The talk of the financial press and venture community during the first half of 2015 has been of private IPOs and unicorns. And for good reason. According to CB Insights, there are more than 588 investor-backed tech companies in the United States that have valuations of more than $100 million. The unicorns among these companies – or those with valuations of more than $1 billion – number more than 100 according to inc.com. Rather than resorting to the public markets for financing and liquidity, many of these companies are choosing to remain private and raise money instead through large, late-stage growth equity rounds (typically including some amount of liquidity for employees and other early shareholders) now being referred to as private IPOs.
The boost in valuations provided by private IPOs has been a boon to founders, employees and early round investors. But even when a tech company target is not yet a unicorn, late-stage investors are often surprised to learn that the Hart-Scott-Rodino (“H-S-R”) Act can require that both the investor and the company make filings to report the acquisition of a minority shareholding.
Reporting Thresholds Can Be Complex
Under the H-S-R Act, parties to large mergers and other acquisitions must file notification before closing with the Department of Justice Antitrust Division and Federal Trade Commission Bureau of Competition. The H-S-R Act filing requirements are usually thought of in the context of mergers and acquisitions of a controlling interest in a company. However, the H-S-R Act can also require a filing even when an investor will not acquire control of a company, but will hold more than $76.3 million of stock in a target company. (Note: The FTC adjusts the H-S-R Act monetary thresholds in mid-January of each year. The minimum value of voting securities or other interests that must be exceeded before an H-S-R Act filing may be required is $76.3 million for 2015).
There are also additional, higher thresholds that can trigger a filing – even if a shareholder has previously filed to report acquiring a minority stake that crossed a lower threshold. These higher thresholds are $152.5 million and $762.7 million. Another filing can be required if an investor acquires 25% or more of the outstanding voting securities of a company if valued at $1.5253 billion or more.
Equally as tricky, the H-S-R Act requires that the value of incremental acquisitions through option exercises, open market purchases, and other follow-on investments must be aggregated with the current fair market value – not the historic cost – of existing holdings to determine whether an H-S-R Act filing is required. Venture capital clients are often surprised to learn that their minority investment of less than $76.3 million may require an H-S-R Act notification. We frequently hear the response, “are you sure – we’ve never had to do this before?”. The answer is you may be eligible for one of the many exemptions written in the H-S-R Act and rules, but you need to do the antitrust legal diligence and analysis to make sure there is not a reporting obligation.
Take as an example an investor who acquired a 10% share of a software startup six years ago. The initial investment was well below the $76.3 million threshold and so an H-S-R Act filing was not required. Several rounds later, the company is now issuing a new series at a post-money valuation of $1 billion. Based on the post-money valuation, the investor’s current holdings have a fair market value of approximately $100 million. Both the investor and the company may have to file to report the investor’s participation in the new round because (i) the total current fair market value of the stock the investor will hold after closing exceeds $76.3 million and (ii) the investor and company have not previously filed to report an acquisition of the company’s stock by the investor. Unless an exemption is available, the investor cannot acquire even a single additional share without making an H-S-R Act filing.
Certain Exemptions May Apply
The exemptions that are most often available in the context of a follow on investment are known as the pro rata exemption and the passive investment exemption. The pro rata exemption applies when an investor’s total per centum shareholding will not increase as a result of the acquisition of additional stock. This is usually the case when all shareholders will participate in a new round on a pro rata basis or new investors are coming in so that an existing investor’s per centum shareholding will be diluted. However, it is still a good idea to consult with antitrust legal counsel even when you think the pro rata exemption will apply.
The reason is that the H-S-R Act rules require parties to use a specific formula to determine the per centum shareholding. The formula is based on the rights each class of stock has to vote for the election of directors. Even if an investor’s straight percentage holding of the outstanding equity will not increase as a result of an acquisition, its per centum shareholding as calculated under the H-S-R Act formula might increase if the investor acquires a greater right to vote for the election of directors. Say, for instance, that an investor holds shares in a previous round that votes along with all other classes of stock for the election of directors – or has no right to vote for the election of directors. The investor intends to participate in a new series that will have the right to elect its own director. This investor’s per centum shareholding might increase because it is acquiring a new class of stock that has a greater right to vote for the election of directors than the shares it currently holds.
The passive investment exemption applies when an investor acquires shares solely for purposes of investment, and has no intention to influence the basic business decisions of the company. The passive investment exemption applies only when the investor will hold 10% or less of the outstanding voting securities post-close. Again, it is a good idea to consult with antitrust counsel before concluding that an acquisition is exempt because the investor will be passive. The conclusion that an investor has a passive investment intent requires a nuanced analysis that is best explored with counsel who are knowledgeable about the FTC’s thinking on this topic.
By way of example, the FTC imposed a civil penalty of $850,000 in 2012 on Biglari Holdings, Inc. after it acquired stock in Cracker Barrel. Biglari asserted its open market acquisition of stock was passive. The FTC sought the fine after Biglari filed a Form 13D with the Securities and Exchange Commission in which it stated its plans “to communicate with the Issuer’s management and members of the Board regarding the business, governance and future plans of the Issuer.” (Read more here.)
In short, both new minority investments of more than $76.3 million and acquisitions of additional stock by existing shareholders in high value portfolio companies can trigger an H-S-R Act filing requirement. The best practice is to consult with antitrust legal counsel in connection with any potential follow-on acquisition.