Accredited Investor Verification

For the past 30 years or so, securities lawyers have advised that an issuer can form a reasonable belief that an investor is accredited by means of a questionnaire.  This verification process was independent of the channel by which entrepreneurs were introduced to the investor.  Suddenly because Congress has legislated that companies should be able to use modern technology to find potential investors, the SEC expresses misgivings about self-certification.  In the process, the SEC has thrown cold water on the only real tool we had.  In its release, the SEC states: “we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.”

But the SEC does not go on to discuss in any useful way what sort of other information the issuer should obtain.  When the release throws in isolated examples – by suggesting that a Form W-2 might be helpful – the SEC completely misses the mark.  Since the overwhelming majority of investors rely on the net worth test ($1,000,000 without counting the equity in their homes) this suggestion is nonsense.  For the hand full of investors who don’t qualify under the net worth test, but do meet the income test (threshold income of $200,000 per individual or $300,000 per married couple), do we really want them to start their investing careers by by-passing the public markets and putting their money into start-ups?  Is the SEC suggesting that it is safer for society if companies were to forgo organized angel groups (whose members made their fortunes in previous jobs and no longer receive W-2s) and instead focus on younger investors in high paying professions?  Has the SEC thought about this at all?

Hedge Fund Advertising

One of the most startling implications of Section 201(b) of the JOBS Act is that hedge funds will be able to publicly solicit potential clients.  To date, registered investment advisers who manage money through pooled funds have been unable to say anything about these products on their websites.  Instead, their sites contain only contact information and a log-in link.  Somehow, once the proposed rules go into effect, these sites will presumably light up and start soliciting investors.  How the paradigm shift is to occur has been the subject of much discussion.  In its release, the SEC simply confirmed the obvious, stating the belief that privately offered funds would be permitted to solicit and advertise under amended Rule 506 without losing their hedge fund exemptions.  The North American Securities Administrators Association has been waiting for the SEC to take the lead regarding SEC registered investment advisers.  NASAA doesn’t have much choice here, since Rule 506 pre-empts state regulation.  But state regulators have jurisdiction over most newly formed hedge funds because they regulate investment advisers who manage up to $100 million in client funds (the larger funds fall under federal jurisdiction).  Having fewer resources, the smaller and newer hedge funds are invariably going to have more issues in transition. Since the SEC totally avoided this subject in its release, perhaps the Commission is speaking to NASAA in private.  I sure hope so.

On a final note, I just wanted to add that I’m not sure what to do with the word “private” going forward.   Once the ban on general solicitation and advertising has been lifted, it will be difficult to call an offering under Rule 506 a “private placement.”  I’m currently leaning towards “fully-compliant unregistered public offering,” but perhaps that may be a bit too cynical.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.

I recall the first time a client successfully sold a venture-financed company in a transaction in which I served as counsel.  My client made a small fortune on the sale of his company, but was somewhat irked that the VC made a large one.  I had to explain to the founder that he not only had to pay the VC a fair share of his company, but he also had to help the VC recoup  losses from all the failed investments the VC had made.

So venture capital is an expensive (but necessary) part of the life cycle of many start-up companies. And that means that angel investors, knowing that VCs may be investing in subsequent rounds, need to help founders with a smooth transition.  If a start-up anticipates multiple angel rounds, the first of these may be in the form of a convertible note for which the investor receives the same security as in the subsequent round, but at a discount.  However, if the subsequent round is a venture capital round, the VC will object to the angels piggy-backing on the VC’s 2X liquidation preference and full participation with the common (not to mention that 30% discount.)  In considering preferred stock, the company and the angels therefore have an incentive to ensure that it does not become toxic.

It is not hard to compare the impact of accrued dividends to liquidation preferences. For example, a 2X liquidation preference is equivalent to a 25% non-compounded dividend if there is an exit in four years.  A mandatory or so-called “cumulative” dividend can therefore be effectively deployed in angel deals.  The dividend is rarely paid and instead accrues to the liquidation preference. The stock pays no liquidation preference upon conversion. Therefore, the dividend only comes into play if the liquidation preference exceeds payment that the common stock would receive upon a liquidity event.  In that case, the angel investor would not convert and instead receive the preference.

 Were a company to offer a dividend of 10%, for example, angel investors would have an incentive to sign on early and not wait to come in at the end of the round.  A dividend at a fair rate whose true cost varies to reflect the time value of money makes sense for all participants. In an angel round, where investors may enter over an extended period, a new series of preferred stock can be issued on each closing date.  If the dividend does not compound, the company can close on the investment any day that an angel wants to write a check.

I invite your comments to this blog post and look forward to posting another missive in the near future.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.

But how does a start-up company find investors?  Up to now, that was the real barrier. In essence, a start-up could raise money from people it already knew, but could not advertise that it was looking for investors.  But Section 201 of the JOBS Act changes the playing field fundamentally.  The SEC has been instructed by Congress to modify Rule 506 by July 4, 2012 so that the prohibition against general solicitation and advertising found in Rule 502(c) will not apply to transactions under Rule 506 if all investors are accredited. The SEC is also charged with promulgating rules that will require issuers to verify whether potential investors are indeed accredited, but the SEC Staff can take their time on that.

Section 201 of the JOBS Act also amends Section 4 of the Securities Act to exempt from broker/dealer registration persons who maintain public platforms that facilitate Rule 506 transactions. These facilitators may co-invest and provide due-diligence services and document templates.  However, these facilitators may not receive brokerage fees, provide custody services, give investment advice, or negotiate the terms of a deal.

While Crowdfunding may be a dud (please see: Complying with the Crowdfund Act Won’t Be Trivial), Rule 506 is now more than ever the king of private placement exemptions.

I invite your comments to this blog post and look forward to posting another missive in the near future.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.

Issuer Volume Limitation.  The total amount of securities an issuer may sell to all investors during the 12-month period immediately preceding the crowfunding transaction, including those securities sold in the crowdfunding transaction, may not exceed $1 million.

Investor Volume Limitation.  The total amount of securities an issuer may sell to any individual investor purchasing securities in a crowdfunding transaction in any 12-month period, including both the crowdfunding transaction and all other transactions during the period is:

• The greater of $2,000 or 5% of annual income or net worth, if the annual income or net worth of the investor is less than $100,000; or
• 10% of annual income or net worth, up to a maximum of $100,000, if the annual income or net worth of the investor is greater than $100,000.

Required Funding Portals.  Crowdfunding transactions must be conducted through a broker or a “funding portal” that has registered with the SEC.  The portals will have significant responsibility for preventing issuer fraud and for protecting investors.  These responsibilities include educating and screening potential investors, taking appropriate action to reduce the risk of fraudulent transactions (including checking the background of the issuer and its insiders), providing disclosure to the SEC, ensuring that the issuer does not receive any funding until the target offering amount has been raised, and taking steps to ensure that investors do not purchase more than their annual limit of securities of the issuer.

Advertising.  Issuers may only use advertisements that direct potential investors to the broker or funding portal. In effect, issuers in crowdfunding transactions will have much greater latitude to sell securities to strangers than they do in traditional private placements, which prohibit “general solicitation” of investors. Of course, the JOBS Act also called for the SEC to introduce a rule to eliminate the ban on advertising and general solicitation in Regulation D — Rule 506 transactions where all investors are accredited. This is by far the most exciting feature of the JOBS Act in the area of private placements.  But it also has the potential for rampant fraud.

Target Offering Size.  Issuers must disclose the amount of money they intend to raise.  Investors will be able to rescind their commitments if the issuer does not reach this target.

Exchange Act Relief.  The Crowdfund Act provides that the investors who join the issuer pursuant to the exemption will not count toward the reporting company shareholder threshold. In the absence of this relief, crowdfunded companies could easily end up with so many shareholders (now 2,000 accredited investors or 500 non-accredited investors) that they would be subject to public company reporting requirements.

Blue Sky Relief.   Securities sold in crowdfunding transactions will be exempt from the substantive registration and qualification requirements of state securities or “blue sky” laws, just as Rule 506 securities are now.

Restrictions on Transfer.  Like other privately placed securities, securities sold in crowdfunding transactions will not be immediately freely transferrable.  Subject to limited exceptions, crowdfunding securities must generally be held for one year before they can be transferred without restriction.

Issuer Disclosure Requirements.  Unlike under Rule 506, the Crowdfund Act does require issuers provide substantial disclosure to potential investors and ongoing financial disclosure on at least an annual basis.  The information that must be disclosed includes:

• the issuer’s directors, officers, and each person holding more than 20% of its shares;
• the issuer’s business plan;
• financial information, depending on the size of the offering:
  • offerings under $100,000 – income tax returns and financial statements certified by the issuer’s principal executive officer;
  • offerings over $100,000 but under $500,000 – financial statements reviewed by an independent public accountant; and
  • offerings over $500,000 – audited financial statements;
• use of proceeds and target offering amount; and
• information about the offered securities and the issuer’s other securities, including  disclosure about the rights of crowdfunding investors relative to the issuer’s other investors.

As you will have gathered by now, crowdfunding transactions will require both the advice of lawyers and accountants.  But the start-up community had hoped for a way of raising money that would avoid complex legal and financial compliance and regulation.  Well they did not get what they wanted, and chances are that once the SEC rules are promulgated, the process will be even more arcane and less straight-forward.

I invite your comments to this blog post and look forward to posting another missive in the near future.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.

Even this system is outdated. Most jurisdictions permit stock to be issued without ever creating a certificate. In Washington State, RCW 23B.06.260 permits the board of directors to approve issuing shares without certificates. In that case, each shareholder is instead sent a record containing the information that would otherwise be on the certificate.

I often advise clients to set up stock registers in spreadsheets that contain all the information required by RCW 23B.06.250. Each spreadsheet has a header with a date, the corporation’s name and the class of stock covered. The footer consists of a stock legend that states that the shares are not registered and therefore may not be transferred by law except pursuant to an exemption and that the shares are also subject to additional transfer restrictions and other rights and obligations under a shareholders’ agreement. In the case of preferred stock, the legend also contains a reference to the articles of designation that define the rights, preferences and limitations of the series.

Each entry or spread sheet row in the stock register lists the date of issuance, to whom the shares were issued, and the number of shares so issued.

Each time the spread sheet is updated, the original is signed by two authorized officers of the corporation and then scanned and saved as a PDF file that can be emailed to each shareholder. Once emailed, the statutory requirement of sending a record has been satisfied. Furthermore, the corporation is well on its way to complying with RCW 23B.07.200, which requires that “after fixing a record date for a meeting, a corporation shall prepare an alphabetical list of the names of all its shareholders on the record date who are entitled to notice of a shareholders’ meeting. The list must be arranged by voting group, and within each voting group by class or series of shares, and show the address of and number of shares held by each shareholder.”

Of course a corporation can still use old fashioned stock certificates. But certificates are expensive to produce, often contain errors, get damaged or misplaced and are difficult to collect when the corporation recapitalizes or is merged into another entity. As far as I am concerned, let’s end this practice and stop using stock certificates.

I invite your comments to this blog post and look forward to posting another missive in the near future.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington. This posting does not constitute legal advice.