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.

Business Taxation
Copyright: yupiramos / 123RF Stock Photo

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.

Copyright: yupiramos / 123RF Stock Photo

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.

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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.

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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 and investing
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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

The SEC recently gave its blessing to a marriage of old and new:  traditional private placements conducted via the Internet. In doing so it lifted the veil on how VC firms can create “pre-existing, substantive relationships” with initially anonymous web-based investors.

Copyright: karenr / 123RF Stock Photo
Copyright: karenr / 123RF Stock Photo

Something Old:  Three years ago the JOBS Act lifted the long-standing prohibition on “advertising or broadly soliciting interests in privately held securities.” However, for a variety of reasons firms and issuers generally prefer the tried and true approach, a private sale of securities known as a 506(b) offering. To qualify for the 506(b) safe harbor, the offering cannot include a general solicitation and general advertising. But if issuers can show a “pre-existing, substantive relationship” with the prospective investor, the offering is not considered a general solicitation or advertisement.

Something New:  Enter the modern, “Add to Cart, Click” anonymity of the Internet. Potential investors from around the world are just a Google search away from a VC firm’s web-based portfolio, creating opportunity…and risk. How does a VC firm take advantage of an online platform and still establish a pre-existing, substantive relationship with prospects?

Catch Me a Catch…But How?:  In a recent no-action letter, Citizen VC, the SEC’s Division of Corporation Finance helped bridge the gap. Citizen VC, Inc. is an online venture capital firm that facilitates through its website indirect investment in private companies from seed to late-stage. In a letter to the SEC, Citizen VC outlined its procedures for developing pre-existing, substantive relationships with its online investors, and the SEC did not disagree with its methods.

Citizen VC set forth a two-step process for establishing pre-existing, substantive relationships. First, visitors to Citizen VC’s password-protected site must register and be accepted for membership. Prospects complete a generic online “accredited investor” questionnaire.  Depending on its evaluation of the questionnaire, Citizen VC will initiate the “relationship establishment period,” which is not limited to a specific time period.  According to Citizen VC, this period is a “process based on specific written policies and procedures created to ensure that the offering of Interests is suitable for each prospective investor.” (Citizen VC, Inc., Incoming Letter p.2). Citizen VC connects with and collects information from prospects in a variety of ways, assessing each prospect’s sophistication, financial circumstances, and ability to comprehend investments and their risks. Citizen VC’s relationship-building activities include:

  1. offline telephone introductions and conversations to discuss investing experience, goals and strategies, financial suitability, awareness of risks and other matters;
  2. an introductory email;
  3. online interaction to answer questions about Citizen VC, its website and its investments;
  4. confirming a prospect’s identity and gathering financial information and credit history using third party services;
  5. encouraging the prospect to review the website and ask questions regarding investment strategy, philosophy and objectives; and
  6. fostering online and offline contacts between the prospect and Citizen VC.

Prospects are finally admitted as members when Citizen VC determines that “(i) the prospective investor has sufficient knowledge and experience in financial and business matters to enable it to evaluate the merits and risks of the investment opportunities on the [website], and (ii) it has taken all reasonable steps it believes necessary to create a substantive relationship with the prospective investor.” (Citizen VC, Inc., Incoming Letter p.3)

Specifically, the SEC agreed with Citizen VC that the most important factor when determining whether a “substantive” relationship exists is the “quality” of the relationship between the issuer and the investor. It also agreed that issuers cannot rely on a specific duration of time or particular short form accreditation questionnaire to establish such a substantive relationship.

Citizen VC shows that building the right relationship between issuer and investor is a process of communication and evaluation at multiple steps. Matchmakers looking to bring investors and portfolio companies together online now have greater certainty of how to structure their activities to satisfy the 506(b) safe harbor.

Sandra Romaszewski writes:

Although not a new issue or requirement, many U.S. companies, including emerging companies and their parent companies, affiliates and investors, may not be aware of certain reporting requirements required by the International Investment and Trade in Services Survey Act (the Act).  In general terms, the Act governs the reporting of investments made in the U.S. by foreign persons and investments made by U.S. persons abroad. (Note that there are other specific filing requirements for airline operators, ocean and freight carriers, insurance companies, and financial service providers.) The Bureau of Economic Analysis (BEA) within the U.S. Department of Commerce is tasked with collecting the data and reporting the statistics.

Copyright: ymgerman / 123RF Stock Photo
Copyright: ymgerman / 123RF Stock Photo

U.S. Direct Investment Abroad

All U.S. persons (in the broad sense, including individuals or business enterprises) who own, directly or indirectly, 10% or more of the voting securities or equivalent interest in a foreign business enterprise, are subject to the BEA’s reporting requirements.  This includes U.S. private equity funds that own foreign affiliates directly or through U.S. portfolio companies that they control.

Foreign Direct Investment in the U.S.

All U.S. business enterprises in which a foreign person (again, in the broad sense, including an individual or business enterprise) owns, directly or indirectly, 10% or more of the voting securities or equivalent interest in a U.S. business enterprise, are also subject to the BEA’s reporting requirements.  This includes foreign ownership of any real estate in the U.S. except residential real estate held exclusively for personal use and not for profit-making purposes.

Reporting is Mandatory But Information is Kept Confidential

Reporting to the BEA is mandatory whether or not companies are contacted by the BEA.  Reporting requirements include quarterly surveys, annual surveys, and benchmark surveys that must be completed every 5 years.  Also, for new foreign direct investment in the U.S., an initial report must be filed no later than 45 days after the date a foreign direct investment in the U.S. is made.  Foreign direct investment includes any of the following by a foreign person:  (1) the establishment of a new U.S. legal entity, (2) the expansion of U.S. operations, or (3) the acquisition of a U.S. business enterprise.

Types of data collected by the BEA may include balance sheets, income statements, sales figures, taxes, employment information, research and development expenditures, capital expenditures, and exports and imports.  The Act protects the confidentiality of the data reported to the BEA, and the survey data can only be used for analytical and statistical purposes.  Exemptions from filing are available if any of the exemption criteria is met, but a Claim for Exemption from filing must still be filed with the BEA for each survey.

Penalties for Non-Compliance

What happens if companies do not file the mandatory BEA surveys?  Companies may be subject to fines and penalties and may be subject to governmental orders directing compliance.  Even worse, a company’s willful failure to report may lead to a more significant fine and an individual’s willful failure to report may lead to a fine, imprisonment for not more than 1 year, or both.  To top it off, any officer, director, employee or agent of any company who or which knowingly participates in such violations may be punished by fines, imprisonment, or both, upon conviction.

It goes without saying that all companies, including emerging companies which rely heavily on their Boards of Directors and management teams, should adhere to the BEA’s filing requirements and seek advice from their legal and tax professionals to avoid fines and/or imprisonment for non-compliance.

Sandra A. Romaszewski is an associate in the firm’s Warrington, PA office.