October Accredited Investor Definition Recommendations

Rule 506 of Regulation D allows for sales by private companies to an unlimited number of “accredited investors” and, for offerings that do not involve general solicitation, to a limited number of sophisticated non-accredited investors.  The definition of who qualifies as an “accredited investor” under Rule 506 of Regulation D has long been questioned. Detractors are quick to question whether the current definition effectively defines the class of individuals who are capable of fending for themselves.  In October the SEC Investor Advisory Committee took a big step towards revising the current definition.  The committee recommended considerable changes to the Securities and Exchange Commission, saying it should broaden the potential accredited investor pool and strengthen verification that potential investors qualify as an accredited investor.  Any changes would seriously impact startups, investors and all of those individuals who are involved with early stage companies and emerging businesses.  The recommendations made by the SEC Investor Advisory Committee are set forth below:

Recommendation 1

The Securities and Exchange Commission should carefully evaluate whether the accredited investor definition, as it pertains to natural persons, is effective in identifying a class of individuals who do not need the protections afforded by the ’33 Act.

Recommendation 2

The Securities and Exchange Commission should revise the definition to enable individuals to qualify as accredited investors based on their financial sophistication.  If this position were to be adopted, it would make sense to consider a wide variety of criteria such as professional experience and professional licenses.

Recommendation 3

If the Securities and Exchange Commission chooses to continue with an approach that relies exclusively or mainly on financial thresholds, the SEC should consider alternative approaches to setting such thresholds – in particular limiting investments in private offerings to a percentage of assets or income – which could better protect investors without unnecessarily shrinking the pool of accredited investors.

Recommendation 4

The Securities and Exchange Commission should take concrete steps to encourage development of an alternative means of verifying accredited investor status that shifts the burden away from issuers who may, in some cases, be poorly equipped to conduct that verification, particularly if the accredited investor definition is made more complex.

Recommendation 5

In addition to any changes to the accredited investor standard, the Securities and Exchange Commission should strengthen the protections that apply when non-accredited individuals, who do not otherwise meet the sophistication test for such investors, qualify to invest solely by virtue of relying on advice from a purchaser representative. Specifically, the Committee recommends that in such circumstances the SEC prohibit individuals who are acting as purchaser representatives in a professional capacity from having any personal financial stake in the investment being recommended, prohibit such purchaser representatives from accepting direct or indirect compensation or payment from the issuer, and require purchaser representatives who are compensated by the purchaser to accept a fiduciary duty to act in the best interests of the purchaser.

Under the Dodd-Frank financial reform law, the SEC must review the accredited investor definition every four years. This is the first such required review since Dodd-Frank was enacted in 2010.  As you can see these recommendations are very high level and it remains to be seen if any changes are implemented by the SEC as a result. Nonetheless, it could be the impetus that leads to several revisions to the definition of an “accredited investor”, but a complete overhaul of the definition is likely unrealistic.

These recommendations along with the committees rational can be viewed at the following link: http://www.sec.gov/spotlight/investor-advisory-committee-2012/accredited-investor-definition-recommendation.pdf

Accredited Investors

Whenever a company offers or sells its securities, it must register with the US Securities and Exchange Commission (the “SEC”) or do its offering under the an exemption from the SEC’s registration requirements.  For many angel rounds, the exemption used is Ruglation D of the Securities Act of 1933 (the “Act”).  An important consideration when ascertaining whether an issuance is properly exempted under Reg D is an inquity into whether the investors are “accredited” under the Act.  The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:

1. a bank, insurance company, registered investment company, business development company, or small business investment company;

2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;

3. a charitable organization, corporation, or partnership with assets exceeding $5 million;

4. a director, executive officer, or general partner of the company selling the securities;

5. a business in which all the equity owners are accredited investors;

6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;

7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

For more information about the SEC’s registration requirements and common exemptions, read the SEC’s brochure, Q&A: Small Business & the SEC.

Corporation or LLC for Startups?

The LLC/Corp question seemed like it was pretty settled about two years ago in favor of corporations, but I recently have had multiple clients make inquiries about which to be and why.  For clients who are anticipating having third party investors, employee option pools, etc. I still think the corporate formation is the way to go in the vast majority of situations.
As a starting point, we can do everything with an LLC that we can do with a corporation – this is due to an LLC at its heart being a contractual arrangement.  While there are some things we can do with an LLC that we cannot do as simply with corporations (for instance, divorcing economic interests from control at the equity level), while the flexibility of LLCs are part of their allure, it also makes it much more complicated to mimic aspects of the corporate form with an LLC than to just use a stock corporation.  For instance, it takes a lot more paper to create employee options plans, vesting arrangements, different tranches of equity, etc. with an LLC than it does with a corporation.  This doesn’t even get into the practical reality of your employees being incentivized by receiving “options,” while receiving “phantom membership unit appreciation rights” does not have the same cache.  If a business were to try and do a raise and keep the LLC form, that transaction could end up being much more complicated.  Moreover, while it is relatively simple to convert a Delaware LLC into a Delaware corp, it is not without cost.  Converting a New York LLC to a Delaware Corp, however, requires a full form merger that is a transaction unto itself.  In either case, many of the formation documents that were in place for the LLC would have to be recreated to address the new corporate form.  Put simply, initial legal costs would increase, as would the cost for any future transaction.  As for the tax benefits of LLC’s, with limited exceptions they are duplicated by corporation making an S election.
Regarding investors, I can not imagine ever being in a situation where someone was asked why they were using the corporate form and not an LLC.  Ownership of an LLC can greatly complicate investor’s personal taxation because it is a pass through entity (for this same reason, you should expect that when a Company gets investors it would need to transition from an S Corp to a C Corp, but that is a very simple process) – put simply, owners of pass through entities can be taxed on their proportion of profits even if no money is distributed to them.  Even removing the complication factor, many VC funds are barred from investing in LLCs because they have tax-exempt partners who would lose that tax-exempt status if they received active business income.  Finally, because these profits are K-1 income, it could also open investors to being liable for state income taxes in states where they otherwise would not have to file.

Seed Round Convertible Debt vs. Preferred Equity

The most common forms of investment in early stage business are convertible debt and preferred equity.  Common stock can also be issued, but in general investors who want equity choose preferred shares because it gives them certain rights that are not shared by the common stock, both in regards to the company and in the case of a follow-on capital raise.

Preferred stock is a new class of stock issued by the company which is given certain rights apart from the company’s common stock.  This can include a dividend right, liquidation preference, conversion rights, pro-rata rights, etc. It is equity and the shareholder has ownership rights in the company (and is owed corresponding fiduciary duties by the board and management).

On the other hand, convertible debt what it sounds like – debt which is convertible into equity at some later point in time.  The angel then receives a discount on the conversion price to reward their risk.  If all goes according to plan, the conversion generally takes place upon receipt of the next round of funding.  The debt can feature many corollaries to the bells and whistles given to preferred shares noted above.  While the intention is for the debt to convert, and many investors think of it as quasi-equity, until it converts it is debt, and needs to be treated as such (with attendant fiduciary duties from the board and management).

The biggest benefit to using the convertible debt model is that it allows for the investment to be made without the company and investor coming to an agreement on a valuation.  As an example, I did a convertible debt deal a month ago where the investor made an investment of $200,000 into a startup with a 20% discount.  The debt will convert upon the startup raising $1m within the next year.  What this means is that upon that startup receiving its next material round of funding, the angel will receive $250,000 ($200k with the 20% discount) worth of shares at the pre money valuation agreed to for that next round, and on equal footing with the new investor (i.e. same class of shares).

In that previous deal, the company believed its valuation to be $5m, but the investor thought it was closer to $3m, and as with all these very early startups, there was no definitive way to break the logjam. Using the convertible debt model, the investor was able to invest, and by the time the next round happens, more information will be available to the company and the investors and that new valuation should be a better reflection of the actual value of the company.

The downside to using convertible debt is that it increases the risk that one party is going to get a sweeter deal than intended.  Continuing with the example above, if the Company receives a valuation of $20m, the investor would have been better off doing a preferred share deal at any valuation below $16m (the effective valuation of the original investment reflecting the 20% discount).  As discussed, a cap can be put in place to shift some of this risk from the investor to the founders, but it cannot be wholly mitigated without agreeing on a current valuation, which negates the point of doing a convertible debt transaction. The cap is also not without a downside, however, as future rounds may view it as a cap on valuation – for that reason it should never be told to a future potential investor before they make an offer. It should be noted that the above-mentioned deal did not contain a cap, and my understanding is that they are not as common as they were circa 2010.

If the parties can agree to a valuation that is a good representation of the value of the company, doing a series seed deal issuing preferred shares makes more sense.  Giving equity gives the angel the full upside for the risks he is taking.  If the valuation is high, however, it also gives the angel the full downside.  For example, if a company is initially valued at the seed stage at $6m, but the next round is done with a $4m pre-money valuation, the equity investor sees an immediate 33% decrease in the value of his investment.  If the valuation is too low, the angel will end up owning a disproportionately large percent of the company compared to the founders, which acts as a disincentive, and limits equity available for bringing on future talent.

Finally, doing a convertible note deal is simpler and cheaper from a legal costs point of view, but the cost difference is not so great that it should be outcome determinative.