Secondary Sales and An Investor Covenant You Don’t Want To Miss

If you are investing in early stage companies, there are certain deal terms you want.

Most you probably know already: if it’s a round of convertible notes, you want a discount and a cap; if it’s a priced round, you want a liquidation preference. Etc.

But there is a new thing you need to add to your list of “must haves.”

You now want your investment documents to include a Section 4(a)(7) covenant.

What the heck is Section 4(a)(7)?

Section 4(a)(7) is a new federal securities law that basically says, it’s OK for you to sell your investment in a private company, as long as you don’t generally advertise the securities for sale, sell to another accredited investor, and the company cooperates with certain information requirements.

The new federal law trumps state law. So state law won’t hold you up.

Unlike the existing resale exemption most commonly used, there is no holding period required under this new law.

What is a Section 4(a)(7) covenant?

This new law is great—but you need the company’s assistance to access it, because the law requires the company to provide certain information to the purchaser.

So, get this covenant in your investment documents, and it may be easier for you to later sell your shares.

You can find draft covenants to include in your securities purchase agreements here. Thank you to Bill Carleton (@wac6) and Gary Kocher for collaborating in putting this together. 

And if you’re a founder or exec, don’t despair: Section 4(a)(7) will work for you, too. For a longer, in depth discussion of the new law, see this article in TechCrunch.

The Beauty of Revenue Based Financing

What is Revenue Based Financing?

For the most part, early stage company financings fall into two categories:

1.​Fixed price financings (e.g., a Series Seed or a Series A Preferred Stock financing); and

2.​Non-fixed price financings (e.g., convertible notes, or convertible equity).

Fixed price rounds are great when you can fix the valuation of a company, price the shares, and you are raising enough money to justify the legal costs involved. An example of when a fixed price round might not make sense: Suppose you are only trying to raise $200,000. A $200,000 round is probably not big enough to justify the legal fees and other expenses of a preferred stock financing (and if you are raising money from angels most won’t want common stock).

Convertible note or convertible equity (such as Y Combinator’s SAFE) financings are great for smaller rounds and for when you can’t settle on a valuation and fix the price per share. For example, in the $200,000 round example mentioned above, convertible debt or convertible equity would work great for that size round.

However, there is a new variant: Revenue Based Financing.

Revenue based financing is debt financing, but the repayment terms are determined by your company’s net receipts. For example: You might borrow $200,000 but your monthly payment would be 8% of the prior month’s net revenue until you have paid the lender some multiple of the initial loan amount (e.g., 2x).

Revenue based financing is nice because:

(1)​As an investor you can start receiving a return on your investment immediately. You do not have to wait some number of years until the company is sold.

(2)​As a company you frequently don’t have to give up equity in your company to raise the money. Non-dilutive financing is a beautiful thing!

There are certainly “knocks” on revenue financing:

(1)​You might say it is more expensive than a regular bank loan, and you might be right. But you might not be able to get a regular bank loan, or that might require a personal guarantee (some revenue based loans might not require a personal guarantees, e.g., Lighter Capital).  

(2)​Depending on the stage your business is at, revenue-based financing might not be the best financing choice available to you – e.g., your revenue is too unpredictable, or conversely, your revenue is so steady that a regular bank loan makes more sense.

(3)​You won’t be able to get any revenue based financing if you are pre-revenue (obviously).

(4)​It is debt, real debt, that must be repaid and “sits on top” of all equity.

Revenue based financing is something to keep in mind as you go about looking for different financing alternatives for your business.

Incentive Stock Options: Post-Termination of Service Exercise Periods

The 90-day post termination of employment exercise period for stock options is under attack.

A lot of companies are moving away from 90 days. You can find a list of them in a GitHub repo maintained by Zach Holman. Zach also has written an impassioned post about this issue.

Why is the 90-day rule problematic? Because if you are fired, or quit, and you do not have the funds to exercise your stock options within 90 days of termination, you lose them.

Some people might ask the following technical question:

What if I have an ISO? Doesn’t it have to prohibit me from exercising beyond 3 months of my termination of employment or it is not an ISO?

This is a good question, for sure.

You can find the answer the plain language of the Internal Revenue Code. Section 422(a) says the following:

Section 421(a) shall apply with respect to the transfer of a share of stock to an individual pursuant to his exercise of an incentive stock option if—
(1) no disposition of such share is made by him within 2 years from the date of the granting of the option nor within 1 year after the transfer of such share to him, and
(2) at all times during the period beginning on the date of the granting of the option and ending on the day 3 months before the date of such exercise, such individual was an employee of either the corporation granting such option, a parent or subsidiary corporation of such corporation, or a corporation or a parent or subsidiary corporation of such corporation issuing or assuming a stock option in a transaction to which section 424(a) applies.

In other words, you don’t qualify for the benefits of incentive stock options under the statute if you exercise beyond 3 months after termination of employment. But that doesn’t mean your stock option couldn’t have a 10 year exercise period–be styled as an ISO–and just tell you that if you exercise later than 3 months after your employment ends the option will be treated as a nonqualified stock option.

There is also a discussion of this at BenefitsLink.com.

One misconception relates to the 3-month period for exercise. Many employers understand, mistakenly, that the ISO rules require expiration of the ISO at the end of this period. The rule is not that strict. An option could be exercisable for more than 3 months after termination of service; it simply would not qualify for ISO status if it is exercised more than 3 months after termination of employment for a reason other than disability or death.

This blog post does not constitute legal or tax advice.

Accredited Investor: Two Tier System Coming?

The staff of the SEC has issued its report on the definition of “accredited investor.”

It could be what we are looking at is the following: a “super accredited investor” definition (credit to Bill Carleton for coining this term), and the current definition–but if you don’t qualify as a “super accredited investor” you will be subject to investment limitations.

Here is what the SEC said about the “super accredited investor” idea:

The staff believes that the financial thresholds should be adjusted to reflect inflation to be consistent with the Commission’s 1982 and 1988 policy choices. The staff also believes that the potential alternative criteria identified below could provide adequate avenues for sophisticated individuals to qualify as accredited investors. The Commission could consider adding new inflation adjusted income and net worth thresholds. Thresholds such as $500,000 for individual income, $750,000 for joint income and $2.5 million for net worth would reflect inflation and maintain the ratios in the current definition. Under this approach, individuals who meet the new income or net worth thresholds would not be subject to the investment limitations suggested in paragraph A above.

And here is the SEC’s investment limitation proposal:

The Commission could consider leaving the current income and net worth thresholds in the accredited investor definition in place, but limiting investments for individuals who qualify as accredited investors solely based on those thresholds to a percentage of their income or net worth (e.g., 10% of prior year income or 10% of net worth, as applicable, per issuer, in any 12-month period).

Are these good ideas?

In general, I don’t think indexing the financial thresholds to inflation is a good idea. Slowly over time we will just define out of the category angels whose income or net worth doesn’t beat inflation.

If we had to choose between indexing and investment limitations, I would choose the investment limitations.

The 9Mile Innovation Framework© – A Structured Methodology for Technology Company Development

9 mile innovation framework

Guest Post by the Team at 9Mile Labs

When we ventured into the startup accelerator business over three years ago, we knew we were headed into brand new territory. The startup accelerator business model was pioneered in 2005 by Paul Graham at YCombinator (YC) and then subsequently adopted by many others after high-profile YC successes such as AirBnB, Dropbox, Heroku and others.

We were perfectly happy to replicate a proven model, but we also wanted to ensure we continued to learn, iterate, refine, and innovate.  And the only way we knew how was to constantly talk to our customers – i.e., entrepreneurs and investors – and try to deeply understand their challenges and pain points.

These conversations are the genesis of the 9Mile Innovation Framework, our foundational methodology for helping launch and grow startups. Using Steve Blank’s customer development methodology and Alex Osterwalder’s Business Model Canvas (BMC) tool as a starting point, we began to build our own proprietary framework for company creation and growth. While we found the BMC to be a great tool, we also needed a foundational framework that helped us with the following:

  1. A tool to assess a startup’s progress over time, including a self-assessment tool for entrepreneurs to track their own company’s performance.
  2. A high-level model for creating enterprise and B2B startups that are focused on solving real-world problems and on customer traction.
  3. Provide us a common language to discuss startup progress, challenges, and solutions with entrepreneurs, mentors, speakers and investors.
  4. A clear foundational structure for our entrepreneurship and company-building curriculum.

With the 9Mile Innovation Framework, we have a tangible rubric we can use to gauge the current and future success of the companies graduating from the accelerator. Since 9Mile Labs is only successful if its companies are successful, the framework also serves as a measure of how our own business is progressing. Applying the framework to everything we do, there is no hand waving, subjective arguments, or seat-of-the-pants rationalizing. If something isn’t working, we go back to the drawing board and refine our framework.

Just a side note: we don’t claim that every concept in our Innovation Framework is original. We read books, browse startup-oriented publications, follow prominent bloggers, and speak to many people every day. And when some concepts resonate with us, we incorporate them into our thinking – consciously as well as inadvertently. For example, we read a startup-oriented book called Nail It, Then Scale It and really liked that term and started using it; we heard the term “Hacker, Hustler, Visionary” from somewhere else and promptly borrowed it. All innovation builds upon existing ideas; progress comes when you put many “borrowed” ideas together with original thinking.

The 9Mile Innovation Framework has nine key strategic steps necessary to build any company from idea-to-execution (Figure 1). We call the first five steps in our framework the “Nail It” stage, so termed because investment in scaling activities such as marketing and sales is useless until a startup has achieved these five basic milestones. No business should spend time and money building a product that no one wants. It’s also important to note, that even though there’s a certain sequential nature to this model, startups of course sometimes hit these milestones in different order. Here’s a brief description of the five steps in the “nail it” phase of our framework:

  1. Team: Investors, especially early-stage ones, invest in teams first, then the market and idea. At 9Mile Labs, we look for a complete team comprising three roles – hacker, hustler, and visionary.
  2. Pain Point: The business idea for a startup must be rooted in a well-understood pain point for a specific customer segment in a significantly large market.
  3. Competitive Differentiation:  Every early-stage startup must have an understanding of, and build strategies for creating sustainable differentiation against competitors.
  4. Value Proposition: The value the customer receives from the startup must be significantly higher than the total cost of ownership from using the startup’s solution.
  5. Product: The actual product the company builds, first as an MVP, later beta, and then as a complete product, must be based on an in-depth understanding of the customer’s pain point and the value delivered to the customer.

The 9Mile Innovation Framework
Figure 1: The 9Mile Innovation Framework

Achieving maturity on the “Nail It” steps leads a startup to the “Scale It” part of the framework. The startup has the beginnings of a good business and now needs to take things to the next level. Of course, the “Scale It” part of the framework remains iterative as well, with startup teams learning what works and what doesn’t as they work to build a scalable, repeatable, and profitable business model. Things change, and the entrepreneurs must be ready to go back to square one or pivot if necessary. Here are the four steps in the “Scale It” part of our framework:

  1. Go-To-Market: Create clear messaging and positioning statements that resonate with the target customer segment, as well as demand generation strategies to target those customers.
  2. Customer Traction: Tactics and strategies employed to achieve and track exponential, proven, sustainable customer growth against non-vanity metrics.
  3. Business Model: Bringing together much of the work in prior milestones, the business model must be scalable, repeatable, and profitable.
  4. Funding Strategy: Every startup should clearly think about its funding needs and explore options such as customer revenue, strategic, angel, or venture investment.

Creating the 9Mile Innovation Framework grew out of our conviction that, while raising money is a very important activity for a startup, a much more important success metric is customer traction. However, amid headlines about unicorns and multimillion-dollar funding rounds, startups sometimes start thinking of funding as the ultimate objective, as opposed to a means to building a successful business.

Following this broad introduction to the 9Mile Innovation Framework, in the next post, we’ll dive into the specifics of each milestone introduced above. First up, the team. Tune into our next post to find out how we evaluate successful teams.

9Mile Labs is a leading Enterprise / B2B high-tech accelerator based in Seattle. 9Mile Labs celebrates the graduation of its fifth cohort on Mar 3, 9:30am; register as our guest with promo code “GOLD” at http://m9.9MileLabs.com!

The accelerator is currently accepting applications for the upcoming program (beginning in July, 2016) at http://apply.9MileLabs.com.

The Text of New Section 4(a)(7)

If you are looking for the complete text of new Section 4(a)(7) of the Securities Act of 1933, as amended, I have quoted it in full below.

You can also find the entire text of the Fixing America’s Surface Transportation Act or the “FAST Act” at this link.

This new law makes it substantially easier for holders of stock in private companies to sell their shares in secondary transactions. You might find this article that appeared in TechCrunch helpful as well: New law changes the liquidity game for tech company founders, workers and investors

The Full Text of the New Section 4(a)(7)

TITLE LXXVI—REFORMING ACCESS FOR INVESTMENTS IN STARTUP ENTERPRISES

SEC. 76001. EXEMPTED TRANSACTIONS.

(a) EXEMPTED TRANSACTIONS.—Section 4 of the Securities Act of 1933 (15 U.S.C. 77d) is amended—

(1) in subsection (a), by adding at the end the following new paragraph:

‘‘(7) transactions meeting the requirements of subsection (d).’’;

(2) by redesignating the second subsection (b) (relating to securities offered and sold in compliance with Rule 506 of Regulation D) as subsection (c); and

(3) by adding at the end the following:

‘‘(d) CERTAIN ACCREDITED INVESTOR TRANSACTIONS.—The transactions referred to in subsection (a)(7) are transactions meeting the following requirements:

‘‘(1) ACCREDITED INVESTOR REQUIREMENT.—Each purchaser is an accredited investor, as that term is defined in section 230.501(a) of title 17, Code of Federal Regulations (or any successor regulation).

‘‘(2) PROHIBITION ON GENERAL SOLICITATION OR ADVERTISING.—Neither the seller, nor any person acting on the seller’s behalf, offers or sells securities by any form of general solicitation or general advertising.

‘‘(3) INFORMATION REQUIREMENT.—In the case of a transaction involving the securities of an issuer that is neither subject to section 13 or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m; 78o(d)), nor exempt from reporting pursuant to section 240.12g3–2(b) of title 17, Code of Federal Regulations, nor a foreign government (as defined in section 230.405 of title 17, Code of Federal Regulations) eligible to register securities under Schedule B, the seller and a prospective purchaser designated by the seller obtain from the issuer, upon request of the seller, and the seller in all cases makes available to a prospective purchaser, the following information (which shall be reasonably current in relation to the date of resale under this section):

‘‘(A) The exact name of the issuer and the issuer’s predecessor (if any).

‘‘(B) The address of the issuer’s principal executive offices.

‘‘(C) The exact title and class of the security.

‘‘(D) The par or stated value of the security.

‘‘(E) The number of shares or total amount of the securities outstanding as of the end of the issuer’s most recent fiscal year.

‘‘(F) The name and address of the transfer agent, corporate secretary, or other person responsible for transferring shares and stock certificates.

‘‘(G) A statement of the nature of the business of the issuer and the products and services it offers, which shall be presumed reasonably current if the statement is as of 12 months before the transaction date.

‘‘(H) The names of the officers and directors of the issuer.

‘‘(I) The names of any persons registered as a broker, dealer, or agent that shall be paid or given, directly or indirectly, any commission or remuneration for such person’s participation in the offer or sale of the securities.

‘‘(J) The issuer’s most recent balance sheet and profit and loss statement and similar financial statements, which shall—

‘‘(i) be for such part of the 2 preceding fiscal years as the issuer has been in operation;

‘‘(ii) be prepared in accordance with generally accepted accounting principles or, in the case of a foreign private issuer, be prepared in accordance with generally accepted accounting principles or the International Financial Reporting Standards issued by the International Accounting Standards Board;

‘‘(iii) be presumed reasonably current if—

‘‘(I) with respect to the balance sheet, the balance sheet is as of a date less than 16 months before the transaction date; and

‘‘(II) with respect to the profit and loss statement, such statement is for the 12 months preceding the date of the issuer’s balance sheet; and

‘‘(iv) if the balance sheet is not as of a date less than 6 months before the transaction date, be accompanied by additional statements of profit and loss for the period from the date of such balance sheet to a date less than 6 months before the transaction date.

‘‘(K) To the extent that the seller is a control person with respect to the issuer, a brief statement regarding the nature of the affiliation, and a statement certified by such seller that they have no reasonable grounds to believe that the issuer is in violation of the securities laws or regulations.

‘‘(4) ISSUERS DISQUALIFIED.—The transaction is not for the sale of a security where the seller is an issuer or a subsidiary, either directly or indirectly, of the issuer.

‘‘(5) BAD ACTOR PROHIBITION.—Neither the seller, nor any person that has been or will be paid (directly or indirectly) remuneration or a commission for their participation in the offer or sale of the securities, including solicitation of purchasers for the seller is subject to an event that would disqualify an issuer or other covered person under Rule 506(d)(1) of Regulation D (17 CFR 230.506(d)(1)) or is subject to a statutory disqualification described under section 3(a)(39) of the Securities Exchange Act of 1934.

‘‘(6) BUSINESS REQUIREMENT.—The issuer is engaged in business, is not in the organizational stage or in bankruptcy or receivership, and is not a blank check, blind pool, or shell company that has no specific business plan or purpose or has indicated that the issuer’s primary business plan is to engage in a merger or combination of the business with, or an acquisition of, an unidentified person.

‘‘(7) UNDERWRITER PROHIBITION.—The transaction is not with respect to a security that constitutes the whole or part of an unsold allotment to, or a subscription or participation by, a broker or dealer as an underwriter of the security or a redistribution.

‘‘(8) OUTSTANDING CLASS REQUIREMENT.—The transaction is with respect to a security of a class that has been authorized and outstanding for at least 90 days prior to the date of the transaction.

‘‘(e) ADDITIONAL REQUIREMENTS.—

‘‘(1) IN GENERAL.—With respect to an exempted transaction described under subsection (a)(7):

‘‘(A) Securities acquired in such transaction shall be deemed to have been acquired in a transaction not involving any public offering.

‘‘(B) Such transaction shall be deemed not to be a distribution for purposes of section 2(a)(11).

‘‘(C) Securities involved in such transaction shall be deemed to be restricted securities within the meaning of Rule 144 (17 CFR 230.144).

‘‘(2) RULE OF CONSTRUCTION.—The exemption provided by subsection (a)(7) shall not be the exclusive means for establishing an exemption from the registration requirements of section 5.’’.

(b) EXEMPTION IN CONNECTION WITH CERTAIN EXEMPT OFFERINGS.—Section 18(b)(4) of the Securities Act of 1933 (15 U.S.C. 77r(b)(4)) is amended—

(1) by redesignating the second subparagraph (D) and subparagraph (E) as subparagraphs (E) and (F), respectively;

(2) in subparagraph (E), as so redesignated, by striking ‘‘; or’’ and inserting a semicolon;

(3) in subparagraph (F), as so redesignated, by striking the period and inserting ‘‘; or’’; and

(4) by adding at the end the following new subparagraph:

‘‘(G) section 4(a)(7).’’.

The Two Definitions of Accredited Investor

You may not be aware, but the federal securities laws contain two definitions of the term accredited investor.

One definition is helpful to startups, and the other is not.

The definition of accredited investor that is helpful to startups is found in Regulation D.

Rule 506 of Regulation D is the securities law exemption used by startups in almost every angel and venture financing. Thus, it is the definition of the term “accredited investor” in Regulation D that is critical to startups.

The securities law also defines “accredited investor” in Section 2(a)(15) of the Securities Act. But this definition only relates to the exemption found in Section 4(6). The exemption in 4(6) is not helpful to startups, because 4(6) does not federally preempt state law and the amount you can raise is capped at $5 million. Thus, startups never use the 4(6) exemption.

When Congress suggests improvements to the definition of accredited investor, if they propose amendments to the 4(6) definition, it is not helpful to startups at all.

From time to time, Congress does this. You might find this old blog post helpful on this topic.

The only reason I bring this up because it appears this is happening again with the Schweikert bill.

Carney Badley Spellman is about Advocacy, Strategy, Results. Located in Seattle, we are a full-service law firm committed to exceptional client service and professional excellence. Our firm serves individuals, professionals, entrepreneurs, educators, closely-held or family businesses, franchises, Fortune 500 corporations, and insurance companies.  They are in the private sector, public sector, and governments.  Our clients are forward thinkers, creative, collaborative, and deliver high-quality products and business services to their markets.  Their markets extend into almost every industry including, food and beverage, retail, professional services, arts, health care, education, manufacturing, technology, construction, real estate, and more.  We advocate for our clients.  We strategize with them to meet their goals.

Crowdfunding Sales Tax Troubles

If you have run a successful crowdfunding campaign, you know what happens next. You owe a lot of crowdfunding sales tax. And you might not have appreciated what you were getting yourself into on the crowdfunding sales tax front.

Crowdfunding Sales Tax Troubles

There is a bill that has been introduced in the Washington State legislature that will attempt to alleviate or fix this problem.

The bill is HB 2655. You can track it here.

There will be hearing on this bill on January 29, at 8:00 a.m., in Olympia.

If you care about this issue, you can drive down to Olympia and sign up to testify in favor of the bill.

Please participate in this issue if you can. I like what the preamble to the bill says:

The legislature finds that crowdfunding plays an increasingly vital role in the economy and in individual communities, and that the global crowdfunding market will surpass ninety billion dollars in the next ten years. The legislature further finds that the current business and sales tax structure of Washington state is an impediment to entrepreneurs, inventors, artists, and private citizens seeking financial contributions to start new businesses, develop new products, complete creative projects, and achieve various goals. The legislature further finds that the current crowdfunding tax structure treats crowdfunding campaigns differently depending on their structure. It is the intent of the legislature to provide a business tax exemption for crowdfunding donations and to improve the sales tax structure as it applies to crowdfunding in order to simplify the tax code, improve fairness, and promote economic growth.

Accredited Investor: Let’s Let People Test In

The idea that you can “test in” to accredited investor status is gaining momentum.

Rep. Schweikert (R-Ariz.) has introduced a bill that would do just that. His bill has passed out of the House Financial Services Committee and is apparently headed to the floor of the House.

You can track the progress of the bill here.

The full text of the bill is quoted below:

SECTION 1. SHORT TITLE.

This Act may be cited as the “Fair Investment Opportunities for Professional Experts Act”.

SEC. 2. ACCREDITED INVESTOR DEFINITION.

Not later than 180 days after the date of enactment of this Act, the Securities and Exchange Commission shall revise its rules under Regulation D (17 C.F.R. 230.501 et seq.) to provide that a natural person shall be considered an accredited investor under such regulation notwithstanding the income and net worth requirements in paragraphs (5) and (6) of section 230.501(a) of title 17, Code of Federal Regulations, if such person certifies to the issuer prior to the sale of securities to such person that he or she—

(1) is a person described in paragraphs (1), (2), (3), or (4) of section 506(c)(2)(ii)(C) of such title;

(2) has retained and used the services of any person referred to in paragraph (1) to make an investment decision relative to the securities being offered; or

(3) is licensed as an accredited investor by the Financial Industry Regulatory Authority after completing an exam administered by such Authority using the criteria established by the Securities and Exchange Commission under section 2.

SEC. 3. FINRA LICENSING PROGRAM.

Not later than 180 days after the date of enactment of this Act, the Securities and Exchange Commission shall establish criteria for use by the Financial Industry Regulatory Authority in administering an exam to license as accredited investors natural persons who don’t meet the income and net worth requirements in paragraphs (5) and (6) of section 230.501(a) of title 17, Code of Federal Regulations. Such criteria may include methods for assuring that licensed accredited investors demonstrate a competency in understanding the following:

(1) The different types of securities.

(2) The disclosure obligations under the securities laws of issuers versus private companies.

(3) The structures of corporate governance.

(4) The components of a financial statement.

(5) Other criteria the Commission shall establish in the public interest and for the protection of investors.

You might be wondering: Who are the folks specified in paragraphs (1), (2), (3), or (4) of section 506(c)(2)(ii)(C). This is the group:

  1. A registered broker-dealer;
  2. An investment adviser registered with the Securities and Exchange Commission;
  3. A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
  4. A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.

I am a fan of this idea. The SEC staff also suggested a way to test into accredited investor status in its recent report on the accredited investor definition.

I can hear the other side. The arguments will be–these folks might have the financial sophistication, but be unable to bear the economic loss. Therefore, they shouldn’t be allowed to test in. I don’t agree. If anything, the response to this is–ok, then limit the amount such persons can invest in any one company.

This will be a fun thing to watch develop. I hope it moves forward. I would like to take the test myself, just to see how I would do.

In its report, the SEC had some ideas on how the test could be assembled from parts of other exams.

Portions of FINRA’s Series 7 and Series 82 examinations cover these areas and could potentially be used as a model for developing an accredited investor examination. Among other subjects, the Series 7 examination covers securities regulatory requirements, securities characteristics and financial analysis. Knowledge of the regulatory landscape is particularly important because individuals who invest in unregistered offerings should understand that they will generally not receive the type of information contained in a registration statement. The Series 7 examination consists of 250 multiple choice questions that candidates have six hours to complete. Among other subjects, the Series 82 examination similarly includes questions related to the regulation of the markets for registered and unregistered securities, securities characteristics and financial analysis. The scope of the Series 82 examination is more limited than the Series 7 examination because it focuses on private transactions. It contains 100 multiple choice questions that candidates have two-and-a-half hours to complete….

It will be fun to watch the legal/regulatory developments here, to let people test in.

For more related articles, visit our website, here.

Stock Options: Don’t Forget Board Approval

If you are in the process of awarding stock options to employees or service providers, do not forget that you need (among other things) board approval of all stock option grants. This is required by the corporate law of Delaware, Washington, and I imagine almost every state corporate law in the country.

(In this post, I am not talking about LLC equity awards; LLC equity awards are something entirely different from corporate stock options.)

Board approval of options can be documented in minutes of a board meeting, or a unanimous written consent of the board.

You can find good examples of board minutes granting options, or board consents granting options, if you search on Google. But I would recommend you use your company’s law firm’s documents. They will have them to share with you. And they would probably prefer you use their forms, since they might be called upon at some future point in time to give a legal opinion on your capitalization, and it will help them do that if they have been involved with your equity issuances.

Why is it important that you promptly and fastidiously document board approval of stock option grants? Well, because if the options haven’t been approved by the board, they haven’t been appropriately awarded under the corporate law. This can give rise to a variety of complexities and problems.

In general, it is a good idea to check in with your corporate counsel before granting stock options. This does not have to be an expensive process, but the costs of not administering your stock option plan in compliance with all of the technical requirements can become very expensive.

For example, if you run over the Rule 701 mathematical limitations, it could actually delay your IPO or result in personal fines. This actually happened to Google. You can find more information about this in this Practical Law Article.

Below is a full-blown stock option grant checklist.

Prior to Granting Stock Options

  • Adopt a stock option plan – First, adopt a plan and draft standard stock option agreements under the plan. If shareholders do not approve the plan, you cannot grant incentive stock options, and you may be required to make special filings with state securities regulators.
  • Grant all of your stock options under the plan-If you are granting options outside the plan, special considerations will arise, which are not addressed in this checklist.
  • Confirm that you have sufficient shares- Prior to granting stock options; confirm you have the number of shares under the plan to grant the new batch of options.
  • Rule 701- Before every grant of stock options, confirm that you are compliant with Rule 701′s mathematical limitations. Rule 701 has mathematical limitations, meaning–there is a limit to the number of securities you can issue under Rule 701, and you do not want to exceed that limit. For a summary of the limits, see What Is Rule 701 and Do I Need to Worry About It? [Be aware that Rule 701 is only available to companies that are not subject to the reporting requirements of section 13 or 15(d) of the Securities Exchange Act]
  • Prospectus- If you have granted more than $5M in options during the last 12 months, make sure to provide the prospectus required by Rule 701.
  • Eligible recipients- Confirm each prospective option recipient is eligible under the plan. Generally, only individuals qualify. Non-employee/consultants can qualify as long as they are natural persons providing bona fide services and not receiving the options in connection with a capital raising transaction.
  • Confirm the residency of recipients – Before every grant of stock options, confirm the residency of the prospective optionees and confirm that you are compliant with the Blue Sky law of each state in which investors are resident. If you are granting options to optionees in California, special attention will need to be given to California’s requirements.
  • Fair market value- Make sure that the options are being granted at fair market value in compliance with Section 409A of the Internal Revenue Code.
  • Board approval- Have the Board approve the option grants pursuant to a Board Consent or resolutions adopted at a meeting. If the vesting schedules for any of the options are different from the standard specified in the standard agreements, make sure the Board consent describes the vesting schedule.
  • Signed agreements- After each grant of stock options, give each recipient a copy of the stock option plan and their stock option agreements, and have them sign the agreements required under the plan.
  • Capitalization ledger- Update the capitalization ledger once the option is approved.