Startup Company Blog : Seattle Startup Lawyer & Attorney : Davis Wright Tremaine Law Firm : Emerging Companies & Venture Capital

Under the proposed law, the Internet Gambling Regulation, Consumer Protection, and Enforcement Act:

• Internet gambling would be controlled by a federal licensing and regulatory regime.
• Licensees would be able to accept bets or wagers from persons located in the United States.
• Financial transaction providers (such as creditors, credit card issuers, or financial institutions) could not be held liable for engaging in financial activities and transactions for or on behalf of a licensee or involving a licensee.
• The act does not authorize any licensee to operate an Internet gambling facility that knowingly accepts bets or wagers on sporting events from persons located in the United States in violation of section 3702 of title 28, United States Code, except for fantasy or simulation sports games (as defined).
• States could opt out, and if they did, federal licensees could still not operate an Internet gambling facility that knowingly accepted bets or wagers initiated by persons who resided in those states.

In announcing the passage of the bill, the House Financial Services Committee said that the legislation would "enable Americans to bet on-line and put an end to an inappropriate interference with their personal freedom." See the House Financial Services Committee press release.

The statement is not really true, because the bill allows states to opt out. Meaning, if it is illegal to gamble online in the state in which you live and your state opts out, then this bill won't help you.

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Today (see floor schedule) the United States Senate will resume consideration of the Small Business Jobs and Credit Act of 2010.

The bill will exempt from capital gains tax gains on qualified small business stock acquired after March 15, 2010, and before January 1, 2012, and held for more than 5 years. The House has already passed this tax incentive.

This is what Senator Max Baucus had to say about this yesterday on the floor of the Senate.

In 1976, the United States economy was reeling from recession. America’s unemployment hovered around eight percent. That year, two guys named Steve started selling computer kits out of a garage in Palo Alto, California.

They founded a small business. An angel investor helped them with $250,000 in seed money. Today, we know that business as Apple. Last month, Apple became the largest technology company in the world.

....

According to a recent report, nearly all net job creation in America from 1980 to 2005 occurred in firms less than five years old. In fact, without start-ups, net job creation would have been negative almost every year for the past three decades.

In 2007, more than two-thirds of the jobs created were in firms between one and five years old.

As our economy emerges from the Great Recession, we need to ensure that American entrepreneurs have the resources, financing, and opportunities that they need to create jobs and realize their dreams.

This small business jobs bill would help American entrepreneurs access the capital that they need by increasing the incentives for investors to purchase and hold equity in start-ups.

Under this bill, for the rest of 2010, any investor who invested in a small business and held that investment for at least five years would pay no income tax on the gains from the sale of that small business stock.

It is a great idea, and one that will certainly be a boost for startup company investment. We need more angel investments like the one the Senator referred to.

It is unfortunate that the tax incentive is only for a limited time period, but perhaps it will be extended and ultimately made permanent.

Recently, Brad Burnham at Union Square Ventures wrote:

We have commented a number of times in a number of ways on this blog about how technology startups can no longer afford to ignore politics. ...Everything is suddenly impacted by public policy and we no longer have a choice about engaging in the process.

I agree with Brad. The startup community needs to be more vocal politically.

The tax bill is a good example. On the one hand we are trying to make entrepreneurship easier but on the other hand we have already made the lives of startups more difficult and are doing nothing about it.

For example, the Dodd-Frank bill's legislative language reduces the number of people who qualify as accredited investors (reducing the number who can act as angels to invest in startups and accordingly reducing the capital available to startups), and on the other hand we are about to offer a tax incentive to invest in startups. This is a conflicting set of policies that at some level doesn't make sense.

Another example, Senator Baucus speaks wisely about startups needing capital, yet we have bad laws which require startups to spend money on foolish things that don't create value--like 409A valuations, or the new healthcare bill's 1099 requirement. We need a global, coherent legislative strategy to make the lives of startups easier and better.

I like the temporary tax incentive the Senate is considering, but it would be nice if the small business bill did other things to make the lives of startups easier rather than just pass a temporary tax incentive. 

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If you are looking for a short, individual accredited investor certification that takes into account the Dodd-Frank changes and the SEC guidance of just a couple of days ago, please see my example below. The changes prompted by the new law and the recent SEC guidance are emphasized in bold.

The Dodd-Frank bill does not change the requirement that the issuer has to reasonably believe that an investor is accredited.  As to what constitutes a reasonable belief, see SEC Release 33-6455, March 3, 1983:

"What constitutes 'reasonable belief' will depend on the facts of each particular case. For this reason, the staff generally will not be in a position to express views or otherwise endorse any one method for ascertaining whether an investor is accredited."

This short form certification is designed for use with other documents. Depending on the size of the offering, how well the principals of the issuer know the individual investors, and the number and type of investors, this short form certification may or may not be sufficient. Issuers should always utilize counsel when engaging in a securities offering.

INDIVIDUAL ACCREDITED INVESTOR CERTIFICATION

I hereby certify that I am familiar with the definition of the term “accredited investor” as defined in Rule 501 of Regulation D issued pursuant to the Securities Act of 1933, as amended, and that I meet the criteria to qualify as an accredited investor, in the category or categories indicated by my initials below.

1. [        ] I am a director, executive officer, or general partner of the issuer of the securities being offered or sold, or a director, executive officer, or general partner of a general partner of that issuer.
2. [        ] I am a natural person whose individual net worth, or joint net worth with that of my spouse, is at least $1,000,000, excluding the value of my primary residence, but including indebtedness secured by such residence in excess of the value of such residence.
3. [        ] I am a natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with my spouse in excess of $300,000 in each of those years and I have a reasonable expectation of reaching the same income level in the current year.

Dated:                                                 

Signature

Print name

Address:                                              

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Thanks to Broc Romanek for flagging this news this morning.

The SEC has issued a Compliance and Disclosure Interpretation ("CDI") relating to the new definition of accredited investor under the Dodd-Frank Act. I have quoted it in full below. You can find it here.

The key takeaway is--"Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth."

Section 179. Rule 215 – Accredited Investor

Question 179.01

Question: Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the “value of the primary residence” of the investor. How should the “value of the primary residence” be determined for purposes of calculating an investor’s net worth?

Answer: Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. [July 23, 2010]

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Now that the new definition of accredited investor is in effect, questions are coming up on how to implement the new definition (aside from just using the new definition going forward). Two questions that we have become aware of are set forth below.

Question:  How does the change in the definition of accredited investor affect ongoing offerings? What if a company is in the middle of an offering and has had a closing and in that closing accepted funds from an investor who was accredited under the old definition but is not accredited under the new definition? Does the company have to return the investor's money?

Answer: For offerings under Regulation D, accreditation is determined "at the time of the sale of the securities" under Rule 501. If a company has had a closing and accepted funds from an investor in that closing who to the company's reasonable belief was accredited at that time, we do not believe that the company should have to return the funds from that investor. But companies should be cautious that they have in fact closed on such funds. If, for example, an investor has completed documents but the subscription agreement has not been accepted by the company, or if there was an escrow or a milestone that had to be met before the closing could occur, the company may very well have to return the investor's funds.

Question: What happens if an investor has a negative value in their primary residence, meaning that an investor has more debt on their primary residence than value? How is that taken into account? We know that we exclude the "value" of the primary residence in determining net worth. But do we include negative value in a primary residence in determining net worth?

Answer: The SEC has indicated orally that negative net value in a primary residence should be taken into account in determining net worth. We expect that the SEC will issue guidance on this in the future.

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President Obama has signed the Dodd-Frank Wall Street Reform and Consumer Protection Act.

This means that the new definition of accredited investor is now in effect. The new definition applies to existing offerings. It is effective immediately.

Under the new definition, in determining whether an individual is an accredited investor under the net worth standard, the value of the primary residence of the investor must be excluded. See Section 413 of the Act, quoted below. 

For individual investors to qualify as accredited investors, they will now have to meet one of the three following categories.

1. A director, executive officer, or general partner of the issuer of the securities being offered or sold, or a director, executive officer, or general partner of a general partner of that issuer.
2. A natural person whose individual net worth, or joint net worth with spouse, is at least $1,000,000, excluding the value (if any) of such investor's primary residence.
3. A natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

(a) In General- The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.

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One issue that is worth paying attention to in minority investment financing transactions in which an S corporation's S corporation status terminates is how losses in the year in which the S corporation status terminates will be allocated.

Investors might think that upon their investment and termination of the S corporation status, the losses funded with their dollars in the year of investment will generate a net operating loss in that year, and that those losses will be available to offset taxable income in future years. This is not necessarily true because of the way in which the losses allocated to the short S corporation tax year and short C corporation tax year will be calculated. If the investors acquire a minority stake, and if the S corporation status terminates on a date other than the first day of the corporation’s taxable year, the corporation's taxable year will be bifurcated into a short S year and a short C year, and it will be necessary to allocate the income and loss recognized by the corporation in the S termination year between these two short tax years.

Default; Pro Rata Allocation Method   

The default method applied to allocate the income or loss recognized by a corporation in an S termination year is the pro rata allocation method. Under this method, first the income or loss for the entire year is determined (for both the short S corporation part of the year and the short C corporation part of the year) and then an equal portion of such amount is assigned to each day of the S termination year (to both the S and C corporation short years). Because this default allocation method disregards the actual time at which items of income or loss are recognized, it can have unexpected results.

For example, suppose an institutional investor or other non-eligible S corporation shareholder invests $2M in an S corporation startup (with two existing shareholders who are both individuals, A and B) on July 1, and it is expected that the $2M will be substantially utilized before the end of the calendar year to fund operations of the startup.  On the investment the startup’s S corporation status will terminate because S corporations cannot generally have non-individual shareholders.  Assuming the startup uses a calendar year, the corporation's taxable year will be bifurcated into a short S year (running form January 1 though June 30) and a short C year (running from July 1 through December 31).    

You might think that the $2M expended from July 1 to December 31 would be allocated to the short C year in which it was realized, generating a net operating loss of approximately $2M--assuming the startup has no revenue.  However, under the default allocation method, half of the $2M loss is allocated to the short S year and passed through to A and B who may not be able to fully utilize this loss due to the limitations on the deductible of loss that apply to individuals.

Election To Have Items Assigned To Each Short Taxable Year Under Normal Tax Accounting Rules

The startup can elect out of the default allocation method – and follow a "closing of the books" method (which the Internal Revenue Code refers to as "Normal Accounting Rules") which allows the startup to close its books on the date its status as an S corporation terminates – but only if all shareholders consent.  In the above example, if all of the shareholders consent to a closing of the books election, the $2M net operating loss generated by the corporation in the C short year would be allocated to the C short year and carried forward to future table years and used to offset taxable income recognized in those future taxable years.  

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In case you forgot, some time ago the Federal Trade Commission issued "Guides Concerning the Use of Endorsements and Testimonials in Advertising." The Guides are administrative interpretations of laws enforced by the FTC. The Guides apply to bloggers. If you are a blogger, you might find the below flowchart helpful to you in understanding these rules.

Summary

• Do you blog, Twitter, or post on message boards about products, companies, or industries?
• Do you receive products to keep, free of charge, or are you paid or given other inducements, with the understanding that you will blog about the products?
• If a connection between you (the endorser) and the maker or seller of the product (the advertiser) might materially affect the credibility of your endorsement, your connection to the advertiser must be fully disclosed.
• As an endorser under the federal guidelines, you must disclose the connections (e.g., payments or free products) between you and the advertiser. In addition, you can be liable for misleading or unsubstantiated representations made in the course of endorsements.
• See the flow chart below to consider whether your blog may be impacted.
• See also the examples below. 

See also the FTC's press release announcing the Guides.

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In the 2010 legislative session, the Washington State legislature enacted a number of new taxes. One of them was a Carbonated Beverage Tax. This tax is imposed on the sale of carbonated beverages at wholesale or retail in this state. The tax does not apply to successive sales of previously taxed beverages. The tax rate is $0.02 per 12 ounces of carbonated beverages. The tax went into effect on July 1st of this year and will expire on June 30, 2013.

If you have questions about the tax, you can call me. You may also find answers to your questions at one of the sites listed below.

There is a $10 million exemption from the tax for "bottlers." But bottlers do not include persons who contract with processors for hire for the bottling activity; bottlers are persons who actually bottle, can, or otherwise package carbonated beverages in contains.

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