New Exemption for Sales of Restricted Stock

President Obama signed legislation this month that creates a new, explicit exemption for private resales of restricted and control securities. The legislation, contained in Fixing America’s Surface Transportation Act (the FAST Act), will make it easier for the holders of restricted stock to cash out their holdings, provided they sell only to accredited investors.

Here is an overview of the new exemption’s requirements:

  • The seller can’t be the issuer of the stock or a direct or indirect subsidiary of the issuer
  • Each purchaser must be an “accredited investor”
  • There cannot be any general solicitation or advertising
  • The stock must be part of a class of stock that has been authorized and outstanding for at least 90 days prior to the sale date
  • The stock cannot be part of an unsold allotment to, or subscription or participation by, a broker or dealer as an underwriter or a redistribution
  • The seller is subject to the “bad actor” disqualification
  • If the issuer is a non-reporting issuer (not subject to the reporting requirements of Sections 13 or 15(d) of the Exchange Act), there are additional information requirements. The issuer must provide the seller and prospective purchaser, upon request, with reasonably current information about the issuer’s management team, financials, etc.

This new exemption, which is found in Section 4(a)(7) of the Securities Act, should provide a useful alternative to the Rule 144 safe harbor, which requires that the securities have been outstanding for at least 6 months if the issuer is a reporting company, or 1 year in all other cases. Rule 144 also places limits on the amount of stock that can be sold, a limitation that is not present in the Section 4(a)(7) exemption.

The new exemption also will provide a simplified alternative to the “Section 4(a)(1 ½) exemption,” which has been developed over a period of several years, but which has never been officially codified into law.

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EQUITY CROWDFUNDING 2.0

On October 30, the SEC took another shot at legalizing equity crowdfunding, by passing final regulations that are much more streamlined and simpler than the original regulations. The new regulations will take effect sometime next spring or summer, at the earliest.

Under the new regulations, a company can raise a maximum aggregate of $1 million through crowdfunding during a 12-month period. The company must use an SEC-registered intermediary – either a broker-dealer or a funding portal. While the company still must file certain information with the SEC and provide it to investors, the new regulations are more relaxed about the required financial statements. If the offering is between $500,000 and $1 million, the financial statements must be “reviewed” by a public accountant, but they need not be audited (unless audited financials are available). This removes a significant cost barrier that had existed in the previous set of regulations. During any 12-month period, the aggregate amount of securities a company can sell to an investor through all crowdfunding offerings cannot exceed $100,000.

On the investor side, the investment limits for individual investors over a 12-month period, across all crowdfunding offerings, are:

  • If either the investor’s annual income or net worth is less than $100,000, he can invest the greater of (a) $2,000 or (b) 5% of the lesser of annual income or net worth
  • If both the investor’s annual income and net worth are equal to or greater than $100,000, she can invest up to 10% of the lesser of her annual income or net worth.

So let’s look at Joe Investor, who earns $75,000 per year and has a net worth of $35,000. Since Joe’s net worth is less than his annual income, he can invest the greater of $2000 or 5% of his net worth, which comes to $1750. So in this scenario, Joe can invest $2000 over a 12-month period.

Now let’s look at Melinda Investor, Joe’s much more successful younger sister. Melinda earns $200,000/year, and has a net worth of $350,000. Since her income is less than her net worth, Melinda can invest up to 10% of her $200,000 income, or $20,000.

Securities purchased through a crowdfunding offering generally cannot be resold for one year after purchase.

While the new regulations greatly simplify the process for doing equity crowdfunding, they don’t really address the main problem that faces any startup that wants to use this. How does the company deal with potentially thousands of new stockholders, many of whom may have invested only a few hundred dollars (if that much)? I call these people the Great Unwashed, because beyond a few handfuls of cash, none of these are value-added investors. None will be bringing their expertise and experience to the company, the way a good angel or venture capital investor does. And yet the startup must prepare an annual report that it has to provide to all these stockholders. It also has to hold an annual meeting, notify all these stockholders of the meeting, hold the meeting at a location where these stockholders can attend (if they want), and allow them to vote on various corporate matters, such as the board of directors. Now the company will need to use some of those new funds to hire an investor relations manager, or use an outside service, and will have to devote time to keeping the Great Unwashed happy.

 

 

The Friends & Family Round

Prior to doing a seed round or a full venture capital financing, startups frequently need to do a “friends and family” round of financing. This money is often essential to carry startups through to the point where an angel investor would be interested, especially in the regions where angels will require more than just an idea or even an MVP before investing. A poorly-handled friends and family round, however, can get a startup in a lot of trouble. It could result in penalties and fines for violating federal and state securities laws, and it could also jeopardize getting angel financing. This piece should give some guidance as to how to do a friends and family round the right way.

Before getting into the details, we need to cover some basic securities laws. I promise to keep it non-technical. The federal securities laws require that before a company can sell any securities, those securities either have to be registered with the SEC, or exempt from registration. The registration process is quite expensive, with public filings and extensive disclosures. Think publicly-traded companies, like Apple, or Google. To avoid the prohibitive expense of registering securities, startups and other private companies look to one of several exemptions. This is how seed rounds and venture capital financings are handled.

These exemptions allow companies to offer and sell to either accredited investors, non-accredited investors, or both. Without going into extensive detail, accredited investors are rich people who can afford to lose their entire investment, or people who are sophisticated enough so that they can understand the risks of investing in an unproven startup. Or both. The preferred route is to offer and sell securities only to accredited investors. This greatly reduces the paperwork and disclosures that would otherwise be required when selling to non-accredited investors, or the Great Unwashed, as I like to call them.

The problem with the friends and family round is twofold. First, there’s no “friends and family” exemption from the registration requirement. So the securities laws apply, and the friends and family round has to fit into one of the other exemptions. Meaning either the investors are accredited, or non-accredited. That leads to the second part of the problem. Most friends and family are non-accredited. It would be great if all our friends and family were wealthy, or highly sophisticated investors, but for most of us that simply isn’t the case. So how can we get financing from friends and family without getting in trouble?

OPTION 1 – Accredited Investors Only

This is the preferred route. Only offer the investment opportunity to accredited investors. You could use a convertible note, much as you would with your angel investors, or you could use the SAFE structure. SAFE is relatively new, and it means Simple Agreement for Future Equity. You can find a discussion of SAFE here. The general idea is to use fairly standardized documents that won’t require a great deal of customization. This will keep your legal costs down (but that doesn’t mean you should try this without a lawyer).

Some key deal points in this option, whether you use a convertible note or SAFE:

  • Don’t include a valuation cap – trying to value the company at such an early stage just doesn’t make sense, and will most likely cause problems with later financing rounds.
  • Do include a discount, to reward your investors for the risk they are incurring by investing at such an early stage. A 20% discount is fairly standard.
  • Do include a “most-favored nation,” or MFN, provision. This allows the terms to be amended to be equivalent to the terms for the next financing round (typically the angel round).
  • You might also consider having your MFN provide a discount to the valuation cap that the angel investors get in a seed round. After all, these early investors are taking on a higher risk than the angels, so they should be rewarded.

OPTION 2 – Non-Accredited Investors

So what about the situation where you need money, you have friends and family that want to invest, but none of them are accredited investors? First of all, if you allow them to invest, you are going to get into trouble with the securities laws, because in all likelihood, you won’t be able to comply with the disclosure requirements. So instead of letting them invest in your company, you should structure this as a loan.

This loan will be a straight loan, not a loan that converts into equity. You will need to make it clear to these people that if they get repaid at all, it will be their principal and interest. If your company gets bought by Google or has an IPO, they won’t become millionaires. Because this is a risky loan, the interest rate should be correspondingly high. The maturity date, which is when the loan becomes due, should be tied to a future funding event, rather than a date on the calendar. Also, set the threshold for this funding event high enough that it is not an angel investment; angels are putting money into your company to help it grow, not to pay back your early lenders. So the loan should mature at a funding event of several million dollars, which will likely be your Series A round. Finally, the loan should be subordinated to any future debt issued to angel investors. That means that the angel investors will get paid back before the friends & family.

Is this option a great deal for the friends & family? No, it isn’t, and there are a lot of risks for them, without much upside other than the satisfaction of helping you succeed. Remember, however, this option is your last resort. You turn to this when there are no accredited investors out there, and you need this money to stay afloat.

A final word about your legal expenses. It’s tempting to think that because the documents are fairly standardized, or because you are dealing with friends and family, you don’t need to use a lawyer. Of course you don’t want your legal expenses to be a significant percentage of the capital you are raising. Resist the temptation to think you can hack this, because you can’t. Somewhere along the line, you’ll make a mistake that will cost you a lot more later. A mistake could mean no angel round, or it could mean serious penalties imposed by the SEC. Even if you find the documents online – and the SAFE documents are – you still want an experienced lawyer to walk you through them, so you know what the terms are and how they affect you. Standardized does not equal simple. You’ll want to make sure you’ve covered all the bases, and the best way to ensure that is to use a professional.*

*The powers-that-be require me to say that this is an attorney advertisement, so just in case you weren’t sure already, this is an attorney advertisement.

AN INTRO TO THE “ACCREDITED INVESTOR”

Startups and other companies seeking investment through private securities offerings will quickly have to master the concept of the “accredited investor.” The underlying idea is that accredited investors have either specialized knowledge or a level of wealth that gives them greater protection in making more speculative investments. By selling only to accredited investors, startups and other companies can make use of the more flexible private placement exemptions, and may be able to avoid some of the more burdensome and expensive disclosure obligations. In addition, accredited investors may be able to provide more value to a startup, through advice, connections, and access to other valuable resources.

On the flip side, anyone that isn’t an accredited investor is an unaccredited investor. These are the widows and orphans, the great unwashed, people like, well, you and me. SEC rules require a much higher level of disclosure when a company seeks investment from an unaccredited investor.

There are three basic categories of accredited investor: one, institutional investors, two, insiders, and three, Very Rich People. The first category, institutional investors, includes:

  • Banks, savings & loans, registered broker-dealers, insurance companies, investment companies registered under the 1940 Investment Company Act, and certain employee benefit plans;
  • Private business development companies as defined in Section 202(a)(22) of the Investment Advisors Act of 1940;
  • Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
  • Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person” as described in the regulations; and
  • Any entity in which all of the equity owners are accredited investors.

Venture capital firms and angel investment firms will typically be included in one of those institutional investor categories. These institutional investors are considered to have the financial resources and expertise to evaluate the prospects and financial condition of companies in which they invest, so that they can evaluate and absorb the risk.

The second category of accredited investors is insiders. These are directors, officers, or general partners of the company that is seeking investment. The idea here is that because they are insiders, they know the financial condition of the company, and are intimately familiar with its business plan and prospects.

The third and final category of accredited investors is Very Rich People. Very Rich People includes:

  • Any person with an individual net worth, or joint net worth with that person’s spouse, of more than $1,000,000. However, when determining someone’s net worth, you do not include that person’s primary residence as an asset. There are additional rules as to what liabilities are counted in determining net worth.
  • Any person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

The notion underlying Very Rich People is that because they are Very Rich, they can afford to lose a lot of money by investing in more risky companies. The problem with the current standard, however, is that it was set more than 30 years ago, in 1982. It’s like the classic scene in Austin Powers when Dr. Evil discovers that $1 million just isn’t that much money anymore:

The SEC is currently exploring an update to the wealth and income levels for individuals that are accredited investors. Adjusted for inflation, the income level would be $500,000/year and the net worth level would be $2.5 million in assets, in 2014 dollars. It’s too soon to tell whether the SEC will update the standards, or perhaps augment them with additional standards regarding education or occupational credentials.

So what are the key takeaways for startups and other companies that may be trying to attract investors? First, make a decision right away as to whether you are only going to talk to accredited investors. This isn’t a decision you can make after you’ve been meeting with potential investors for several weeks or months. In general, restricting your pool of potential investors to accredited investors will be a better strategy — you will have reduced disclosure obligations, and the investors you do attract will be better able to provide benefits to the company that goes beyond mere investment dollars. Second, have a way to confirm that your potential investors are indeed accredited. You may need to have them complete a questionnaire, or you may need to review tax returns or other personal financial statements from individual investors. This may seem awkward, but they are asking to see your company’s financials, too. They are evaluating you, and you are evaluating them. If they aren’t willing to actually share their tax returns or financials with you, ask for a letter from their attorney or accountant, stating that the attorney or accountant has reviewed the relevant materials and determined that the investor meets the standards of an “accredited investor.” Third, and finally, this is a complex area of law, with lots of traps for the unsophisticated. Before beginning to seek outside investments, it is wise to meet with a lawyer to discuss the various requirements, and to lay out a strategy for doing things the right way.

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