SEC Proposes General Solicitation Rules Under the JOBS Act

Just yesterday, the SEC published its proposed rules to eliminate the prohibition on general solicitation of investors required by the JOBS Act. As I mentioned all the way back in last November (and in several posts since), this part of the JOBS Act may be most significant to many of the entrepreneurial clients I represent who are trying to raise early stage capital.

As is almost always the case, the proposed Rules are only a small part of the chore, with much of the rest being left to the reasoning and background contained in the Release.

The Rules address modifications regarding general solicitations in both Rule 506 and Rule 144A  offerings. My educated guess is that most readers of entreVIEW aren’t particularly interested in Rule 144A offerings (made to “Qualified Institutional Buyers”), but many are probably interested in what happens to Rule 506 offerings, by far the most widely used exemption from registration of securities offerings under Regulation D.

I won’t bore you with all the detail in the release, which is 69 pages long (yes, I wasted a hot summer evening digesting it instead of taking a slalom run out on the lake).  The detailed summaries (some of which will be as long as the proposed rules themselves) will be forthcoming from dozens of law firms in the days and weeks to come. Given that they are only proposed rules, I don’t recommend taking the time to even read these summaries because the final rules will, inevitably, be different.

As we knew it would be, the key proposal relates to what “reasonable steps” an issuer selling securities in a 506 offering to all accredited investors must take to “verify” that the investors are accredited.  The SEC release states that “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.”  Essentially, the issuer would need to consider a number of factors in determining how to verify accredited status, including:

·        The nature of the purchaser and the type of accredited investor they claim to be;

·        The amount and type of information that the issuer has about the purchaser; and

·        The nature of the offering (manner, terms, minimum investment, etc.)

I had been joking with colleagues that, as securities lawyers, the removal of the prohibition on general solicitation under the JOBS Act may have eliminated about 50% of what we discussed with clients relative to their private offerings. If the proposed rules are ultimately adopted, it looks like we’ll have plenty to talk to clients about regarding verification of accredited status (cynics might claim that lawyers working at the SEC are trying to make sure their brethren in the securities bar stay fully employed).  This is because each set of circumstances will need to be reviewed independently and, likely, with advice of competent securities counsel.

Of course, these are only proposed rules. Given the large volume of comments on the subject already received by the SEC prior to their proposal and the specific litany of questions upon which the SEC is requesting advice, a flood of commentary is likely to ensue during the 30-day comment period.

I guess, as with prior posts on the subject, all I can say with certainty is this—stay tuned for future updates…

Apple's Big Win

The big news last week was the verdict in the “tech trial of the century,” the lawsuit brought by Apple against Samsung for infringement of various patents related to Apple’s iPhone and iPad designs and technology.

Apple was the big winner in this jury trial that lasted nearly four weeks, and involved complex evidence, allegations of evidence tampering, media leaks, infringement counterclaims by Samsung, a 20-page verdict form and 100 pages of jury instructions.  While I’m not sure that it has the drama to be made into a movie (or even a television movie-of-the week), the $1 billion plus damage award to Apple is certainly attention-getting.  But that’s not the half of it.

Apple sued Samsung claiming, among other things, infringement of several utility and design patents.  The jury found that Samsung infringed all but one of the design patents - willfully in some cases - so the damage award could still go up.

The key here is that in finding infringement, the jury determined that the Apple patents were valid.  This is a big deal.  Many in the industry, as well as general techies, have suggested that at least some of the Apple patents should never have been granted.  In some cases, these beliefs are based on reasonable arguments that certain of the technology is not “useful”, “new” and/or “nonobvious” under the standards required to qualify for patent protection.  In other cases, it is out of concern for the potential market limitations that could, and are likely to occur from Apple’s favored position.   In still others, it is just envy or dislike of Apple.  Whatever the reason, most agree that validation of  Apple’s exclusive right to technologies such as the “pinch and zoom” and “bounce-back” features, as well as some relatively trivial “design” features,  is sure to severely limit competition – at least in the short term. 

Samsung has been the largest seller of smartphones in the U.S. for the past couple of years, and the single biggest user of Google’s Android operating system.  There is little doubt in the industry that Google is Apple’s ultimate target, but it’s still anyone’s guess whether Apple will take on Google directly or bring Samsung-type suits against other manufactures of smartphones and tablet computers using the Android system.   For the present, Apple is expected to use the verdict to seek an immediate injunction against the further sale in the U.S. of Samsung products (of which there are several) that were found to be infringing one or more of the Apple patents.   That hearing is set for late September so that a number of Samsung products could be off the market for the lucrative holiday season.

While there is still much to come, (e.g., pending cases in other countries, patent re-examinations, appeal of this decision), and considerable speculation about the fall-out from this decision, it seems likely that innovation and competition may be stifled for a while.  Frankly, that’s a price we must be willing to pay for a fair and just application of the law.  But did that happen here?

With all due respect to our current legal system, I have a hard time believing that this is the kind of case we should be sending to a jury.  This is not a case involving rules that we all live with every day and that apply to ordinary human events.  This is a case involving complex laws, complex issues and complex facts.  Is it even fair to expect that persons untrained in the field should be expected to make these decisions after only a few short weeks?  I admit that I don’t know enough to say that this decision is bad law – but I do believe that cases such as this make bad law more likely.

An Upate on Lot18: Too Much of a Good Thing?

Some of you may have read my post about Lot18 back in November, wherein I extolled its virtues and hypothesized as to why the New York startup was so phenomenally successful at raising money from venture capitalists.  Since that post, tech news outlets have reported two rounds of layoffs at the company and the closing of its short-lived UK operations.  Lot18 also stopped offering food and travel products for sale, which it had recently been doing in addition to its primary business of selling wine.

When I was reading about the company to write my previous post, Lot18 reportedly had about 500,000 members; now there are almost 1,000,000, according to online reports!  Things seemed to be going so well!  As it turns out, the wealth of cash the company was able to raise might have also made it easier to lose sight of its core business.  As founder Philip James told Betabeat, “One of the perils of having a lot of money is, it’s easy to launch a lot of things.”  We can all understand how a company flush with cash might be more apt to take risks on premature expansion than one that needs to watch every dollar just to keep the lights on.  

While the decision to wind down the company’s short-lived food and travel businesses is unfortunate for the employees who lost their jobs, it should help Lot18 refocus on building its wine business for long-term sustainability.  Luckily for Lot18, the nature of its business is such that its investment in those complementary businesses probably was “just” those people and maybe a few other ancillary services, marketing expenses, etc.  One can imagine many other types of businesses where expansion into ancillary businesses would require huge capital outlays at the beginning for things like equipment and regulatory approvals, which are not easily recouped.  This reminds us of the important life lessons we can take from Lot18 so far:

1. Drink good wine.
2. Do not expand so quickly into new businesses that doing so jeopardizes the long-term success of your core business.

A Post by Alyssa Hirschfeld, Guest Blogger

Pre-Transaction Estate Planning Part 3: Installment Sales to Intentionally Defective Grantor Trusts (IDGTs)

Continuing from the first two parts of this series (the simple gift of business units and grantor retained annuity trusts), this installment is about the second leveraged gifting option—installment sales to intentionally defective grantor trusts, or IDGTs. I know…another acronym.

This transaction mimics a sale of business interests to a third party, but it is really a sale of business interests to a trust for the benefit of others that is disregarded for income tax purposes. Because it is disregarded, we call it “defective” and there are no capital gains on the sale.

An IDGT involves another irrevocable trust that is established by the grantor. Because it is a grantor trust, the grantor pays all the income taxes associated with the assets held in the trust.  The grantor establishes a trust to benefit others (usually children or grandchildren), and that trust will be the buyer of certain business interests.

Along with the creation of that trust, the grantor usually gifts some assets to the trust to fund it. Typically we recommend the gift represent about 10% of the value of the assets that will be sold to the trust. After the gift, the grantor usually sells business interests, at a price determined by an appraisal, in exchange for a promissory note. The assets are immediately owned by the trust, and thus any appreciation that happens after the sale is owned by the trust and eventually passed tax free to the trust beneficiaries.  Even if the grantor dies before the note is paid off, he or she is the owner of only the remaining payments on the promissory note, not the business assets.

The grantor retains the right to payments on the promissory note equal to the sales price for a specified term plus a prescribed interest rate.  The mid-term rate for August, or up to a nine year promissory note period, is only 0.88%.  The note can be structured to pay only interest with a balloon principal payment at maturity, or interest and principal payments for the entire note period.

As is the case with the GRAT example, this technique is especially successful if the grantor is expecting an appreciation event to happen.  If the stock is sold at a lower price to the trust, and then appreciates to a higher value, the trust beneficiaries retain that benefit tax free.

• Example. Business owner gifts $5,000,000 to an irrevocable trust. Subsequently, grantor sells $50,000,000 worth of stock to the trust in exchange for a $5,000,000 down payment and 9 year promissory note with interest-only payments. The business owner will receive eight annual payments of $396,000 based on August’s mid-term interest rate of 0.88% (an all-time low), and one final balloon payment of principal and interest of $45,396,000.  If the assets grow at 10% per year, the trust will contain over $75,000,000 after the nine years. All transfer tax free.  If the assets grow at 20% per year, the trust will contain over $200,000,000.

There are no income tax implications to selling the stock to the trust and only the initial gift has gift tax implications. This is a great technique if you are expecting an appreciation event, or even have steadily appreciating business assets. The owner continues to have an income stream, but removes the appreciation from his or her taxable estate.  This also passes some ownership interest without control, and the grantor can manage how that interest is voted and managed through the use of a trust.  This technique is a great way to take advantage of an appreciation event and the low interest rate environment, and to begin the succession planning process without giving up control of the entity.

Some “Deep” Thoughts from the Windy City

I write this post having just returned from a short family trip to Chicago. For those who know me, it won’t come as any surprise that the trip was instigated by the opportunity to see two new musicals (“Hero” and “Eastland”), as well as a chance to catch up with a law school classmate and her family. We also hit some tourist destinations (the Museum of Science and Industry and the Brookfield Zoo) and had the obligatory Chicago hot dog (actually a polish “char dog" at Portillos).

Of course, there was also plenty of pizza. I’m not talking about the thin chewy variety served at Ray’s Pizza in NYC (or is it “Famous Rays,” “Original Rays,” “Famous Original Ray’s,” or “Original Famous Ray’s” (I guess that’s another post for a trademark lawyer), but the deep dish variety for which Chicago is known. Given that I named Gino’s East as part of my desired last meal on earth, you know my preference—although I do admit that I like both types of pie.

As I ate my way through Lou Malnati’s and Gino’s East (along with an unsuccessful try at convincing the family to have a lunch at My π), I was struck by how many different folks had managed to successfully start deep dish pizza chains in Chicago. When you read through the histories of these restaurants, along with Pizzeria Uno, you’ll notice some entrepreneurial themes: 

• Having a large public appetite (pun intended) for your product means there’s room for multiple successes, even in a seemingly crowded field.
• As with many great technology company disputes (e.g., Apple Computer v. Microsoft Corporation), it seems that there’s a lot of controversy about who actually invented deep dish pizza—was it Ike Sewell at Uno’s or his chef, Rudy Malnati, father of Lou.
• Many of these restaurateurs had difficulties as they tried to expand and/or franchise their concepts. As with many companies, maintaining culture and managing cash during a growth phase proved a daunting task.

For the record, while it is a close call with some of the aforementioned culinary establishments, I still think Gino’s East is the tastiest, largely the result of the corn meal component to the crust.

Do Your Facebook Friends Know What You Are Doing Tonight?

Chef Lorena Garcia was on TV showcasing the new cantina salad from Taco Bell.  Citrus-herb marinated chicken, flavorful black beans, fresh guacamole made from real Haas avocadoes, roasted corn and pepper salsa, creamy cilantro dressing, freshly prepared Pico de Gallo—all on a bed of cilantro rice.

My wife and I looked at each other and the decision was made. We were eating dinner at Taco Bell that night. Better yet, if we went to Facebook, we could download a BOGO (BUY ONE GET ONE FREE COUPON).

With our BOGO in hand we headed for a food destination that neither of us had been to for years.  What can I say? The salads bore no resemblance to the colorful and fresh salad prepared by Ms. Garcia in the TV commercial. And I am sure that she was nowhere near the kitchen of our Taco Bell.

It was awful. My wife and I agreed that we would not tell anyone that we succumbed to the media hype and no one would ever know that we had dinner that night at a Taco Bell. It was our deep dark secret.

Later that night my son posted the following on Facebook:

What world do we live in where I turn on my computer and it tells me that my dad ate a burrito for free from Taco Bell?

Lesson learned.  If you are going to accept an offer through Facebook, be prepared for the world to find out.  Especially if you have a son with a gazillion friends.

I do not remember ever giving Facebook or Taco Bell permission to share this information with anyone.  I understand, however, that as a cost of joining the Facebook community I have probably agreed to concede many rights that allow them to share certain information.  Is that not what fuels this Facebook community of information sharing?  So what did I agree to let Taco Bell and Facebook do with this information?

Here is what Facebook and I so clearly negotiated and agreed upon in a meeting of the minds when we considered what rights they would have to share my acceptance of a BOGO offer from Taco Bell with others:

Who can see offers I’ve claimed?

When you claim an offer, a story about it will get added to your profile (timeline). By default, this story is visible to your friends, but you can change the audience of this story. To choose who can see that you've claimed an offer: On desktop:

1. Click Friends next to Post offer to profile (timeline).
2. Select the audience you want to share the story with. Choose Only Me if you don't want others to see that you claimed the offer.
3. Click Okay.

Lesson learned. If you accept that BOGO through Facebook be prepared to get comments from your friends and their friends. If you want to enjoy that Big Mac in secret, make sure that you choose ONLY ME.

Finally, if you want a reasonably priced and delicious Mexican salad, go to Chipotle.

Casino Moscow: A Tale of Greed and Adventure on Capitalism’s Wildest Frontier

The Book: Casino Moscow: A Tale of Greed and Adventure on Capitalism’s Wildest Frontier, by Matthew Brzezinski (Free Press, 2001).

Why You Should Care: Illuminating insights into what can go wrong when capitalism runs rampant without a supporting structure of law to ensure fair play.

One of the more adventurous things I did in my youth was to take advantage of a very cheap travel package whereby, for a couple of very enlightening weeks, I was whisked away from the comfortable surroundings of Mother England (where I was then living) to the land of the arch-enemy of the democratic West, the Soviet Union.

This was in the early 80s. The Cold War was still a very real phenomenon. The week I arrived in Moscow aboard an Aeroflot jet, deplaning along a path closely guarded on both sides by Soviet soldiers armed with AK-47s, just happened to be the same week a Russian trawler sunk after running into an American mine off Nicaragua. Let’s just say that, as someone holding an American passport, I was not met with a terribly warm welcome.

The trip did have a number of bright spots, among them Leningrad (now St. Petersburg), a beautiful city of pastel-colored buildings perched along canals where I managed to buy for five rubles a map of the world centered not on Kansas City, but on Moscow. Moscow? What I remember is an overall impression of gray—gray weather, gray buildings, gray people, gray food—with the sole exception of the underground subway stations, which were colorful and inviting. Overall, though, much of what I saw confirmed my prejudices, probably the opposite of what the Intourist sponsors of the trip intended.

I’ve often wondered if things have changed in Moscow since the disintegration of the Soviet Union in the early 90s. Like everyone else, I’ve heard the stories of fabulous wealth and organized crime, but Matthew Brzezinski’s Casino Moscow gives us an inside picture of what it was like during the turbulent years immediately following the fall of the Communist state.

If you recognize the author’s last name, you must be about my age—his uncle was none other than Zbigniew Brzezinski, national security adviser to Jimmy Carter. Matthew Brzezinski, himself a Canadian, was uniquely positioned to watch the unfolding of the new capitalistic Russia from his position as a member of the Wall Street Journal’s Moscow bureau. And what he saw, for the most part, was not pretty.

His Russia was a place where organized crime controlled almost all aspects of private enterprise, workers were paid in commodities (if they were paid at all), there was no sense of private property, and the legal system was ineffective at best. Pity the Western investment bankers and lawyers who, seeking a quick buck, assumed that Russians would adhere to reasonable tenets of commercial and corporate law in conducting business. Some became fabulously wealthy, but many found that their investments disappeared without trace, leaving them with pieces of paper but no way to enforce their rights.

The essential problem, it appears, was the introduction of the idea of capitalism to a people who had no respect for personal rights, the rule of law or private ownership—all residual effects of decades of Communist rule. In the early days of the social transition, many Russians fancied themselves successful entrepreneurs, but Brzezinski highlights the crucial distinction between them and Westerners: “Rockefeller built his Standard Oil from nothing, while the oligarchs seized the assets of the Soviet Union. They had not created wealth; they had simply grabbed it.”

Understanding Online Fundraising

Last week, a client called to ask what I thought about him raising money through AngelList, or Kickstarter, or any of the other popular online fundraising sites. He has been having trouble raising money recently and was intrigued by the possibility of soliciting funds from the large networks available online. He was also concerned about the possible securities law implications and other unintended consequences he might face, and before he proceeded wanted to know about all the downsides.

I haven’t actually worked with anyone yet who has raised money through AngelList or Kickstarter (or similar platforms), so I didn’t initially appreciate the distinctions between offerings on those two sites.  However, there are some significant differences, which I discovered after talking with colleagues and doing a little research of my own.

As I learned, Kickstarter provides a forum through which companies and individuals can raise money in the form of donations. Rather than selling securities, the companies and individuals soliciting funding through Kickstarter offer some type of reward in exchange for the money donated. Usually the rewards increase based on the dollar amount of the donation.

For example, I have a friend who is currently looking for money on Kickstarter for his start-up QONQR.  QONQR developed a location based, multi-player, mobile game of global domination. On QONQR’s Kickstarter page, there are at least 10 different levels of rewards for donations of between $10 and $10,000, most of which relate to bonus features that can be deployed as part of the game. 

In contrast, AngelList is a site through which companies can make connections with angel investors.  Some companies have had good success raising money in this forum.

If you are going to raise money through Kickstarter, or another forum where securities aren’t being sold, then there are no securities law implications. A prerequisite to the application of the federal and state securities laws is that there must be an offer or sale of a security. Essentially, if someone is getting a possible “return” on their money that is contingent on the success of the business, then it is a security.

Any investment made through a connection on AngelList or other online venue, however, definitely has securities law implications. The solicitation of an offering in an online forum is considered a “general solicitation” for purposes of the securities laws. If your offering involves general solicitation, you cannot raise more than $1,000,000 and still qualify for any of the exemptions from federal registration. Even the federal exemption that would permit you to raise up to $1,000,000 is qualified by state law requirements, and may not be available for all offerings or in all states. As always, it’s best to consult with your securities lawyer before offering or selling any securities.

Some of you will recall that the JOBS Act, which was passed in early April, would remove the general solicitation prohibition on Rule 506 offerings. Once that change has been implemented, offerings through sites like AngelList will not be limited to $1,000,000. Technically, Rule 506 has not been changed yet as the SEC still needs to enact final regulations. In my last post, I noted that the SEC missed its deadline in early July to enact regulations implementing the change to Rule 506. The latest update is that the SEC has scheduled a hearing for August 22nd to consider the regulations. Until those regulations are enacted, the general solicitation prohibition technically remains part of Rule 506.

Our client hasn’t yet decided whether either of these online portals will be helpful in raising the money he needs. For companies that are looking to raise relatively little capital to get an idea off the ground, Kickstarter could be a great option. For those who will need significant amounts of “other people’s money,” to launch and build a business enterprise, it probably isn’t the answer.

Given the $1,000,000 limitation, AngelList will also probably not be able to provide the capital our client wants or needs, but it’s a start, and he might make valuable connections in the angel community. At least for his situation, a site like AngelList will probably have more value once the Rule 506 regulations have been enacted and the general solicitation prohibition has been removed.

In any case, these online fundraising sites provide another option to entrepreneurs looking for start-up capital and are the start of what probably will be a growing trend. Before proceeding with any offering in these forums, however, you need to understand the potential implications on your past, current, and future fundraising. I know our client is glad he called first before he decided how to proceed.

2012 Minnesota Angel Tax Credits Officially Gone

In case you haven’t already heard, Minnesota’s allotment of $12 million in angel tax credits for 2012 has been officially exhausted. If this seems early, you’re not imagining things—last year, credits didn’t run out until mid-November (and if I’m having deja vu writing this article, it’s probably because I posted about the tapping out of the 2011 credits just 8 months ago).

To be fair, the state’s angel tax credit program, which offers qualifying investors up to a 25% tax credit on eligible investments in Minnesota start-up businesses, was allocated $16 million in 2011, $4 million more than this year (and, I should add, $4 million more than the next two years, which are both slated to be allocated $12 million again). However, the relatively quick exhaustion reflects the increasing popularity of the program.

As of early May, only 27% of the allocated credits was spoken for. By mid-June, this number had increased to 63%. Early in July, articles were published predicting that the tax credits would be gone by the end of the summer, and according to the Star Tribune this caused a last-minute rush that depleted the credits officially as of July 24th.

Despite the program’s “success” as reflected by its popularity, there are of course its critics. Some commentators feel that the program influences the timing of investments more than the actual investment decision itself, and worry that Minnesota start-ups will now face a drought in angel funding for the rest of 2012. A notification from the Minnesota Angel Network sent out regarding the exhaustion of the funding appeared to recognize this concern, encouraging its recipients to continue to consider investments for the remaining five months of this year.

Despite these concerns, DEED continues to tout the positive impact of the program, which it says has garnered over $140 million in investments for Minnesota start-ups since its inception and helped raise money for over 100 businesses in 2012.

Applications for 2013 will be become available in November. And, if the trend continues (and the legislature doesn’t act to increase the allocations), look for another “tax credits” post from yours truly in about 7 months.

A Post by Karen Wenzel, Guest Blogger

New Patent Office Rocket Docket Shaves Years Off Patent Wait Times

 Startups looking to deter copy-cat competition, attract angel or VC funding, lure licensees, or boost their share valuations now have access to a new fast track program designed to take them from patent pending to patent-hood status in 12 months or less. Early results of the program, which was created with enactment of the America Invents Act, are nothing short of stunning.

  

More than 95% (827 out of 855) of those who jumped on the fast track program in September 2011 already have their patents, with the vast majority of these zipping through the patent office in less than six months. Given that typical wait times are on the order of three or more years (and frequently even longer for popular technical fields, such as computer software, telecom, or business-methods), I'm teaching my clients to think of this "prioritized examination" program as the rocket docket.

   

Here's the fine print you need to know. The rocket docket is only available for 10,000 applications per fiscal year (October 1 to September 30) and requires payment of an extra fee ($2400 for small businesses) on top of regular filing fees to the patent office. This fee is over and above the investment that a startup makes in expert design and construction of the patent application, and well worth it if you'd rather chase a competitor out of your backyard with a loaded gun than a water pistol, or show an angel investor your six-pack instead of a diet plan.    

For already pending patent applications, the rocket docket can be leveraged by refiling a copy of an existing patent application with the required fees, leaving your original application exactly where it is in line. (In patent parlance, the refiled application is called a continuation.)  Depending on the condition of the application, it may be necessary to reduce the number of claims to comply with rocket-docket requirements. (The claim portion of a patent document, whether it be an issued patent or a pending application, defines the boundaries of the invention.)

Even if your claim count is compliant, you should look at tuning them up based on your latest strategic pivots or competitive intelligence. For example, if the original claims were designed to cover a tooth brush with silicon bristles, and a competitor came out with a tooth brush that used textured silicon loops or you pivoted your technology to use loops instead bristles, the claims could be "lawyer-neered" to say tooth brushes with silicon tooth-rubbing members, thereby ensuring that any resulting patent is in sync with your evolving business.

  

What you should do now is huddle up with your business attorney and patent counsel to talk about where you're at in your business and whether having a patent in your pocket would help move the needle in the right direction. I say now because 3272 of this year's 10,000 available spots have already been taken (as of June 18). This is surprisingly low, given that more than 40,000 U.S. patent applications are filed every month. However, as word spreads and entrepreneurs learn about this tool, the window of opportunity could slam shut without much notice.

Although the 10,000-count will reset to zero on October 1st (the start of a new fiscal year), more folks will know about the rocket docket option then, meaning not only that there could be a stampede to take advantage of this fantastically valuable program, but also that many entrepreneurs could be left kicking themselves for not having acted sooner.

A Post by Eduardo Drake, Guest Blogger