The Startup Law Blog

By Dennis Kasimov and Joe Wallin

In the early days of a startup, it is common for founders to not pay themselves any cash compensation. This approach is sometimes also applied to other service providers, who receive just stock option compensation. Despite the prevalence of this practice in the early days, as things progress it can lead to situations that put the company and its founders in a tough spot.

Startup Compensation

Here are a couple of examples showing how things can go wrong.

Example 1: A minority co-founder (say, 10%), who has not been paid any cash compensation (and is not an exempt salaried employee – see below), is not working out and is let go. If this co-founder feels aggrieved, he or she might sue the company and the other founders personally for failing to pay the minimum wage. The minority co-founder may face an uphill battle to prove his/her claim, but this situation would be a thorn in the side of any startup, with the potential to grow into a costly lawsuit. You can avoid this entire scenario by simply paying the individual at least the minimum wage in cash.

Example 2: You classify a service provider as an independent contractor, and you do not pay them cash. Instead, you pay them in vesting equity. The person works for a while, but their work is unsatisfactory so you terminate them. Their equity is unvested, and so it all reverts to the company. This person may not only sue you for failure to compensate them (a hard claim to win on maybe, but if they make it you have to deal with it), but, to add insult to injury, they might also assert that they own the IP they created while working for you, because you didn’t pay them anything for it.

It is obviously in a startup’s best interest to steer clear of these issues. So, it is important you handle paying people correctly.

What are the Rules?

For founders acting as corporate officers, it is generally difficult to escape “employee” status and the minimum wage and overtime requirements. Under the federal income tax law, an officer of a corporation is defined as a “statutory employee” (see https://www.irs.gov/irm/part4/irm_04-023-005r.html) which may hint to a similar classification under the wage and hour laws. Admittedly, the federal Fair Labor Standards Act has an exception to the minimum wage for 20% or greater equity owners, but Washington state law does not have a similar provision (c’mon legislature!). Because Washington and Seattle minimum wage levels are higher than the federal standard, these are the applicable rules to Seattle-area based startups.

The risk with not paying your employee co-founders (and if they are an officer of the company, then they are likely an employee) at least the minimum wage is that they might sue you personally if things don’t work out. Washington state has an unlawful wage statute (RCW 49.52 (http://app.leg.wa.gov/RCW/default.aspx?cite=49.52.070)) that imposes personal liability “for twice the amount of the wages unlawfully rebated or withheld” on corporate directors, officers and investor representatives on the board. This is one reason investors usually want to know if a company has severance plans in place before they invest. Failure to pay severance when a company runs out of cash is another potential source of troubles for directors and officers of the company.

But wait, you might say, how can some famous CEOs pay themselves $1 a year, as Steve Jobs did at one point? Well, for one, Steve had millions of dollars in equity incentives and retirement benefits that more than made up for a lack of payment of minimum wage to him; this type of plan is not applicable in the early startup world.

Here is the startup rule: If you are the majority founder, you are probably not going to sue the company. So, you can probably not pay yourself in the very early days. But this situation will change as your company grows, particularly when you begin to solicit investment funding. Investors are going to want to have the assurance that there is zero potential of outstanding wage claims.

For Minority Co-Founders, The Problem Can Be Especially Acute

But what about your minority co-founders at the early stages? Do you pay them at least the minimum wage?

Maybe not. If they are independent contractors (and properly classified under the law as independent contractors), then the minimum wage doesn’t apply. Accordingly, for most cash strapped startups it is important to keep as many of their workers classified as contractors as possible.

But it is not always possible to classify a co-founder as an independent contractor. As mentioned above, if the co-founder is an officer of the company, contractor status may be unattainable. Worker classification is a highly fact specific inquiry and largely depends on how much control the company has over the individual.

Usually a startup has one or two dominant founders and one or two minority founders. The minority founders might not be receiving any cash compensation, and their stock compensation is probably subject to vesting. If the company has to cut a minority founder loose, that person might sue the company and the dominant founders for failure to pay the minimum wage, and under Washington law for double damages and attorneys’ fees.

So, What Should A Startup Do?

Here are some tips:

* Every worker, regardless of whether they are an employee or an independent contractor, should sign a confidentiality and proprietary rights assignment agreement, assigning all IP they create to the company. Think of your startup as a ski mountain. You don’t let anyone ski your mountain without a lift pass. Here, the “lift pass” is a solid IP assignment and confidentiality agreement.

* Every worker should also sign a document governing the terms of their service relationship. Are they an employee? If so, have them sign an at-will offer letter. If they can properly be classified as a contractor, have them sign a well drafted Independent Contractor Agreement.

* You need to pay your minority co-founders at least the minimum wage if they are an employee (e.g., an officer) of the company. Otherwise, you are accepting a risk of lawsuit. If you don’t have any cash to pay them the minimum wage, don’t make them an officer, and treat them as an independent contractor as long as you reasonably can (and pay them a small amount of cash to make an IP assignment binding). This can work well for someone working part-time on the weekends and evenings during the company’s early days.

* Be wary of informal and unspoken agreements among friends and family (“Dont worry, I won’t sue!”). This is business and the relationship can go south quickly. Moreover, an individual can never waive their right to minimum wage, even in writing.

* Use a payroll service so that you can rest assured that all taxes are deposited with the IRS and all employment tax returns are filed. See  http://startupclass.samaltman.com/courses/lec18/.

* You may attempt to qualify a founder/employee as a salaried executive exempt from the wage and hours laws. The requirements are detailed in WAC 296-128-510. This option will not eliminate the need to compensate the individual, but it may lower the required wages to as low as $155.00/week provided that the other requirements are met as well.

As you can see, this can be a complicated area of the law. Every company should seek a trusted legal advisor. One thing is clear though: do not sweep these issues under the rug during the early stages of your company.

If you are thinking about starting an early stage tech company, one of the first things you will have to figure out is what type of legal entity to form.

Fortunately, there are only a few choices available to you. Your choices are basically only 1 of the following 3 possibilities:

• an LLC taxed as a partnership for federal income tax purposes
• a corporation that has made an election to be taxed as an S corporation for federal income tax purposes, or
• a C corporation

Entity Choices

LLCs Taxed as Partnerships. An LLC taxed as a partnership is a state law limited liability company that has multiple members that has not made an election to be taxed as a corporation. An LLC taxed as a partnership does not pay federal income tax. Intead, it’s owners pay the income tax on the LLC’s income. The LLC files an information return with the IRS each year and sends each owner a Form K-1, so that the owners know what income they owe tax on. If the LLC incurs losses, sometimes the owners can deduct those losses on their tax returns.

S Corporation. S corporations are like LLCs in that they are pass through companies–meaning, an S corporation does not pay federal income tax; its owners pay the tax on the entity’s income. The entity files an information return with the IRS and sends each stockholder a Form K-1 each year so that the stockholders can pay the tax on the entity’s income. S corporations are only available if all of the stockholders are individuals (generally) and US citizens or lawful permanent residents (VC funds can’t be S corporation stockholders). Again, if the entity loses money, sometimes the stockholders can deduct those losses on their tax returns.

C Corporation. A C corporation pays its own taxes. Its stockholders do not pay tax on the entity’s income. If the C corporation pays dividends to its stockholders, the stockholders pay tax on the dividends. Thus, if a corporation is profitable, it will pay federal income taxes. Then when it pays dividends to its stockholders, the stockholders will pay tax on the dividends. This is sometimes referred to as the double tax problem.

The Importance of the Choice of Entity

Your choice of entity is important because it affects important immediate and downstream consequences, including:

• How much money it will cost you and your co-founders to set up the company.
• Whether the entity will be an entity that is easy to use to do important things like (i) grant stock options to advisors and service providers, and (ii) raise money from angels and venture capitalists.
• How the founders will be taxed on the ultimate sale of the company, or their ultimate sale of their stock.

In general, LLCs taxed as partnerships are lousy choices for an early stage tech company that wants to follow the traditional path of granting stock options and raising money from Angels and VCs. Granting the equivalent of stock options in an LLC is complex and costly from a legal and accounting fees perspective.

That leaves you with the choice of S corporation or C corporation. Most angel investors do not want to invest in pass through companies and receive a Form K-1 from a company they invested in. This rules out S corporations.

Thus, you are left with a C corporation as the default best choice if you want to follow the traditional path.

But what if you desire to be able to take the losses from the company on your personal income tax return? Shouldn’t you form an S corporation then, and stay an S until you take money from investors?

The answer depends. But if you choose anything other than a C corporation you are potentially walking away from a very important tax benefit available to founders.

Tax Free Founder Stock

Under the federal income tax law, if you acquire stock in a C corporation with less than $50M in gross assets (both before and after you acquire your stock), and the corporation is engaged in a qualified trade or business (see definitions below) and observes some other rules–if you sell that stock after holding it for 5 years, up to $10M in gain can be completely excluded from federal income tax.

This exclusion doesn’t work if you form an S corporation or an LLC taxed as a partnership.

Below you will find the defined terms used in Section 1202 of the Internal Revenue Code. Don’t overlook this potentially very significant tax benefit when you decide on your choice of entity.

Keep this in mind when choosing what type of entity to form. If you qualify, you don’t to inadvertently miss this potential benefit.

Section 1202 Definitions

“Aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation.

“Eligible corporation” means any domestic corporation; except that such term shall not include—
(A) a DISC or former DISC,
(B) a corporation with respect to which an election under section 936 is in effect or which has a direct or indirect subsidiary with respect to which such an election is in effect,
(C) a regulated investment company, real estate investment trust, or REMIC, and
(D) a cooperative.

“Eligible gain” means any gain from the sale or exchange of qualified small business stock held for more than 5 years.

“Parent-subsidiary controlled group” means any controlled group of corporations as defined in section 1563(a)(1), except that—
(i) “more than 50 percent” shall be substituted for “at least 80 percent” each place it appears in section 1563(a)(1), and
(ii) section 1563(a)(4) shall not apply.

“Pass-thru entity” means—
(A) any partnership,
(B) any S corporation,
(C) any regulated investment company, and
(D) any common trust fund.

“Qualified small business” means any domestic corporation which is a C corporation if—
(A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,
(B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and
(C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.

“Qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—
(A) as of the date of issuance, such corporation is a qualified small business, and
(B) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—
(i) in exchange for money or other property (not including stock), or
(ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

“Qualified trade or business” means any trade or business other than—
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
(B) any banking, insurance, financing, leasing, investing, or similar business,
(C) any farming business (including the business of raising or harvesting trees),
(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
(E) any business of operating a hotel, motel, restaurant, or similar business.

“Specialized small business investment company” means any eligible corporation (as defined in subsection (e)(4)) which is licensed to operate under section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993).

This blog post does not constitute legal or tax advice. Always consult a legal or tax professional with your tax questions.

 

Ashley Stewart (@ashannstew) recently wrote a great piece in the Puget Sound Business Journal on Washington State equity crowdfunding titled “Crowdfailure: Not a single company has been able to use Washington’s 2-year-old crowdfunding law.” She also wrote an accompanying blog post.

Washington State Equity Crowdfunding

The article tells the story of a company frustrated at its inability to make use of Washington’s equity crowdfunding law, and what might be done to fix it.

I know many people who think that equity crowdfunding is going to be a failure and that the whole concept is a bad mistake.

I don’t think we should give up yet. I think the concept has huge promise, but we need to continue to refine our laws and regulations until we get this right.

Here are my suggestions on how to make the Washington crowdfunding law more usable, more user friendly, and better.

Suggested Improvements

• Allow companies to use the law for smaller rounds ($250,000 or less) without having to hire an escrow agent and without have the DFI review and approve their Crowdfunding Form first. In other words, allow what they allow in Oregon: File the form, pay the fee, wait 7 days, and you can go ahead. This is one of the secrets of Oregon’s success. Oregon’s law went into effect after ours–and not through legislative action–the regulators just put a rule in place. Query whether we couldn’t just do that in Washington now. How about we adopt rules substantially similar to Oregon’s?
• Don’t require public disclosure of executive officer and director compensation. It makes sense to require these disclosures to company shareholders for sure. But requiring disclosure of to the public at large doesn’t make sense. The public at large is not invested in these companies, and these are, after all, private companies. Either RCW 21.20.880(3) needs to be amended or the Washington State DFI needs to adopt a regulatory exemption like Oregon’s. 
• Allow portal operators or similarly situated people to earn a success fee on the closing of an offering (such as 3-5%) without having to be registered broker-dealers. As of right now, not a single person in Washington State has started a crowdfunding portal. This could be because there is no money to be made in it. If you can’t charge a success fee without being a registered broker dealer, and registration and maintenance of that registration costs hundreds of thousands of dollars, it makes the business calculus hard. It is hard to see people taking the time and effort to create a portal without being able to make a reasonable fee for the work they do. I don’t think allowing a portal to make a fee of some percent without a broker-dealer registration should be off limits. Allowing market participants to make a reasonable fee will help this industry take off.
• Allow the law to be used for real estate investments. Right now crowdfunding a real estate investment requires special approval of the DFI. This doesn’t make sense. Non-accredited investors ought to be able to pool their money to buy rental properties.
• Allow the law to be used to sell convertible debt securities (such as convertible note, convertible equity instruments, and revenue loans). Right now the DFI’s rules disallow the sale of debt securities. Again, I don’t think this makes sense. Most early stage companies raise money in convertible debt offerings. Under the Washington State DFI’s current rules, the crowdfunding law can’t be used to sell debt securities.
• Repeal the DFI’s rules on what preferences preferred stock must have. The DFI adopted minimum standards for preferred stock that are out of market. The most common form of early stage company preferred stock investment right now is the Series Seed round. But the Series Seed terms won’t meet the minimums the DFI laid out in its regulations for what rights, preferences and privileges preferred stock must have to be sold under the law. The current DFI rules push companies that want to issue preferred stock into a more complex, more expensive position than what angel and early stage VC funds demand in terms of deal terms.
• Allow accredited investors to invest an unlimited amount. There is no reason to limit the amount accredited investors can invest. They are not limited in a Rule 506 offering.
• Allow non-individuals to invest. Right now, only individuals can invest, but it would be better if an LLC could invest. That way, a company could take on one shareholder (the LLC), rather than potentially dozens of individual shareholders.

Summary

On Monday, May 16th, Title III equity crowdfunding is going to launch. It may turn out to be a lot more successful than people thought. I am optimistic, especially after having WeFunder Co-Founder Nick Tommarello on TheLawofStartups podcast (www.thelawofstartups.com). This isn’t the time to give up, but to improve what we have done to make it better.

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.

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.

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.

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.

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).’’.

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.