Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

When start-ups raise money, the question inevitably comes up whether the proposed investor is “accredited” or not. One question is simply who is and who is not accredited. Another question is why should you care. 

To begin with the second question: The way the SEC regulates sales of securities is to begin with the principle that all transactions in securities must be registered with the SEC, unless there is a specified exemption from registration. (For those of you not familiar with registration, one example of it is the process that companies go through in their initial public offering. It can be expensive, time consuming and a real hassle, although there are streamlined versions of the process.) In any event, the SEC has exemptions for all sorts of transactions in securities, including trades on exchanges and the like. One exemption that the SEC has is for private transactions: so-called private placements. There are many forms of private placement, but almost all investments in venture financed companies fit this exemption. Having said that, if you make offers to too many people, its public – not private. If you advertise (maybe mail to the Harvard Business School class of 1999) it is public – not private. Anyway, you get the idea. It is not always clear what is qualifies a public and what qualifies as private. As a result of the ambiguities that have arisen in this area, the SEC adopted Regulation D.   Regulation D is a so-called safe harbor. It has a set of objective requirements. If your transaction meets these requirements, then it qualifies as an exempt private placement. 

Among the requirements of Regulation D is that if you make offers to sell securities to persons who are not accredited, you must make disclosures essentially equivalent to those made by public companies in their SEC filings. These requirements are onerous. They include delivery of all sorts of information that may not be readily available to a start up. In any event it will be expensive and time consuming to pull together. Not a desirable, or easy to meet, requirement for an early stage company. If you restrict your offers to “accredited investors”, as defined in the rule, the disclosure requirements are much much lower. As practical matter, the only applicable disclosure requirement is that you not commit fraud. The reason for this is that the SEC deems accredited investors to be able to fend for themselves. So, offerings that are restricted to accredited investors are faster, easier and cheaper. 

So, what is an accredited investor? It is someone (or some entity) that meets one of the criteria described below. Actually, there are other categories of accredited investor, but I have just listed the ones that apply to natural persons (lawyer speak for people). Needless to say, complexity can creep into the definition, so you must get professional advice to make sure you are compliant. But, below is the gist of it.

Accredited investor means any person who comes within any of the following categories:

Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000;

Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii) and

Any entity in which all of the equity owners are accredited investors.

I am on the email list for Rutberg & Co.’s Digital Media Industry Newsletter. Usually I don’t pay much attention to it, but the most recent issue caught my attention. According to Rutberg, during the month of October, there were 49 venture financings in the digital media space. Well, that sounds like a lot. But, when you look at the amounts invested there are 18 deals with investments in excess of $5 million and there are many with either undisclosed valuations or valuations under $2 million. These numbers suggest that Rutberg is lumping a lot of angel deals into their definition of venture financings. 

I know from our Perspectives publication, that it can be difficult to identify what is and what is not a Series A financing. Simply searching data bases for Series A or first round is way over inclusive. We actually pull copies of the charters of the companies upon which we report and review the charters to determine if the company fits the relevant category. In any given issue, our search turns up many companies and transactions that really are not venture financings (or at least Series A etc.). 

Along similar lines, some industry organizations publish number of transactions and total valuations that seem way high. I can’t get behind their numbers, so I don’t know if they are accurate, but I suspect that the definitions used include lots of deals that maybe don’t really fit the definition of a venture investment. The point of all this is that, nobody (including industry players whose published numbers purport to be definitive), really knows what the industry numbers are.

To follow up on comments on my post of a couple days ago and based solely upon our published numbers (which does not include all the transaction that we track),  77% of Series A investments tracked by us used the NVCA forms and 22% did not.   If I add unpublished data the adoption rate is slightly higher.  With respect to Series B and later stage investmens based solely upon our published numbers, 58% of transactions used the NVCA forms and 42% did not.  Again, if I add unpublished data the adoption rate becomes slightly higher.

The increase from 58% of Series B and later stage transactions to 77% of Series A transactions suggests that, at least in New England, the NVCA forms are gaining increasing acceptance. 

Let’s start with an assumption: You are forming a company with the intention of obtaining venture financing within a year. (I will hold aside the probability of such a thing actually occurring.) If you followed my posts on Delaware franchise tax and par value you know that the number of shares you pick can affect your franchise tax – but it is not likely to have much of an effect if you use the so-called alternative calculation. Let’s also be clear with one definition. "Authorized shares" are all the shares a company may issue – not just the ones that are issued and not just the ones that are not issued. "Authorized shares" are all the shares.

One approach to the issue of how many shares could be to pick a number that kinda – sorta – looks like what you might have in the case of a venture financing. That might be something like ten million. When you have a large number of authorized shares, you can have a large number of issued shares and a large number of options.

Another approach might be to pick a small number to minimize franchise tax (under the basic calculation) and deal with changing later when you get financing. BTW, making a change in the authorized shares early in the life of a company is very straight forward. A stock split authorized by the holders of a majority of the shares is all that is needed.

Different strokes for different folks, but despite the fact that what is important is the percentage and not the number of shares, it sounds chintzy to give a new employee an option to buy one share – compared to, say, an option to buy 100,000 shares. Perception has a value. For this reason, despite the fact that it has no substantive effect on anything, most of my clients pick big numbers for authorized shares.

I had lunch with Sarah Reed ,of Charles River Ventures, who was the moving force behind the NVCA forms project, and our discussion got onto the subject of adoption rates for the NVCA forms.  This harkens back to some old posts I have on the subject of forms.  This inspired me to go back and look at some research our firm had done (a portion of which is published in EEC Perspectives) and calculate the actual adoption rate in New England deals.  Based  on a somewhat random unscientific sample of more than 140 VC investments over the last two years, the actual adoption rate for investments that we looked at is 64.54% used the NVCA forms and 35.46% did not.  The transactions selected for analysis were drawn primarily from a search of the Dow Jones VentureSource data base. The sample included only a small number of transactions handled by our firm and, I believe, includes a broad selection of Boston based (and other) law firms and venture funds.  Based upon what I know of the practices here in Boston, I suspect that this "survey" if you can call it that, understates the level of adoption.   

That annual statement from Delaware is always a heart stopping experience. Clients often get statements indicating a franchise tax bill in the many tens of thousands. This is because when Delaware sends out their invoice, they calculate the amount owed based upon the number of shares authorized. But, there is an alternative calculation based upon gross asset value, that is very likely to lead to a much lower number. Below is what the Delaware Secretary of State has to say about calculating franchise tax.

HOW TO CALCULATE FRANCHISE TAXES

A domestic stock for profit corporation incorporated in the State of Delaware is required to pay annual franchise tax.  The minimum tax is $75.00 with a maximum tax of $180,000.00.  Corporations owing $5,000.00 or more make estimated payments with 40% due June 1st, 20% due by September 1st, 20% due by December 1st, and the remainder due March 1st.

The Annual Franchise Tax assessment is based on the authorized shares. Use the method that results in the lesser tax. The total tax will never be less than $75.00 or more than $180,000.00.

Authorized Shares Method

For corporations having no par value stock the authorized shares method will always result in the lesser tax.

·         5,000 shares or less (minimum tax) $75.00

·         5,001 - 10,000 shares - $150.00

·         each additional 10,000 shares or portion thereof add $75.00

·         maximum annual tax is $180,000.00

For Example

A corporation with 10,005 shares  authorized pays $225.00 ($150.00 plus $75.00)
A corporation with 100,000 shares authorized pays $825.00 ($150.00 plus $675.00[$75.00 x 9])

Assumed Par Value Capital Method

To use this method, you must give figures for all issued shares (including treasury shares) and total gross assets in the spaces provided in your Annual Franchise Tax Report.  Total Gross Assets shall be those "total assets" reported on the U.S. Form 1120, Schedule L (Federal Return) relative to the company's fiscal year ending the calendar year of the report.  The tax rate under this method is $350.00 per million or portion of a million.  If the assumed par value capital is less than $1,000,000, the tax is calculated by dividing the assumed par value capital by $1,000,000 then multiplying that result by $350.00.  

The example cited below is for a corporation having 1,000,000 shares of stock with a par value of $1.00 and 250,000 shares of stock with a par value of $5.00 , gross assets of $1,000,000.00 and issued shares totaling 485,000.

1.      Divide your total gross assets by your total issued shares carrying to 6 decimal places.  The result is your "assumed par".

Example: $1,000,000 assets, 485,000 issued shares = $2.061856 assumed par.

2.      Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par.

Example: $2.061856 assumed par s 1,000,000 shares = $2,061,856.

3.      Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value.

Example: 250,000 shares s $5.00 par value = $1,250,000

 

4.      Add the results of #2 and #3 above.  The result is your assumed par value capital.

Example:  $2,061,856 plus $1,250,000 = $3,311 956 assumed par value capital.

5.      Figure your tax by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $350.00.

Example: 4 x $350.00 = $1,400.00

NOTE: If an amendment changing your stock or par value was filed with the Division of Corporations during the year, issued shares and total gross assets within 30 days of the amendment must be given for each portion of the year during which each distinct authorized amount of capital stock or par value was in effect.  The tax is then prorated for each portion of the year dividing the number of days the stock/par value was in effect by 365 days (366 leap year), then multiplying this result by the tax calculated for that portion of the year.  The total tax for the year is the sum of all the prorated taxes for each portion of the year.

There is a frenzy after every quarter during which various blogs and others comment on the industry numbers as they come out.  We are about to publish our next issue of EEC Perspectives (I will post a link when we actually publish.)  Unfortunately, most of the news is not good:  fewer funds raising less money, etc.  Mike Feinstein's recent blog sums it up nicely.

While I don't think there is a limit to entrepreneurial innovation (good ideas around which good businesses can be built), I wonder if there is a limit to the rate of absorption (the rate at which the world economy can embrace good new entrepreneurial businesses).  If there is, then this rate would define the outer limits of what entrepreneurs and the people who invest in them can achieve at any given moment.

I can't believe there is a scientific way of figuring out what the rate of absorption might be, but it might be possible to have a subject insight into it.  Unfortunately for me, one of the best things that can happen to my clients is to be acquired by some Fortune 500 company.  (I say unfortunately for me because they then cease to be my client.)  However, in the process  I get a glimpse of how the largest companies in the world integrate newly acquired companies and technologies into their existing operations. 

Integrating newly acquired companies is a real challenge, even to the very largest companies.  As a result even Fortune 50 or Fortune 5 companies can only do a limited amount of it.   So, I suppose you could figure out what a company the size of Microsoft, IBM, Google or GE does in a year and extrapolate from that.  You would have to include the possibility that some of these companies remain stand alone companies. 

My hypothesis is that there are not now (nor indeed have ever been) enough exit opportunities or opportunities to exist as profitable stand alone companies to support the size of the venture capital industry as it existed in 2007 (and probably now as it exists now).

In a way this approach is just looking at the problem "from the other end of the telescope" from the paucity of returns and the incredible shrinking number of funds and amount of dollars being allocated to them.