The National Labor Relations Board recently issued a ruling in a case involving the employment classification of FedEx delivery drivers, ruling that the drivers were employees, not independent contractors. The most important piece of the NLRB’s ruling was the role of the factor of “entrepreneurial opportunity for gain or loss” in conjunction with the other factors of the employee/independent contractor test. The factors of the primary employee/independent contractor test include the extent of the employer’s control over the work, whether the work is typically done under the direction of a supervisor or by a specialist without supervision, whether the worker is engaged in another business, whether the worker supplies his or her own tools, materials, and place of work, the length of time of the job, whether payment is by time or by the job, whether the work is part of the regular business of the employer, and the expectations of the parties. The “entrepreneurial opportunity for gain or loss” factor, added by the NLRB and the courts, examines whether the worker has the opportunity for both profit or loss from the work and whether the worker has the opportunity make profit or loss in general by seeking other work. The NLRB’s ruling clarified what it saw as an overemphasis on the entrepreneurial opportunity factor by the courts. The Board stated that entrepreneurial opportunity should be considered alongside the other factors, but should not be granted overriding “animating” importance. Furthermore, the NLRB emphasized that any alleged entrepreneurial opportunity must be real and not hypothetical — for example, just because an alleged contractor can obtain other work, doesn’t mean he or she can because he or she is working 40+ hours a week for the employer. Of course, the employee/independent contractor test is a fact-specific test, and the factors in the test are not a checklist, as any one factor, in the totality of the circumstances, can sway the decision one way or another. It is also worth noting in conclusion that each agency that distinguishes between employees and independent contractors does so according to its own standards, and is not necessarily constrained by the views of other agencies — accordingly, the IRS’ independent contractor test may end up being slightly different from the NLRB’s test, and may even reach a different conclusion. For startups and small businesses, the NLRB’s test can be important in the context of a disgruntled “contractor” who feels that he or she is an employee entitled to minimum wage, overtime, benefits, etc.; whereas the IRS is concerned with ensuring that payroll taxes are properly paid.
A recent Forbes article pointed out that the Rule 506(c) exemption authorized by the JOBS Act has been less utilized than initially predicted. Rule 506(c) permits companies to make a general (public) solicitation of securities being sold in a private offering under Regulation D. The catch with Rule 506(c) is that all sales must be made to accredited investors (whereas old Rule 506 — now Rule 506(b) — permits a limited number of sales to non-accredited, sophisticated investors). More importantly, companies must take “reasonable steps” to verify the accredited status of purchasers, whereas the standard practice under Rule 506(b) had purchasers self-certify their accredited status. The SEC provided several “safe harbor” methods that it deemed met the “reasonable steps” standard, most of which involve the investors providing financial records. However, many angel investors are less than eager to have their financial records reviewed, especially by the selling company, but even by attorneys, accountants, or brokers, as also permitted under the safe harbors. The SEC was very clear that its safe harbors were not an exclusive list of “reasonable steps”, and invited issuing companies to come up with new methods of verification under the “principles-based methodology” (which looks at the particular facts and circumstances of an offering, subject to the approval of the SEC. Of course, not many companies are willing to jeopardize their fundraising round by using a verification method that is ultimately rejected by the SEC. The Angel Capital Association has been working on a PBM that allows for verification of investors by their membership in an “established angel group” — the process would define criteria for angels to join an EAG, and a certification method for angel groups to become EAGs. The benefit of such a method is that issuers look at an investor’s membership, rather than their financial records. As the Forbes article points out, many companies are being advised and are electing to either stick with the safe harbor methods, rather than utilize a new method that may ultimately be rejected by the SEC, or avoid general solicitation altogether. I would personally advise companies looking to utilize Rule 506(c) to use the safe harbor methods only, unless and until the SEC officially upholds another method as meeting the verification standards. Although, as the article concludes, general solicitation will become more utilized as the market become more accustomed to certain processes (such as the processes developed for old Rule 506 private offerings), it could be helped along if the SEC were to provide a mechanism for authorizing new methods for verification, such as endorsing methods as they are developed and used, ideally one easier and more definite than a no-action letter. Further reading: http://www.forbes.com/sites/mariannehudson/2014/09/23/general-solicitation-one-year-later-where-are-we-now/
Two accelerator firms, 500 Startups and Y Combinator, have introduced two new structures for early-stage equity financing in the past few months. Y Combinator’s structure is called SAFE (which stands for Simple Agreement for Future Equity); 500 Startups calls their structure KISS (for keep it simple security). SAFE appears to be a form of convertible equity, while KISS comes in either convertible debt or convertible equity forms. SAFE comes in several forms that can come with caps and/or discounts, or the ability to amend the SAFE in the event the company issues a further SAFE along more favorable terms. Of course, SAFE converts into preferred stock in the event of a preferred equity financing round, or an IPO or change of control transaction. SAFE appears to require a valuation of the company, as SAFE allows the investor to convert upon the higher of the valuation in the SAFE round or the valuation in the equity financing. Unlike convertible debt, there is no interest or debt attached to the investor’s money with SAFE; however, unlike types of convertible equity I’ve heard about, there is no conversion to common stock (typically founder’s common stock) upon maturity. KISS convertible debt is a simplified convertible note, with interest at 5% and maturity in 18 months, with the option for the company to pay the note in cash. Unsurprisingly, the note converts to preferred stock upon a round of $1 million plus. Upon change of control, KISS-holders can cash out at 2X or convert into common stock. In the event that a KISS security does not hit a conversion event and the company does not want to pay the balance of the note in cash, the balance can be converted into a series stock along standardized terms or the maturity of the note can be extended, at the option of a majority of the KISS-holders. KISS convertible equity works like KISS convertible debt, except there is no interest rate, and have both a cap and a discount and convert at the lesser of the two. However, KISS convertible equity doesn’t appear to have any other differences from KISS convertible debt, and really isn’t structured like convertible equity that I’ve read about. I still wonder about the reception for convertible equity, including the convertible equity forms outlined above. While some convertible equity structures come with an interest rate, the ones above do not, and in any event are not as secure as debt, as no part of the investment can be recovered in the even the company dissolves, unlike debt-holders who can usually receive at least cents on the dollar. I’d be interested to hear stories from anyone who has proposed a convertible equity deal to an angel or professional investor, and what the reception was like. Further reading: http://www.businesslawpost.com/2014/08/new-seed-financing-documents-500.html?spref=tw
Last month, the SEC Investor Advisory Committee met to discuss a subcommittee’s proposal to amend the natural person definition of an “accredited investor”, as defined under Regulation D. The simplest private securities offerings require sales to accredited investors only, so it is no surprise that most private offerings occur with only accredited investor purchasers. To briefly review, the natural person definition of an accredited investor includes any person with an annual income of $200,000 ($300,000 combined with a spouse’s income) in the past two years with the expectation of surpassing that threshold in the current year, or a total net worth in excess of $1 million (not including the value of one’s primary residence). The committee that discussed potential changes to the accredited investor definition seemed to think that the definition “was broken” or “didn’t work”, apparently simply because the definition has not been amended since it was first adopted in the 1980s, as the committee could not really identify how the current definition was not working or was causing harm. One of the amended versions of the accredited investor definition the committee discussed involved upping the limits to $500,000 annual income ($700,000 with spouse) and $2.5 million net worth, but again the committee apparently did not describe how these new limits would fix any “problem”, nor did the committee apparently give any consideration to any detrimental effect of changes such as these. The committee did note issues with private offerings such as lack of information/disclosures in private offerings, lack of sophistication by investors, inability of investors to bear the risk of their investment, and outright fraud, but again failed to explain how simply raising the financial thresholds would solve any of these problems — except for maybe inability to bear risk, but I doubt that many accredited investors are wagering substantial portions of their wealth on startups, or even anything above what they can afford to lose. While the accredited investor status nominally presumes that an investor is sophisticated (which is a different classification of purchaser under the securities laws), in reality the standard largely ensures that the purchaser has financial means to withstand the risk of loss. Of course, in most private placement offerings there is no limit on how much an individual accredited investor can invest, so presumably an accredited investor who just comes in over the threshold can invest his entire $200,000 annual income or $1 million net worth -— I doubt that anyone can withstand the loss of their entire annual income or net worth. And even though the accredited investor standard presumes that the investor is sophisticated enough to evaluate the investment by sheer reason of his or her wealth, there are obviously individuals who are far more qualified to evaluate investments than many accredited investors. I’d imagine that a CFA making $150,000 a year is probably more qualified to evaluate an investment than even a very wealthy and successful surgeon making seven figures a year. But the surgeon is an accredited investor and permitted to freely participate in most private offerings, while the CFA is not. In the end, I do agree that the accredited investor standard is broken and must be fixed. However, upping the limits doesn’t solve what I consider to be the real problems with the standard — it simply focuses on persons who merely have the financial means to bear the risk of loss, and ignores investors who may have the educational and professional background that properly equips them to evaluate private placement offerings. Simply upping the limits will likely actually cause more harm than good, as raising the limits as proposed by the Investor Advisory Committee could shrink the accredited investor pool by as much as 60%. And I’d be willing to bet that the majority of the accredited investors who participate in Reg. D offerings are in that 60%. So simply raising the limits would shut off an important source of capital for and absolutely kill America’s startups. Bad idea. Seattle startup attorney Joe Wallin suggested leaving the current financial standards in a new accredited investor definition, while also permitting persons who don’t meet the financial standards but possess certain specialized knowledge and/or experience to become accredited investors — persons such as certified financial and investment analysts and other persons who have the education and training to evaluate businesses and the risks of investment. Second, he would limit the amount that persons who fall under the education/training standard could invest, such as 5% of their annual income or net worth. I largely agree with Attorney Wallin’s proposal. I have no problem with permitting people who have the financial means to absorb investment losses from participating in private offerings — let’s be honest, most of those investments will be completely lost. But I think that persons who have the education and training to evaluate investments should also be permitted to invest in private offerings — they’re likely better equipped to figure out who the likely winners are than people who qualify under the wealth standards. However, to address the Investor Advisory Committee’s concerns (read: kill any objection they may have to — *gasp* — expanding the investor pool), especially ability to withstand loss of risk or outright fraud, I would also place caps on the amount that accredited investors under a sophistication standard could invest, but also on accredited investors under the wealth standards. My proposal for an accredited investor rule would look something like this: (1) A natural person is an accredited investor if he or she: (a) Has an annual income in excess of $200,000 ($300,000 in conjunction with his or her spouse) for the past two years and a reasonable expectation of annual income in excess of said limit in the current year (b) Has a net worth in excess of $1,000,000 (either alone or in conjunction with his or her spouse), excluding the value of the person’s primary residence (c) Is a (insert various regulatory credentials and/or registrations such as CFA, CAIA, FRM, or broker/dealer), or, in the judgment of the Commission, possesses sufficient educational background, regulatory credentials, and/or professional training to properly evaluate the merits and risks of a private placement offering (2) A natural person who qualifies as an accredited investor under clause (a) or (b) of the preceding Section (1) may not invest, in private placement offerings, more than 10% of their annual income in any one year if qualified under clause (a) only, or 10% of their net worth at any time if qualified under clause (b) only, or the greater of 10% of their annual income in any one year or 10% of their net worth at any time if qualified under both clauses (a) and (b) (3) A natural person who qualifies as an accredited investor under clause (c) of the preceding Section (1) may not invest, in private placement offerings, more than 5% of their annual income in any one year This rule keeps all current accredited investors, and adds all sophisticated persons to the pool, effectively doing away with the sophisticated investor as a separate classification. An accredited investor who just meets the annual income limit of $200,000 can invest up to $20,000 in any one year, while one who meets the net worth standard of $1 million can have as much as $100,000 invested in private placements at any one time (referring of course to the amount of money originally invested, not the current value of the investments); meanwhile the CFA making $150,000 can invest up to $7,500 in any one year. Of course, the sophistication standards and investment limits would depend on what would be reasonable. I believe this rule also addresses any concerns investor advocates may have about ability to withstand risk of loss, or senior citizens being defrauded by investing their whole retirement in some half-cooked scheme, or whatever doomsday scenario troubles them. Some may oppose limiting the investment ability of accredited investors under the income or net worth standards, but I would imagine that accredited investors usually don’t exceed some annual or total percentage of their income or net worth, be it 10, 15, or 20 percent. And I’d be perfectly open to no limits on the ultra-wealthy, such as persons with annual income in excess of $10 million or net worth in excess of $100 million — people with that kind of money usually aren’t so careless with it as to invest more than they could afford to lose, and I don’t want to have a season of Shark Tank cut midway simply because the Sharks hit their investment limits! Further reading: http://www.crowdfundinsider.com/2014/07/44794-sec-investor-advisory-committee-tackles-non-problem/