity Distribution Agreement, sometimes also called the Standby Equity Purchase Agreement (SEPA). Please don't confuse this acronym with the Single Euro Payments Area, Solar Electric Power Association, Science Education Partnership Award, or Southeastern Power Administration. None of those things have anything to do with a SEPA financing agreement. I only mention them to keep my readers away from distractions.
The company must first register with the SEC by filing the appropriate forms. Companies that execute a SEPA sign a term sheet with a private investor that allows said investor to buy shares in predetermined dollar amounts. The term sheet defines the funding formula under which the company will sell shares to the investor to net its desired amount of capital. That's why this type of deal is also called an "equity line," because it resembles a credit line that draws predefined amounts of capital in tranches.
My concern with this type of arrangement is that it may resemble a floorless convertible debenture that becomes toxic. The term sheet must define a floor price that prevents an investor from bidding down the public trading price of the company. This protects the company from an unscrupulous investor who shorts the stock into a death spiral and prevents it from raising further rounds outside the SEPA. The investor can then buy a controlling interest for very little money and the pre-SEPA investors are diluted into irrelevance.
The SEC knows that convertibles pose risks of dilution. I won't let this death spiral happen to any company in which I hold an early-stage equity stake. I want to see covenants in the term sheet that prevent it from becoming a toxic convertible. The company must define the price floor using a convention like the volume-weighted average price (VWAP) that will enable it to cancel a draw down if the price moves adversely during the funding window. The term sheet should limit the SEPA to the growth period of the company, say two or three years. Beyond that time the company should have sufficient cash flow that it won't need to return to private investors to seek more capital. I also want a covenant that prevents the outside investor from short-selling the stock once they purchase it under a SEPA. The threat of legal action for violating this covenant should be sufficient to scare away SEPA investors who secretly covet total control after cramming down the stock.
Term sheets for equity line SEPAs limit the funding window to a number of days after the company issues the private investor a draw down notice. I am agnostic as to how long this window should be open. It would seem that a company with a very volatile stock should keep the number of days the window is open in the single digits. Less volatile stocks allow the company a longer period during which the VWAP is not expected to deteriorate. Volatility is difficult to anticipate during the pre-registration phase when the term sheet is being drafted and the stock is not trading publicly. The length of this window comes down to trust between the company and investor. I typically don't trust anyone, so my incubated company had better get a longer window for more flexibility. Investors who want to negotiate anything shorter should be prepared to give up something favorable, like fewer shares for the dollar amount invested in each tranche of the equity line.
I can do only so much as an angel investor who does not own a majority stake in a startup. The entrepreneurs need the services of a good securities attorney to help draft the term sheet for a SEPA. I could probably find a few here in the SF Bay Area. I'm not an attorney and my blog articles do not constitute legal advice. The SEPA is useful if its term sheet protects companies from exploitation by predatory investors.
The company must first register with the SEC by filing the appropriate forms. Companies that execute a SEPA sign a term sheet with a private investor that allows said investor to buy shares in predetermined dollar amounts. The term sheet defines the funding formula under which the company will sell shares to the investor to net its desired amount of capital. That's why this type of deal is also called an "equity line," because it resembles a credit line that draws predefined amounts of capital in tranches.
My concern with this type of arrangement is that it may resemble a floorless convertible debenture that becomes toxic. The term sheet must define a floor price that prevents an investor from bidding down the public trading price of the company. This protects the company from an unscrupulous investor who shorts the stock into a death spiral and prevents it from raising further rounds outside the SEPA. The investor can then buy a controlling interest for very little money and the pre-SEPA investors are diluted into irrelevance.
The SEC knows that convertibles pose risks of dilution. I won't let this death spiral happen to any company in which I hold an early-stage equity stake. I want to see covenants in the term sheet that prevent it from becoming a toxic convertible. The company must define the price floor using a convention like the volume-weighted average price (VWAP) that will enable it to cancel a draw down if the price moves adversely during the funding window. The term sheet should limit the SEPA to the growth period of the company, say two or three years. Beyond that time the company should have sufficient cash flow that it won't need to return to private investors to seek more capital. I also want a covenant that prevents the outside investor from short-selling the stock once they purchase it under a SEPA. The threat of legal action for violating this covenant should be sufficient to scare away SEPA investors who secretly covet total control after cramming down the stock.
Term sheets for equity line SEPAs limit the funding window to a number of days after the company issues the private investor a draw down notice. I am agnostic as to how long this window should be open. It would seem that a company with a very volatile stock should keep the number of days the window is open in the single digits. Less volatile stocks allow the company a longer period during which the VWAP is not expected to deteriorate. Volatility is difficult to anticipate during the pre-registration phase when the term sheet is being drafted and the stock is not trading publicly. The length of this window comes down to trust between the company and investor. I typically don't trust anyone, so my incubated company had better get a longer window for more flexibility. Investors who want to negotiate anything shorter should be prepared to give up something favorable, like fewer shares for the dollar amount invested in each tranche of the equity line.
I can do only so much as an angel investor who does not own a majority stake in a startup. The entrepreneurs need the services of a good securities attorney to help draft the term sheet for a SEPA. I could probably find a few here in the SF Bay Area. I'm not an attorney and my blog articles do not constitute legal advice. The SEPA is useful if its term sheet protects companies from exploitation by predatory investors.
