BILL ANALYSIS �
SB 1181
Page 1
SENATE THIRD READING
SB 1181 (Correa)
As Introduced February 20, 2014
Majority vote
SENATE VOTE :34-0
BANKING & FINANCE 12-0
--------------------------------
|Ayes:|Dickinson, Allen, |
| |Achadjian, Bonta, Chau, |
| |Gatto, Harkey, Linder, |
| |Perea, Rodriguez, Weber, |
| |Williams |
|-----+--------------------------|
| | |
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SUMMARY : Revises provisions of the California Finance Lenders
Law (CFLL) relating to venture capital (VC) companies.
Specifically, this bill :
1)Would provide for exemptions from the CFLL for the following:
a) A commercial bridge loan made by a VC company to an
operating company; or
b) A VC investment made by a VC company in an equity
security issued by an operating company.
2)Revises the definition of "commercial bridge loan" for
purposes of exemption from the CFLL to extend the permitted
maturity date to three years.
EXISTING LAW :
1)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:
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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 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 other than personal, family, or
household purposes;
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ii) Has a maturity date not to exceed one year and is
made in connection with or in bona fide 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.
2)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.
FISCAL EFFECT : None
COMMENTS : VC is a type of equity financing that addresses the
funding needs of entrepreneurial companies that for reasons of
size, assets, and stage of development cannot seek capital from
more traditional sources, such as public markets and banks. VC
investments are generally made as cash in exchange for shares
and an active role in the invested company. VC differs from
traditional financing sources in that VC typically:
1)Focuses on young, high-growth companies;
2)Invests equity capital, rather than debt;
3)Takes higher risks in exchange for potential higher returns;
4)Has a longer investment horizon than traditional financing;
and,
5)Actively monitors portfolio companies via board participation,
strategic marketing, governance, and capital structure.
Successful long-term growth for most businesses is dependent
upon the availability of equity capital. Lenders generally
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require some equity cushion or security (collateral) before they
will lend to a small business. A lack of equity limits the debt
financing available to businesses. Additionally, debt financing
requires the ability to service the debt through current
interest payments. These funds are then not available to grow
the business. VC provides businesses a financial cushion.
However, equity providers have the last call against the
company's assets. In view of this lower priority and the usual
lack of a current pay requirement, equity providers require a
higher rate of return/return on investment than lenders receive.
VC for new and emerging businesses typically comes from high net
worth individuals ("angel investors") and VC firms. These
investors usually provide capital unsecured by assets to young,
private companies with the potential for rapid growth. This
type of investing inherently carries a high degree of risk. But
VC is long-term or "patient capital" that allows companies the
time to mature into profitable organizations.
VC is also an active rather than passive form of financing.
These investors seek to add value, in addition to capital, to
the companies in which they invest in an effort to help them
grow and achieve a greater return on the investment. This
requires active involvement; almost all VC investors will, at a
minimum, want a seat on the board of directors. Although
investors are committed to a company for the long haul, that
does not mean indefinitely. The primary objective of equity
investors is to achieve a superior rate of return through the
eventual and timely disposal of investments. A good investor
will be considering potential exit strategies from the time the
investment is first presented and investigated.
Arguments in support. Gunderson Dettmer Stough Villeneuve
Franklin & Hachigian (Gunderson Dettmer) is sponsoring this bill
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
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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
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.
Analysis Prepared by : Mark Farouk / B. & F. / (916) 319-3081
FN: 0003932