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Section 1202: Original Issuance

Section 1202 Original Issuance

Question

I am a small business owner and investor who read your informative blog post “Section 1202, Qualified Small Business Stock.”  However, I would like to ask for your clarification of an important requirement for the small business stock capital gain exclusion.

Concerning the “original issuance” requirement, you stated that “QSB stock means any stock acquired on original issuance by the taxpayer from a domestic C corporation…”

My understanding of the meaning of “original issuance,” is that it is stock issued by a corporation at the time of its incorporation, and does not include new stock subsequently authorized and issued by the corporation at a later time.  Practically speaking, this would mean that QSB “original issue” stock could be purchased from a new startup, but not from a corporation that had been in existence for a year, whose directors opted to raise capital by authorizing and offering a new issue.

Alternatively, does “original issue” simply mean stock an investor purchased directly from the issuing C corporation (or through its underwriter), as opposed to acquiring the stock from another investor, or from a broker?  Must an investor desiring the benefit of the gain exclusion provided under Section 1202 purchase only from a startup at its time of incorporation?

Short Answer

The short answer:  Section 1202 can cover shares issued at any time and from time to time after the incorporation of the Company, provided the various requirements of Section 1202 are met at the time the shares are issued and throughout the time the shares are held.

Not-So-Short Answer

Internal Revenue Code section 1202 defines “qualified small business stock” as any stock in a C corporation which is “originally issued” after the date of the enactment of the Revenue Reconciliation Act of 1993, if:

(a) as of the date of the issuance, the corporation is a “qualified small business,” and

(b) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its “original issue” (directly or through an underwriter) –

(i) in exchange for money or other property (not including stock), or

(ii)as compensation for services provided to such corporation (other than services performed as underwriter of such stock).

The statute does not define “originally issued” or “original issue.”  But a plain English reading of the phrase would mean to me, as a lawyer, that the shares are supposed to come directly from the company – not purchased from another shareholder.  In other words, shares purchased on the secondary market wouldn’t qualify.

Nowhere does the statute say that the stock has to be issued at the time of incorporation.  If Congress had wanted to say that Section 1202 only worked for shares issued as part of the incorporation process, it could have easily done so.

Plus, there is language in the statute which would be completely incongruous with the meaning of “original issue” being  only at the time of incorporation.  For example, the reference to an “underwriter.”  Underwriters aren’t typically present at incorporation.  Similarly, Section 1202 (c)(3) says that stock acquired by the taxpayer will not be treated as qualified small business stock if at any time during the 4-year period beginning on the date 2 years before the issuance of the stock, the corporation issuing the stock purchased any of its stock from the taxpayer or a person related to the taxpayer.  If the statute only covered shares issued at incorporation, the inclusion of the 2year look back language wouldn’t make sense.

There are a number of things that have to happen in order for stock to be “qualified small business stock,” but none of them is that the stock has to be issued on the incorporation or in connection with the incorporation of the company.

In other words, stock issued several years after the incorporation of the company can qualify, if the various requirements are satisfied.

To give you a sense of some of the things that are required:

  1. The aggregate gross assets of the corporation before and after the issuance of the shares cannot exceed $50,000,000;
  2. The corporation must be a domestic C corporation;
  3. The corporation must be engaged in an active trade or business; and
  4. The corporation’s business must be a “qualified trade or business.”

So, to answer your question, there is no requirement in Section 1202 or the regulations under Section 1202 limiting the benefits solely to stock issuance at the time of incorporation.

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Raising Money – The Law Side

Raising MoneyListen to the podcast:

A friend peppered me with questions about startup fundraising and recorded it. I thought you might find it informative and enjoy listening in. The transcript is below. Feel free to keep the dialogue going in the comments section.

What Do You Do?

My name is Joe Wallin and I’m a startup lawyer in Seattle, Washington.  I work at the law firm of Davis Wright Tremaine and I work with a lot of startup and emerging companies.

How Do Startups Raise Money by Selling Securities?

The best and easiest way for a startup to raise money is:

  • to rely upon federal securities Rule 506;
  • not generally solicit or generally advertise your offering;
  • work from contact to contact, with people you know; and
  • only take money from accredited investors.

What Is An Accredited Investor?

An accredited investor is an investor with over a $1 million net worth, excluding their primary residence or more than $200,000 in income each year over the last two years with the expectation of the same in the current year, or, with their spouse, $300,000 of income each year over the last two years with the expectation of the same in the current year.

What Do The Securities Laws Require?

First off, what you should know is, before you can sell any security, you have to either register the security with the SEC and with state securities departments in states in which you wish the sell the securities, or you have to find an exemption from registration.  Registration is a very expensive process, so finding an exemption is a critical step in a fundraising.

Most startup and early-stage companies rely on the federal exemption known as Rule 506.  That is an exemption that allows you to raise an unlimited amount of money as long as you raise it from accredited investors.  The requirements for using Rule 506 are not that burdensome.  So, for example, you have to ensure that your investors are accredited.  You have to file forms with the SEC and in each state in which you have investors.  But there are no specific information requirements.  You do not have to have multiple years of audited financials or any sort of detailed or lengthy prospectus, as long as you’re taking money solely from accredited investors.

What About Raising Money from Non-Accredited Investors?

Raising money from non-accredited investors involves a lot more complexity and expense.  This is why most startup companies will limit their rounds to solely accredited investors.

Can you Generally Solicit Your Securities Offering?

Rule 506 was recently amended, so now, under Rule 506, you have what could be referred to as a non-generally solicited Rule 506 offering, and then you also have what could be referred to as a generally solicited Rule 506 offering.

I think right now, and probably for the foreseeable future, most companies are going to stick to the non-generally solicited Rule 506 offering.

So, if you’re going to go with what we’re referring to as the non-generally solicited offering, you cannot advertise your offering.  You can’t publicize it; you can’t post it on the Internet.  You can’t use Twitter or Facebook to promote the offering.  You’ve got to work from one contact who you know to another contact who you know, with whom you have a preexisting, substantive relationship.

I think, for the most part, companies are going to continue to use the old Rule 506, which is the non-generally solicited Rule 506 and not generally solicit their offerings.  And the reason for this is because if you generally solicit your offering, you have to ask your investors for proof that they’re accredited investors, proof of their income, proof of their net worth, and there is a potential reluctance on the part of investors to share that information with companies in which they are considering making an investment.

What If You Generally Solicit and an Investor Won’t Give You the Information?

So, there are third-party services.  Suppose you’re a company raising money in a Rule 506 offering and you’ve chosen to solicit your offering, advertise your offering, and so now you have to ask your investors for their financial statements or proof of their income or net worth, and suppose your investors say they don’t want to give that information to you, the company.  What are your alternatives?

There are third-party service providers like Second Market or 506Accredited.com or Second Market or Seed Invest that will work with the investor to verify the investor’s net worth or income, and then send you, the company, a letter saying that they have done that.

Has The Jobs Act Made Life Better for Startups?

There was a lot of hope surrounding the Jobs Act, and there was a lot of optimism that it was going to make things easier for companies.  Unfortunately, the SEC rules implementing the Jobs Act hamper the promise of the Jobs Act.  A lot of companies, I think, are going to generally steer away from generally soliciting their offerings just because of the additional work involved and the potential investor reluctance to share their personal financial information.

Isn’t There Such a Thing As a Friends & Family Offering?

There’s no such thing as Friends & Family Securities Law exemption.  The easiest securities law exemption is going to be the all-accredited investor exemption under federal securities Rule 506, and so you generally don’t want to take any money from any friends or family unless they are accredited investors.

What Do You Recommend Startups Do When Raising Money?

If you’re trying to keep your legal costs down, you’re trying to keep your life as administratively simple and easy as possible, the answer is:

  • don’t generally solicit;
  • take money from only accredited investors; and
  • use what’s known as federal securities Rule 506(b), the non-generally solicited Rule 506 offering.

State Securities Law Compliance

Remember, if you are raising money, you need both a federal and a state securities law exemption.  If your federal securities law exemption is Rule 506, you will need to make state securities law filings.

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Securities Law 101

Securities Law 101If you are the founder of a startup, unless you plan to self-fund and never grant stock options or other types of compensatory equity awards, you will need to familiarize yourself with both federal and state securities laws.

The reason?  Because if you don’t comply with the securities laws you may significantly harm the value of your company (not to mention exposing you and your company to potential civil and criminal liability).

If you can’t find an exemption, or you don’t have the time or money to file all the applicable forms and pay the required fees, do not issue the securities.

I know, I know, you’d prefer to spend your time on matters more directly related to the immediate success of your business, like typing out your next line of code.  But here is the key for you to remember:  Any time your company issues stock or any time your company grants stock options or compensatory equity awards of any kind (stock bonuses, for example), your company either must comply with the registration requirements of federal and applicable state securities laws (which, for the most part, are overly complex, burdensome and expensive to comply with at the startup stage of a company’s existence) or will have to identify an applicable exemption from the registration requirements.

The table below lists securities exemptions private companies commonly use.  The table does not contain a complete list, but it might be helpful to you in understanding the most likely choices applicable to the typical emerging business.  You should always consult with a legal counsel before issuing securities.

Section 4(a)(2)The Securities Act of 1933, as amended, provides an exemption for “transactions by an issuer not involving any public offering.”  This is the exemption relied upon when founders come together to form a company in which they are each going to be actively involved.  See SEC Release No. 33-4552. (http://www.sec.gov/rules/final/33-4552.htm).  If you issue securities based on Section 4(a)(2), you will also have to find a state law securities exemption.  This can require the filing of forms with various states, and the payment of fees.  See, e.g., California Form 25102(f).
Rule 506 of Regulation D

Rule 506 allows companies to raise an unlimited amount of money from “accredited investors.”  Effective September 23, 2013, there are now two types of offerings under Rule 506.  A non-generally solicited type of offering – referred to as a 506(b) offering, and a generally solicited offering – referred to as a Rule 506 (c) offering.  (“Accredited investors” generally are investors with either (i) a $1M net worth excluding primary residence (but taking into account debt on such residence in excess of the fair market value), or (ii) $200,000 of income for the last two years with the expectation of the same in the current year, or $300,000 with spouse.)  Generally solicited 506(c) offerings involve complications not present in non-generally solicited Rule 506(b) offerings.

One great thing about Rule 506 is that a security sold under Rule 506 is considered a federal “covered security,” meaning that state securities regulators cannot condition or merit review the issuance of the security. They can require the payment of a fee incident to the filing of the Form D, but they cannot otherwise impose limitations or conditions on the issuance. See http://www.sec.gov/news/studies/uniformy.htm

Rule 701Rule 701 is a federal securities law exemption for compensatory equity issuances.  For example, if you want to grant an employee or an independent contractor a stock option, you would typically rely on Rule 701 as your exemption.  Rule 701 has a number of qualifications, conditions and limitations.  See this blog post, What is Rule 701 and Do I Need to Worry About It?
Washington Equity Compensation ExemptionRCW 21.20.310(10) provides a Washington securities law exemption for, among other things, compensatory equity awards (i) issued pursuant to a plan that provides for the issuance of ISOs and NQOs and (ii) similar plans if the director of the DFI is notified in writing with a copy of the plan 30 days before offering the plan to employees.
California Equity Compensation ExemptionSee California Corporation Code 25102(o). See also this blog post: California Compensatory Equity Issuances.
Equity Crowdfunding Under Title III of the JOBS Act (Section 4(a)(6) offerings)Equity crowdfunding under the JOBS Act is not yet available.  The SEC has issued the proposed rules, but those rules won’t be final for some time.

I am sometimes told by a company that they issued securities under the “friends and family” offering. There is no such thing as a “friends and family” exemption.

If you are looking for a more comprehensive exemption table, albeit one with many exemptions inapplicable to startups, see the Exemption Table.

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