The SEC recently adopted amendments to its long-standing "accredited investor" definition that determines which investors qualify for investment in private securities offerings conducted under Regulation D under the Securities Act of 1933 without the issuers having to comply with state and federal disclosure or registration requirements.

At a high level, the definitional changes broaden the categories of individuals and entities that qualify as accredited investors by adding categories of eligibility based on those investors’ professional knowledge, experience or certifications.  The definitional change also acknowledges societal changes in the 35+ years since the definition was first adopted by recognizing that “spousal equivalents” (i.e., domestic partners and similar relationships) are now common and permitting their assets and income to be pooled to enable accredited investor qualification.  The stated purpose of the amendments is to “update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in those markets.” Thus, individuals and entities may now qualify as accredited investors based not only on income or net worth, including that of non-traditional families, but also based on defined measures of financial sophistication.

Primary changes
Investors who meet the following criteria will now qualify as accredited investors under the amended definition:

• Holders of certain professional licenses which are deemed to demonstrate relevant professional knowledge. Initially this will include persons who hold Series 7, Series 65 and Series 82 licenses.  The SEC has reserved the authority to periodically add categories to this list.
• Limited liability companies with at least $5 million in assets.  Currently, partnerships, 501(c)(3) organizations, business trusts and corporations qualify for accredited investor status if they have total assets in excess of $5 million and were not formed for the specific purpose of acquiring the securities being offered. The amendment adds limited liability companies to this list in recognition of the growing role they play in company formations.
• SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies.  Exempt reporting advisers are considered "registered" for purposes of the newly changed definition.
• Any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered.
• “Family offices” with at least $5 million in assets under management and their “family clients.” Family Offices are entities established by families to manage their assets, plan for their families' financial future, and provide other services to family members. Family Clients generally are family members, former family members, and certain key employees of the family office, as well as certain of their charitable organizations trusts, and other types of entities. Both of these definitions largely mirror their counterparts in the Investment Advisers Act of 1940.
• For investment in a private fund, “knowledgeable employees” of the private fund.  These will include the fund’s executive officers, directors, trustees, general partners and advisory board members, as well as persons serving in a similar capacity of the fund or an affiliated management person of the fund.
  

Qualification Through Owner Status.  Currently, an entity can qualify as an accredited investor if all of its owners are accredited investors. In some cases the entity seeking to be an accredited investor is owned by another entity. The SEC has added language clarifying that for purposes of this test all of the entities in the chain may be looked through to the ultimate owners to determine accredited investor status.

Spousal equivalent. Under the adopted rule, a natural person, together with a spouse, may qualify as an accredited investor by either having at least $300,000 in joint income in the two most recent years or at least $1 million in joint net worth. The amendments broaden both the income and net worth criteria to include “spousal equivalents.” The SEC views a Spousal Equivalent as a cohabitant occupying a relationship generally equivalent to that of a spouse.

Practical considerations

The amendments will become effective 60 days following formal publication in the Federal Register, which means the rules will likely start to apply to new offerings in December 2020 or January 2021.

Crowdfunding of securities offerings is continuing its inevitable emergence, albeit with the active pushback of the SEC and its staff.  As many of you who have been following the crowdfunding movement know, Section 201(c) of the JOBS Act added a new Section 4(b) to the Securities Act of 1933.  On an initial read, that new section seemed to provide crowdfunding platforms an exemption from registration as a broker-dealer solely by reason of actions to facilitate Rule 506 offerings so long as they complied with specified conditions.  Section 201 also directs the SEC to adopt rules lifting the ban on general solicitation in Rule 506 offerings to only accredited investors (provided that the issuers take reasonable steps to verify accredited investor status).  While the lift of the ban on general solicitation in certain Rule 506 offerings depends upon SEC rulemaking (the SEC proposed rules in August of 2012, and there has been no action since), the Section 4(b) exemption from broker-dealer registration supposedly was effective immediately as a statutory change.  The seeming purpose of these provisions was to permit crowdfunding portals or other platforms or mechanisms to conduct operations without becoming subject to broker-dealer registration.   The SEC, however, continues its pushback against the crowdfunding revolution. 

Further evidence for this comes as the SEC staff has now published a series of FAQs relating to this new limited exemption from broker-dealer registration for crowdfunding platforms.  The FAQs were published on February 5, 2013 by the Staff of the SEC’s Division of Trading and Markets and are available here.

These FAQs formalize the guidance that has been provided by the SEC in various no-action letters relating to the types of activities that may be conducted by finders and others without broker-dealer registration.  The FAQs clarify that the Section 4(b) does not require further rulemaking, but do make a point of noting that a crowdfunding platform cannot permit an issuer to conduct a general solicitation on its platform until the SEC issues its final rules on the general solicitation exemption.  The FAQs also note that the exemption from broker-dealer registration in this section is applicable only when securities are offered and sold pursuant to Rule 506 – which effectively means only sales to accredited investors.  Additionally, they set forth the staff's opinion that the exemption is only available if the crowdfunding platform provides only certain specified activities - basically,  operating a “platform or mechanism” to facilitate the sale of securities, co-investing with an issuer, or providing “ancillary services” such as due diligence services without investment advice.   Finally, a crowdfunding site seeking to rely on the exemption may not be subject to statutory bad-boy disqualifications, may not take possession of customer funds or securities, and, importantly, may not receive compensation – transaction based or otherwise – in connection with the purchase or sale of securities on the site.

As to this latter point, the FAQs specifically note that “Congress conditioned the exemption on a person and its associated persons not receiving any ‘compensation’ in connection with the purchase or sale of such security.”  Because the JOBS act bill did not limit the condition to transaction-based compensation, the FAQs state:

the staff interprets the term ‘compensation’ broadly, to include any direct or indirect economic benefit to the [platform] or any of its associated persons. At the same time, we recognize that Congress expressly permitted co-investment in the securities offered on the platform or mechanism. We do not believe that profits associated with these investments would be impermissible compensation for purposes of Securities Act Section 4(b).

To this end, the FAQs note that a venture fund may operate a crowdfunding platform, and in fact go further to note that “[a]s a practical matter, we believe that the prohibition on compensation makes it unlikely that a person outside the venture capital area would be able to rely on the exemption from broker-dealer registration.”

The FAQs also make clear that the staff is viewing the ban on compensation condition broadly.  After positing the situation of a fund group that has an internal marketing department or investor relations department of an affiliated adviser whose staff is paid a salary to promote, offer, and sell shares of the privately offered funds and asking “Can these persons rely on the exemption from broker-dealer registration in Section 4(b) if the funds are offered and sold pursuant to Rule 506?” the FAQs answer in the negative, stating “[a]ny salary paid to a person for engaging in these activities is compensation to that person in connection with the purchase or sale of securities. As a result, that person would not be able to rely on the exemption from registration as a broker-dealer provided in Section 4(b).”

In short, while crowdfunding in coming, the SEC and its staff continue to try to do their best to make it as difficult as possible for aspiring crowd funding platforms.

Capital gains dispositions on "qualified small business stock" (“QSBS”) are once again temporarily 100% exempt from federal taxation under Section 1202 of the Internal Revenue Code. Historically, under Section 1202 a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of QSBS shares held for more than five years could exclude 50% of such gain from gross income for regular income tax purposes.  Generally, however, such gain was included in alternative minimum tax (“AMT”) calculations, which could claw back much of the exclusion in the right (or wrong) circumstances.  As part of recent legislative and executive branch efforts to stimulate the economy, the Section 1202 exclusion was raised from 50% to 75% for QSBS shares acquired during most of 2009 and 2010. Then in September 2010, the Small Business Jobs Act of 2010 was enacted, further amending Section 1202 to exclude 100% of qualifying gain from gross income.  It also excluded all of the qualifying gain from AMT calculations.

This increased exemption expired on December 31, 2011, with the result that the exemption was returned to the historic 50% amount for QSBS acquisitions completed thereafter.  Several abortive attempts were made in late 2011 and early 2012 to reinstate the 100% exemption, though none were successful.  Under the 2012 American Taxpayer Relief Act (the "ATRA"), however, which was adopted in early January, 2013 in connection with efforts to avoid the "fiscal cliff," the 100% exclusion was retroactively reinstated for acquisitions of QSBS shares effected in 2012 and extended for acquisitions completed by the end of 2013.  Also reinstated is the 100% exclusion of the gain for purposes of AMT calculations, which means that in most instances gains on sales of QSBS shares held for 5 years will be completely tax free, subject to certain dollar thresholds discussed below.

Under Section 1202, "QSBS" shares are shares issued in exchange for cash, assets or services directly to the acquirer by a C corporation that meets certain requirements – which will encompass most startups. These requirements include (i) that the qualifying corporation's total gross assets must not exceed $50 million, (ii) the corporation must be engaged in the active conduct of a trade or business (excluding certain businesses, such as most service business, as well as banking, investing, farming and  mining entities, and companies operating restaurants or hotels), and (iii) the corporation must not have engaged in certain prohibited redemptions in the prior 2 years, among other restrictions.

To qualify for the capital gains exclusion, the QSBS shares must be held for at least five years before disposition.  The amount of the exclusion for an investment in a particular corporation is limited to the greater of $10 million or 10 times the acquiror’s adjusted basis of the QSBS.  Thus, the first $10 million in gain on dispositions of a founder’s shares acquired for $100 would be tax free, as would the first $50 million in gain on shares acquired by a (super) angel or VC firm for $5 million. In certain circumstances, such as tax-free mergers and Section 351 transactions (which involve contributions of shares and assets into another corporation), gain on qualifying 1202 securities may be rolled over into new QSBS shares and deferred until a future disposition.

While most of the Section 1202 provisions have remained unchanged from prior law, one significant change in ATRA is a modification of the method for determining when stock is "acquired" for purposes of Section 1202.  Under the new rules, if the holding period of newly issued stock is tacked onto a taxpayer's holding period for other securities that were exchanged for the stock, then the "acquisition date" of the stock will be the beginning of the earlier holding period. Therefore, if previously acquired QSBS shares are exchanged for shares of a new QSBS qualifying entity, or a qualifying LLC interest is converted into QSBS shares, the holding period of the prior QSBS shares or LLC interest counts towards the five year minimum holding period, so long as the original interests were acquired after September 28, 2010.  

I expect that the reinstatement of the 100% exclusion of Section 1202 will increase interest in investments in qualified small businesses in 2013.  Founders, angels and other startup investors should seek, where possible, to structure their investments to take advantage of this exclusion.  Additionally, owners of existing small businesses seeking additional investments should consider reorganizing in ways that will allow their investors to take advantage of the exclusion, which could make their company more attractive to potential investors.  After all, who doesn’t like completely tax-free gains?  All parties, however, should be mindful that the opportunities presented by Section 1202 require thoughtful planning. So as always, consult with your friendly neighborhood startup lawyer.

So, you’ve just received a grant of restricted stock from your employer or consulting client. Or, more likely if you’re a founder, your new investors are requiring, as a condition of completing their investment, that your founders’ shares be subject to typical vesting restrictions over a four year period – hopefully from the date you acquired them, but maybe from the date they complete their investment. Should you make an 83(b) election or not?

Making an 83(b) election can have a significant effect on the timing and amount of taxes you have to pay on the lapse of vesting restrictions. The Internal Revenue Code generally requires consultants or employees that receive shares of restricted stock to report income as the stock vests, even if they’ve paid full price for the shares at the time of receipt. The same holds true for founders who add vesting restrictions on already owned shares. Accordingly, any increase in stock value beyond the original purchase price is not only recognized at vesting, but also is taxed at ordinary income rates. Section 83(b) of the Code, however, allows founders (or employees, consultants or anyone else who receives shares subject to vesting requirements) to elect to be taxed on the excess of the value of stock over the purchase price at the time of grant or purchase (or, in the case of founders adding retroactive vesting restrictions, at the time of such imposition) rather than at the time of vesting. In addition, by making the election the holder starts the ticking of the one-year capital gain holding period, often resulting in capital gain treatment rather than ordinary income treatment upon sale of the shares. One big condition, however is you have to act quickly - the election must be made within 30 days after you purchase or receive the stock (or impose the vesting restrictions).

To use a concrete example, assume you’re a founder who paid $0.0001 per share when the founders’ shares were issued. You receive your investment, the company starts getting some traction and, at the time of the one year cliff, your founders’ shares are worth $0.20 per share. If you haven’t timely made an 83(b) election, you would recognize income of (and be required to pay ordinary taxes on) $0.1999 per share, even though you’ve not received any cash for your shares and likely are precluded from the provisions of the investment agreements from selling them to realize any cash. And, as the remaining stock vests each month, you recognize income equal to the difference between the fair market value as of the date of each monthly vesting and $0.0001/share. If, however, you’ve made an 83(b) election, then you don’t recognize any income as the stock vests, as the 83(b) election accelerates the timing of recognition of income to the purchase date (or date of imposition of the vesting restrictions, if later).

So, if you’re an employee or consultant who paid full price for your restricted shares, or a founder who purchased founders’ shares at fair market value which has not changed significantly before the imposition of the vesting restrictions, the answer is a no-brainer – make the 83(b) election. Because the purchase price of the shares and their fair market value are the same, there is no income recognized as a result of making the election, and no taxes due on subsequent vesting of the shares. What if, however, you’ve received your restricted shares free as full or partial compensation for your services? Or, you acquired your founders’ shares a year or two ago, bootstrapped the company to the point of funding, increased the value of the company, and thus would recognize an increase in the fair market value of your founders’ shares when the vesting is imposed. Do you still make the election? The answer in those circumstances is less clear.

If the stock goes up significantly (think Facebook or Linked-In), then you’ve saved yourself a bundle of tax on phantom income if you’ve made the 83(b) election. If the stock doesn't rise in value after you make the election, however, you've accelerated your tax without receiving any benefit. Even worse is if you forfeit the stock after making the election. In that circumstance, you get no relief from the taxes you paid when you made the election. So, not only are you out your shares, but you’ve paid income taxes on the value of the shares you’ve forfeited.

Thus, to answer the prior question, an 83(b) election should likely be made if the amount of income you have to report is small, you believe your stock’s growth prospects are good and you think the risk of forfeiture is low. If, however, you think there is a high risk of forfeiture or a large tax payment is due at the time of the election or your company’s growth prospects are low or uncertain, you should consider carefully whether the benefits of the election outweigh the pain of the tax payment due as a result of making the election.

One way founders who think their company is a strong candidate for venture capital investment may avoid this conundrum is to implement their own vesting at the time they acquire their founders’ shares. Not only, as noted above, does this make the 83(b) election a no-brainer, but it also likely avoids the later imposition by the VC’s of vesting starting at the time of the investment, as they’ll probably accept your earlier start date. And, adopting a vesting requirement for all founders has an added benefit, if the company has co-founders, of avoiding the problem created where one of them walks away after a year or two because of a disagreement over strategy or for a better offer but keeps his or her full equity piece. You may not be planning on leaving your company, and thus think vesting unnecessary, but would you want your co-founder to leave you high and dry after a year and be able to walk away with all of his or her shares?

If you do decide to make an 83(b) election, in order for it to be effective you must file the election with the IRS either prior to the date of the stock purchase or receipt or within 30 days thereafter. You also need to provide a copy of the election to the company and file another copy with your federal income tax return for the tax year in respect of which the election is made.

The 30 day deadline (and there are no exceptions to this deadline) is determined by counting every day (Saturdays, Sundays and holidays included) from the day after the date of purchase or receipt of the stock until the date the election is filed with the IRS, with the postmark date of the mailing deemed to be the filing date. The election should be filed by mailing a signed election by certified mail, return receipt requested, to the IRS Service Center where you file your individual tax return. It’s also a good idea to have the receipt hand stamped by the post office from which you’ve mailed the election so you have evidence of the mailing date.

There’s no specified form required to make the election, just required information, which includes:

• A statement that you’re making an 83(b) election;
• Your name, address and social security number;
• A description of the property (for example, 200,000 shares of common stock of My Corp, Inc.);
• The date you acquired or received the shares and the taxable year for which you're making the election;
• The nature of the restriction(s) on your shares (for example, "forfeit 100% of the shares if employment terminates before December 31, 2013; forfeit 75% less an additional 2.0833% per month if employment terminates before the end of each subsequent month").
• The fair market value of the shares at the time you received or acquired them. Note that for this purpose you can't use the possibility of a forfeiture to reduce the value.
• The amount, if any, you paid for the shares.

For ease of preparing the required information, a sample form for making the election is here. As always, consult with your tax advisor to determine how a Section 83(b) election applies to your individual circumstances and consult that same advisor or your lawyer to confirm you’ve filled the information in properly.

One of the first questions any lawyer who works with startups receives at the initial meeting with a new client is “What type of entity should I (we) form?” Historically the answer came from one of three options – C corporation, limited liability company or, more rarely, S corporation.  A more detailed posting on the primary (and secondary and tertiary, etc.) differences between the three entity types than I’d ever the attention span to post can be found here.

My advice generally has been a Delaware C corporation if your company is going to be looking for funding from outside investors and a Delaware LLC if your company is going to be bootstrapped or funded solely by friends and family.  Recently, however, a fourth option has been added to the mix, particularly for those companies whose likely investors will come from the socially responsible investing (SRI) world – a benefit corporation.

For those who haven’t heard of them yet, benefit corporations (not to be confused with B Corps – more on that later) are a relatively new type of corporation now permitted to be formed in four states – Maryland, Virginia, Vermont and New Jersey – with a fifth, New York, likely on the way before the end of summer and other states likely to follow.** Benefit corporations are like C corporations in many respects. The two principal differences are significant, however.

First, the existing and contemplated benefit corporation laws provide that benefit corporations are accountable not only for shareholder returns, but also for having a positive impact on society and the environment. For instance, under the Maryland statute, the first one adopted, benefit corporations are required to provide public benefits such as “preserving the environment” and “improving human health.” It further requires that benefit corporations’ social and environmental performance be assessed by an independent third party that meets certain required standards

Second, the benefit corporation statutes generally permit boards and managers to consider factors other than shareholder returns when making corporate decisions, and instead allow them to consider the impact of such decisions on a variety of stakeholders – including not only shareholders, but also employees, communities, consumers and the environment. The hope is that by insulating managers from liability for considering factors other than solely shareholder returns, those managers will be able to focus on creating long-term value – not only for shareholders, but for other stakeholders as well.

A further step down the road for startups who plan on operating in the “triple bottom line” space (people-planet-profits) or who intend to seek funding from SRI investors is to seek certification as a Certified B Corporation™ (or a B Corp, as they are colloquially known, and not to be confused with benefit corps, also often called B corps in blogs and media reports). B Corp certification comes from B Labs (one of the driving forces behind the adoption of the benefit corporation statutes nationwide). B Corp certification requires, among other things, a self assessment, an assessment review by a B Labs team, delivery of supporting documentation and random reviews of continued compliance. Complete details can be found at the B Corp website. B Corp certification is not necessarily as easy or inexpensive as the B Labs website would lead you to believe (one article dealing in some detail with the process can be found here), but B Corp certification is looked on favorably in the SRI world and would satisfy the independent third party assessment requirement of the benefit corporation statutes. As benefit corporations become more prevalent you can expect other certifying entities to follow.

Benefit corporations are not for everyone. In particular, if you’re in a triple bottom line or other green business but expect to seek investment from traditional angels or venture funds, I’d advise you tread carefully, as benefit corporations are still too new (Maryland’s statute, the first, was only adopted in April of last year) to know how those investors are going to react to them. But, if your likely source of funds will come from the SRI world, then you should consider forming as a benefit corporation and possibly seeking B Corp certification.

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**Update - as of January 2013, 10 states have passed some form of benefit corporation legislation - California, Hawaii, Illinois, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, South Carolina, Vermont - and DC has introduce a bill authorizing benefit corporations.