Florida Small Business Law » Financing

Financial Reform Act; Accredited Investors and Venture Capital

Shannon DeRouselle — Mon, 26 Jul 2010 16:46:50 +0000

The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21, 2010.

Prior to enactment of this legislation, much rumbling surfaced within the private equity community over the ultimate extent and potential impact of the proposed regulations on angel and venture capital investment. The concern was that anything that made raising capital more difficult for early-stage companies was bad – for businesses, for investors, for job creation, and hence, for the economy.

Background on the Sale of Securities

Most emerging companies seek to raise capital by selling securities. The securities must be either registered with the Securities and Exchange Commission and applicable state securities law commissions, or sold pursuant to an exemption from registration. Startup companies frequently rely on an exemption from registration, since registration can be a lengthy and prohibitively expensive process. The most frequently used exemptions are found in Regulation D under the Securities Act of 1933. Of the exemptions under Regulation D, Rule 506 is the most commonly used by startup companies, because of the relatively modest disclosure requirements and compliance costs.

Under Rule 506, a company can sell its securities to an unlimited number of accredited investors and up to 35 non-accredited investors without registration (definitions of “accredited” and “non-accredited” described below). Although a company is not required to make any specific disclosures to accredited investors, if a sale is made to a non-accredited investor, the company must disclose to the non-accredited investor certain information that is generally the same as is required in registered offerings, such as information about the company, the company’s business, the offering, and the risks involved. Because of the increased and substantial costs of providing such information (think of additional attorney and accountant fees), I advise startup clients to avoid non-accredited investors.

Unaccredited Investor: Additional time + Very expensive + Other risks + IncessantlyDemanding = AVOID!

Non-compliance with the securities laws can result in significant monetary and injunctive penalties against a company, including the right of investors to receive their money back plus interest.

Generally, dealing only with accredited investors is much less costly and easier for the company and for investors.

So, what is an “accredited” investor?

The SEC uses the accredited investor test as a means to determine whether an investor has the ability to bear the economic risk of a private placement investment.

An “accredited” investor, as defined in Regulation D, is one of the following:

a bank, insurance company, registered investment company, business development company, or small business investment company;
an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
a charitable organization, corporation, or partnership with assets exceeding $5 million;
a director, executive officer, or general partner of the company selling the securities;
a business in which all the equity owners are accredited investors;
a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

An investor that does not meet any of the above criteria is non-accredited.

Why should a startup be concerned about the Dodd-Frank Act?

Under the Dodd-Frank Act,

The standard for determining the net worth of a natural person now excludes the value of the person’s primary residence.
The SEC may review the definition of “accredited investor” as such term applies to natural persons to determine whether any modifications are appropriate for the protection of investors, in the public interest, and in light of the economy.
Beginning in July 2014, the SEC is directed to review the definition of “accredited investor” at least once every four years to determine whether changes are needed for the protection of investors, in the public interest, and in light of the economy.

By most accounts, the Dodd-Frank Act is not as onerous as feared, because many of the proposed provisions relating to the private placement of securities were omitted in the final legislation. Venture capital was spared, since certain regulations in the bill that would have required VC firms with over a certain amount of assets to register with the SEC were excluded from the final Act. The Act did, however, address the definition of “accredited investor,” which had not been revised since 1982, to account for increases in salaries and home values since the early 1980’s, and to provide a mechanism through which the SEC can revise the definition as appropriate going forward.

For emerging companies, changes to the definition of accredited investor could potentially reduce the number of individuals who qualify as accredited investors, which could have a negative effect on angel and venture capital investment by raising the cost of obtaining financing.

Most pressing for a company in the middle of a funding transaction or seeking financing: review subscription and disclosure documents immediately to ensure compliance with this new standard, or risk running afoul with federal and/or state securities laws.

Next up for venture capital: The Carried Interest debate.

2Q 2010 Venture Capital Investment Up (signs of life)

Shannon DeRouselle — Mon, 26 Jul 2010 15:30:37 +0000

PricewaterhouseCoopers and the National Venture Capital Association recently released their 2Q 2010 summary of venture capital investment in U.S. private emerging companies, which indicates that venture capital investment for the first half of 2010 totaled $11.4 billion, representing a 49% increase in dollars from the first half of 2009, when $7.7 billion was invested.

Notable highlights: Investment in the Clean Technology sector doubled in the second quarter compared to the first quarter of 2010; seed and early stage investments rose 54% over the last quarter; and first-time financing dollars rose 7% from the last quarter.

As noted previously, the venture investment landscape is tough, and perhaps you should explore other career options if the fire is too hot for you. These recent figures suggest, however, that the amount of dollars invested and the number of deals are increasing — very positive signs for the skeptic.

What can your company do to increase its chances of obtaining funding? To repeat: you must ensure that your company’s ducks are in order.

> You must have a solid strategy and business plan.

> You must understand the hurdles facing your business and be able to articulate how to overcome those hurdles.

> You must be prepared for the business and legal due diligence process.

> You must have a strong management team with relevant experience — both technical and business.

> (NEW) You must be willing to adjust your expectations with respect to what you must give up in exchange for dollars.

2009 Venture Capital Investment Down (but not gone)

Shannon DeRouselle — Fri, 29 Jan 2010 20:00:04 +0000

Last week, PricewaterhouseCoopers and the National Venture Capital Association released the MoneyTree Report, a summary of venture capital investment in U.S. private emerging companies, which indicates that 2009 VC investment was down to its lowest levels in more than a decade.

“First-time financings fell to the lowest dollar level and deal level since the MoneyTree began reporting venture capital investing in 1995.”

Pouring gasoline on a burning house does not help raise spirits, I realize. But the report does confirm that financing dollars were in 2009, and likely will be in 2010, exceedingly difficult to obtain. You can either concede and start your job search (more bad news), or you can buckle down and prepare for the turnaround.

I do not doubt that investments will reach their peak levels again, as the abundant cash that is on the sidelines now will eventually fund the next wave of innovative companies. Until then, or if you are actively seeking financing now, you must ensure that all ducks are in order within your company.

> You must have a solid strategy and business plan.

> You must understand the hurdles facing your business and be able to articulate how to overcome those hurdles.

> You must be prepared for the business and legal due diligence process.

> You must have a strong management team with relevant experience — both technical and business.

NDA’s – Am I Protected?

Shannon DeRouselle — Fri, 22 Jan 2010 23:12:00 +0000

My neighbor is a good guy. Very smart and ambitious. We discuss things. Recently, as he described his new venture to me, he mentioned that he had been using a Non-disclosure Agreement (NDA or Confidentiality Agreement) that he found on the web. I knew that it was time to add a blog entry on this topic.

Requests for NDA’s are among the most frequent inquiries that I receive. NDA’s are commonly used, normally short in length, and serve the ostensible function of proscribing the revelation of certain information. Most of the time, a client who asks for an NDA is on the right track, since that client is at least considering the handling of important information that has value to either the client or another party.

Sometimes, however, a party chooses to utilize a “form” NDA found on the Internet. This act is not necessarily cataclysmic — I have found useful forms on the net; also, the party may not want to pay a lawyer to draft an NDA.

At other junctures, a party may sign another party’s NDA, perhaps as a result of either an assumption that the NDA covers both parties’ interests, or a simple lack of negotiation power.

Whether you are an actual client, or an ambitious web user, take note: a single NDA template is not appropriate for all circumstances, and to better protect your valuable information, a properly drafted NDA is necessary.

NDA’s are worded differently depending on the intended use of the document. For instance, certain language may be appropriate for discussions with a potential new client, but may not properly address the handling of information when evaluating a potential sale of the company. Similarly, the specific language used in an NDA might vary according to whether you are disclosing or receiving confidential information. Moreover, how the term “Confidential Information” is defined in an NDA can vary widely, as can exceptions to confidentiality obligations, the duration for which such obligations are in effect, and the remedies for breach of the agreement. NDA’s can be very sophisticated.

An NDA is an important step in safeguarding valuable information. Like any contract, however, an NDA is not foolproof and does not guarantee that your information will not be misappropriated or misused. For absolutely security, you must never reveal information at all – not very practicable for business (in fact, sometimes the measured disclosure of information is customary, such as in discussions with VC’s and investors who do not normally sign NDA’s when evaluating potential investments).

My neighbor will be fine: while I have not revealed any confidences, and have received his blessing for this note, the NDA form that he uses is the most restrictive that I have ever seen, and, presumably as a result, no one has yet agreed to sign it.