Venture Capital Office Hours with Voyager Capital

UW students and faculty interested in startups can talk monthly, face-to-face, with a venture capital investor and startup attorney.  Randall Lucas of Voyager Capital and I hold open office hours the first Wednesday of each month at the University of Washington.

Who comes to see us?  A wide range, from skateboard-toting sophomores who have coded up an iPhone app, to senior researchers considering commercializing robotics technology, to rising seniors considering whether to work at a startup and what “stock options” are — all have come by to chat during open office hours.

You can find us at the Information School (Mary Gates Hall, iLounge 4th floor) from 10-11, and then at the Computer Science School (Allen Center, atrium) from 11-12. We do these typically on the first Wednesday of every month, while school is in session.  (If you want to talk during summer vacation, drop us a line and we’ll set something up.)

So, if you’d like to come see us, we will be there on Wednesday, March 1.  Happy to give you feedback on your startup ideas, guidance on thinking about intellectual property, or suggestions on raising capital — or just to hear what you’re excited about working on.

 

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Dear IRS: Let’s Make the Filing of 83(b) Elections Easier

Right now, the law sets an unfair tax trap for company founders.

The 83(b) Election Tax Trap

When founders come together to form a startup, they usually put vesting on their shares. They do this for tax reasons.

Here are the tax reasons to put vesting on shares: When a company issues stock to a service provider, the service provider’s receipt of the stock is taxable to the service provider.

For example, if you joined a company, and the company wanted to pay you in stock for services performed (say, 10,000 shares for each calendar quarter of service), you would have a problem. Each time the company issued you shares, you would owe taxes on the value of the shares received. This would be the case even if you couldn’t sell the shares to pay the tax (private company shares can’t be re-sold, generally).

This is a flaw in our income tax code, but it is a flaw that shows no signs of being fixed.

How Do Founder’s Get Out of this Mess?

The tax code is not entirely anti-founder. It gives them an out. Here is how it works:

Instead of the company paying you 10,000 in shares for each calendar quarter of services, the company will issue you all of the shares up front, so that you can pay tax on them now, at today’s value. But the company will retain the right to repurchase them at the price you paid if you leave before your service period is expected to end. Typically this right to repurchase at the price you paid lapses monthly over the vesting period, usually with a cliff vesting period at the front end.

This is a nifty tax trick. If the shares are worth a small amount of money now, because the company was just formed, you can pay tax today (and hopefully not very much).

But to not pay tax when the shares vest, you have to file an 83(b) election with the IRS within 30 days of receiving the shares subject to vesting.

The 83(b) election is the only way to avoid a terrible tax outcome when vesting conditions are imposed on founder shares.

If a founder files the 83(b) election with the IRS within 30 days of receiving his or her shares, the founder won’t have any more tax consequences associated with their shares until they sell them. If they hold them for more than a year and sell them, any gains will be taxed as long-term capital gain.

If the founder misses the 30 day deadline, each time their shares vest they will owe ordinary income tax if the value of the shares has increased. This affects not only the founder adversely, but also the company, which must withhold and remit taxes to the IRS if the founder is considered an employee for federal income tax purposes.

Why does the tax code treat founders this way? In almost all instances when an 83(b) election is filed, no additional taxes are due. The 83(b) tax is a tax on the unprepared or the un-initiated. As such, it is not fair tax policy.

I have written that Congress should amend Section 83(b) to reverse its presumption.  In other words, deem the election made if at the time of receipt of the shares no additional tax would be owed, because the person paid FMV for their shares.

There are other simple fixes too. How about just require the attachment of the 83(b) election to the Form 1040 for the year? In other words, delete the 30 day filing requirement?

Or, how about this? Allow electronic filing of 83(b) elections. Right now, the tax code and regulations are silent on whether electronic signatures on Section 83(b) elections work. This is a shame. The result is that to be safe, the recommended advice is to file origanally signed elections, which makes these elections more difficult to file. Some companies, such as eShares, are taking the position that electronic signatures will not be disputed by the IRS. I applaud the approach. But if we have a pro-business administration right now, the very least that ought to happen is the IRS ought to publish guidance that electronic signatures are completely acceptable in this context.

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Washington State Equity Crowdfunding Update

Good news! Senators Fain and Mullet have sponsored SB 5680 in the Washington State Senate. This is the same bill as HB 1593 in the House.

The bill would make important technical improvements to Washington State’s equity crowdfunding law

The highlights of the bill include:

  • Allowing Delaware corporations to use Washington State’s equity crowdfunding law.
  • Bringing the Washington State law into alignment with the federal exemptions now in place (we have a new federal exemption, Rule 147A).
  • Allowing accredited investors to participate in Washington State equity crowdfunding offerings without a limit on the amount of their investment.
  • Repealing the poison pill of having to publicly disclose executive officer and director compensation; instead, disclosure will just be required to shareholders and the DFI.
  • Allows companies to sell “[a]ny type of equity or convertible debt security” under the exemption (this will allow companies to sell convertible debt).

This is a great bill, and should result in companies using Washington State’s equity crowdfunding law.

The public hearing on the Senate bill is currently scheduled for February 9th. Anyone interested in testifying can come down to Olympia and sign up and be heard in support of the bill.

If you want to track the progress of the bill, you can track it here.

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Washington State Equity Crowdfunding Update

My colleague Danny Neuman and I testified this morning in support of HB 1593. This bill would improve the Washington State equity crowdfunding law.

The bill is sponsored by Representatives Vick and Kirby.

HB 1593 Would Do a Number of Helpful Things

HB 1593 would do the following:

  • Eliminate the quarterly public disclosure of executive officer and director compensation. Instead, there would be a required annual disclosure to the Company’s shareholders and the DFI.
  • Allow “accredited investors” to invest an unlimited amount in approved crowdfunding offerings.
  • Align the statute with new SEC regulations on Rule 147A offerings. This would allow companies incorporated in Delaware to use the law.
  • The bill would also allow companies to sell convertible debt or “any type of equity.”

The Washington State DFI testified in favor of the bill.

Hopefully this bill moves to passage and signature by the Governor this year. It would be a good series of improvements in the law. HB 1593 will make the law more accessible to companies and more desirable as a fundraising tool.

If you would like to know how to support the bill, email either me or Danny at wallin@carneylaw.com or neuman@carneylaw.com and we can give you some ideas.

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Congress: Please Fix 83(b) Elections

Congress is trying to make life easier for early stage and startup companies. This is good.

But so far, nothing has been proposed to fix Section 83(b) of the Internal Revenue Code.

Section 83(b) haunts every founder who receives shares subject to vesting.

If you are founding an early stage technology company with other founders, you will probably impose vesting on all of the shares issued to the founders. Vesting in this context means the following: if you quit providing services, the company has the right to buy back your “unvested” shares. The purchase price is the lesser of either (i) the FMV of the shares at the time of repurchase, or (ii) the price you paid for them (usually this is not a big number). This lower-of-fmv-or-cost repurchase right lapses over the vesting period, usually 4 years with a cliff of some kind.

Vesting is critical to include in company formation documents. If a 30% founder leaves, your company will essentially be un-fundable if a 30% owner is no longer working at the company.

But the current tax law does not make life easy for founders in this circumstance.

The Current Tax Law

The current tax law requires founders to file an 83(b) within 30 days of receiving their shares or suffer horrible, potentially debilitating tax consequences.

If you file the election, you typically won’t owe any tax as a result of filing. And your filing the form timely means that you won’t owe any tax when your shares vest.

If you don’t file the election, you will owe tax when your shares vest if the shares have gone up in value. The tax you owe will be based on the difference between the fair market value of the shares at the time of vesting over what you paid for them. If you are an employee, you will have to write a check to the company so that the company can send the funds to the IRS to pay the employee’s side of income and employment tax withholding. This can get expensive fast.

The tax code should not be written like it is now. We shouldn’t put founders on a 30 day ticking time bomb whenever they found a company. This is hostile to people founding companies.

Instead, we should reverse the presumption in Section 83(b). What I mean is that an 83(b) election is “deemed filed” if the Founder would not owe any tax as a result of filing it.

This would allow founders to sleep at night, and making forming and starting companies easier. Isn’t that what we want Congress?

I drafted proposed legislation along these lines a few years back. You can find it here.

If you happen to run into legislators or legislative staff working on federal tax issues, please mention this idea to them.

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The Financial Choice Act: How to Make it Better re Form D

Congress is preparing a bill known as the Financial CHOICE Act of 2016. There is a lot in the bill (and so it is worth scanning the table of contents for issues you might care about). One of the provisions of the bill, Section 1066, would revise the Form D filing requirements to make them easier on companies in general, including startups.

For the sake of clarity, Section 1066 makes it clear that the SEC is not to condition the availability of the exemption under Rule 506 on the filing of the form. This is good, but it leaves a gap in the law.

Many states require issuers to file the Form D in their state if the company is either resident there or has investors resident there. This means that even if the Congress clarifies that a federal Form D filing is not required, companies will still have to file and file with sometimes a variety of states. Many states impose substantial filings fees (e.g., $525 in Pennsylvania). Other states impose late filing fees (e.g., New Mexico).

Let’s fix 1066 to fix the state problem.

Let’s expressly add to Section 1066 that no state securities law administrator or authority can condition the availability the exemption on the Form D filing as well.

If you know anyone who is working on this bill, please suggest this to them. I am going to try as well.

 

 

 

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The Accredited Investor Definition: Let’s Not Index it to Inflation

The first bill out of the new Congress next year might set the accredited investor definition to adjust with inflation. As the bill is currently drafted, every 5 years the financial thresholds would go up based on inflation.

The bill is called the Financial Choice Act. You can find it here.

I think this is a bad idea for the following reasons:

  • The inflation adjustments will slowly disqualify angels who meet the current standards, reducing the number of angel investors available to invest in early stage startup companies.
  • If inflation adjustments had been in place when the current financial thresholds had been adopted, we would have 1/3rd fewer angel investors than we do today.
  • Already, outside of Silicon Valley, finding angel investors to invest in companies is extremely difficult.
  • This automatic inflation adjustment will hurt middle America worse. It is harder to meet the income tests in middle America. In middle America, we ought to adjust the thresholds down to take into account regional variations in income.
  • Along the lines of the last point, check out this great article by Leslie Jump. She makes what I think is a great point. We need to facilitate getting angel and venture capital investment dollars into areas that have been traditionally under-served by those sources of capital.
  • As stated in the Comprehensive Summary of the Financial Choice Act:

“Private placement offerings are a key source of equity capital for many small and emerging companies that generate a disproportionate share of the new jobs in our economy. Because such offerings are generally available only to accredited and other sophisticated investors, it is essential that the SEC not overly restrict the pool of accredited investors.”

Oddly enough, the Comprehensive Summary of the bill doesn’t mention indexing.

  • Even though inflation has been relatively tame, it might ramp up at any time. The President-elect’s big infrastructure plans could heat up inflation, for example.

If you can think of any other reasons why you think indexing these standards to inflation is a bad idea, please share them. Let’s press this case. I think the early stage ecosystem will be harmed by indexing. Thank you.

 

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Indexing the Accredited Investor Standard to Inflation: A Bad Idea

Now that the election is over, it is unclear, at least to me, which direction startup public policy will take. It is in all of our best interests that we have a startup public policy that promotes innovation and creativity. Too often we have laws that slow us down, impede us, or flat out make it illegal, whatever new product or innovation it is we are working on. 

It appears that one of the first acts of Congress is going to be the Financial Choice Act. There are provisions of this act that will affect the startup ecosystem. We should make our voices heard if we care about this.

Section 452 of the Financial Choice Act would do the following:

  • Repeal Section 413 of Dodd-Frank. The primary effect of this would be to take out of the SEC’s hands the review and modification of the accredited investor standards. Section 413 also requires the SEC to review and issue a report on the definition every 4 years. You can read the first report here. This would apparently go away with the repeal of section 413 as well. I agree in general that the SEC should not be able to make the definition of accredited investor worse, but it ought to be able to make it better (meaning, bringing more people into the definition, perhaps, for example, by imposing investment limitations on individuals that do not meet the current financial thresholders). I liked the SEC’s first report on the matter. It had some good ideas. Such as allowing Indian tribes to qualify as accredited investors (by a weird quirk of the way the current SEC rules are written, Indian tribes do not qualify as accredited investors, even if they have tens of millions of dollars in assets and investments). 
  • Codify the financial thresholds to qualify as an accredited investor. I would also view this as a positive. 
  • Set the financial thresholds to qualify to automatically adjust with inflation. I view this as a negative. 
  • Create two new categories of accredited investor:
    • anyone who is currently licensed or registered as a broker or investment advisor by the SEC, FINRA, or an equivalent SRO, or the securities division of a state or equivalent state division responsible for licensing or registration of individuals in connection with securities activities; and
    • anyone the SEC determines, by regulation, to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA or an equivalent SRO.

Both of the latter two ideas are good ideas. But as far as testing in, I am not sure FINRA is the right entity to administer such a test. Wouldn’t it be great if individual state securities administrators could administer such a test? The young MBA grad, for example, who doesn’t have $1M in net worth, but is young and has a long investment time horizon, seems to me ought be allowed to test in.

Indexing is a Bad Idea

I know different people have different thoughts on this. But I personally think indexing the financial thresholds to adjust with inflation is a bad idea. Sure, inflation has been low for years. But for all we know we will go through a period again, in the not too far future, where we have significant inflation. If we do, then this law will start automatically defining people out of the category of accredited investor. I think it would be more logical to leave the current numbers in place, and if Congress decides to change them in the future, Congress can change them.

To put it in context, one of the early versions of Dodd-Frank would have adjusted the financial thresholds to inflation, going all the way back to when they were set. We estimated that 2/3rds of all angel investors in America would no longer have qualified as accredited investors.

If Congress wants to index something to inflation that will improve the business regulation environment, it ought to index the $600 1099 threshold to inflation. That number hasn’t changed in forever. If it had been set to adjust to inflation, it would be something on the order of $5,000 right now.

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506(c) Offerings: Let’s Fix the Verification Rules

Section 201(a) of the JOBS Act repealed the ban on generally soliciting or generally advertising private securities offerings, provided certain conditions were met.

Many people believed that this change in the law would be one of the most dramatic brought about by the JOBS Act. But things didn’t go as planned. Today, only a small fraction of private companies raising money generally solicit or generally advertise their offerings. Why is this? Because along the way to passage, the original Section 201(a) was amended to include what many people thought was a reasonable addition, and then the SEC enacted rules requiring something a lot of people don’t want to do.

Rule 506(c) Offerings

In Rule 506(c) offerings, a company can generally solicit or generally advertise that they are selling securities but only if:

  • All of the investors in the round are accredited, and
  • the issuer verifies that the investors are accredited.

The verification rules require companies to ask their investors for their personal tax returns, or their personal financial statements. These verification rules surprised a lot of angels, and essentially made Section 201(a) not quite the improvement in the law we all hoped it would be. Most angel investors don’t want to turn over their personal tax returns or personal financial statements as a condition to making an investment in a private company. Similarly, most private companies don’t want to put any more hurdles in front of receiving an investment than absolutely necessary.

This is the reason the overwhelming majority of private company securities offerings are still done the old fashioned way, without general solicitation or advertising. This is the the reason almost all companes proceed under Rule 506(b). Rule 506(b) offerings can’t be generally solicited or advertised–but they also don’t require verification. In a Rule 506(b) offering, you can rely on an investor checking a box averring that they are accredited, as long as your belief that they are accredited is reasonable.

I’ve quoted Section 201(a) below. The original Section 201(a) did not include the verification language. I have put in bold below the language that was added after a comment at a House Committee hearing that if companies didn’t verify the accredited investor status of their investors, non-accredited investors might be lured into risky investments and lose their money.

I am in favor of repealing this verification requirement, and returning to the original language of Section 201(a). Short of repeal, I think we should change the verification requirements to make them less intrusive, and more obervant of investors’ desire for personal privacy. Perhaps simply allowing investors to certify under penalty of perjury that they are accredited after reading the rules re accreditation and averring that they understand them would be a good compromise.

It would be nice to fix these rules so that Rule 506(c) would be more widely used.

The Language of Section 201(a)

Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under

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Intrastate Crowdfunding: SEC Adopts Helpful Rules

The SEC adopted final rules today to facilitate intrastate crowdfunding offerings.

Intrastate Crowdfunding

Intrastate crowdfunding is a phenomenon I am not sure many people anticipated. In the wake of the JOBS Act, when everyone was waiting for the SEC to finalize the Title III JOBS Act equity crowdfunding rules, states started passing their own laws. Amy Cortese has a really nice graphic on her site showing that 35 states so far have passed intrastate equity crowdfunding laws.

The new SEC rules will remove some of the impediments to intrastate crowdfunding. There are still things left to improve at the federal level to help intrastate crowdfunding, but today is a good day for the local investment movement.

Links to the SEC’s Press Release and the Final Rules

The SEC didn’t undermine existing state law. There was a risk of this. The SEC initially proposed rules that would have removed Rule 147 as a safe harbor under Securities Act Section 3(a)(11). This would have disrupted a number of state statutes. Instead, the SEC left Rule 147 in place, but amended it, and then adopted a new exemption designated Rule 147A.

The SEC also increased the amount that can be raised under Rule 504 to $5M (from $1M), applied the bad actor restrictions to Rule 504 offerings, and repealed the never used Rule 505.

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