Our colleague Kristen Howell has published an alert reporting on an important development in the cryptocurrency industry. The U.S. Securities and Exchange Commission has declared that Bitcoin, Ethereum and other coins operating on truly decentralized platforms are not securities. The agency’s reasoning was revealed in remarks by William Hinman, Director of the SEC’s Division of Corporate Finance, at the Yahoo Finance “All Markets Summit: Crypto” on June 14. Hinman explained that since the value of cryptocurrency is not based on the expectation of profits resulting from the success or failure of the issuer, it does not compare to a typical security. You can read Kristen’s alert on the Fox Rothschild website.
For early-stage companies in need of capital, finding potential investors can be difficult and time-consuming, especially when conditions in the capital markets are tight. For many companies, using a “finder,” an individual or entity that identifies, introduces and negotiates with potential investors, to help locate potential investors may seem to be a promising solution to this problem. However, there are risks involved in using finders, including those arising from potential violations of the SEC’s broker-dealer registration requirements. These risks are significant and, as investors become increasingly wary of the potential consequences, could threaten a company’s ability to raise capital in the future and its prospects for long-term growth and success. Finders operating as unregistered broker-dealers also face significant risks, including the possibility of severe SEC sanctions.
On April 12 at the ABA Business Law Section Spring 2018 Meeting in Orlando, Fox partner Emily Yukich and associate Matt Kittay, as well as Martin Hewitt, prominent New Jersey attorney and chair of the ABA’s Committee on State Regulation of Securities, will provide an in-depth CLE presentation on these risks. They will discuss the main risks finders face when acting as an unregistered broker-dealer, cover a critical SEC No Action Letter on the topic (the M&A Broker Letter), and will look at certain state regimes in applying the general prohibitions and restrictions in place.
The program will take place from 9:00 AM to 10:00 AM at the Rosen Shingle Creek in Orlando. If you’d like to attend, please register for the Spring Meeting on the ABA’s website.
Ethan Zook and Jacob Oksman write:
Attracting and retaining high-performing employees is critical to the success of any emerging company. A key ingredient to securing the right talent base is an attractive and aligned remuneration plan. Most emerging companies will structure their remuneration plan leveraging three key elements: a competitive base salary, a short-term bonus plan, and a long-term incentive plan (LTI) that typically comes in the form of a stock option plan. The base salary and bonus plan are typically structured to align the individual and the company against critical objectives, and normally present in the form of cash compensation. The LTI plan, on the other hand, is structured with a longer-term horizon in mind, and is intended to align the company, employees, and shareholders for long-term value creation.
While an integral way for emerging companies to attract top talent, employees need to understand the type of LTI vehicle used, and tax implications from a vesting, exercising and selling perspective.
In general, there are two basic kinds of stock options: statutory stock options and nonstatutory stock options (NSOs). Both generally allow the recipient to buy stock at a fixed price for a defined number of years into the future. By doing so, the option holder takes part in the overall value creation of the company. The award will typically vest over a pre-determined period of time, or upon certain milestone achievements. Once shares are vested, the holder has the option of selling the earned shares. There are, however, significant differences between the two types of awards from a tax perspective.
Statutory stock options include incentive stock options (ISOs) and options granted under employee stock purchase plans. Upon grant and exercise of ISOs, there are generally no tax consequences to the employee. However, the employee may be subject to alternative minimum tax in the year of exercise. Upon sale of the stock received by exercising the ISOs, the employee will generally have capital gain or loss if the stock acquired on exercise is held for at least two years from the date of grant and one year after the ISOs were exercised.
NSOs are not taxed to the employee receiving them when granted unless the options have a readily ascertainable fair market value at that time (this generally includes marketable securities). If the options do not have a readily ascertainable fair market value when granted, the employee is taxed on the gain from the options at the time of exercise or transfer (even if the fair market value becomes readily ascertainable before the exercise or transfer). Unlike statutory stock options, upon exercise of NSOs, an employee will have compensation income (taxed as ordinary income) equal to the difference between the fair market value of the stock at the time of exercise and the price paid for the stock (if any). If the options are sold, then the employee will have compensation income equal to the gain on disposition. The sale of the stock received by exercising NSOs will generally result in capital gain or loss (and are not subject to the special holding period requirement discussed above for ISOs).
ISOs are generally considered more tax friendly than NSOs, but both employees and employers need to be aware of the tax scheme.
Navigating the tax treatment of options can get complex quickly; it would be wise to reach out to a tax professional before making the ultimate decision of receiving or exercising equity compensation.
Ethan Zook is an associate in the firm’s Corporate Department, resident in its Exton, PA office.
Jacob M. Oksman is an associate in the firm’s Taxation & Wealth Planning Department, resident in its New York office.
On April 5, the Division of Corporate Finance of the Securities and Exchange Commission released two new compliance and disclosure interpretations (“C&DIs”) regarding Regulation Crowdfunding. Regulation Crowdfunding was adopted in 2015 in order to implement the provisions of Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 that exempt certain crowdfunding transactions from registration under the Securities Act of 1933.
The first new C&DI addresses the disclosure requirements of Rule 201, and specifically the related party disclosure requirements of Rule 201(r). Rule 201(r) requires that in connection with a crowdfunding offering, a crowdfunding issuer must disclose and describe any related party transactions that are currently proposed or that occurred since the beginning of the issuer’s last fiscal year in which the amount involved is greater than 5% of the total amount that the issuer raised under the crowdfunding exemption over the previous 12 months, including the amount proposed to be raised in the current offering.
C&DI Question 201.02 clarified that for purposes of this requirement, crowdfunding issuers should calculate the 5% threshold for disclosure of related party transactions based on the target offering amount plus the amount already raised during the previous 12 months, even if the issuer indicates that it will accept offering proceeds in excess of the target offering amount. In other words, the possibility of accepting additional offering proceeds in excess of the target offering amount should be disregarded for purposes of calculating the 5% threshold for disclosure.
The second C&DI released by the Division of Corporate Finance clarifies Rule 202(b)(2), which provides that an issuer is no longer required to comply with the ongoing reporting requirements of Rule 202 once the issuer has filed at least one annual report pursuant to Rule 202 and has fewer than 300 shareholders of record.
C&DI Question 202.01 provides that, when calculating the number of shareholders of record for purposes of Rule 202(b)(2), the issuer is required to count all shareholders of the same class of securities issued in the crowdfunding offering, even if some of those shareholders did not obtain such securities in connection with the crowdfunding offering.
The full text of the two new C&DIs described above, along with all previously released C&DIs regarding Regulation Crowfunding, can be found on the SEC’s website. In addition, an overview of the Regulation Crowdfunding rules can be found in this earlier Emerging Companies Insider post.
On January 10, 2017, the U.S. House of Representatives passed a bill commonly known at the “HALOS Act”, which directs the Securities and Exchange Commission (SEC) to revise Regulation D. Prior to the proposed amendment, Regulation D exempts certain offerings from SEC registration requirements but prohibits “general solicitation” with respect to such offerings. The proposed amendment states that the prohibition shall not apply to events with specified kinds of sponsors — including “angel investor groups” unconnected to broker-dealers or investment advisers — where presentations or communications are made by or on behalf of an issuer, but:
- the advertising does not refer to any specific offering of securities by the issuer;
- the sponsor does not provide investment recommendation or advice to attendees, engage in investment negotiations with attendees, charge certain fees, or receive certain compensation; and
- no specific information regarding a securities offering is communicated beyond the type and amount of securities being offered, the amount of securities already subscribed for, and the intended use of proceeds from the offering.
If the bill becomes law, early stage companies which present at demo days and other “pitch events” will have clear guidance that such actions are exempt from violating the SEC’s prohibition on “general solicitation”, avoiding the need to verify investors as “accredited” as a result of their pitches. Investors likewise would have better assurances that companies have not tripped the general solicitation trigger.
Matthew R. Kittay is a corporate attorney in Fox Rothschild’s New York office and Co-Chair of the American Bar Association’s Angel Venture Capital Subcommittee.
Founding a company is an exciting moment in an entrepreneur’s career. But even on Day 1, there are steps entrepreneurs should take to avoid major financial and diligence issues in the future. In this series of posts, we’ll cover some basics that often trip up founders to help guide you through those early steps.
Entrepreneurs often assume they own their company de facto (i.e., by virtue of the fact that they formed it, without any other required action)- a proposition that seems so logical and fundamental, it’s hard to believe its not true.
Later in their company’s lifecycle (typically, when there’s pressure on due diligence because the founders either consult an attorney knowledgeable in the space or there’s an interested incubator, accelerator or angel investor), many founders are surprised to learn that after forming their company, they must take another critical step to become shareholders in the company they founded – purchasing their company’s stock.
This often overlooked step works to the founder’s benefit, when it’s done correctly. In fact, we often tell founders that the ability to purchase their company’s stock on Day 1 is one of the core economic upsides to founding a business in the first place. While this seems backwards (why should you have to buy stock in a company founded by you- isn’t that the investor’s role?), it makes sense considering the price the founders pay for that stock, as long as the stock is purchased at or near the time of formation of the company. Because at formation of the company, there’s typically no assets or value associated with the company other than the nominal par value of the stock, allowing a founder to purchase their shares at a fraction of a penny per share (whatever the par value is set to).
Of course, there’s nuances and unique circumstances to each company formation that need to be discussed with your lawyer and financial advisor. Sometimes, there is real value associated with the stock, even on Day 1 (for example, if the company is a spinout with assets). And there are other steps that a prudent founder or founding team may need to take at inception along with the purchase of their stock (e.g., consider imposing vesting restrictions on the stock and filing an 83(b) election).
But first things first, make sure you purchase your stock on Day 1, before that hockey stick growth you’re projecting becomes a reality…
Fox Rothschild’s Emerging Company Resource Center includes formation document checklists developed by our nationally recognized emerging companies attorneys; information on relevant intellectual property issues (trademarks, patents, licenses); data room portals for investor due diligence; and other resources for emerging companies. We encourage our entrepreneurs to reach out to us with questions as they grow their company with these resources.
Two states have brought legal action against the U.S. Securities and Exchange Commission (SEC) for exceeding the authority granted to it under the Jumpstart Our Business Startups (JOBS) Act. Massachusetts and Montana, which initiated the lawsuit at the behest of the North American Securities Administrators Association, believe that the SEC exceeded its authority in issuing the rules known as Reg A+ in 2015.
Massachusetts Secretary William Galvin and Montana State Auditor Monica Lindeen oppose the aspects of Reg A+ that lift state securities registration requirements, known as blue sky laws. They argue that the SEC went beyond its authority and encroached upon an area of the law traditionally reserved to the states. Galvin, in particular, who submitted two sets of comments in 2013 and 2014 before the SEC voted on the new rules in March of 2015, argues that this form of state law preemption contradicts congressional intent and puts investors at risk.
Most observers believe that the lawsuit brought by Massachusetts and Montana lacks substantive merit if one focuses on the investor protections built into Reg A+. Nonetheless, given the relative youth and novelty of Reg A+, the litigation may serve to temper enthusiasm for the new rule, at least temporarily. It is unclear when the Court of Appeals will issue its ruling.
Canada has seen some recent success in having its venture-backed companies progress through IPO, and total venture capital invested in Canadian companies has doubled over the past 5 years. As U.S.-based investors look across the border for investment opportunities involving Canadian technology companies, they should be aware of some key differences between U.S. and Canadian laws that impact the way deals are structured in Canada. Here is a quick summary of some of the important items to consider:
- Canadian securities laws are set at the provincial, as opposed to the federal, level. Canada is working towards a national securities law framework, but for now Canadian companies have to consider the laws of their particular province. From a practical point of view, this is much less likely to impact private companies than companies entering the public markets.
- Canadian corporate law allows a company to have unlimited authorized capital, and most Canadian companies take advantage of this opportunity. Obviously, this raises dilution concerns which are usually addressed by including protective provisions in a company’s charter documents or an investor rights type agreement which imposes a predetermined level of shareholder approval before additional shares may be issued.
- Canadian companies can issue preferred shares in series, as seen in the US. However, in Canada, no series of shares can have a priority over any other series within the same class of shares with respect to dividends or return of capital. Consequently, Canadian companies will typically issue multiple classes of preferred shares, rather than multiple series within a single class of shares, in order to allow for differing liquidation preferences among different investment rounds.
- Investors should review any possible conflicts between Canadian statutory voting rights, which provide for separate class voting rights in connection with certain extraordinary corporate events, and negotiated approval rights. Similarly, Canadian law is not as flexible as, for example, Delaware law in the area of shareholder consents. In Canada, shareholder consent must be obtained either at a duly called shareholder meeting or by way of a unanimous written consent (although this does not apply as to matters that require shareholder consent as a result of contractual approval rights). Considering that at some point a unanimous written consent of shareholders may be a logistical nightmare, voting trusts are sometime used, or powers of attorney are granted by investors.
- Unanimous shareholder agreements are an interesting creature of Canadian law. This is an agreement among all of the shareholders of a company that, although a contract, is considered as one of the company’s organizational documents, alongside the company’s articles and bylaws. As such, they are considered binding on all future shareholders, even if they do not sign the agreement. Also, they allow shareholders to impose limits on the authority of the company’s directors to manage the business of the company, so that the shareholders may bypass the board and manage the company directly. These agreements are widely used by Canadian private companies, and frequently also cover, in a single document, many of the governance, voting and shareholder rights that U.S.-based transactions may address in multiple agreements, such as investor rights, voting and registration rights agreements.
- Board nomination rights are also typically found in a unanimous shareholder agreement as opposed to the articles of incorporation. In this regard, it is important to note that some Canadian companies, depending upon their province of organization, may require that at least 25 percent of the company’s directors be Canadian residents, and that, in order for a valid meeting of the directors of the company to be held, at least 25 percent of the directors present must be Canadian residents. U.S.-based investors who wish to ensure that they can place non-Canadian residents on the board of directors should negotiate for these rights in the context of the composition of the non-Canadian members of the board.
Certainly this is not an exhaustive list of issues to be considered in a cross-border investment transaction. However, it is important for U.S. investors to understand and be prepared to address these significant differences between U.S. and Canadian deal structure when developing and implementing investment strategies.
Montréal, QC, Canada; Thursday, April 7, 2:30pm
Title III Equity Crowdfunding goes live in May 2016. As co-chairs of the ABA’s Angel Venture Capital Subcommittee, Fox Rothschild attorneys Emily J. Yukich and Matthew R. Kittay will host a panel conversation featuring Amos J. Richards, General Counsel of leading equity crowdfunding platform EquityNet, alongside former SEC Division of Corporation Finance Special Counsel David J. Lavan, for insights on legal and practical implications.
Unlike traditional capital markets, the crowdfunding market has no gatekeepers – underwriters, accountants and lawyers that are able to monitor the process and press issuers when offerings may run askew of regulatory rules or when deal terms become too one-sided – which may spur new regulatory as well as commercial concerns. The group will discuss topics including the tension between state and federal securities regulators , how lawyers can provide input on deals that are capped at $1mm without pricing themselves out of the market, and the need for the crowdfunding market to police itself to avoid increased regulation. We’re excited to discuss these and other issues as the new rules go live.
If you plan to attend the conference, please join us for this informative discussion.
On October 30, 2015, the Securities and Exchange Commission (the “SEC”) adopted final rules under Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”). Among other things, the JOBS Act permits companies seeking to raise capital, or “issuing companies”, to sell securities to investors through crowdfunding. Below is a brief overview of what companies, investors and others affected by the new crowdfunding rules need to know. Continue Reading The New Crowdfunding Rules: What You Need To Know