Complying with every applicable tax law can be a daunting obligation even for a taxpayer well versed in tax rules. For start-ups, the task can be more than daunting when the taxing authorities do not tell you about your reporting obligations. This can frequently happen with city business taxes on gross receipts or the peculiar Seattle square footage tax.

Another such tax is the property tax on personal property. Non-businesses do not have property taxes on their personal belongings, because the state exempts them. Non-businesses typically pay “in lieu of” taxes instead of property taxes. For example, the motor vehicle and watercraft excise taxes are paid in lieu of the property tax.

For start-up businesses however, it is easy to overlook the personal property tax. With the real property tax, the county knows who owns real property. Each year, it will send you a notice of the value and a bill for the taxes due. Unlike the real property tax, the county does not know who owns tangible personal property in the county until you tell it. So, until you have begun reporting the personal property tax, the county will not send you a personal property tax affidavit to remind you to report and pay it.

Because so many businesses are unaware of this obligation, King County has enacted an amnesty to give the taxpayers who are unaware of the obligation an opportunity to come forward. If you report previously unreported tangible personal property before July 1, 2012, King County will waive the penalty (which can be as high as 25% of the tax due) for failing to report them in a timely fashion.

Essential Links:

King County Assessor’s Office Press Release
Penalty Waiver Request Form
Personal Property Amnesty Q & A

For more information about startup tax issues:

• ASSAULT ON THE B&O HIGH TECHNOLOGY TAX CREDIT
• NEW, HIGHER TAX PROPOSALS FLOATING AROUND OLYMPIA
• TIME FOR A TAX INCREASE?

By John Reed and Ame Wellman Lewis

With increasing frequency, companies are seeking to build social values into corporate identities. Starting June 7, 2012, Washington State will recognize “social purpose corporations,” a new form of for-profit corporation. While the primary objective of a traditional business corporation is to create economic value for its shareholders, the social purpose corporation now gives companies the latitude to also promote one or more broader goals of social responsibility, such as environmental sustainability or committing to improve other aspects of the local, national, or world communities.

Background

On March 30, 2012, Governor Christine Gregoire signed HB 2239 into law, establishing the framework for the social purpose corporation as a new corporate entity. DWT partner John Reed chairs the Corporate Act Revision Committee, the 13-member Washington State Bar Association committee that developed the proposed legislation. The committee, which also included DWT partner Jonathan Michaels, worked for nearly two years to shape the proposed bill that was presented to the Washington Legislature. The committee studied similar legislation that had been adopted in a handful of other states that authorizes formation of an entity referred to as a “benefit corporation.”

The benefit corporation statutes generally require that:

• a benefit corporation include in its articles of incorporation and pursue as part of its mission all of the “benefits” specified in the statute;
• its board of directors and officers consider the impact of every corporate decision they make on the prescribed societal and environmental benefits; and
• the benefit corporation adopt third-party standards against which the board is required to measure its achievement of the prescribed societal and environmental benefits.

After considerable deliberation, the Corporate Act Revision Committee crafted legislation in Washington creating a slightly different version of this type of corporation which will be known as a “social purpose corporation.” The social purpose corporation statute is intended to provide more flexibility to the socially responsible entrepreneur than that which is afforded by the comparable benefit corporation statutes. It does not attempt to legislate corporate behavior. Rather, it will enable each social purpose corporation to determine what corporate behavior is applicable to it by so stating in its articles of incorporation. In turn, the social purpose corporation’s board and officers will be permitted to attach such weight to the corporation’s social purposes in making corporate decisions as they determine is appropriate and cannot be found liable simply because they made a corporate decision that subordinated shareholder economic value in favor of pursuit of one of the corporation’s social purposes.

Features of the Social Purpose Corporation

The social purpose corporation will be provided for in a new chapter of the Washington Business Corporation Act, Chapter 23B of the Revised Code of Washington. Starting June 7, entrepreneurs will be able to form new entities as social purpose corporations and shareholders of existing business corporations will be able to convert them to social purpose corporations upon the approval of two-thirds of the outstanding voting shares of the shareholders. The principal features of the social purpose corporation are described below.

Articles of Incorporation

The chapter sets forth a number of new provisions for the governing documents of a social purpose corporation. A handful of the new provisions are mandatory, but the majority will be left to the discretion of the shareholders or prospective shareholders of the corporation and their individual preferences and goals.

The mandatory elements of the articles of incorporation generally promote transparency of the corporation’s social purpose or purposes. The requirements include:

• A statement in the articles of incorporation that the entity is organized as a social purpose corporation.
• Having a corporate name that contains the words “social purpose corporation” or “SPC.”
• Being organized to promote the positive short-term or long-term effects of, or to minimize the adverse short-term or long-term effects of, the corporation’s activities upon any or all of the following general social purposes:
  • the corporation’s employees, suppliers or customers;
  • the local, state, national or world community; or
  • the environment and setting forth the selected general social purposes in the articles of incorporation.
• A statement in the articles of incorporation providing that:

“[t]he mission of this social purpose corporation is not necessarily compatible with and may be contrary to maximizing profits and earnings for shareholders, or maximizing shareholder value in any sale, merger, acquisition, or other similar actions of the corporation.”

The new chapter also sets forth numerous optional provisions that the shareholders of a social purpose corporation may include in their articles of incorporation. For example, the shareholders or prospective shareholders may require that:

• Directors and officers consider the impact that each corporate decision will have on the social purposes of the corporation.
• Directors provide a periodic assessment to the shareholders of the corporation’s performance against a selected third party standard.

By adding the foregoing optional provisions to its articles of incorporation, a social purpose corporation will look like the more prescriptive “benefit corporation” described above, and should qualify for certification by third party standards organizations like B Lab, a nonprofit corporation that has actively promoted socially and environmentally conscious corporate responsibility nationally.

Directors’ and Officers’ Standard of Conduct

In the traditional corporation, directors are vulnerable to potential liability for breach of the statutory standard of conduct caused by taking actions intended to further a social purpose at the expense of maximizing the economic value of the shareholders’ investment in the enterprise. The statutory standard of conduct set forth in the new chapter addresses this concern by providing that, in discharging the director’s duties, the director may consider and give weight to the corporation’s stated social purpose or purposes as the director deems relevant. In addition, the director will be deemed to have satisfied the statutory standard of conduct if the director reasonably believes that an action the director took or the director’s failure to take an action was intended to promote one or more of the social purposes of the corporation.

• Stock Certificates

  Stock certificates must include a legend containing language specified in the chapter that identifies the company as a social purpose corporation.
• Alteration or elimination of the social purposes
  The social purpose or purposes selected by the shareholders will be anchored to the corporation’s charter and will remain part of the corporation’s “DNA” unless shareholders holding two-thirds of the outstanding voting shares of the social purpose corporation vote to alter or eliminate any of the designated social purposes, whether through amendment of the articles of incorporation, sale, merger or otherwise.
• Reporting requirements
  In order to make a social purpose corporation’s efforts to promote its stated social purpose transparent to its shareholders, the corporation is required to post to its website annually a social purpose report that describes the corporation’s efforts to promote its social purposes. The report may include a discussion of the specific actions taken during the prior year to achieve the company’s social purpose or purposes, the actions to be taken in the coming year and the standards used to evaluate its performance in furthering such social purposes.

A social purpose corporation may also elect to formalize in its articles of incorporation a requirement that the corporation furnish to shareholders an assessment of the overall performance of the corporation with respect to its social purpose or purpose that is prepared according to a third-party standard.

Uses of the Social Purpose Corporation

Although it is too early to tell what kinds Washington businesses will adopt the social purpose corporation form in which to conduct their business, possibilities include those desiring to:

• Promote environmental stewardship and sustainability.
• Use renewable or low-impact sources of energy whose marginal cost may be higher to the corporation than other options.
• Provide certain “quality of life” benefits to employees that it considers central to the corporate identity.
• Select international suppliers whose practices are consistent with the company’s values for worker conditions.
• Create a taxable affiliate of an existing nonprofit corporation whose social purposes are consistent with the nonprofit’s mission.
• Commit to donating a certain percentage of the corporation’s profits to charity.

The flexibility of the new social purpose corporation statute will accommodate all companies that want to combine pursuing a social mission and pursuing profits, ranging from those corporations that desire a more prescriptive structure, similar to the B Lab-inspired “B Corporation”, to those that desire a different model. Socially responsible or sustainable business entrepreneurs, “green” companies, and certain family businesses may wish to consider forming, or converting to, a social purpose corporation.

DWT regularly advises companies on corporate formation and governance issues. Please contact any member of our business transactions group for more information about social purpose corporations and other services we provide to our business clients.

***

John Reed – Partner – DWT – Focuses on corporate law and mergers and acquisitions. He has extensive experience in business sales and purchases, and acts as general outside counsel for a number of mature, closely held companies in a variety of industries.

Ame Wellman Lewis – Associate – DWT - Practices in the areas of business, corporate law, finance, real property transactions, and environmental law and compliance assistance.

***

Disclaimer – This advisory is a publication of Davis Wright Tremaine LLP. Our purpose in publishing this advisory is to inform our clients and friends of recent legal developments. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

For More Information About Taxes:

• NEW, HIGHER TAX PROPOSALS FLOATING AROUND OLYMPIA
• DOR: RAIDING THE SEAT CUSHIONS
• WASHINGTON STATE B&O TAX ON DIRECTOR FEES

Summary of Remarks of Joe Wallin to Section 201 of the JOBS Act Given at a Presentation to the Angel Capital Association, Northwest Regional Meeting, held in Seattle, Washington, on May 2, 2012.

Last week I spoke on a panel with Dan Rosen,Tom Alberg, William Carleton and Gary Kocher at the Northwest Regional Meeting of the Angel Capital Association.

I put together these materials as a guide to my remarks. After I prepared them, the Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association (ABA) submitted its comments to the Securities and Exchange Commission (SEC) on Section 201 of the JOBS Act. You can find that letter HERE. I have added excerpts from the ABA Committee Letter where helpful to understanding the material.

What Section 201 requires:

The JOBS Act (the “Act’) requires the SEC, not later than 90 days after the enactment of the Act, to revise its rules under Rule 506:

• To provide that the prohibition against general solicitation or general advertising contained in Regulation D (Reg D) does not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers are accredited.
• The new rules must require the issuer to take “reasonable steps to verify” that purchasers are accredited, “using such methods as determined by” the SEC.

The law is quoted below:

Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).

Statutory Interpretation

• To issue the new rules, the SEC will look at the text of the JOBS Act and is likely going to look at the legislative history so that it can turn what it believes to be Congress’ intent into rules and regulations.
• Title II of the JOBS Act allowing general solicitation doesn’t say “provided that the issuer reasonably believes that all purchasers of securities are accredited investors.” It says “provided that all purchasers of securities areaccredited investors.” It is unclear if the SEC will emphasize this difference in language in its rulemaking.
  • Contrast this with the existing rules under Rule 506. Those rules say: “Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories…”
  • The current practice in accredited investor offerings now is to have investors certify that they are accredited, and depending who they are–have them initial or check a box next the definition that they fall within.
  • The ABA Committee letter recommends that the SEC’s proposed rules or accompanying release include a reasonable belief standard.

Public Comments

The SEC is allowing the public to comment on how the SEC should implement the provisions of the JOBS Act before it proposes the new rules.  Comments are accessible to the public.

• Professor William K. Sjostrom, a Professor of Law at the University of Arizona made the following argument, which I believe the SEC should accept:

“I believe it is critical that the Rule allow general solicitation and advertising provided that the issuer REASONABLY BELIEVES that all purchasers are accredited investors. If instead the Rule requires all purchasers to be accredited investors, I suspect that many issuers will forgo engaging in general solicitation and advertising out of concern of destroying the exempt status of their offerings by selling to an investor whom they reasonably believed was accredited but turns out not to be.”  (http://sec.gov/comments/jobs-title-ii/jobstitleii-1.htm)

• Other commentators have also argued that anything more than the current practice of collecting accredited investor certifications would be too burdensome on companies.  A comment from a law firm states:

“[T]he current practice to assure the securities purchasers … are accredited investors is … an investor suitability evaluation on all the subscribed investors. Only basic self-certificated information is provided in this process. We believe the current practice of providing a suitability questionnaire is sufficient to fulfill the issuer’s duty to assure the … investors are accredited. It would be rather onerous for … securities issuers to request tax returns, bank statements, and financial information to  verify the  self certification…” (http://sec.gov/comments/jobs-title-ii/jobstitleii-5.pdf )

• The ABA Committee Letter takes a similar tact:

”In setting forth the reasonable sets to be taken to verify that the purchasers of the securities offered by means of general solicitation or general advertisement in Rule 506 offerings are accredited investors, the proposed rules should reflect current custom and practice.”

What was the intent behind the statute?

The language requiring the SEC to pass rules requiring issuers to take steps to verify that they are selling to accredited invested was added in the mark-up session on H.R. 2490, as amendment no. 1 to that bill.

In the transcript of that committee mark-up session, the following argument was made for adding the verification language:

This amendment would clarify that the SEC shall write rules to require that the issuer of a security, using the exemption provided for under this bill shall take reasonable steps to verify their purchases of the securities are accredited investors using such methods as determined by the commission.

Mr. Chairman, I understand that lifting the ban on general solicitation and general advertising on private offerings may make sense that those offerings are only sold to accredited investors. We know that because of their wealth or their level of sophistication, accredited investors are not in need of as many investor protections as the average retail investor.

And we know that with the current prohibition on solicitation and advertising it can be tough for a company to connect with accredited investors who may be interested in investing in their company.

But I am concerned about the process in which accredited investors verify that they are in fact accredited. As I understand it, it is currently a self-certification process. This obviously leaves room for fraud.

In testimony from the North American Securities Administration Association the state securities commissioner from Arkansas notes it is going to be impossible to limit the sale to only accredited investors when issuers advertise to everyone. Indeed, there will be no reason to believe that any investor seduced by public advertising will hesitate to be dishonest with completing the investor suitability questionnaire.

That is why I have offered this amendment. My amendment would require the SEC when issuing a rule to provide for the exemption under Representative McCarthy’s bill to include a provision mandating that issuers take reasonable steps to verify investor status as an accredited investor.

If we are rolling back protections for our targeted audience of sophisticated individuals, we must take steps to ensure that those folks are in fact sophisticated.

If this argument is going to inform the SEC’s rulemaking on this subject, and if the SEC believes that this is what the legislative history indicates should inform the rulemaking, then it is unlikely we are going to see a continuation or retention of a check-the-box or questionnaire regime for advertised offerings. However, for non-advertised offerings, perhaps the old regime can continue. And in fact, the argument can be made that it should continue because if there is no advertising then the heightened risk which prompted these verification processes be added won’t exist. Of course, it remains to be seen whether the SEC will require verification in just offerings in which there is general solicitation, or all offerings.

The ABA Committee letter makes a good argument–that the purpose of the JOBS Act is to encourage and support capital formation, and “any requirement that imposes additional burdens on issuers or on purchasers would contravene the fundamental impetus for the JOBS Act.”

What are the stakes?

• The standard that issuers will need to meet to engage in an exempt offering is important because presumably under the new JOBS Act scheme, if you advertise your offering and then inadvertently accept a non-accredited investor, then you will not be able to fall back on Section 4(2) to avoid registration because you will have engaged in a public offering. This raises the stakes considerably on the determination of whether an investor is accredited or not.
• The new rules regarding “reasonable steps to verify” have the potential of being very onerous on companies trying to raise capital. This has arguably been the trend in SEC rulemaking. For example, the SEC’s recent rules on the bad actor disqualification are  lengthy and complex and impose onerous due diligence burdens on issuers.
• Lily Brown, Senior Special Counsel to the Director from the SEC’s Division of Corporation Finance, said in a recent web conference that issuers will likely have to do more than have investors check the box or fill out a questionnaire. We won’t know what this means until rules are issued.
  • Presumably this means that issuers are going to have to request documentation from investors demonstrating their incomes or net worth, such as tax returns, net worth statements prepared by third party accountants, bank statements, brokerage account statements, etc.
• We also won’t know whether issuers will be able to rely on the old rules as long as they don’t advertise, or if the new SEC rules will apply whether issuers advertise or not.
• For now, the current rules are still in effect. Meaning, you can’t advertise or Twitter or LinkedIn your offerings yet.

Suggested Comments

Make a comment to the SEC HERE.

If you want to write a comment to the SEC on these rules, I’d suggest the following comments:

• The new rules should make clear that the issuer only has to “reasonably believe” that all purchasers are accredited investors.
• The current practice of having an investor certify in a questionnaire that they are accredited, after having been given the definitions of accredited investor, is sufficient to fulfill the issuer’s duty to assure that investors are accredited.
• If the SEC is going to require documentation from investors to show that they meet the net worth or income tests, tax returns from the last 2 years should be sufficient to prove the income tests are met. Similarly, a net worth statement prepared by a third party accountant should be sufficient to demonstrate the net worth test has been met.
• If the SEC is going to require documentation from investors to show that they are accredited, the SEC should not require this in offerings in which there is not advertising.
• The new rules should make clear that, if an issuer obtains evidence that an investor is accredited, the issuer can rely on that for a reasonable period of time (e.g., a year or two).
• If a company raises money in a convertible debt offering from investors who provided sufficient information that they are accredited at the time that  they invested, the company should not have to obtain updated information from the investor on conversion of the note into stock.
• In general, the SEC should create a safe harbor to the effect that an issuer can rely on the information provided by investors and, if company acts reasonably, the exemption is in place.

For More Information:

• DESPITE THE JOBS ACT, THE OLD RULES STILL APPLY FOR NOW
• MY FAVORITE PART OF THE JOBS ACT
• THE PRESIDENT FAVORS CROWDFUNDING, BUT IS IT GOOD ENOUGH?

As we wrote last week, the most exciting provisions of the JOBS Act, at least for private companies–the repeal of the ban on general solicitation in all accredited offerings and crowdfunding–are not yet effective and won’t be effective until the SEC issues new regulations. On the same day we published that post, the Securities and Exchange Commission (SEC) issued a notice reminding everyone that crowdfunding is still unlawful until the SEC adopts new rules implementing the JOBS Act’s crowdfunding exemption.

The SEC Reminder

The SEC notice is short and to the point stating:

“The [JOBS] Act requires the Commission to adopt rules to implement a new exemption that will allow crowdfunding. Until then, we are reminding issuers that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.”

The SEC hasn’t issued a reminder about using general solicitation in Reg D Rule 506 offerings, but the new rules on that will also not be effective until they are issued in final form by the SEC.

Repeal of Ban on General Solicitation Not Yet Effective Either

If you are currently raising money in a Reg D Rule 506 offering, you also cannot yet use the media to publicize your offering.

Example: You should not announce or post on Facebook or Twitter or LinkedIn that you are trying to raise money, or have raised money and are looking for more to close out your round.

The SEC has 90 days to amend its existing rules to remove the prohibition on general solicitation and advertising in offers made under Rule 506, provided that securities are sold only to accredited investors.

New Rule Complexities

The new law requires that the SEC revise its rules to require companies “to take reasonable steps to verify that the purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

In a recent webcast* on theCorporateCounsel.net, Lily Brown, Senior Special Counsel to the Director from the SEC’s Division of Corporation Finance indicated (although she was careful to say that her views were not the views of the SEC) that under the proposed rules she believed companies were going to have to get more engaged in verifying that their investors were accredited, and that companies were probably not going to be able to rely on a checked-box or a questionnaire filled out by the potential investor.  According to Ms. Brown, the legislative history of the JOBS Act indicates that Congress intended that the process be more involved.  Depending on what the new rules say, this could potentially be a big change from current practice.

Conclusion

The SEC is currently seeking public comment before they propose the new rules.  You can click on this link here to submit a comment to particular parts of the JOBS Act.

*Listen to the full webcast held on April 24, 2012 by following this link (login required).

For more information:

• CROWDFUNDING: CURRENT LEGALITIES & PROPOSALS
• RELAXING THE BAN ON GENERAL SOLICITATION
• “CROWDFUNDING”: AN IDEA WHOSE TIME HAS (LEGALLY) COME?

In the last couple of weeks I’ve received the same two questions from numerous people:

• Can I start using my Twitter, Facebook, or LinkedIn account (etc.) to raise funds for my company?
• Can I start crowdfunding my company?

The answer to both questions is a resounding NO (at least not yet).

The SEC still needs to amend its current rules and issue new rules to put these provisions of the JOBS Act into action.

The JOBS Act removes the prohibition on general solicitation and advertising in offerings made under Rule 506 solely to accredited investors (subject to certain limitations).  Recall that Rule 506 is a safe harbor exemption from registration that most startups use to raise capital.  Under Rule 506, a startup can solicit accredited investors and there is no limit to the amount of capital that can be raised.  But, a big limitation under the current version of Rule 506 is that startups can’t generally solicit or advertise their securities.  Section 201(c) of the JOBS Act requires the SEC to amend the current Rule 506 no later than 90 days after the enactment of the JOBS Act.  While we wait for the SEC to act, the current rules remain in effect during the interim.

The JOBS Act also exempts from registration with the SEC certain crowdfunding activities.  Section 302(c) of the JOBS Act requires the SEC to issue new rules to carry out the crowdfunding exemption within 270 days after the enactment of the JOBS Act.  Before then, there is no crowdfunding exemption available for startups.

This means companies trying to raise funds during the interim periods should proceed as they would have before the JOBS Act passed and comply with the provisions and safe harbors under the current rules promulgated by the SEC.

So startups should not get too excited yet.  It remains to be seen how the SEC will implement the JOBS Act (see some of my concerns in a previous post).  Let’s hope they keep things simple for startups and not undermine the spirit of the JOBS Act.

For More Information:

• MY FAVORITE PART OF THE JOBS ACT
• THE PRESIDENT FAVORS CROWDFUNDING, BUT IS IT GOOD ENOUGH?
• RELAXING THE BAN ON GENERAL SOLICITATION

Guest Post By Neil Beaton

This article is the first of two that explore a fairly new, but expanding, phenomena in the pricing of privately-held securities: secondary market transactions.  In this first article, the development of secondary markets is covered along with a brief overview of how such markets operate. The article then explores the trade-off of the impact of secondary market transactions on fair value or fair market value.  In a subsequent article, an empirical analysis of various secondary market transactions before an initial public offering (“IPO”) is provided compared to the pricing of those securities after these companies completed their IPOs.

A Definition and Background

Secondary markets are defined as markets where non-public debt and equity securities are traded either directly on the exchange or by the use of the exchange as an intermediary.  Such traded securities include private company stock, restricted securities, auction-rate securities, structured products such as residential mortgage-backed securities, collateralized mortgage bonds and collateralized debt obligations, limited partnership interests and bankruptcy claims.  There are over 25,000 secondary market participants managing trillions of dollars of alternative investments, including private company stock.  Many of these participants are registered broker-dealers and include such names as Second Markets, SharesPost, GSTrUE, OPUS-5, 144a-Plus and others.  Although they have an international reach, most transactions performed by these intermediaries are focused in the U.S.

Secondary markets have grown rapidly in volume, the number of funds and the number of exchanges since 2003.  The slowing of initial public offerings and liquidity events for venture-backed companies following the Dot.com bust in 2000 left many investors, including employees holding stock options, without the ability to liquidate their investments.  Although they  existed well before 2003, these secondary exchanges, and the volume on them, began to grow considerably after 2003.  As shown in the following chart, secondary market volume increased steadily from 2003 through 2008 before the great recession negatively impacted investments and related liquidity across all investments.

Although a number of different securities are traded on secondary exchanges, this article focuses on transactions of the common stocks of venture-backed companies on such exchanges.  According to the National Venture Capital Association (“NVCA”), IPOs for venture-backed companies essentially disappeared after the Internet meltdown that began in March 2000.  As shown in the following graph, there have only been about 50 venture-backed IPOs, on average, since the over 250 annual IPOs in 1999 and 2000.

Furthermore, as shown in the following graph, the median age of a venture-backed company at IPO increased from four years in 1999 to 10 years in both 2008 and 2009 before decreasing modestly in 2010.  As a result, the number of venture-backed company exits as a percentage of total deals has remained anemic over the past ten years (see following graph).  On the positive side, sophisticated tracking and financial platforms have been created allowing for greater control over private transactions.  Because of this confluence of events, secondary markets have sprouted and flourished over the past ten years.

However, challenges remain.  IPOs are still considered a superior path to value and liquidity, but the cost to become and remain public has increased and complying with Sarbanes-Oxley has increased potential corporate governance problems, not to mention the plethora of class action lawsuits whenever a public company’s stock has a hiccup.  In contrast, on the private side, equity capital is usually restricted for extended periods, and even when allowed to trade in secondary markets, the mechanics of a sale are often cost prohibitive or a only a limited pool of buyers exists.  In addition, ex-employees often own common shares in the private companies they left, creating bookkeeping hassles and reporting nightmares, not to mention legal exposure, for such companies.  Even existing employees have become disgruntled as they have foregone higher salaries for stock options that, statistically, won’t be liquid for years.  Accordingly, secondary markets have stepped in to fill the void created by these circumstances.

Implications of Secondary Markets on Private Company Valuations

From a valuation standpoint,  many questions are raised by transactions on secondary markets.  Do trades on these secondary markets reflect fair market value (or fair value)?  Do the investors buying these securities represent market participants?  Can secondary market transactions be considered orderly?  To answer these questions, one must look at the structure of the secondary markets.  First, they are largely unregulated.  Second, investors buying securities on the secondary markets must be “accredited investors” and satisfy such investor criteria before they are allowed to trade.  Sellers are often bound by company shareholder agreements and restrictions and other legal requirements.  A many private companies have responded to the possibility of having their shares traded on secondary markets by including “right of first refusal” restrictions in their stock option and restricted stock unit plans.  Furthermore, and probably the most important aspect of these secondary markets, is the relative dearth of financial information on the companies whose securities trade on such markets.  Unlike companies traded on public exchanges, private companies or investors offering securities on secondary markets often only have access to minimal financial data on the companies whose securities they are buying, and many times, the financial data that is available is derived from secondary sources unrelated to the company itself.  Thus, by and large, the securities transactions that occur on these exchanges are often done “blind.”  Granted, there may be, and often is, public financial information on the latest round of financing closed by the company, but again, that information is limited and obviously doesn’t allow for an independent assessment of the securities’ value.

So, do these trades represent fair market value (or fair value) or not?  Of course, the answer is: “It depends.”  The process to list such securities on a secondary exchange provides some insight into a possible answer.  The first step in the process is a company partnering with a secondary intermediary.  Next, the company decides which information is to be released, if any.  Often, very little information is released publicly; however, a company may provide a limited approved list of buyers.  The share offering is then marketed to specified buyers, with approved information provided to these company-approved buyers.  Once the information has been reviewed by the buyer or buyers, an offer, or offers, are made and the trades are settled.  Many of these trades are done by auction allowing for some market influence, but again, the number of sellers and buyers is often unknown.

Without complete disclosure of a company’s financial condition and future prospects, it is doubtful buying decisions, let alone selling decisions, can be a considered fully informed and therefore representative of fair value or fair market value.  Furthermore, the trades on these exchanges are not regulated in the same way trades on public exchanges are regulated.  The companies that do list their securities on these exchanges generally exert a tremendous amount of control over the amount of information that gets disseminated and who can buy or sell such securities.  Such control blunts the “market participant” criteria under Accounting Standards Codification Topic 820 (“ASC 820”) Fair Value Measurements and Disclosures..

ASC 820 was adopted by the Financial Accounting Standards Board (“FASB”) on July 1, 2009.  It is now the sole source for guidance on how entities should measure and disclose fair value in their financial statements. The definition of fair value in ASC 820 is the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  ASC 820 assumes an “exit price” approach which is important in dealing with secondary market transactions.

Fair value continues to be measured using all assumptions utilized by marketplace participants, including risk assumptions considered by those participants.  The measurement of fair value assumes an orderly, hypothetical transaction in the principal market for the asset or liability.  However, if the volume and level of market activity for an asset or liability has significantly decreased, and transactions in a particular market are not orderly, ASC 820 provides additional guidance on factors to consider in estimating fair value.  Again, another important point in assessing the impact of secondary market transactions.

For illiquid securities where a market may not exist, a fair value approach much be developed based upon a hypothetical market which incorporates assumptions potential market participants would use in purchasing the security.  In the secondary markets, an “artificial” market is created wherein shares are exchanged without complete information.  An important concept in the secondary markets for early stage companies is that the unit of account is a single share of common stock.  Even when a share is exchanged on the market, it may not rise to Level 1 status.   ASC 820 outlines a three-level fair value hierarchy.  Level 1 consists of the most “observable” market inputs to arrive at fair value (e.g., liquid investments).  Level 2 would broadly include assets and liabilities valued using observable inputs other than quoted prices used to value Level 1 securities, while Level 3 consists of the most “unobservable” inputs.  ASC 820 emphasizes that valuation techniques used to measure fair value shall maximize the use of observable inputs and minimize the use of unobservable inputs.  Secondary markets may be considered either a Level 1 input or a Level 2 input.

Observable inputs are inputs based on market data obtained from sources independent of the entity and should not be limited to information that is only available to the entity making the fair value determination or to a small group of users.  Observable market inputs should be readily available to participants in that particular market.  Of even more importance in the secondary markets is that observable market inputs should include a level of transparency that is reliable and verifiable.

As a result of the financial crisis in 2008, the FASB issued additional fair value measurement guidance in April of 2009 for estimating fair value when the volume and level of activity for an asset or liability has significantly decreased and when a transaction is deemed “not orderly.” This guidance reinforces the notion that fair value is based on orderly transactions under current marketplace assumptions.  When current prices are not indicative of orderly market transactions, an appraiser should utilize alternate valuation techniques to estimate fair value under current market conditions.

In order to determine the reasonableness of secondary market transactions, one must consider  whether an active and/or orderly market exists.  According to ASC 820, an active market is defined as “[a] market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.”  Furthermore, an orderly transaction is defined as “[a] transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction.”

ASC 820-10-35-54C expands on the volume criteria for an active market.  Some of these criteria are listed as:

1. There are few recent transactions.
2. Price quotations are not developed using current information.
3. Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
4. There is a significant decline in the activity of, or there is an absence of, a market for new issues (that is, a primary market) for the asset or liability or similar assets or liabilities.
5. Little information is publicly available (for example, for transactions that take place in a principal-to-principal market).

Based on the foregoing, transactions of many secondary common stock transactions would not qualify as being conducted in an active market.  Secondary transactions do not necessarily occur with regularity nor is volume usually very high.  In many instances, there are only one or two major buyers although there may be a large number of individual sellers.  As noted earlier, price quotations are often set by the intermediary without a lot of current financial data.  Transaction activity may also be impacted by external events unrelated to the company’s own fundamental financial underpinnings.  For example, if a successful IPO of a similarly-situated company occurs, transaction activity often increases on that information alone.

ASC 820-10-35-54I expands on the orderly transaction criteria including:

1. There was not adequate exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities under current market conditions.
2. There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.
3. The seller is in or near bankruptcy or receivership (that is, the seller is distressed).
4. The seller was required to sell to meet regulatory or legal requirements (that is, the seller was forced).
5. The transaction price is an outlier when compared with other recent transactions for the same or a similar asset or liability.

The operating phrase above is “usual and customary”.  When compared to shares traded on public exchanges, secondary transactions often lack “usual and customary” exposure to the market for a period before the measurement date.  Secondary transactions lack a lengthy exposure period and, as noted, are not often accompanied by customary financial disclosures that typical investors have available to them in the public markets.  Under these circumstances, ASC 820-10-35-54J indicates that little, if any, weight be placed on such transactions when compared to other indications of fair value.  This is not to say that secondary transactions are to be ignored; quite the contrary.  Rather, they should be considered in the context of the overall valuation assignment.

To summarize, the relevance of transaction prices in the secondary markets on fair value will depend on the specific facts and circumstances of each particular company’s circumstances. The analyst must not lose sight of the fact that valuations of common stock options related to employees  often have limited or no access to secondary markets.  There is often limited data available on the volume of shares traded on secondary markets and the number of buyers or sellers.  A reconciliation, or at least an acknowledgment, of secondary transactions is highly recommended.  In Part 2 of this series, an empirical analysis of secondary transactions will be performed to assess the accuracy, or lack thereof, of secondary transactions compared to subsequent share prices of companies that have completed IPOs.  As a teaser, the following chart shows the prices of common stock traded on a secondary market before IPO and the share prices of that company’s common stock after IPO.  Can you guess the stock?

Neil Beaton is managing director of Alvarez & Marsal Valuation Services where he provides a broad range of valuation and litigation support services. Please see www.alvarezandmarsal.com for a more information.

More Information:

• DO YOU REALLY NEED A BUSINESS PLAN TO RAISE ANGEL FUNDING?
• EARLY HOMO SAPIENS, STARTUPS, PERSISTENCE HUNTING & CONGRESS
• DON’T “DEFER” COMPENSATION IN TIMES OF TROUBLE

There has been a lot of ink spilled about the JOBS Act, especially its “crowdfunding for securities” provisions. The JOBS Act is an exciting piece of legislation for the startup community. What is my favorite part of the Act? Section 201 (quoted below).

Why is Section 201 my favorite section and not Section 301 (the crowdfunding exemption), or Sections 101-108 (the IPO on-ramp provisions)? Because Section 201 will dramatically change the playing field for the investment rounds that I am most actively involved in–all accredited investor Rule 506 offerings under the 1933 Securities Act.

Crowdfunding has promise, but currently 95% of all private securities offerings are done via Rule 506 of Regulation D. In other words, Reg D Rule 506 is where the game is played. In my opinion, startup companies will continue to predominantly rely on Rule 506 offerings to raise capital due to limits on crowdfunding contained in the JOBS Act. Unfortunately, the crowdfunding provisions in the JOBS Act are not what advocates hoped for (see my previous critiques here). Regardless, let’s look at the bright side for a minute with respect to Section 201.

What will Section 201 do for 506 offerings?

• It will allow companies to advertise to the public that they are engaged in securities offerings, without costing them the 506 exemption. This is a dramatic and astounding change from the previous ban on general solicitation. Companies could run ads in the NYTimes or the WSJ if they wanted to, for example.
• Even if they don’t advertise, companies will no longer have to be silent when they raise capital. Companies could not only advertise to the public, but they can talk to the press about their offerings.  This has been a regulatory “gotcha” for companies for a long time.  So many startups have unwittingly been caught in the following scenario:  First, you file a Form D within 15 days of the first sale of securities (as required by the SEC), then after seeing the public filing, the press calls, and you inadvertently talk about your offering and blow your 506 exemption by violating the ban on general solicitation.
• Companies will be able to post on their web sites that they are raising capital. Rule 506 offerings may not be as democratizing as crowdfunding, but they may come close as old barriers about how companies can connect to investors melt away.  Companies no longer will have to rely only on word of mouth or people with whom the company had preexisting relationships to reach out to investors. Web sites indexing and rating offerings by private companies will probably spring up. Look for Angel List to become even more  significant.
• Companies will no longer have to worry about blowing their Rule 506 exemption by pitching at seminars or meetings where  “attendees have been invited by any general solicitation or general advertising” (quoted from the current version of the rules). Under the current rules, this was a real risk (albeit one not too many companies concerned themselves with).

These are all, in my opinion, very welcome and positive developments for the startup community.

What To Look Forward To

The SEC must act within 90 days of the enactment of the JOBS Act to revise the current rules to “provide that the prohibition against general solicitation or general advertising” not apply to Rule 506 offerings, provided that all purchasers of the securities are accredited investors.

What Could Go Wrong?

Not to be cynical, but we will have to wait and see if the SEC’s proposed regulations actually carry out the intent of the JOBS Act. For instance, Section 201 states that the new rules are going to “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

Let’s hope the SEC does not impose burdensome information gathering and disclosure requirements on companies. We have already seen how the “bad actor” provisions spun out of control in the regulatory process:  In the bad actor case, the SEC proposed an onerous “did not know, and in the exercise of reasonable care could not have known” standard of diligence for companies identifying potential bad actors.

Let’s hope the SEC does not take the same tact with these new regulations.

TITLE II—ACCESS TO CAPITAL FOR JOB CREATORS

SEC. 201. MODIFICATION OF EXEMPTION

(a) MODIFICATION OF RULES.— (1) Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)).

For more information:

• CROWDFUNDING: CURRENT LEGALITIES & PROPOSALS
• RELAXING THE BAN ON GENERAL SOLICITATION
• “CROWDFUNDING”: AN IDEA WHOSE TIME HAS (LEGALLY) COME?

Asia’s innovation hot spots are fast emerging as first-choice destinations for bright, young entrepreneurs as the Silicon Dragon entrepreneurial revolution moves beyond China into new frontier markets. Throughout Asia, technology hubs are forming to rival the original Silicon Valley.

Startup Asia author Rebecca A. Fannin gives a close-up view into the key growth trends shaping venture capital and entrepreneurship in Beijing, Shanghai, Hong Kong, Bangalore, Delhi, Mumbai, Singapore, Taipei, and Ho Chi Minh City. She shows how a new generation is no longer looking to the West for cues but instead crafting its own local business models for succeeding in tackling the risks of doing business in Asia’s developing markets. Rebecca’s website is www.siliconasiainvest.com.

Joining Rebecca for a fireside chat will be Fraser Mendel, a partner at Davis Wright Tremaine LLP, Edwin Green, a partner at Deloitte Touche Tohmatsu, and Keith Armstrong of Startup Weekend who will be talking with Rebecca about challenges and opportunities in the emerging company space in Asia.

• Monday, April 16, 2012 
5:30 – 6:30 p.m. Registration, Book Signing, and Networking
• Cocktail Reception
 6:30 – 8:00 p.m. Book Talk and Fireside Chat
• Davis Wright Tremaine 
1201 Third Avenue, Suite 2200, Seattle

Early Bird Registration is $20 before Monday, April 9th, and $25 after. Registration includes a copy of Rebecca’s book Startup Asia.
Register at: http://startupasiaseattle.eventbrite.com.

With support from the Washington State China Relations Council, Startup Weekend and the Asia Business Forum.

Cocktails included | Reservations Required | Tickets are Non-refundable

By Joe Wallin

Many times I have seen the following happen: a company is running out of money. In order to keep going, the team is going to have to take pay cuts. The Founder & CEO tells the team–”We’ll have to ‘defer’ your salary. As soon as we raise our next round (or as soon as we sell), we’ll pay you what you have deferred.”

This is a mistake, and sometimes a costly one. The word “defer” is a dirty word in the law. Sort of like the word “back dating” (ok, maybe not that bad, but it is still not a good word). Why is “defer” a dirty word? Because when you “defer” you give rise to a number of potential adverse legal complications that you should, and can, avoid.

 What are these bad consequences? 

• Potential employment law violations–including a potential personal obligation to pay damages and attorneys’ fees if the “deferred” wages are not ultimately paid. (The size of the penalty can vary from state to state.)
• Potential Section 409A tax problems, which include a 20% penalty tax on the affected employees.

How can you avoid these problems? Don’t “defer,” instead:

• Reduce folks’ salaries to whatever you need to.  This can be tricky because you do not want to breach any written or verbal employment contracts, so document a consensual written agreement.
• Offer incentive bonus payments, which only vest upon the triggering event (i.e., completion of the next round of financing, sale of the company, etc.).  It is best to make it clear this money is at risk—if the company does not hit the target, then there is no obligation to pay.
• Usually, a salary reduction/bonus agreement will achieve the business goals.

What are the benefits of this type of agreement rather than deferring salary amounts?

• If you don’t raise your next round, or sell, you don’t have potential personal liability, including double damages and attorneys’ fees, for the deferred amounts.

In conclusion, be careful.

Joe Wallin is a Partner ar Davis Wright Tremaine LLP and the Founder and Editor of this Blog.

For More Information About Deferrals See:

• SECTION 409A
• SECTION 409A–WHAT IS IT?
• SHOULD WE REPEAL SECTION 409A?

A few days ago, someone posted a question on the Seattle Tech Startups email list about crowdfunding. The gist of the question was, “Hey, I’m seeing a bunch of advertisements for workshops on selling securities through crowdfunding. Wouldn’t this be illegal under the Securities Act of 1933?”

I think the Seattle Tech Startups email list is fantastic. It is a good list full of helpful discussions on a variety of topics and participants can discuss questions like the one posed above.  (You can learn more about this mailing list and subscribe to it here: http://seattletechstartups.com/doku.php)

The Current State of the Law on Crowdfunding

The answer to the crowdfunding question is “yes.” Under current law, crowdfunding to sell securities is illegal.

Why? To issue securities you either have to register those securities with the SEC (a very expensive process; read Facebook’s S-1 to get a sense of the complexity and expense), or find an “exemption” from registration.  For startups, the most common  exemption for raising funds in non-public offerings is Rule 506 of Regulation D under the Securities Act of 1933 (Rule 506 offerings account for approximately 95% of all venture and angel financings –see here).  Rule 506 prohibits:

• using advertising, or general broadcast media, to solicit investments;
• taking money from non-accredited investors–unless you provide public offering level disclosure.

So don’t post to your blog or Facebook or LinkedIn stating that you are trying to raise angel or venture money. Even if you don’t ultimately take any money from investors, you could still face regulatory action from the SEC and other federal and state authorities. For a recent example of the SEC cracking down on crowdfunding, some folks got in serious trouble for trying to use online social media, including Facebook and Twitter, to try to raise money for a brewery in exchange for an interest in the brewery (See the SEC Order here: http://www.sec.gov/litigation/admin/2011/33-9216.pdf).  The SEC took action despite the fact that no money was ever collected.

The Necessary Components of a Good Crowdfunding Bill

The House of Representatives has passed a crowdfunding bill by a large bipartisan majority.  But although the House is taking positive steps towards creating a good crowdfunding bill,  the Senate is more reluctant.  One bill introduced in the Senate only allows startups to issue securities through a “crowdfunding intermediary,” which would presumably prevent use of social networking sites like Facebook or Twitter to raise money.   The other Senate bill  only allows the issuance of securities through a registered “funding portal” and would require companies to deliver audited financial statements to the SEC if it wants to raise more than $500,000.

In my opinion, a workable crowdfunding bill that can significantly benefit entrepreneurs would contain only the following three components (consider these the 3 legs of the stool):

• First, the crowdfunding bill must preempt state law regulation of the solicitation for the sale of securities in crowdfunding offerings, just as federal law preempts state law in Rule 506 offerings. State regulator pre-approval of crowdfunding offerings would significantly hinder crowdfunding as a viable fundraising method. Witness the lack of success of Rule 504 offerings; almost no one uses Rule 504, even though you can theoretically raise up to $1M from non-accredited investors, because complying with different state regulations is costly and time consuming.  In contrast, the reason why Rule 506 works so well and is used so often is that the federal law preempts state law and doesn’t allow state regulators to pre-approve or subject to merit review securities offering documents.
• Second, crowdfunding legislation must allow startups to engage in general solicitation, such as by advertising for funds on the internet. The House is already taking a step in the right direction by passing a bill repealing the ban on general solicitation in all accredited investor offerings. Also, if Congress repeals the ban on general solicitation for crowdfunding offerings it should also do the same for Rule 506 offerings.  Otherwise startups would be unable to raise funds through crowdfunding and Rule 506 offerings simultaneously.
• Third, a successful crowdfunding bill must allow startups to take money from non-accredited investors, up to caps of say $1,000 or $500 (and aggregate caps), without triggering public offering type disclosure obligations.   These caps allow startups to raise significant funds while also minimizing the risk to investors.

With these 3 elements, crowdfunding could in fact become a “real” reality.

Conclusion

Unfortunately, with the way crowdfunding legislation is shaping up in Congress, any crowdfunding securities law exemption from registration could end up being a mirage — something to get the hopes up of the entrepreneurial community, only to dash them later upon the hard rocks of a reality full of overly complex rules and expensive compliance requirements.

But if we can convince Congress to concentrate on passing a bill based solely on the three priorities outlined above, a new crowdfunding exemption could in fact create a better reality for startups.