House of Representatives Passes Jumpstart Our Business Startups Act (H.R. 3606)

March 21, 2012

On March 8, 2012, the U.S. House of Representatives passed the “Jumpstart Our Business Startups Act” (H.R. 3606) with very strong bipartisan support. Competing, but more restrictive, legislation is pending in the U.S. Senate. The JOBS Act contains a number of important provisions intended to benefit startup companies and emerging growth companies, including loosening the current prohibition on general solicitation of investors and allowing crowdfunding by investors subject to a number of protective requirements.

Access to Capital – General Solicitation

In a major departure from existing limitations under federal securities law, the current prohibition on general solicitation or general advertising in connection with the offer or sale of securities under Rule 506 of Regulation D under the U.S. Securities Act of 1933 would not apply to an offering if all purchasers of the securities are “accredited investors.” See Raising Capital for Your Business for a description of the requirements for an accredited investor. As a result, startup companies and established businesses would be free to solicit potential investors via internet websites and other means, including a company’s own website and other promotional materials, as long as the company accepts actual investments only from accredited investors. A company would be required to take reasonable steps to verify that purchasers of securities are accredited investors. All solicitations would remain subject to the anti-fraud provisions of federal and state securities law which require accuracy and completeness of information provided in connection with a purchase or sale of securities.

Entrepreneur Access to Capital – Crowdfunding Exemption

In another major innovation, startup companies would be able to raise up to $1,000,000 (or $2,000,000 if the company provides audited financial statements) in any 12-month period without regard to an investor’s financial qualifications, provided that the amount purchased by each investor does not exceed the lesser of $10,000 and 10% of the investor’s annual income. In order to use the proposed new crowdfunding exemption, the company issuing securities would have to:

  • warn investors, including on the company’s website, of the speculative nature generally applicable to investments in startups, emerging businesses and small issuers, including risks of illiquidity (inability to resell or transfer securities)
  • warn investors that they may not transfer the securities for 1 year following purchase, except for transfers to an accredited investor or to the company
  • take reasonable measures to reduce the risk of fraud in connection with the transaction
  • provide the Securities and Exchange Commission (SEC) with the company’s physical address, website address and the names of the principals and employees of the company, and keep this information up-to-date
  • provide the SEC with continuous investor-level access to the company’s website
  • require each potential investor to answer questions demonstrating: an understanding of the level of risk generally applicable to investments in startups, emerging businesses and small companies; an understanding of the risk of illiquidity; and other areas determined by the SEC
  • state a target offering amount and ensure that cash proceeds are held by a third-party custodian (such as a registered broker-dealer or insured depository institution) until the company receives at least 60% of the target offering amount
  • provide notice to the SEC no later than the first day securities are offered to potential investors, including the stated purpose and intended use of proceeds of the offering, the target offering amount and the deadline to reach the target offering amount
  • outsource cash-management functions to a qualified third-party custodian, such as a registered broker-dealer or an insured depository institution
  • maintain books and records as required by the SEC
  • make available on the company’s website a method of communication that permits the company and investors to communicate with one another
  • not offer investment advice to potential investors
  • provide notice to the SEC upon completion of the offering, including the aggregate offering amount and number of purchasers
  • disclose to potential investors on the company’s website that the company has an interest in the issuance of the securities

A company also would be able to satisfy these requirements through the use of a qualified intermediary who would comply with each of the above requirements and in addition would be required to carry out a background check on the principals of the company. It is likely that a significant number of qualified intermediaries would offer their services to the startup universe. Importantly, an intermediary would not be required to register as a broker-dealer in order to qualify under the proposed legislation.

Initial Public Offerings by Emerging Growth Companies

Emerging growth companies would be defined as companies with total annual gross revenues of less than $1,000,000,000. The Jumpstart Our Business Startups Act would reduce compliance requirements for emerging growth companies for up to 5 years after an initial public offering (IPO), including waiver or reduction of requirements for:

  • Shareholder approval of executive compensation
  • Shareholder approval of golden parachute compensation
  • Certain executive compensation disclosure
  • Number of years of audited financial statements presented when going public
  • Internal controls audit under Section 404(b) of the Sarbanes-Oxley Act of 2002
  • Restrictions on communications with securities analysts and investors

The Jumpstart Our Business Startups Act would also permit an emerging growth company, before an IPO, to confidentially submit to the SEC a draft registration statement for confidential nonpublic review by the SEC before public filing. Current law generally requires immediate public availability of all registration statements submitted to the SEC.

Private Company Flexibility and Growth

The threshold for mandatory SEC registration by private companies (comparable in scope and cost to voluntary registration in connection with an IPO) would be increased from $1,000,000 total assets and 500 holders of equity securities under current law to $10,000,000 total assets and either 2,000 holders of equity securities or 500 holders who are not accredited investors, excluding holders who received securities pursuant to an employee compensation plan.

Next Steps

In order to become law, the Jumpstart Our Business Startups Act must be passed by the U.S. Senate and signed by the President. The SEC would then have 90 – 180 days to propose detailed regulations to implement the legislation. Until such time as final legislation is passed by the House and Senate and approved by the President, and new SEC regulations become effective, companies must continue to adhere to existing law in connection with the sale of securities. If enacted, however, the legislation would greatly expand the ability of startups and other businesses to seek capital from investors in the United States.

Differences between Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs)

September 1, 2011

Here is an outline of some of the principal differences between two different types of compensatory stock options: incentive stock options (ISOs) and nonstatutory stock options (NSOs). This outline is intended as a starting point, but does not address all of the tax aspects of stock options or all of the differences between ISOs and NSOs. This outline is based on U.S. federal tax treatment and does not address any differences under state, local or foreign tax law.

  • ISOs may only be granted to employees; NSOs may be granted to employees, consultants and advisors.
  • The exercise price of an ISO or NSO must be at least 100% of the fair market value of the underlying shares on the date the option is granted.  For ISOs granted to an individual who owns more than 10% of the company, the exercise price must be at least 110% of the fair market value of the shares on the date of grant, and the option term cannot exceed 5 years.
  • In general, neither ISOs nor NSOs are taxable at the time of grant.
  • Ordinary income tax does not apply at the time of exercise of an ISO, but alternative minimum tax (AMT) may apply, especially for executives.  Upon sale of ISO shares, tax is based on the difference between the sale price and the original exercise price.  If the holding periods noted below have been satisfied, the entire amount of gain is eligible for long-term capital gain treatment.
  • Ordinary income tax applies at the time of exercise of an NSO, based on the difference between the exercise price and the fair market value of the shares at the time of exercise.  The taxable compensation upon exercise then effectively increases the tax basis of the shares.  Upon sale of NSO shares, tax is based on the difference between the sale price and the fair market value on the date of exercise, and the amount of this difference may be eligible for capital gain treatment (depending on how long the shares are held).
  • The first $100,000 in aggregate exercise price for options vesting during any calendar year is eligible for ISO treatment.  Options in excess of this amount are treated as NSOs from the date of grant.  As an example, for options priced at $0.10 per share, this means that up to 1,000,000 shares can vest in a calendar year and be treated as ISOs.  Any additional shares vesting in that calendar year, even if originally designated as ISOs, will be considered NSOs from the date of grant.  Note that in the calendar year of an employee’s first anniversary under a typical 4-year vesting schedule, vesting will include the first 25% of the option shares plus monthly vesting between the anniversary date and the end of the year (up to an additional 22.9% of the option shares).
  • ISOs that exceed the $100,000 limitation in any calendar year must be tracked with separate ISO and NSO components (and are sometimes issued in separate stock option agreements, one designated as an ISO and the other as an NSO).
  • In order to retain ISO treatment, ISO shares must be held for at least 12 months following exercise of the option (and at least 24 months from the date of option grant).  If shares are sold before the completion of either of these holding periods, the ISO is “disqualified” and becomes an NSO for most purposes.  At that point, the company is generally required to treat the option as an NSO for accounting and withholding purposes.
  • Except in cases of termination of employment, employees often wait to exercise (and to pay the purchase price) until there is a market for the shares (such as following an initial public offering (IPO) or in connection with a merger) and then sell shares soon after exercise resulting in disqualification.  A large number of ISOs are ultimately disqualified for this reason.
  • The company may generally take a tax deduction for the compensation deemed paid upon exercise of an NSO.  Some companies prefer to grant NSOs for this reason.
  • Employees may prefer ISOs due to the ability to defer ordinary income tax until the sale of the shares and the potential for a lower tax rate on the component of gain between grant and exercise (if holding periods are satisfied).  Note that alternative minimum tax, if applicable, is not deferred for the exercise of an ISO.
  • The company should consult with its outside accountants regarding the various tax, accounting, withholding and financial statement differences between ISOs, disqualified ISOs, and NSOs.
  • Individual option recipients should always consult with their personal tax advisors because of differences in individual tax situations.
  • For some of the best guidance on the tax treatment and other key aspects of stock options, I highly recommend The Stock Options Book by Alisa J. Baker published by the National Center for Employee Ownership.

Choice of Entity for a Startup Company

June 1, 2011

The choice of legal entity for your business is a critical decision for any startup company.  If you want to attract venture capital investment, you need to form a corporation, most likely under Delaware law, for a number of reasons.  Venture capital funds are generally unable to invest in an LLC, LP or other so-called [...]

Read the full article →