Technology Company Issues

Following up on my post on the subject, I had the opportunity to speak with Colin O’Keefe of LXBN regarding the Facebook/Instagram deal.  In the brief interview, I explain how things have changed since Facebook’s IPO and what, if anything, that meant for the deal’s fairness review with the California Department of Corporations.

Following up on my post on the subject, I had the opportunity to speak with Colin O’Keefe of LXBN regarding the Facebook/Instagram deal.  In the brief interview, I explain how things have changed since Facebook’s IPO and what, if anything, that meant for the deal’s fairness review with the California Department of Corporations.

California Department of Corporations, One Sansome Street, San Francisco

We previously blogged about the potential liability for Facebook, Inc. directors if the company paid too much for the social media start-up company Instagram. Recall that in April, Facebook agreed to acquire Instagram for, at the time, approximately $1 billion with the consideration payable 30% in cash and 70% in Facebook common stock (now, due to the decrease in Facebook’s share price from the stipulated price of $30 per share, the deal is only worth about $650 million). A recent NY Times Deal Book article points out that if the deal fixed the total purchase price rather than the number of shares to be issued, Instagram would have gotten a much better deal due to the depressed Facebook share price. Given the declining share price of Facebook stock, is Facebook’s reduced consideration still fair to Instagram’s shareholders? This is exactly the question that will be determined by the California Department of Corporations which will be conducting a fairness review of the acquisition this Wednesday.

The purpose of this fairness hearing is to allow Facebook to take advantage of a lesser-known exemption from registration under the Securities Act of 1933 known as the “3(a)(10) exemption.” Because Facebook is issuing securities in connection with the Instagram acquisition, the 23 million shares to be issued are required to either be registered or they must be exempt from the registration requirements of the Securities Act. The 3(a)(10) exemption allows companies to issue securities in an exchange transaction without registration provided that either a court or designated state agency finds that the transaction is fair to the recipients of the new securities. This exemption was popular during the tech boom and has both advantages and disadvantages when compared with the most common exemption provided by Rule 506 of Regulation D promulgated under the Securities Act. 

Most smaller companies tend to offer and sell securities on an exempt basis because of the substantial costs of conducting a registered offering. There are a laundry list of exemptions but only a few are of much practical use. Most exempt offerings are structured to take advantage
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More interesting times have arrived for holders of Facebook stock. The stock, which has been brutally beaten down from its IPO price, faces new challenges as the “lockup” restrictions (which have been in place since the IPO) began to expire on August 16. This means that a significant number of Facebook shareholders are now able to sell their shares in the open market, and significant numbers of Facebook shares will be freed from these restrictions over the next few months. The sale of a substantial number of Facebook shares could obviously drive the stock price down even more. The big questions now:  Who will or won’t sell their stock as these restrictions lapse?

This situation is also a great lesson for entrepreneurs who are contemplating the possibility of taking their companies public. Most observers thought that Facebook’s IPO was a certain success, but so far it’s been a very tough road. One big concern here is that the problems that Facebook has faced with its transition to public company status will divert management’s attention from the company’s business tactics and strategy at a very critical time. 

Facebook went public at a price of $38 per share. Many observers felt that this price was too high, and the market apparently agreed. The stock has not been back to its IPO price since the first day of trading, and its closing price on August 17 was $19.05 per share (a 49.9% decline from the IPO price). The stock price went below $19.00, but has since rebounded to close at $19.44 today. In any case the company has lost almost half of its market value since the IPO. Even at this reduced price the stock is still trading at about 30 times projected next years’ earnings. It’s interesting to note that Google and Apple currently trade at 12 to 13 multiples, so Facebook’s stock is still very highly valued even after its decline.

Lockup restrictions on stock sales by insiders and other parties are normally demanded by underwriters as part of the IPO process. These restrictions help to reduce volatility in the market price of a newly public company’s stock, and they help to ensure that existing shareholders
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New mandated cybersecurity disclosure requirements appear to be imminent. Cybersecurity has become a critical issue for most companies, and almost all companies today face cybersecurity risks due to the substantial increases in the volume of data and information stored online, the rise of multiple platforms for accessing data and the sophistication of criminal hackers. Cyber incidents such as a data breach or an intrusion into a company’s systems can have very negative and expensive results. These risks are considerably higher for any company that stores personal information or that operates in a regulated industry such as financial services or health care. Despite this significant increase in cybersecurity risks and the liabilities associated with such cyber incidents, however, public companies to date have had very little guidance regarding their disclosure obligations in this area.

The primary guidance that the SEC has issued on cybersecurity disclosure to date has been the 2011 CF Disclosure Guidance:  Topic No. 2 (Cybersecurity) (the “Release”) issued by the SEC’s Division of Corporation Finance on October 13, 2011. This Release was helpful in that it gave some indication of the Division of Corporation Finance’s positions on cybersecurity issues and cyber incidents. The Release provided overall guidance, however, and did not provide detailed information or instructions on cyber disclosure. Additionally, the Release did not contain official SEC rules or regulations. Accordingly, companies could use the Release for broad principles but were still left to develop disclosure information about cybersecurity and other similar matters based on their own evaluations of what should be disclosed.

Under the Release, some of the items that public companies are advised to address include:

  1. review the adequacy of their disclosure regarding cybersecurity and cyber incidents on a regular basis;
  2. disclose the risks of cyber incidents in “Risk Factors” if these items are significant risk factors that would make an investment in the company speculative or risky;
  3. disclose known or threatened cyber incidents;
  4. address cybersecurity risks and cyber incidents in the Company’s Management’s Discussion and Analysis if the costs or other consequences associated with such incidents are reasonably likely to have a material effect on the Company’s results of operations, liquidity or financial condition or would cause reported financial information to not be indicative of future operating results or financial condition;
  5. disclose a cyber incident in “Description of Business” if the cyber incident materially affected the company’s products, services, relationships with customers or suppliers or competitive conditions;
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The “Risk Factors” section of any disclosure document is vital to the protection of the issuer. Generations of securities lawyers and accountants have worked into the night to develop lists of risks that would make any sane potential investor run away screaming. Most of us have seen innumerable examples of conventional risk factors like competition, legal and regulatory changes, impact of the loss of key personnel and others. Many of these risk factors are virtually identical regardless of the issuer’s industry space, and it’s doubtful that many readers of disclosure materials pay much attention to these risk factors.

The new breed of public technology companies, however, present some novel and interesting risks. The disclosure of these risks still strives to protect the issuer and give the potential purchaser the relevant information necessary to make an informed investment decision, but they focus on areas that are quite different from the disclosures used by more conventional companies. These technology company disclosure documents still contain many conventional risk factors, but it’s interesting to see the new areas that are considered material risks for these companies.

Here are several of the key items that been used as material risk factors in recent technology company disclosure documents filed by prominent technology companies:

Data Security.  This is a very hot issue for most technology companies these days, especially in the social media space. Facebook is a great example, as it has data from close to 900 million users. LinkedIn has similar dynamics and issues on a smaller scale. A data breach for any of these companies would have huge legal ramifications, as state, Federal and international regulatory authorities and private plaintiffs would quickly react. LinkedIn recently experienced these negative ramifications first hand as it was sued for $5 million in connection with its recent data breach.  The potential damage to a company’s brand and credibility could also be significant.  Click here for language from the Facebook prospectus and the LinkedIn prospectus as good examples. The SEC also offered some guidance on this topic in “CF Disclosure Guidance Topic No. 2 – Cybersecurity”.
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Facebook’s IPO seemed like a sure thing only a short time ago. This iconic leader in the technology space led by a charismatic CEO seemed destined to have a blockbuster IPO. The IPO encountered a number of substantial problems and challenges, however, and the stock’s post-IPO performance has been far less than stellar, with none of the big increase in the stock price that was widely anticipated. This IPO is now widely viewed as flawed and as a failure in many respects.

 After three full trading days, Facebook’s shares are trading about 16% below the IPO price. The stock closed slightly above its IPO price on its first day of trading, but this only happened because the underwriters bought enough shares to support the stock. A variety of problems contributed to this poor debut, including the sale of large blocks of stock by existing Facebook shareholders, General Motors’ last minute decision to curtail substantial advertising on Facebook, a negative assessment of Facebook’s second quarter revenue forecast by analysts for the lead underwriter (which was allegedly only shared with potential large institutional purchasers), strange technical glitches at NASDAQ and the underwriters’ decision to increase both the number of shares sold and the offering price. Facebook’s final IPO prospectus can be found here.

The stock’s performance suggests that the underwriters’ original valuation ($34 per share) was only slightly higher than the company’s valuation as perceived by investors. The decision to take the IPO price to $38 per share increased the valuation beyond this perceived fair value. The subsequent decline in the stock value has taken the stock price down to a level that the market perceives is reasonable.

While Facebook’s current and prospective problems are daunting, the company was able to raise a huge amount of money at a premium to its actual value, so the IPO transaction was beneficial to the company. This is understandable given the tremendous demand for the stock that existed prior to the IPO, even in light of the problems that existed. The post-IPO results so far, while disappointing when compared to other technology IPOs, are short term and will correct themselves if the company increases its value. I’m actually surprised that the IPO price was as low as it was given the extremely high profile of this offering, but the significant negative factors that surrounded the offering contributed to this. In any case the company’s final valuation was still a huge multiple of historical earnings.


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One of the most well-known and popular Internet companies, Groupon, Inc., has again encountered significant accounting problems. These problems appear to be potentially severe. This situation is very negative for Groupon, but it also has troubling ramifications for the entire technology industry and especially for technology companies that have recently gone public. There is

On February 13, 2012, the Securities and Exchange Commission issued a No-Action Letter to the Fenwick & West LLP law firm. This No-Action Letter is good news for private companies that are approaching the statutory 500 shareholder limit (which would generally require them to register as public reporting companies under Section 12(g) of the Securities Exchange Act of 1934). Exceeding this limit can be very painful for a company, as it may be forced to register its class of shares under the Securities Exchange Act of 1934, which would require significant disclosures of information (the same as if it had undertaken an initial public offering) without realizing any of the benefits of public company status. The No-Action Letter will allow private companies to issue certain equity-based compensation to employees, directors and some consultants without triggering the reporting requirements of the 500 shareholder limit. Fenwick’s original request for the No Action Letter (which describes the background of this situation) can be found here.

Fenwick is the law firm that represents Facebook in its current initial public offering. Fenwick had previously sought and obtained similar relief specifically for Facebook in 2008. In this No-Action Letter, however, Fenwick obtained a much broader exemption from the SEC on this issue. Since the No-Action Letter was issued to the law firm rather than to a single company, the relief from these public reporting requirements should be very broad and should be applicable to any company whose situation is close enough to that described by Fenwick in its request for the No-Action Letter.

The situation that Fenwick used here involved “restricted stock units” (“RSUs”). RSU’s as described by Fenwick in the No Action Letter are equity compensation vehicles that generally entitle the holder to receive shares of a company’s common stock if certain future conditions are met before the RSUs expire. These RSUs are widely used by some companies, but there was a question regarding whether the issuance of an RSU caused the recipient to become a shareholder of the company, thus increasing the number of total shareholders and potentially causing the company to exceed the 500 shareholder limit.
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Risks of Cyber Attacks

If you are an executive for a public company, new SEC guidance requires you to consider cybersecurity in your ongoing periodic reports.  As evidenced by the barrage of news reports over the past couple of years, cyber incidents have become very significant events for all types of companies.  A recent example was the data breach of Sony Corporation’s Playstation Network.  These cyber incidents can cause companies to spend substantial amounts of money and time to attempt to reduce or correct the associated damage, including significant reputational damage.  All companies must make significant capital investments for systems and measures designed to prevent future cyber incidents or at least mitigate their harmful effects. Unfortunately, the number of cyber incidents will continue to increase, and the tactics used by hackers will become more sophisticated and harder to prevent and control.

Congress Gets Involved

Last year, a group of U.S. senators recognized that cybersecurity incidents and the associated costs were a major risk for many companies and that many public companies were not adequately disclosing these events. The Senators also recognized the growing risks of cybersecurity and cyber incidents, and that there was very little guidance for public companies on their disclosure responsibilities in connection with cybersecurity. These senators wrote a letter to SEC Chairman Shapiro asking for some interpretative guidance on how to address disclosure of cybersecurity and cyber incidents and the associated risks and economic effects.

SEC Sets Expectations

In response to the Senate inquiry, the SEC recently issued CF Disclosure Guidance:  Topic No. 2 (the “Disclosure Guidance”), which set forth the SEC’s expectations of public company cybersecurity disclosure. Public companies of all sizes and industries should
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