Corporation or LLC?

Look at the end game when deciding whether to structure your startup as a corporation or LLC. You’re probably starting a business to make money. How will you get your money out of the corporation or LLC? If you take on investors, how will they get their money out of the corporation or LLC? The answer will lead you to the right structure.

Raise Capital, Grow the Business, Then Sell it.  Corporation or LLC?  In this Case You Want to Structure Your Business as a Corporation.

For many startups, the end game is to grow the business and sell it: that is how the founders will make money.  Along the way, in order to grow the business you will need to take in outside investment, and the investors’ expectation is that they will make their money when you sell the business.  In order to grow the business you may also need to use equity compensation (stock options) to attract and retain the best talent because the company will not have sufficient cash or profits to pay market salaries.

When this is the case, the optimal structure is a corporation. Investors prefer investing in corporations because there can be significant tax advantages to invest in corporations rather than LLCs. Investors also prefer investing in corporations rather than LLCs because their legal rights and obligations, such as the duties of members of the board of directors, and the legal documentation, are more standardized. From the employee growth perspective, the corporation or LLC question favors the corporation as well because awarding employees stock options is fairly easy and doesn’t require amending the company’s formative documents every time the company wants to add a new equity owner.

As for the “double tax” pitfall of structuring your business as a corporation, it doesn’t come into play if the goal is to create a high-growth company and grow it big.  To the extent there are profits in the business, the profits will be reinvested in the business and not distributed to the stockholders, so the “double tax” should not be an issue.

See related blog post When to Form a C Corporation.

Generate Profits and Cash Flow the Business.  Corporation or LLC?  In this Case You Want to Structure Your Business as an LLC.

For other kinds of business the end game is to make profits and distribute them to the owners, in other words, to cash flow the business.  When this is the case, the corporation or LLC formation question favors the LLC because it has pass-through taxation.  In other words, the LLC is not taxed on its profits, the owners of the LLC are taxed on the profits, but when the LLC distributes the profits to the owners, the distribution is tax free.  With only one layer of federal income taxes, when the goal is to distribute cash to the owners the after-tax returns will be higher with LLCs.

See related blog post When to Form an LLC.

VentureDocs Founder Bo Sartain Explains Whether to Structure Your Business as a Corporation or LLC.

 

Where to Get the Corporation and LLC Formation Documents

You can get all of the legal documents for Incorporation and LLC Formation at VentureDocs.

The Delaware Franchise Tax Gotcha

If your startup receives a large franchise tax bill from Delaware, make sure you run the calculations for using the “Assumed Par Value Capital Method” for calculating the amount of franchise tax due. It will often times result in less tax than using the default method that is presented on your franchise tax bill.

Startups often times get extreme sticker shock when they get a franchise tax bill from the State of Delaware. This is because Delaware uses two methods to calculate the amount of franchise tax due but presents a bill based on a method that often times results in an absurd amount for startups.

The Authorized Shares Method for Calculating Franchise Tax Due

The first method, which is the default method that Delaware uses to calculate the franchise tax due, is the Authorized Shares method. This method looks solely at the number of authorized shares of the corporation and makes a calculation to determine the franchise tax due. The more authorized shares, the more franchise tax due.  The problem for startups is that startups often authorize millions of shares. A number quite often used is 10,000,000 authorized shares.  10,000,000 authorized shares will result in franchise taxes of $75,075! Why do startups want to authorize so many shares? There are two principal reason.  The first is one of optics. Let’s say a startup wants to issue a new employee 1% of the company’s stock. If there are 100,000 shares, that’s 1,000 shares. If there are 10,000,000 shares, that’s 100,000 shares. 100,000 shares just sounds a lot better, even if economically it’s the same 1%. A second reason is that startups and their investors like to price the first equity round of financing at $1.00 per share, often times requiring that the company have millions of shares outstanding.  See related blog post How Many Shares Should You Issue to Founders?  The key to understanding the Delaware franchise tax is that the corporation has an alternative method for calculating the tax due, and the company pays the lesser amount if the franchise tax calculation is lower than using the Authorized Shares Method.

Assumed Par Value Capital Method for Calculating Franchise Tax Due

The second method, called the “Assumed Par Value Capital Method,” uses a formula that includes the “gross assets” of the company. This is the key. A startup is not likely to have much in terms of assets on its balance sheet, so the Assumed Par Value Method of calculating franchise tax will almost always result in a lower number than using the Authorized Shares method. The Delaware Division of Corporation’s web site has a spreadsheet you can download to calculate the franchise tax due based on each method, and the company will need to pay the lower amount.

Another Delaware Franchise Tax Glitch

Using the Assumed Par Value Capital franchise tax calculation method will solve most problems for startups, but it may not solve them all. I came across a startup that had decided to capitalize all of its software development costs, so it did have enough “gross assets” on its balance sheet to cause a considerable amount of franchise tax to be due for a pre-revenue startup company.  Another strange fact compounded the company’s problem when calculating the amount of franchise tax due: the company had authorized many millions of shares but only issued 1% of them.  Because of the way the Assumed Par Value Capital Method calculations work, the additional authorized but unissued shares worked against the company and it had to pay a large franchise tax bill.

Term Sheet 101: Protective Provisions

Protective Provisions are separate class voting rights for a company’s investors holding shares of preferred stock. The protective provisions provide investors greater control over the company, even if they don’t own a majority of the stock.

One of the great lies that startups tell, in this case tell themselves, is that if the founders own at least 51% of the company’s stock, they will maintain control. When everyone owns the same class of stock, this will generally be the case. Sophisticated angel investors and venture capital funds do not own common stock like the founders and management do, however, they own preferred stock for the very reason that it can give them greater control when they don’t own a majority of the shares. See related blog post Structuring Your Financing as the Purchase and Sale of Preferred Stock .

What are Protective Provisions?

Protective provisions are class voting rights that run in favor of the holders of preferred stock. When negotiating and setting up preferred stock, investors will place these protective provisions into the company’s certificate or articles of incorporation. The protective provisions are essentially veto powers, giving the investors a blocking position over certain material company transactions where they want to have a say. In other words, in order to do the things that are spelled out as the protective provisions, the company must obtain the approval vote of the holders of a majority of the shares of preferred stock, voting separately as a class and not together with the holders of the commmon stock (founders and management).

Commonly Used Protective Provisions

Here is a list of protective provisions that you might see in an angel or early-stage VC term sheet, stating that the company may not, without the consent of the holders of preferred stock, voting as a separate class:

  • change the rights, powers or privileges of the preferred stock (this is an automatic protective provision. It is essentially repeating what is in the corporations code)
  • increase or decrease the authorized number of shares of preferred stock (this is an automatic protective provision. It is essentially repeating what is in the corporations code)
  • sell assets, merge or effect any change of control transaction (this is a fairly standard protective provision)
  • authorize or issue any security that is senior to or pari passu with the shares of preferred stock (this is a fairly standard protective provision)
  • liquidate, dissolve or wind up the company (this is a fairly standard protective provision)
  • redeem any shares of common stock (this is a fairly standard protective provision)
  • pay or declare a dividend on the shares of common stock (this is a fairly standard protective provision)
  • increase or decrease the size of the board of directors (this is a fairly standard protective provision)
  • amend the corporation’s Equity Incentive Plan or create any new stock option or equity incentive plan (this protective provision is less standard. For example, it is not included in the Series Seed form Amended and Restated Certificate of Incorporation)
  • grant a security interest in all of the corporation’s assets (this protective provision is less standard. For example, it is not included in the Series Seed form Amended and Restated Certificate of Incorporation)
  • amend the corporation’s certificate of incorporation or bylaws (this protective provision is less standard. For example, it is not included in the Series Seed form Amended and Restated Certificate of Incorporation)

As you can see, protective provisions cover major corporate transactions, in particular those that will affect the expected returns of the investors on their investment. In laymen terms, these provisions give the investors greater control over selling the company, changing the terms of the preferred stock financing, allowing founders and management to get liquidity for their shares before the investors do, selling more shares on terms that they are not happy with, or changing the way in which the company is run. Protective provisions do not generally get into the day-to-day management of the company’s affairs, although some times you might see protective provisions regarding capital spending limits, borrowing funds and approving the annual budget and business plan of the company. These are big ticket items, so investor control of the company through protective provisions can be substantial, even when the investors own a very small percentage of the stock of the company (theoretically as little as 1 share).

Where to Get the Legal Documents with Protective Provisions

The protective provisions will normally be drafted into a preferred stock financing term sheet and into the certificate of incorporation in the full set of preferred stock financing documents.

Make a General Solicitation Before Regulation D and Form D Change

For startups that want to raise funds by means of a general solicitation or general advertising permitted by SEC Rule 506(c), the time to make the general solicitation is now.  The general solicitation regulations are only going to get worse.

Have the floodgates opened?  Well, they should.  The new regulations under SEC Rule 506(c) allow startups issuing securities to make general solicitations (public offerings) for the sale of their convertible notes, preferred stock or common stock are as lenient as they will ever be.

Accredited Investor and Reasonable Steps Requirements when Making General Solicitations

In a nutshell, the new general solicitation regulations have two main requirements: that startups issuing securities when they make a general solicitation may only sell to “accredited investors” and that they take “reasonable steps” to verify that their investors are indeed accredited investors.  For the definition of accredited investor and a discussion of the reasonable steps companies have to take when making a general solicitation permitted by Rule 506(c), including the safe harbors, see What are Reasonable Steps to Verify Accredited Investors? While the investor community is by no means happy with these requirements, things are going to get worse.

Proposed Regulation D and Form D Amendments

On the same day that the SEC published the Rule 506(c) adopting release allowing general solicitation, the SEC published proposed Amendments to Regulation D, Form D and Rule 156 which will make compliance nearly impossible for startups that want to raise funds by means of a general solicitation. The SEC’s proposed rules would:

  • Require filing an “Advance Form D” 15 days before any general solicitation is made for 506(c) transactions
  • Require filing a Form D within 15 days after the first sale of securities in 506(b) private placement transactions and 506(c) offerings involving general solicitation (This is already the rule)
  • Require filing a Form D within 30 days after the offering is completed or cancelled (for 506(b) private placement transactions and 506(c) offerings involving general solicitation)
  • Require filing an updated Form D at least annually if the offering is ongoing
  • Allow a 30 day cure period for 1 late form D filing in any offering (this seems to be the only reprieve in the proposed Regulation D amendments)
  • Require specific legends and other disclosures to be added to all offering documents
  • Require filing all offering documents used in a general solicitation with the SEC no later than the first day a general solicitation is made, and
  • increase the information required to be filed in Form D.

Automatic Disqualification for 1 Year for Failure to Comply with new General Solicitation Rules

To cap it off, the proposed amendments to Regulation D and Form D for offerings involving general solicitation include provision that the failure by an issuer to comply with the new general solicitation rules would automatically disqualify an issuer from using 506(b) (which is used for true private placements without employing a general solicitation) and 506(c) for a period of 1 year from the time the deficiency, such as failure to timely file a Form D, is rectified.

What startup knows that it will be making a general solicitation in 15 days, or even 15 hours for that matter?  Startup capital raising is extremely fluid; startups have to seize an opportunity when they have it, even at a moment’s notice.  The “Advance Form D” filing requirement 15 days before making a general solicitation is perhaps the most unreasonable requirement for startups.  It’s a trap for the unwary, putting startups in the penalty box before they even begin their offering with a general solicitation and subjecting them to automatic draconian penalties.

Stay tuned.  Given the backlash against the SEC’s proposed amendments to Regulation D and Form D, the final rules are unlikely to embody the heavy regulation of the proposed amendments.  One thing is certain, however, more regulation to transactions involving general solicitation is coming.  The first and best advice may be not to make a general solicitation at all, but for those startups that do want to use 506(c) and make a general solicitation, it behooves them to make a general solicitation now before more, potentially very ugly regulation is in place.

Where to Get the Legal Documents for Offerings that Include General Solicitation

Get a term sheet for a preferred stock, convertible note, or common stock financing and the full set of closing documents for a preferred stock, convertible note, or common stock financing at VentureDocs.

Founder Bo Sartain Explains New General Solicitation Rules

General solicitation becomes legal on September 23, but not without strings attached. Companies making a general solicitation may only sell to accredited investors and must use “reasonable steps” to verify they are accredited.

As of September 23, general solicitation (soliciting investors in a public manner) for the sale of securities, such as preferred stock, common stock and convertible notes, will be legal under SEC Rule 506(c). But the new law permitting general solicitation going into effect has strings attached. Companies making a general solicitation for the sale of securities may only sell to accredited investors and must take “reasonable steps to verify that they are indeed accredited. Self-certification as to accredited investor status by investors is no longer enough; companies raising money under the new SEC Rule 506(c) general solicitation laws must actively do due diligence on their investors. VentureDocs Founder Bo Sartain talks through the issues of when a general solicitation occurs and what are reasonable steps to verify accredited investor status of investors on blogtalkradio.

Where to Get Legal Documents For Offerings with General Solicitation

Get a term sheet for a preferred stock, convertible note, or common stock financing and the full set of closing documents for a preferred stock, convertible note, or common stock financing at VentureDocs. Beginning September 23, 2013 (the effective date of Rule 506(c) allowing general solicitation), our term sheets and purchase agreements for the purchase of securities in reliance on Rule 506(c) transactions involving a general solicitation will contain appropriate legends and representations and warranties for Rule 506(c) securities law compliance.

Is Submitting Offering Materials Through Gust/AngelList/EquityNet a General Solicitation?

SEC Rule 506(c) does not make soliciting investors through a database of pre-screened investors a general solicitation. If soliciting investors through these services has not been a general solicitation in the past, soliciting investors through these services (assuming they don’t change) will not be a general solicitation going forward because of the adoption of Rule 506(c).

Using Reasonable Steps when Verifying Accredited Investors from a Database of Pre-Screened Accredited Investors.

In the final SEC Regulations implementing Rule 506(c), the SEC wrote this passage when describing what kinds of reasonable steps issuers of securities need to take to verify a purchaser’s status as an accredited investor when a general solicitation has occurred: “[a]n issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party.” Many, including this author (see related blog post What is a General Solicitation?), have feared that the SEC had just changed the standards for what constitutes a general solicitation. Soliciting new investors from a database of pre-screened accredited investors–that sounds a lot like the services that Gust, AngelList, EquityNet and other internet-based portals offer, and an issuer would only need to take reasonable steps to verify accredited investor status from new investors solicited from a database of pre-screened accredited investors if the issuer has made a general solicitation. This passage is disturbing to say the least.

SEC Does Not Publish New General Solicitation Guidance

But it is not the case that soliciting new investors from a database of pre-screened accredited investors will automatically be a general solicitation. The 506(c) adopting release is not intended to change or provide new guidance with respect to the general solicitations and Rule 502(c), other than to provide that the prohibition against general solicitation in Rule 502(c) will not apply to general solicitations made in reliance on Rule 506(c), provided that all purchasers of securities are accredited investors. The amendment to Rule 506 “does not amend or modify the requirements relating to existing Rule 506(b).” Rule 506(b) remains unchanged by the adopting release for Rule 506(c). If the solicitation was not a general solicitation and thus permitted under Rule 506(b) before adoption of Rule 506(c), the solicitation will not be a general solicitation and will continue to be permitted under Rule 506(b) after the adoption of Rule 506(c), and there is a body of authority indicating that solicitations though internet web sites to pre-qualified accredited investors, if done properly, will not be general solicitations.

SEC Confirms Existing General Solicitation Authority

In the Rule 506(c) adopting release, the SEC confirms and cites this authority. See footnote 67 on page 18 of the adopting release (referencing Release No. 33-7856 (noting that “one method of ensuring that general solicitation is not involved is to establish the existence of a ‘pre-existing, substantive relationship’” and that “there may be facts and circumstances in which a third party, other than a registered broker-dealer, could established a ‘pre-existing, substantive relationship’ sufficient to avoid a ‘general solicitation’”). Release No. 33-7856 references additional SEC authority on when a general solicitation does or does not occur, for example, the IPOnet No Action Letter of July 26, 1996 and the Lamp Technologies No Action Letter of May 29, 1997, indicating that an internet matchmaking service may be used to create the necessary substantial, pre-existing relationship with potential investors to prevent a general solicitation.

More recently, KL Gates has confirmed in a published legal opinion for AngelList that companies may post information relating to financings on the AngelList website without making a general solicitation, therefore preserving the Rule 506(b) exemption for private placements.

All of this is still valid authority on when a general solicitation occurs (note, however, that only AngelList is entitled to rely on the KL Gates opinion). Perhaps the SEC could have used a different fact scenario to describe what kinds of reasonable steps are required in different situations when a general solicitation is made, but that’s all it was doing, describing how reasonable steps can vary depending on the circumstances when companies make a general solicitation. The SEC did not say solicitation of new investors through a database of pre-screened accredited investors is a general solicitation.

Proposed Representations and Warranties for 506(c) Transactions Involving a General Solicitation

General Solicitation Becomes Legal on September 23

Beginning September 23, 2013, companies selling securities will be allowed to make general solicitations (public offerings) for the sale of securities under Rule 506(c) (see related blog posts New SEC Rules Allow General Solicitation and What is a General Solicitation?). Companies raising capital will have to choose whether they want to solicit potential investors for the sale of securities by the traditional “private placement” rules without making a general solicitation (Securities Act Section 4(a)(2) and Rule 506(b)), or solicit investors by means of a general solicitation (Rule 506(c)). Either way, companies will need to follow the new general solicitation rules carefully and give assurances to its investors that the offer, sale and issuance of the securities in its financing transactions are compliant with the new general solicitation laws. In addition, both issuers of securities and investors will need to give assurances that the “Bad Boy” provisions of Rule 506(d) will not invalidate the offer, sale and issuance of the securities to be sold in financing transactions involving a general solicitation and those not involving a general solicitation.

Companies and Investors Need to Give Assurances of Compliance with General Solicitation Laws.

In this post we propose representations and warranties for our Preferred Stock Purchase Agreement for the companies issuing shares of preferred stock and the investors purchasing them in transactions that will involve a general solicitation. Our Convertible Note Purchase Agreements and Common Stock Purchase Agreements will contain similar representations and warranties for transactions involving a general solicitation. For our proposed representations and warranties for transactions not involving a general solicitation, see our related blog post Proposed Representations and Warranties for 506(b) Transactions Not Involving a General Solicitation).

[ISSUER REPRESENTATIONS AND WARRANTIES]

___. Securities Law Compliance.

(a) Basic Compliance. Based in part on the accuracy of the representations of the Purchasers in Section 4 of this Agreement, and subject to timely applicable Form D filings pursuant to Regulation D of the Securities Act of 1933, as amended (the “Securities Act”), with the Securities and Exchange Commission and pursuant to applicable state securities laws, the offer, sale and issuance of the Shares to be issued pursuant to and in conformity with the terms of this Agreement, and the issuance of the Conversion Shares pursuant to the terms of the Restated Certificate, will be issued in compliance with all applicable federal and state securities laws.

(b) General Solicitation. In connection with the offering of Shares made pursuant to this Agreement, the Company has made or intends to make a general solicitation within the meaning of Rule 502 under the Securities Act (“General Solicitation”). The offer, sale and issuance of the Shares is being made in reliance on Rule 506(c) under the Securities Act. The Company represents, warrants, covenants and agrees that all sales of Shares shall be made only to “accredited investors” (as such term is defined in Rule 501 of Regulation D under the Securities Act), and that it has taken or will take reasonable steps to verify that such purchasers are accredited investors, which reasonable steps may include but are not limited to the methods identified in Rule 506(c). The Company has made all filings, including applicable Form D filings, with the Securities and Exchange Commission relating to the offer, sale and issuance of the Shares required to be made prior to the date hereof, and the Company covenants and agrees it shall make all additional required filings, including applicable Form D filings, with the Securities and Exchange commission following the offer, sale and issuance of the Shares pursuant to this Agreement.

(c) Subsequent Closings/No Integration. The Company has not made any prior offering nor sold any securities in any prior offering that would be integrated pursuant to Rule 502(a) with the sale of the Shares and the transactions contemplated by this Agreement in which the Company has not taken reasonable steps to verify that the purchasers of such securities were accredited investors. Further, the Company covenants and agrees it shall take reasonable steps to verify that all investors are accredited investors in connection with (i) the offer, sale and issuance of the Shares pursuant to this Agreement in any Subsequent Closing and (ii) pursuant to any other future securities offering that would be integrated with the transactions contemplated by this Agreement.

(d) No Disqualification Events. None of the Company, any of its predecessors, any affiliated issuer, any director, executive officer, other officer of the Company participating in the offering, any beneficial owner of 20% or more of the Company’s outstanding voting equity securities, calculated on the basis of voting power, nor any promoter (as that term is defined in Rule 405 under the Securities Act) connected with the Company in any capacity at the time of sale (each, an “Issuer Covered Person” and, together, “Issuer Covered Persons”) is subject to any of the “Bad Actor” disqualifications described in Rule 506(d)(1)(i) to (viii) under the Securities Act (a “Disqualification Event”), except for a Disqualification Event covered by Rule 506(d)(2) or (d)(3). The Company has exercised reasonable care to determine whether any Issuer Covered Person is subject to a Disqualification Event.

[INVESTOR REPRESENTATIONS AND WARRANTIES]

___ No Disqualification Events. Neither the Investor nor, to the extent it has them, any of its shareholders, members, managers, general or limited partners, directors, affiliates or executive officers (collectively with the Investor, the “Investor Covered Persons”), are subject to any Disqualification Event, except for a Disqualification Event covered by Rule 506(d)(2) or (d)(3). The Investor has exercised reasonable care to determine whether any Investor Covered Person is subject to a Disqualification Event. The purchase of the Shares by the Investor will not subject the Company to any Disqualification Event.

Where to Get Legal Documents with General Solicitation Representations and Warranties

Get a term sheet for a preferred stock, convertible note, or common stock financing and the full set of closing documents for a preferred stock, convertible note, or common stock financing at VentureDocs. Beginning September 23, 2013 (the effective date of Rule 506(c) allowing general solicitation), our term sheets and purchase agreements for the purchase of securities in reliance on Rule 506(c) transactions involving a general solicitation will contain appropriate legends and representations and warranties for Rule 506(c) securities law compliance.

Proposed Representations and Warranties for 506(b) Transactions Not Involving a General Solicitation

General Solicitation Becomes Legal on September 23

Beginning September 23, 2013, companies selling securities will be allowed to make general solicitations (public offerings) for the sale of securities under Rule 506(c) (see related blog posts New SEC Rules Allow General Solicitation and What is a General Solicitation?). Companies raising capital will have to choose whether they want to solicit potential investors for the sale of securities by the traditional “private placement” rules not involving a general solicitation(Securities Act Section 4(a)(2) and Rule 506(b)) or by means of a general solicitation (Rule 506(c)). Either way, companies will need to follow the new general solicitation rules carefully and give assurances to its investors that the offer, sale and issuance of the securities in its financing transactions are compliant with the new general solicitation laws. In addition, both issuers of securities and investors will need to give assurances that the “Bad Boy” provisions of Rule 506(d) will not invalidate the offer, sale and issuance of the securities to be sold in financing transactions.

Companies and Investors Need to Give Assurances of Compliance with General Solicitation Laws.

In this post we propose representations and warranties for our Preferred Stock Purchase Agreement for the companies issuing shares of preferred stock and the investors purchasing them in transactions where there will not be a general solicitation. Our Convertible Note Purchase Agreements and Common Stock Purchase Agreements will contain similar representations and warranties for transactions not involving a general solicitation. For our proposed representations and warranties for transactions that will involve a general solicitation, see our related blog post Proposed Representations and Warranties for 506(c) Transactions Involving a General Solicitation).

[ISSUER REPRESENTATIONS AND WARRANTIES]

___. Securities Law Compliance.

(a) Basic Compliance. Based in part on the accuracy of the representations of the Purchasers in Section 4 of this Agreement and, with respect to Shares to be offered and sold hereunder in reliance on Rule 506(b) of the Securities Act of 1933, as amended (the “Securities Act”), subject to timely applicable Form D filings pursuant to Regulation D with the Securities and Exchange Commission and pursuant to applicable state securities laws, the offer, sale and issuance of the Shares to be issued pursuant to and in conformity with the terms of this Agreement, and the issuance of the Conversion Shares pursuant to the terms of the Restated Certificate, will be issued in compliance with all applicable federal and state securities laws. With respect to Shares to be offered and sold hereunder in reliance on Rule 506(b), the Company covenants and agrees it shall timely make applicable Form D filings.

(b) No General Solicitation. In connection with the offering of Shares made pursuant to this Agreement, the Company has not published, distributed, issued, posted or otherwise used or employed and shall not publish, distribute, issue, post or otherwise use or employ any form of general solicitation or advertising within the meaning of Rule 502 under the Securities Act (“General Solicitation”).

(c) Subsequent Closings/No Integration. The Company has not made a General Solicitation in any prior offering of securities that would be integrated pursuant to Rule 502(a) with the sale of the Shares and the transactions contemplated by this Agreement. Further, the Company covenants and agrees it shall not make any General Solicitation in connection with (i) the offer, sale and issuance of the Shares pursuant to this Agreement in any Subsequent Closing or (ii) pursuant to any other future securities offering that would be integrated with the transactions contemplated by this Agreement.

(d) No Disqualification Events. None of the Company, any of its predecessors, any affiliated issuer, any director, executive officer, other officer of the Company participating in the offering, any beneficial owner of 20% or more of the Company’s outstanding voting equity securities, calculated on the basis of voting power, nor any promoter (as that term is defined in Rule 405 under the Securities Act) connected with the Company in any capacity at the time of sale (each, an “Issuer Covered Person” and, together, “Issuer Covered Persons”) is subject to any of the “Bad Actor” disqualifications described in Rule 506(d)(1)(i) to (viii) under the Securities Act (a “Disqualification Event”), except for a Disqualification Event covered by Rule 506(d)(2) or (d)(3). The Company has exercised reasonable care to determine whether any Issuer Covered Person is subject to a Disqualification Event.

[INVESTOR REPRESENTATIONS AND WARRANTIES]

___ No Disqualification Events. Neither the Investor nor, to the extent it has them, any of its shareholders, members, managers, general or limited partners, directors, affiliates or executive officers (collectively with the Investor, the “Investor Covered Persons”), are subject to any Disqualification Event, except for a Disqualification Event covered by Rule 506(d)(2) or (d)(3). The Investor has exercised reasonable care to determine whether any Investor Covered Person is subject to a Disqualification Event. The purchase of the Shares by the Investor will not subject the Company to any Disqualification Event.

Get a term sheet for a preferred stock, convertible note, or common stock financing and the full set of closing documents for a preferred stock, convertible note, or common stock financing at VentureDocs.

Will All Offerings Now Involve General Solicitation?

It may be virtually impossible for startups to avoid general solicitation when selling preferred stock, convertible notes or common stock. Many activities that companies are already doing constitute general solicitation.

Demo Day Events are Often a General Solicitation.

Companies pitch all the time at “pitch day” and “demo day” events. Rule 502(c)(2) says that a pitch at “any seminar or meeting whose attendees have been invited by any general solicitation or general advertising” is a general solicitation. The SEC has further confirmed that unrestricted websites also constitute general solicitation. What “pitch day” or “demo day” event is not announced on an unrestricted website? Connecting the dots here, one has to conclude that companies pitching in these forums that are open to the public and announced on websites are making general solicitations.

Soliciting Investors Through a Database of Pre-Screened Accredited Investors May Be a General Solicitation.

Perhaps the most disturbing language in the final SEC Regulations adopting Rule 506(c) seems to indicate that submitting offering materials to a “database of pre-screened accredited investors created and maintained by a reasonably reliable third party” is a general solicitation requiring the issuer to take reasonable steps to verify accredited investor status. Does this mean that any company seeking angels on Angellist, Gust, EquityNet and other similar services are all making general solicitations? I’ve spoken to many lawyers about this and all say that the rule is not clear. [For an update on this topic, see Is Submitting Offering Materials Through Gust/AngelList/EquityNet a General Solicitation?]

Integration Can Mean a Prior Private Placement Becomes a General Solicitation.

A final wrinkle that has not received much attention is that the rules of integrating offerings in Rule 502(a) apply to 506(c) transactions. Integration means treating separate offerings of securities as one offering if they take place within 6 months of each other. Numerous factors are analyzed to determine if offerings should be integrated. If a perfectly good “private placement” under 506(b) without general solicitation is integrated with a prior or subsequent offering under Rule 506(c) that has general solicitation, the whole transaction is a 506(c) transaction and the issuer has probably blown it on the part it thought was a 506(b) transaction.

There Are No Hybrid Deals; any General Solicitation Makes the Whole Offering a General Solicitation.

Let me hammer this last point home, the SEC has made it clear that any general solicitation at all makes the whole offering a general solicitation subject to Rule 506(c), even if the purchasers did not make their investment decision based on the general solicitation. For example, a company could close a financing round with investors with whom the CEO has a prior relationship without making a general solicitation. Later, during the subsequent closing period, the company pitches at a “pitch day” competition to finish out the round. Even if the “pitch day” event leads to nothing, because the pitch at the “pitch day” competition is a general solicitation, the whole transaction involves a general solicitation and is subject to 506(c). If the company sold securities in the first closing to any non-accredited investors or did not take reasonable steps to verify that all investors in the first closing were accredited investors (and this may very well be the case if it didn’t think it would be making a general solicitation at all), then the company will be in violation of Rule 506(c).

Given the specter of integration, and not knowing if it will make a general solicitation in the future when there are potentially multiple closings in a subsequent closing period, shouldn’t every issuer assume that every offering will involve general solicitation? What companies selling securities do in the future may invalidate what they have already done. Who wants to take that chance?

Get a term sheet for a preferred stock, convertible note, or common stock financing and the full set of closing documents for a preferred stock, convertible note, or common stock financing at VentureDocs. Beginning September 23, 2013 (the effective date of Rule 506(c) allowing general solicitation), our term sheets and purchase agreements for the purchase of securities in reliance on Rule 506(c) will contain appropriate legends and representations and warranties for Rule 506(c) securities law compliance.

What are Reasonable Steps to Verify Accredited Investors?

Issuers must take “reasonable steps” to verify investors are accredited in Rule 506(c) transactions involving general solicitation.

SEC Rule 506(c), which becomes effective September 23, 2013, allows general solicitation (see related blog post What is a General Solicitation?) in connection with the offer, sale and issuance of preferred stock, convertible notes and common stock without having to register the shares with the SEC, but only if such sales are made only to “accredited investors” and the issuer takes “reasonable steps” to verify that such purchasers of securities are accredited investors.

Accredited Investor Defined.

First, what is an “accredited investor”? For individuals, it means:

  • a person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000 (excluding the value of his or her primary residence); or
  • a person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

Self-Certification is Out; Companies Must Take Reasonable Steps.

The new rule requires the issuer of securities to take reasonable steps to verify accredited investor status. This means two things: first, that the purchaser are no longer able to self-certify that they are accredited investors by filling out a questionnaire and/or making accredited investor representations and warranties in a stock purchase agreement (such process is still allowed under Rule 506(b) transactions not involving a general solicitation); and second, that the issuer must do something to verify accredited investor status, even if it’s investor is Mark Cuban and the issuer is 1,000% certain the investor is accredited.

What are Reasonable Steps?

So, what are reasonable steps to verify accredited investor status? The answer is: it depends. The SEC has adopted a “principles-based method” of accredited investor verification, indicating that the reasonable steps that are necessary to give an issuer a “reasonable belief” that all investors are accredited depends on the following factors:

  • the nature of the purchaser and the type of accredited investor,
  • the amount and type of information that the issuer has about the purchaser, and
  • the nature of the offering, such as the manner in which the purchaser was solicited.

The SEC gives certain examples in the final SEC Regulations implementing Rule 506(c) discussing how the reasonable steps necessary to verify accredited investor status depend on the facts and circumstances. For Example, “An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party.” Another example is as follows: “… if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.”

Safe Harbor for Reasonable Steps.

Fortunately, in the final release adopting Rule 506(c), the SEC adopted a non-exclusive “safe harbor” to provide some certainty that issuers are complying with the reasonable steps requirement for natural person investors. Provided that the issuer of securities does not otherwise have knowledge that such person is not an accredited investor, the issuer will be deemed to have taken reasonable steps if:

  • with respect to purchasers who are accredited investors based on income, the issuer reviews IRS forms that report revenue (W-2, Form 1099, Schedule K-1 or filed Form 1040) for the last two years and obtains a written representation from such person that he or she has a reasonable expectation of reaching the income level in the current year;
  • with respect to purchaser who are accredited investors based on net worth, the issuer reviews bank statements, brokerage statements, other statements of securities holdings, certificates of deposit, and/or tax assessments and appraisal reports issued by third parties in order to verify assets, a consumer report from at least one of the nationwide consumer reporting agencies to verify liabilities, and obtains a written representation that all liabilities necessary to make a net worth determination have been disclosed (all information reviewed may not be more than 3 months old);
  • the issuer has obtained a written confirmation from a broker-dealer, a registered investment advisor, a licensed attorney or a CPA that such person has taken reasonable steps to verify that the purchaser is an accredited investor within the prior 3 months and determined that such purchaser is an accredited investor, and
  • for purchasers who previously purchased securities in an issuer’s Rule 506(b) transaction prior to the effectiveness of Rule 506(c), a certification that such person is an accredited investor.

Although the safe harbors outlined above are not mandatory and are non-exclusive, most issuers with individual purchasers will likely take all necessary means to fall within of of the safe harbors because nobody wants to be one of the SEC’s initial test cases regarding whether the issuer of securities has taken reasonable steps.

Get a term sheet for a preferred stock, convertible note, or common stock financing and the full set of closing documents for a preferred stock, convertible note, or common stock financing at VentureDocs. Beginning September 23, 2013 (the effective date of Rule 506(c) allowing general solicitation), our term sheets and purchase agreements for the purchase of securities in reliance on Rule 506(c) will contain appropriate legends and representations and warranties for Rule 506(c) securities law compliance.