BILL ANALYSIS �
SENATE BANKING & FINANCIAL INSTITUTIONS COMMITTEE
Senator Noreen Evans, Chair
2013-2014 Regular Session
SB 1181 (Correa) Hearing Date: April 9,
2014
As Introduced: February 20, 2014
Fiscal: No
Urgency: No
SUMMARY Would exempt specified loans made by venture capital
(VC) companies to operating companies and specified investments
made by VC companies in operating companies from the California
Finance Lenders Law (CFLL).
DESCRIPTION
1. Would increase, from one year to three years, the length of
a commercial bridge loan to which the CFLL does not apply,
when that loan is made by a VC company, as defined, to an
operating company, as defined.
2. Would provide that the CFLL does not apply to a VC
investment that is made by a VC company in an equity
security issued by an operating company.
3. Would define equity security, for purposes of Number 2
above, by reference to federal securities law (Section
3(a)(11) of the federal Securities Exchange Act of 1934).
EXISTING LAW
4. Provides that the CFLL does not apply to a commercial
bridge loan made by a VC company to an operating company, as
follows (Financial Code Section 22062):
a. "VC company" is defined as a person other than an
individual or a sole proprietorship that meets all of the
following requirements:
i. Engages primarily in the business of
promoting economic, business, or industrial
development through VC investments or the provision
of financial or management assistance to operating
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companies;
ii. At all times maintains at least 50% of
its assets in VC investments or commitments to make
VC investments, and maintains or will maintain a
material equity interest in the operating company;
iii. Approves each loan made to an operating
company through the VC's board of directors or
similar governing body, based on a reasonable belief
that the loan is appropriate for the operating
company; and,
iv. Complies with all applicable federal and
state laws and rules or orders governing securities
transactions when making the loan.
b. "Operating company" is defined as a person other
than an individual or a sole proprietorship that meets
all of the following:
i. Primarily engages in the production or
sale, or the research or development, of a product
or service other than the management or investment
of capital;
ii. Uses all of the proceeds of the
commercial bridge loan for the operations of its
business; and,
iii. Approves each commercial bridge loan
through its board of directors or similar governing
body, based on a reasonable belief that the loan is
appropriate for the operating company.
c. "Commercial bridge loan" is defined as a loan that
meets all of the following:
i. Has a principal amount of $5,000 or more,
or any loan under an open-end credit program,
whether secured or unsecured, the proceeds of which
are intended by the operating company for other than
personal, family, or household purposes;
ii. Has a maturity date not to exceed one
year and is made in connection with or in bona fide
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contemplation of an equity investment in the
operating company;
iii. Is secured, if at all, solely by the
operating company's business assets, exclusive of
any real property; and,
iv. Is subject to the implied covenant of
good faith and fair dealing under Civil Code Section
1655.
d. "VC investment" is defined as an acquisition of
securities in an operating company to which a person,
that person's investment advisor, or an affiliated person
of either has or obtains management rights.
5. Provides that a VC company may rely on any written
statement of intended purposes signed by the operating
company for purposes of determining whether a loan is a
commercial bridge loan.
COMMENTS
1. Purpose: This bill is sponsored by Gunderson, Dettmer,
Stough, Villeneuve, Franklin & Hachigian to clarify the
circumstances under which VC firms require California
lending licenses.
2. Background: The VC industry provides a significant source
of funding for a considerable number of innovative small
businesses within California. According to the National
Venture Capital Association 2013 Yearbook, VC firms invested
over $14 billion in 1,280 California companies during 2012.
Despite VC's importance to California, California law is vague
regarding the extent to which firms that provide VC funding
to businesses require lending licenses. The only provision
in California's lending laws that speaks directly to VC
provides an exemption for VC bridge loans, which are defined
as loans of up to one year in length that are made by VC
companies, as defined, to operating companies, as defined.
That provision was added by AB 169 (Chavez), Chapter 163,
Statutes of 2003.
The one-year bridge loan exemption was intended to remove
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confusion over the treatment of bridge financing under the
CFLL and ensure that VC companies are not subject to the
CFLL when making short-term commercial bridge loans which
are not secured by real property. VC companies provide
investment capital to start-up companies in exchange for a
percentage ownership interest in the company's equity.
Equity financing is typically provided by VC firms in
stages, based on the start-up company's progress in meeting
its stated business plan milestones. In some instances,
interim financing in the form of a commercial bridge loan is
necessary, as the company moves from product development to
product sales. AB 169 was intended to ensure that these
bridge loans did not subject the VC firms which made them to
licensing under the CFLL.
In a letter of support it wrote for the 2003 bill, the National
Venture Capital Association stated that "VC and
entrepreneurial activity thrive in a clearly defined
regulatory environment." Similar arguments (see below) are
being advanced in support of SB 1181.
3. Discussion: The one-year commercial bridge loan provision
was enacted in 2003, a period of time during which the VC
market was very different than it is now. During the
economic boom times of the mid 2000s, a one-year bridge loan
exemption may have made sense; in today's current economic
environment, twelve months is far too short. Most VC bridge
loans are between one and three years in length. SB 1181
reflects this new reality by changing the bridge loan
exemption from a maximum of one year to a maximum of three
years.
According to this bill's sponsor, another problem in
California law that confronts VC firms is the lack of
clarity around treatment of their equity investments.
California law is silent on the extent to which VC
investments in operating companies represent loans, versus
the extent to which they represent investments in
securities. This uncertainty has led different firms to
interpret the law in different ways, a situation which has
created an unlevel playing field within the VC community,
and which has changed the structures of certain transactions
to the detriment of both VC firms and the operating
companies they seek to support.
SB 1181 would clarify that the CFLL does not apply to VC
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investments in equity securities issued by VC-backed
operating companies. This clarification is based upon the
long-standing premise that a loan represents an extension of
capital, which the lender expects to be paid back, with
interest, at some point in the future, while an investment
represents an extension of capital in exchange for equity in
a company, with an expectation that the value of the equity
will increase over time. Equity investments should not be
treated as loans, nor be subject to California's lending
laws. This change is intended to provide the clearly
defined regulatory environment that the National Venture
Capital Association promoted as encouraging VC and
entrepreneurial activity in its 2003 letter of support for
AB 169 (Chavez).
4. Summary of Arguments in Support:
a. The law firm letter from Gunderson Dettmer Stough
Villeneuve Franklin & Hachigian (Gunderson Dettmer) is
sponsoring SB 1181 to modernize the CFLL as it applies to
the VC community. In support of the commercial bridge
loan provision of the bill, Gunderson Dettmer writes,
"today's entrepreneurs in California can do more, for a
longer period of time, with less capital. When venture
capital firms invest in a start-up company via a
cost-effective commercial bridge loan, this further
assists the small business in keeping its expenses under
control. Unfortunately, the CFLL imposes a 1-year
maturity date on such loans under the 2003 safe harbor,
which is at odds with the extended time that today's
small businesses can operate on such capital. We believe
that SB 1181 (Correa) solves this issue by extending the
permitted maturity date for a commercial bridge loan
under the safe harbor from one year to three years.
Requiring that a commercial bridge loan under the safe
harbor have a maturity date not to exceed one year is an
antiquated, and damaging, limitation."
In support of the provision which clarifies that equity
investments should be treated as investments rather than
loans, the sponsor explains that VC firms may invest in
portfolio companies through preferred stock financings or
through issuance of a streamlined, convertible promissory
note. "In such cases, the principal and interest of the
promissory note are convertible into equity of the
company. Because these convertible promissory notes
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represent equity investments rather than loans, we
believe that they should be regulated as equity
securities subject to applicable state and federal
securities laws, rather than as loans subject to the
CFLL. SB 1181 provides that clarification. The bill
makes clear that standard loans are subject to the CFLL,
while instruments that are considered equity securities
are subject to existing state and federal securities laws
and not to the CFLL. Given California's well-established
securities laws and enforcement resources, we believe
that this clarification will result in overall greater
protections to industry participants."
b. Several VC firms, including Charles River Ventures,
Felicis Ventures, August Capital, Sofinnova Ventures,
VantagePoint Capital Partners, SoftTech VC, and others,
believe that "SB 1181 will greatly assist in restoring
efficiency for both entrepreneurs and venture capital
funds that use bridge financings as a means to capitalize
small businesses. The California Finance Lenders Law
imposes unwarranted restrictions on the ability of
venture capital firms to finance entrepreneurs and small
businesses in a manner consistent with the practical
needs of venture-backed companies. SB 1181 is
instrumental in removing some of these unnecessary
inefficiencies that currently inhibit the making of
commercial bridge loans by venture capital funds and the
issuance of convertible promissory notes by small
businesses."
5. Summary of Arguments in Opposition: None received.
6. Prior and Related Legislation:
a. AB 169 (Chavez), Chapter 163, Statutes of 2003:
Established the one-year VC commercial bridge loan
exemption which this bill would extend to three years.
LIST OF REGISTERED SUPPORT/OPPOSITION
Support
Gunderson Dettmer Stough Villeneuve Franklin & Hachigian LLP
(sponsor)
500 Startups
SB 1181 (Correa), Page 7
August Capital
Charles River Ventures
DCM
Felicis Ventures
Illuminate Ventures
Relay Ventures
Sofinnova Ventures
SoftTech VC
VantagePoint Capital Partners
Opposition
None received
Consultant: Eileen Newhall (916) 651-4102