The Startup Law Blog

The RAISE Act would allow holders of stock in private companies to more easily sell their shares. Sales of private company stock are known as “secondary transactions.” Secondary transactions are currently hard to do because of the securities law restrictions on sales of shares in private companies, and also because companies frequently impose a number of contractual limitations on share resales (such as rights of first refusal).

However, even though share resales are currently difficult does not mean that they do not occur. Facebook stockholders found a healthy secondary market for their shares before Facebook went public. But Facebook is the clear exception–for most private companies no secondary market exists. This is in part due to the law in this area.

The securities laws impose significant limitations on share issuances and share transfers. This makes sense in a lot of instances (when people are being scammed). In other circumstances, restricting share transfers doesn’t seem to have as sound a public policy rationale. Allowing workers to more easily transfer shares they received as part of their compensation makes the law more fair to them, for sure. The new law would require that the purchasers be accredited investors, and that certain information about the company be supplied to the purchaser.

The Raise Act was embedded in the highway bill that passed both the House and the Senate and is on the way to the President’s desk.

We will see how soon the President signs it. Unfortunately, as the end of 2015 nears, it does not appear that the 100% tax exclusion from qualified small business stock held for more than five years is not going to be retroactively renewed like last year.

Text of The Raise Act

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).”.

A lot of companies, including a large portion of Silicon Valley startups, grant new hires immediately exercisable ISOs (incentive stock options) with the expectation that many will exercise their options “early” for favorable tax treatment. In fact, employees are often given a kit with all the paperwork, including everything needed to exercise and file an 83(b) election with the IRS.

In general, this is a nice offer. ISOs are generally more favorable to employees than nonqualified or nonstatutory stock options (“NQOs,” also called “NSOs”). And the opportunity to immediately exercise the options, receive the shares (subject to vesting), and make an 83(b) election is generally thought to mean the start of the capital gains holding period.

The primary benefit of an ISO is that on exercise, an employee does not have ordinary income when there is a “spread” on exercise (meaning, on exercise the fair market value of the stock exceeds the strike price).

The ISO exclusion from ordinary income tax also extends to employment taxes on the spread. And any spread is also not subject to the new Medicare surtaxes that were part of Obamacare, which impose an additional 3.8% tax on gains from stock that are considered “net investment income” in excess of certain thresholds.

If you are familiar with the math, income and employment taxes on the receipt of illiquid stock of your employer can be a huge financial burden that you may not have the ability to pay. (This is why employees frequently say, in response to an offer from an employer of high-value company stock, “No, I don’t want your stock. I can’t afford it.”) This is why options are so helpful–with an option you can defer the tax until you exercise (an event typically within the optonee’s control).

So, an offer of an immediately exercisable ISO is a reasonable approach to equity compensation, and should be appreciated for its advantages. We’re not here to knock the Silicon Valley way. But there is another fact most people miss.

Immediately Exercisable ISOs: Not Always Ideal

If you plan to exercise your options immediately (that is, immediately upon receipt), you would be better off if the option were an NQO rather than an ISO.

Why? How would an immediately exercisable option be better for you if set up as an NQO than an ISO? Well, like everything with ISO taxation, it’s complicated.

Firstly, it’s worth remembering the well-known “AMT trap,” where you sometimes have to pay taxes at time of exercise anyway, not as ordinary income tax, but in the form of AMT. As a reminder, when you exercise your ISO, even though you will have no ordinary income on exercise, the spread will be considered an AMT adjustment. This AMT tax event can be a big problem, particularly since the private stock probably can’t be sold to pay the possibly large tax bill. During the first dotcom boom, this tax trap drove a number of people into bankruptcy. The problem got so bad Congress passed a one-time forgiveness.

However, the usual AMT trap isn’t an issue for immediately exercisable options granted to new employees, where the strike price and fair market are likely the same—when the employee intends to exercise immediately.

Differing Holding Period Requirements

The issue to worry about here is a second and more subtle factor to do with holding periods to get more favorable long-term capital gains tax rates. The basic holding period requirements for ISOs and NQOs are different:

• ISO: To get long-term capital gains on the exercise of an ISO, you have to hold the shares for two years from the date of grant of the option until sale, and at least one year from the date of exercise until sale. In other words, you have a two-year holding period if you plan to immediately exercise.
• NQO: If you receive an immediately exercisable NQO, and exercise it immediately, you will have no income and employment taxes due because the strike price equals the fair market value. And if you file your 83(b) election, you will then start your capital gains holding period. And on an NQO, you only have to hold the shares for longer than one year to get long term capital gains treatment, not two.

Waiting two years is worse than waiting one. But to make matters worse, there are technicalities about ISOs that can make it even harder to meet the long-term capital gains holding period than the two years you’d expect. Many people believe early exercise together with an 83(b) election will start the clock sooner and help them hold the stock longer, to qualify for long-term capital gains. While this is true for NQOs, it’s not true for ISOs.

The IRS rules on ISOs say that the 83(b) election is valid only for AMT purposes — not for ordinary income tax purposes. What this means is that if you make a disqualifying disposition, then your capital gains holding period for ordinary income tax purposes does not start until the shares actually vest (see Example 2 in Treas. Reg. §1.422-1(b)(3), quoted in its entirety below). If you timely make an 83(b) election on early exercise of an ISO, the election works for ISO and AMT purposes. This means that if there is no disqualifying disposition, and you meet your holding period requirements, and the other ISO qualifications, you start your capital gains holding period on exercise, not on vesting.

So, if you want to immediately exercise an option and file an Section 83(b) election, it’s better if you can have it be an NQO. If you ask your employer to make your option grant an NQO, your employer should be able to accommodate you. And if you’re a founder or CFO, you might want to consider if this is the right choice for early employees in your company.

Some Rules of Thumb

We would offer the following rules of thumb:

• If you can choose between an immediately exercisable ISO and an immediately exercisable NQO, and you plan to exercise right away—you should choose the immediately exercisable NQO.
• If you can choose between an immediately exercisable ISO and an immediately exercisable NQO, and you don’t know if you are going to exercise right away, the question becomes more difficult. In general, in this scenario—choose the ISO.

Below are examples from the Treasury Regulations which show the IRS’s view on immediately exercisable ISOs. The IRS takes the view that since there is no ordinary income on the exercise of ISO, an 83(b) election with respect to an ISO can’t have any effect on the tax outcome, and the election is only effective for AMT purposes.

Of course, it would be nice if Congress fixed this whole mess. Indeed, if Congress really cared to remove perverse penalties from the tax code, it would simply repeal income and employment taxes on the receipt of illiquid stock altogether. It is not as if you can sell the stock to pay the taxes. You can’t do anything with the stock (and if your high-risk startup tanks, it’s ultimately worth little or nothing). In fact, thanks to the securities laws, you have to represent and warrant that you plan to hold the shares “indefinitely” for “investment purposes.” In other words, you pay your taxes… on illiquid shares… that you represent you will hold forever.

But we digress. None of those tax code changes are likely soon. So in the meantime, if you receive an immediately exercisable ISO, and you plan to exercise right away, consider asking that it be an NQO, not an ISO.

Examples from the Treasury Regulations at 1.422-1:

Example 1. Disqualifying disposition of vested stock.

On June 1, 2006, X Corporation grants an incentive stock option to A, an employee of X Corporation, entitling A to purchase one share of X Corporation stock. On August 1, 2006, A exercises the option, and the share of X Corporation stock is transferred to A on that date. The option price is $100 (the fair market value of a share of X Corporation stock on June 1, 2006), and the fair market value of a share of X Corporation stock on August 1, 2006 (the date of transfer) is $200. The share transferred to A is transferable and not subject to a substantial risk of forfeiture. A makes a disqualifying disposition by selling the share on June 1, 2007, for $250. The amount of compensation attributable to A’s exercise is $100 (the difference between the fair market value of the share at the date of transfer, $200, and the amount paid for the share, $100). Because the amount realized ($250) is greater than the value of the share at transfer ($200), paragraph (b)(2)(i) of this section does not apply and thus does not affect the amount includible as compensation in A’s gross income and deductible by X. A must include in gross income for the taxable year in which the sale occurred $100 as compensation and $50 as capital gain ($250, the amount realized from the sale, less A’s basis of $200 (the $100 paid for the share plus the $100 increase in basis resulting from the inclusion of that amount in A’s gross income as compensation attributable to the exercise of the option)). If the requirements of section 83(h) and § 1.83-6(a) are satisfied and the deduction is otherwise allowable under section 162, for its taxable year in which the disqualifying disposition occurs, X Corporation is allowed a deduction of $100 for compensation attributable to A’s exercise of the incentive stock option.

Example 2. Disqualifying disposition of unvested stock.

Assume the same facts as in Example 1, except that the share of X Corporation stock received by A is subject to a substantial risk of forfeiture and not transferable for a period of six months after such exercise. Assume further that the fair market value of X Corporation stock is $225 on February 1, 2007, the date on which the six-month restriction lapses. Because section 83 does not apply for ordinary income tax purposes on the date of exercise, A cannot make an effective section 83(b) election at that time (although such an election is permissible for alternative minimum tax purposes). Additionally, at the time of the disposition, section 422 and § 1.422-1(a) no longer apply, and thus, section 83(a) is used to measure the consequences of the disposition, and the holding period for capital gain purposes begins on the vesting date, six months after exercise. The amount of compensation attributable to A’s exercise of the option and disqualifying disposition of the share is $125 (the difference between the fair market value of the share on the date that the restriction lapsed, $225, and the amount paid for the share, $100). Because the amount realized ($225) is greater than the value of the share at transfer ($200), paragraph (b)(2)(i) of this section does not apply and thus does not affect the amount includible as compensation in A’s gross income and deductible by X. A must include $125 of compensation income and $25 of capital gain in gross income for the taxable year in which the disposition occurs ($250, the amount realized from the sale, less A’s basis of $225 (the $100 paid for the share plus the $125 increase in basis resulting from the inclusion of that amount of compensation in A’s gross income)). If the requirements of section 83(h) and § 1.83-6(a) are satisfied and the deduction is otherwise allowable under section 162, for its taxable year in which the disqualifying disposition occurs, X Corporation is allowed a deduction of $125 for the compensation attributable to A’s exercise of the option.
This blog post does not constitute legal advice or the establishment of an attorney-client relationship. In all instances you should consult your own attorney or tax advisor with respect to the facts of your particular situation.

 

By Joshua Levy and Joe Wallin

I overreacted a bit in my last blog post when I said that Washington State’s crowdfunding law might be statutorily “broken” if the SEC’s proposed rules on Rule 147 were adopted.

If you are not familiar with how the securities laws in this area are written, Rule 147 is the rule that interprets Section 3(a)(11) of the Securities Act. Almost all state crowdfunding laws that have been enacted have based compliance with their law on compliance with Section 3(a)(11).

Now the SEC has proposed that Rule 147 be removed as a safe harbor from Section 3(a)(11). Rule 147 would disappear and become its own stand-alone exemption. Section 3(a)(11) would not have an underlying set of regulations that interpret it and provide a safe harbor for compliance. This would put companies trying to raise money in a state crowdfunding offering in an tougher spot than they are in right now, because there is very little guidance under Section 3(a)(11), and application of the statute is unclear.

So by removing the Rule 147 safe harbor, the SEC is removing a pillar in the support beams for state crowdfunding.

The SEC is accepting comments on its proposed rules. The SEC in fact suggested something in its proposed rules that made a lot of sense. Here is what the SEC asked:

Should we leave existing Rule 147 in place and unchanged as a safe harbor for compliance with Section 3(a)(11) while adopting the proposed revisions to Rule 147 as a new rule instead? For example, if we were to repeal Rule 505 of Regulation D, should the Commission adopt the proposed revisions to Rule 147 as new Rule 505 of Regulation D?

This is exactly what the SEC should do (as long as moving the new proposed Rule 147 to Rule 505 also doesn’t somehow cause problems with the state crowdfunding statutes).

But the SEC should also take parts of their proposed rules that do not violate Section 3(a)(11), and they should port those into existing Rule 147. For example, proposed Rule 147 has a better, more flexible definition of what constitutes an in-state business.

If you want to know exactly why the SEC’s proposed rules would harm the Washington crowdfunding statute, this is why:

Section 3(a)(11) requires that companies using it:

• be incorporated in the state in which they are conducting the offering; and
• not sell OR offer any securities outside of the state in which the offering is being conducted.

The requirement that you not offer your securities across state lines is difficult. How do you advertise your offering on the Internet if you can’t make the “offer” to anyone outside of your state. The SEC would fix this problem in its proposed rules, and I applaud that. But there is no reason to upset existing Rule 147 to do so.

Dear SEC:

Please leave the existing Rule 147 safe harbor to Section 3(a)(11) in place. Please adopt your proposed rules as the new rule somewhere else that will not harm state crowdfunding statutes.

If you keep existing Rule 147 in place, you will avoid harming state crowdfunding statutes.

You asked in your proposed rules whether the Commission’s process gave states enough time to fix their statutes in light of your proposed rules. It will not. It took two years to pass Washington’s crowdfunding bill. In other states it has taken much longer. In other states people have been trying for years and still not gotten something passed. Sometimes it is not possible to get amendments to securities law statutes through a legislature even after a dozen years of effort.

Please do not upset the currently in place state crowdfunding laws. It would be unfair to the rights of the states to set their own path for the SEC to disrupt the settled expectations of existing Rule 147.

You can still improve Rule 147 at the same time. Loosening up the 80% test is a great idea. That is something that can be changed to existing Rule 147 that will not violate Section 3(a)(11).

Thank you.

Joe Wallin

The SEC has proposed amendments to Rule 147.

The trouble is, the proposed rules would take away one of the federal law support beams for Washington State’s equity crowdfunding law.

Our statute requires compliance with Section 3(a)(11) of the Securities Act of 1933, as amended, and Rule 147, and the SEC has proposed that Rule 147 no longer be a safe harbor under Section 3(a)(11), but its own stand-alone exemption.

Section 3(a)(11) prohibits offers and sales to persons outside of the state of the local offering. The new Rule 147 would only prohibit sales, not offers. This is great. It means that companies crowdfunding could advertise on the Internet without having to worry about their advertising crossing state lines. They just couldn’t ultimately take money from someone who doesn’t live here.

But because our statute requires compliance with both Rule 147 and Section 3(a)(11)–if the SEC’s proposed rules are adopted as proposed–Washington companies would not be able to take full advantage of the new Rule 147. Plus, they would no longer have a safe harbor under Section 3(a)(11) to rely upon.

Here is what the SEC said about this quandary in the proposed rules:

If we were to adopt a rule in substantially the form proposed today, we believe that states that currently have statutes and/or rules that require compliance with Securities Act Section 3(a)(11) and Rule 147 would need to amend their provisions in order for issuers to fully avail themselves of the new rule.

The SEC’s proposals have a lot of good in them, and I think they should be adopted, but not as a replacement to the existing Rule 147 safe harbor.

Once the SEC’s new rules are in place, the Washington State legislature will want to amend our crowdfunding law to take full advantage of it.

But statutory amendments sometimes take years to get through, if ever.

We should write comment letters to the SEC asking them not to do this.

I will write a draft letter and share it.

We have until January 11, 2016 to submit comments.

Here are instructions on how to submit comments:

DATES: Comments should be received by January 11, 2016.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments: • Use the Commission’s Internet comment forms (http://www.sec.gov/rules/proposed.shtml); • Send an e-mail to rule-comments@sec.gov. Please include File Number S7-22-15 on the subject line; or • Use the Federal Rulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments: • Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-22-15. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method.

The Commission will post all comments on the Commission’s website (http://www.sec.gov/rules/proposed.shtml). Comments also are available for website viewing and printing in the Commission’s Public Reference Room, 100 F Street, NE, Washington, DC 20549, on official business days between the hours of 10:00 am and 3:00 pm. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

The SEC has finalized the Title III crowdfunding rules. Now it is time to see how people will use the new rules.

One thing that I think might have been overlooked in all of the excitement over the final rules is the possibility of doing a Title III equity crowdfunding at the same time as you pursue a Reg D or Reg A offering.

The SEC made this possibility clear in a number of different places in the final rules.

In one place, in talking about the economic impacts of the rules, the SEC said this:

The costs associated with not increasing the investment limit above $1 million are mitigated in part by the ability of issuers to concurrently seek additional financing in reliance on another type of exempt offering, such as Regulation D or Regulation A, in addition to the offering in reliance on Section 4(a)(6).

Issuers that go through with the pain and difficulty of a Title III offering might consider doing a Reg A at the same time.

In another place, the SEC had this to say.

We also provided guidance clarifying our view that offerings made in reliance on Section 4(a)(6) will not be integrated with other exempt offerings made by the issuer, provided that each offering complies with the requirements of the applicable exemption that is being relied upon for the particular offering.

But the SEC was careful to note it wasn’t providing a blanket exemption from integration.

While we recognize this concern, we note that the final rules do not provide a blanket exemption from integration with other private offerings that are conducted simultaneously with, or around the same time as, a Section 4(a)(6) offering. Rather, we provide guidance that an offering made in reliance on Section 4(a)(6) is not required to be integrated with another exempt offering made by the issuer to the extent that each offering complies with the requirements of the applicable exemption that is being relied upon for that particular offering. As mentioned earlier, an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6). Alternatively, an issuer conducting a concurrent exempt offering for which general solicitation is permitted, for example, under Rule 506(c), cannot include in any such general solicitation an advertisement of the terms of an offering made in reliance on Section 4(a)(6), unless that advertisement otherwise complies with Section 4(a)(6) and the final rules.

One piece of really interesting language above is the following: “an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6).”

This language is interesting because it implies that you can avoid blowing the prohibition of general solicitation if you can be “satisfied that purchasers in the offering were not solicited by means” of a general solicitation. This is not guidance on the Reg D area, but I think it informs what might be some legitimate thinking about the parameters of the prohibition on general solicitation.

It will be interesting to see if issuers can actually navigate this pathway.

 

The final Title III Equity Crowdfunding rules contain a number of changes from the proposed rules. Some of the changes are good, and some are arguably not so good.

On the good side:

• First time issuers raising more than $500,000 and up to $1 million will not have to have their financial statements audited. Instead, they can rely on reviewed financial statements.
• The annual report will not have to include reviewed or audited financial statements.

On the bad side:

• The final rules adopt stricter limits on the amounts that individuals can invest.
• The Section 12(g) rules may force some companies on to the path of becoming full-blown public reporting companies.

Financial Statements

All issuers have to provide in their offering materials financial statements prepared in accordance with U.S. GAAP.

But, depending on the amount to be raised in the offerings, issuers either have to provide “financial statements of the issuer that are certified by the principal executive officer of the issuer to be true and complete in all material respects,” provide financial statements that have been reviewed by an audit firm, or provide audited financial statement.

The proposed rules would have required issuers raising up to $100,000 to disclose their tax returns. The final rules changed this requirement.

Instead of mandating that issuers offering $100,000 or less provide copies of their federal income tax returns as proposed, the final rules require an issuer to disclose the amount of total income, taxable income and total tax, or the equivalent line items from the applicable form, exactly as reflected in its filed federal income tax returns, and to have the principal executive officer certify that those amounts reflect accurately the information in the issuer’s federal income tax returns.

Ongoing Reporting

The proposed rules would have required issuers to “disclose information similar to that required in the offering statement, including disclosure about its financial condition that meets the highest financial statement requirements that were applicable to its offering statement.”

But the SEC backed off this requirement:

After considering the comments, we are persuaded by the commenters that opposed requiring that an audit or review of the financial statements be included in the annual report that meet the highest standard previously provided, the final rules require financial statements of the issuer certified by the principal executive officer of the issuer to be true and complete in all material respects. However, issuers that have available financial statements that have been reviewed or audited by an independent certified public accountant because they prepare them for other purposes must provide them and will not be required to have the principal executive officer certification.

Investment Limitations

The final rules resolve an ambiguity in the statutory limitation on amounts that can be invested. Here is how the statute described the investment limitations.

the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption provided under this paragraph during the 12-month period preceding the date of such transaction, does not exceed—(i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and (ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;

But what if your income is greater than $100,000, but your net worth is less than $100,000? What is your limit then?

The final rules opt for the lesser amount. So, if your income or net worth is less than $100,000, you are subject to the $2,000 or if greater 5% test.

Here is how the SEC described this change from the proposed rules, which would have opted for the “greater of” approach.

After considering the comments received, we have decided to adopt a “lesser of” approach. Thus, under the final rules, an investor will be limited to investing: (1) the greater of: $2,000 or 5 percent of the lesser of the investor’s annual income or net worth if either annual income or net worth is less than $100,000; or (2) 10 percent of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more.

Under this approach, an investor with annual income of $50,000 a year and $105,000 in net worth would be subject to an investment limit of $2,500, in contrast to the proposed rules in which that same investor would have been eligible for an investment limit of $10,500. 

12(g) Reporting

The final rules set up a situation where crowdfunding companies may be essentially putting themselves on a forced path to becoming a public reporting company. I wrote a blog post about this that you can find at this link.

Integration

Crowdfunding offerings under Title III will not be integrated with other offerings, provided all of the offerings comply with their applicable exemptions. Here is how the SEC described their final say on this point:

[W]e note that the final rules do not provide a blanket exemption from integration with other private offerings that are conducted simultaneously with, or around the same time as, a Section 4(a)(6) offering. Rather, we provide guidance that an offering made in reliance on Section 4(a)(6) is not required to be integrated with another exempt offering made by the issuer to the extent that each offering complies with the requirements of the applicable exemption that is being relied upon for that particular offering. As mentioned earlier, an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6). Alternatively, an issuer conducting a concurrent exempt offering for which general solicitation is permitted, for example, under Rule 506(c), cannot include in any such general solicitation an advertisement of the terms of an offering made in reliance on Section 4(a)(6), unless that advertisement otherwise complies with Section 4(a)(6) and the final rules.

Summary

I still think the crowdfunding rules are too complex. I think issuers are going to be spending a lot of money trying to comply. And my hunch is that many issuers are going to take a pass on equity crowdfunding under Title III altogether because of the complexity.

Perhaps one of the most interesting aspects of the new Title III Equity Crowdfunding Rules is Rule 303(c).

Rule 303(c) of Regulation Crowdfunding requires an intermediary to provide, on its platform:

• Channels through which investors can communicate with one another and with representatives of the issuer about offerings made available on the intermediary’s platform.
• An intermediary that is a funding portal is prohibited from participating in communications in these channels.
• Rule 303(c) also requires the intermediary to:
  • make the communications channels publicly available;
  • permit only those persons who have opened accounts to post comments; and
  • require any person posting a comment in the communication channels to disclose whether he or she is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or is otherwise compensated, whether in the past or prospectively, to promote the issuer’s offering.

To my knowledge, this will make crowdfunding offerings unique. I am not sure of another type of securities offering exemption or registration process that has these types of requirements built into it.

The idea behind these communication channels is that the “wisdom of the crowd” will become known. As the final rules say:

[T]hough communications among investors may occur outside of the intermediary’s platform, communications by an investor with a crowdfunding issuer or its representatives about the terms of the offering are required to occur through these channels on the single platform through which the offering is conducted. This requirement is expected to provide transparency and accountability, and thereby further the protection of investors.

What is nice/no-so-nice about the rule?

• These channels will be on intermediaries’ web sites, not the web sites of companies doing crowdfunding offerings.
• These channels will be open to the public.
• To post a comment, you will have to open an account, but you will not have to be an investor.
• These communication channels do not have to be kept open post-offering.
• The rules “prohibit an intermediary that is a funding portal from participating in any communications in these channels, apart from establishing guidelines for communication and removing abusive or potentially fraudulent communications.”

As far as monitoring the chatter on these channels:

A funding portal can, for example, establish guidelines pertaining to the length or size of individual postings in the communication channels and can remove postings that include offensive or incendiary language. Also, although we understand the reasons for commenters’ suggestions that there should be more privacy or control in the manner in which comments are posted, we believe that aside from intermediaries removing abusive or potentially fraudulent communications, investor protection is better served by providing the opportunity for uncensored and transparent crowd discussions about a potential investment opportunity.

We will have to wait and see how “wisdom of the crowds” develops.

 

You might be wondering what I am talking about when I say that there is a 12(g) problem with equity crowdfunding.

What is Section 12(g), anyway?

Section 12(g) is a section of the Securities Exchange Act of 1934 that requires companies to start reporting as a public company if they allow themselves to have too many stockholders and too much in assets.

Right now, a private company has to start reporting to the SEC if it has over 2,000 securities holders of record, or 500 persons who non-accredited investors and more than $10M in assets.

Here is how the SEC put it in the Final Crowdfunding Rules:

As amended by the JOBS Act, Section 12(g) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, register such class of securities with the Commission.

You see the problem. In an equity crowdfunding  you may very well bring on more than 500 non-accredited shareholders. And if you raise $1M in cash, you may well be on your way to the $10M threshold.

Congress saw this problem too, and provided an accommodation for issuers that crowdfund under Title III. But Congress’s accommodation says nothing about issuers who crowdfunding under state equity crowdfunding laws. When the JOBS Act was being put together, I don’t think anyone anticipated state-level equity crowdfunding at all. 

In the final crowdfunding rules, the SEC summarized the final rule’s approach to this issue as follows:

Holders of these securities do not count toward the threshold that requires an issuer to register its securities with the Commission under Section 12(g) of the Exchange Act if the issuer is current in its annual reporting obligation, retains the services of a registered transfer agent and has less than $25 million in assets.

But this isn’t so great, really. A successful equity crowdfunded company will probably exceed the 500 non-accredited investor threshold and if it is a successful company exceed the $25M in assets test before too long. So, one thing issuers are going to have to consider carefully as they prepare to do an equity crowdfunding offering is how they may be effectively putting themselves on the path to having to report as a public company.

Here is how the SEC described how a company in this situation would have to proceed:

An issuer that exceeds the $25 million total asset threshold, in addition to exceeding the thresholds in Section 12(g), will be granted a two-year transition period before it will be required to register its class of securities pursuant to Section 12(g), provided it timely files all its ongoing reports pursuant to Rule 202 of Regulation Crowdfunding during such period. Section 12(g) registration will be required only if, on the last day of the fiscal year the company has total assets in excess of the $25 million total asset threshold, the class of equity securities is held by more than 2,000 persons or 500 persons who are not accredited investors. In such circumstances, an issuer that exceeds the thresholds in Section 12(g) and has total assets of $25 million or more will be required to begin reporting under the Exchange Act the fiscal year immediately following the end of the two-year transition period. An issuer entering Exchange Act reporting will be considered an “emerging growth company” to the extent the issuer otherwise qualifies for such status.

I am not sure $25M was the right threshold to set, but it is what was done.

This is just something companies are going to keep in mind as they consider equity crowdfunding as a financing alternative.

The SEC has proposed changes to Rule 147. You can find the proposed amendments here.

Rule 147 is one of the federal securities law rules that makes state-level equity crowdfunding more difficult.

The reason? Rule 147 is the rule issued pursuant to Section 3(a)(11) of the Securities Act of 1933. Section 3(a)(11) is the statutory basis for avoiding the application of the federal Securities Act in a state-level equity crowdfunding.

Rule 147 says that if you offer your securities across state lines, your offering is no longer “intrastate.” It has been interpreted by the SEC to mean you can’t post anything on the Internet that might be read in another state. Because if you do, you have “offered” the security in that other state, your offering is no longer intrastate, and then your offering doesn’t qualify for the 3(a)(11) exemption.

The SEC issued guidance right after states started enacting state-level equity crowdfunding laws. Here is this guidance from the SEC, which is issued before it issued the proposed Rule 147 amendments.

Question 141.03

Question: If an issuer plans to conduct an intrastate offering pursuant to the Section 3(a)(11) exemption, may the issuer engage in general advertising or a general solicitation?

Answer: Securities Act Rule 147 does not prohibit general advertising or general solicitation. Any such general advertising or solicitation, however, must be conducted in a manner consistent with the requirement that offers made in reliance on Section 3(a)(11) and Rule 147 be made only to persons resident within the state or territory of which the issuer is a resident. [April 10, 2014]

Question 141.04

Question: An issuer plans to use a third-party Internet portal to promote an offering to residents of a single state in accordance with a state statute or regulation intended to enable securities crowdfunding within that state. Assuming the issuer met the other conditions of Rule 147, could it rely on Rule 147 for an exemption from Securities Act registration for the offering, or would use of an Internet portal necessarily entail making offers to persons outside the relevant state or territory?

Answer: Use of the Internet would not be incompatible with a claim of exemption under Rule 147 if the portal implements adequate measures so that offers of securities are made only to persons resident in the relevant state or territory. In the context of an offering conducted in accordance with state crowdfunding requirements, such measures would include, at a minimum, disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law, and limiting access to information about specific investment opportunities to persons who confirm they are residents of the relevant state (for example, by providing a representation as to residence or in-state residence information, such as a zip code or residence address). Of course, any issuer seeking to rely on Rule 147 for the offering also would have to meet all the other conditions of Rule 147. [April 10, 2014]

Question 141.05

Question: Can an issuer use its own website or social media presence to offer securities in a manner consistent with Rule 147?

Answer: Issuers generally use their websites and social media presence to advertise their market presence in a broad and open manner so that information is widely disseminated to any member of the general public. Although whether a particular communication is an “offer” of securities will depend on all of the facts and circumstances, using such established Internet presence to convey information about specific investment opportunities would likely involve offers to residents outside the particular state in which the issuer did business.

We believe, however, that issuers could implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories. Offers should include disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law. Issuers must comply with all other conditions of Rule 147, including that sales may only be made to residents of the same state as the issuer. [October 2, 2014]

So, the trouble with trying to raise money in a state-level equity crowdfunding is that you want to let people know about your offering. You would, if you could, like to post about the offering on Internet, without having to “implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories.”

Now the SEC appears ready to modernize Rule 147. This is good. Interested parties should read the proposed rule carefully and put their comments into the SEC.

I like this statement from the proposed rules.

The proposed amendments to Rule 147 would amend these requirements and revise the rule to allow an issuer to engage in any form of general solicitation or general advertising, including the use of publicly accessible Internet websites, to offer and sell its securities, so long as all sales occur within the same state or territory in which the issuer’s principal place of business is located, and the offering is registered in the state in which all of the purchasers are resident or is conducted pursuant to an exemption from state law registration in such state that limits the amount of securities an issuer may sell pursuant to such exemption to no more than $5 million in a twelve-month period and imposes an investment limitation on investors.

And here is another quote from the explanatory materials in the proposed rules:

Rule 147, as proposed to be amended, would require issuers to limit sales to in-state residents, but would no longer limit offers by the issuer to in-state residents. 40 Accordingly, amended Rule 147 would permit issuers to engage in general solicitation and general advertising that could reach out-of-state residents in order to locate potential in-state investors using any form of mass media, including unrestricted, publicly available websites, to advertise their offerings, so long as all sales of securities so offered are made to residents of the state or territory in which the issuer has its principal place of business

Yesterday was a good day for crowdfunding.

What should Congress or the SEC do next? We need Congress or the SEC to extend the same exemption from ’34 Act reporting for companies that crowdfunding under state law that Congress extended to companies crowdfunding under Title III.

As part of Seattle Startup Week I am giving a talk on equity crowdfunding.

The talk will be this Friday.

There is a link about the event on the Seattle Startup Week calendar.

Washington State was one of the first state’s to have a state-level equity crowdfunding law.

In fact, Washington State might have been the first state in which a state legislator proposed a state crowdfunding statute. Thank you Cyrus Habib.

Regulators in Kansas and Georgia put in place regulatory crowdfunding exemptions before the JOBS Act.

But after the JOBS Act, I think Washington State might have been the first state to have a legislator propose an actual crowdfunding statute.

Now 20+ states have put in place state-level equity crowdfunding laws. You can find a good slide showing which states have put in place state-level equity crowdfunding laws in this slide deck.

In my talk Friday, I plan to talk about a number of things, including:

• how state-level equity crowdfunding compares to the traditional Rule 506(b) offering, and the new Rule 506(c) offering.
• how state-level equity crowdfunding will be impacted by the SEC’s long-awaited adoption of the federal equity crowdfunding rules.
• the requirements of Washington’s statute.
• the future of equity crowdfunding.

How State-Level Crowdfunding Compares to Rule 506(b) and (c)

You might wonder, how is state-level equity crowdfunding different from traditional fund raising paths, and in particular Rule 506(b) and (c).

The primary difference between Rules 506(b) and (c) and state-level equity crowdfunding is the promise to be able to sell shares to non-accredited investors without a huge legal hassle.

Rule 506(b) allows sales of up to 35 non-accredited investors, but only if a company provides registered offering level disclosure. This is impractical for most companies, and so most Rule 506(b) offerings are accredited investors only.

State-level equity crowdfunding laws allow the sale to non-accredited investors. But these laws comes with a variety of challenges. For example, Washington State’s law allows the sale to non-accredits, but before you can proceed you have to do the following:

• You have to file and have approved by the state a crowdfunding form
• You have to have a target minimum fundraising and hire an escrow agent
• For as long as the securities are outstanding, you have make regular disclosures to the public of executive officer and director compensation

Once the state approves your crowdfunding form, you can raise up to $1M during a 12-month period. There are individual investment limitations that mirror the same limitations in the JOBS Act.

Impact of Finalization of Federal Law

The SEC is about to adopt the federal crowdfunding rules. Will the finalization of federal equity crowdfunding negatively impact the operation of state laws?

No.

The various state-level equity crowdfunding laws that have been adopted carefully avoid the application of the federal law.

So even after the federal rules are finalized state laws will still be in place and available.

The Future of Equity Crowdfunding

Although I am excited about the SEC’s meeting on Friday to consider whether to adopt final crowdfunding regulations, the federal statute is complex. Companies will have to spend a lot of money to do a federal crowdfunding offering. State-level equity crowdfunding will be substantially less costly. This is a competitive advantage point for the state laws.

However, most companies will probably continue to pursue the traditional fundraising path–Rule 506(b).

The big problem with both the federal and at least the Washington statute is that both require significant cost expenditures before any deal is certain.

The great thing about a Rule 506 offering is you can avoid incurring much in the way of legal or accounting expenses at all until you know you have a deal. Then, if you have investor interest lined up, you can then spend the money on legal fees to prepare the final documents. In a Rule 506 offering, as long as you are selling to only accredited investors, you do not need audited financial statements.

So, for many startups and early stage companies–the idea of spending even say $10,000 to get the state to approve a crowdfunding form before you even know if you can line up investor interest doesn’t seem like a great approach. Especially when you can go and shop a 1 page term sheet with a slide deck to accredited investors for almost no legal expense at all.

Still, crowdfunding has great promise. Perhaps Washington will update and fix its statute to remove the pre-approval requirement. Oregon law does not require pre-approval, but only a pre-filing which is not reviewed. This would make the Washington law more easily usable by companies.