Fundraising Policy & Law
September 4th, 2021
Legal Overview of Private Offerings and Accredited Investor Standard
Both federal and local governments have long been concerned with regulating the financial sector. This has impacted many aspects of the startup environment, from reporting requirements and disclosures to private and public offerings, and many other domains. Two of the earliest such regulatory efforts were the Securities Act of 1933 and the Securities Exchange Act of 1934.
Securities Acts of 1933
The ’33 Act introduced regulation aimed at primary markets of public security offerings. This included public disclosure of details about the company and its capital-raising intentions. The disclosures occurred through filings that were reviewed and approved by a federal bureaucratic body before the securities were to be sold.
The Act also introduced guidelines for third parties involved in securities offerings and a ban on what is now commonly referred to as “general solicitation”. In other words, marketing activities around securities offerings were restricted (especially for private offerings). Additionally, high liability standards were put in place for the issuers of securities (Thompson).
Securities Exchange Act of 1934
The ’34 Act was meant to expand on the ’33 Act and also regulate secondary markets. It imposed further disclosure and registration requirements for issuers, and it authorized the creation of the Securities and Exchange Commission (SEC), the federal agency in charge of upholding securities laws (Thompson).
These two Acts were born out of the 1929 crash and the feeling that many had lost money due to their foolishness and lack of knowledge. This prompted the idea that inexperienced investors should be shielded from some risky markets.
Private securities are by definition riskier than public securities as investors have access to less — and lower quality — information. Throughout the years, a series of amendments and changes were made to these Acts to reflect the evolving needs of issuers, buyers, and the government to stimulate innovation while protecting unsophisticated investors.
The regulatory changes most relevant to this guide are the exemptions from public disclosure requirements and registration filings with the SEC relating to some public and private offerings.
Regulatory Changes and Their Implications
Specifically, Regulation A provides a degree of exemptions for smaller offerings (up to $50 million in any one-year period) to nonaccredited investors (Regulation A), while Rule 506 of Regulation D provides for the private sale of restricted, unregistered securities to an unlimited number of “accredited investors” (a standard based on wealth which will be discussed later) with no bounds on capital raised (Thompson).
One potential explanation for the difference between Regulations A and D is that smaller offerings might be perceived as less risky and thus can be opened to nonaccredited investors.
Rule 506 is the standard under which most private capital is raised in the United States (Ivanov). Regulations 504 and 505 also play prominent roles in private offerings, providing similar exemptions but imposing limits on the amounts raised. Other exemptions are based on company size, offering size, or a combination of these and other characteristics.
Jobs Act 2012
One recent and particularly large body of legislation concerning startups was the Jumpstart Our Business Startups (JOBS) Act of 2012. According to Investopedia, the key goals of the JOBS Act were to facilitate capital raising for small businesses (less than $1 billion in revenues) by loosening SEC restrictions and reporting requirements, allow “general solicitation” (advertising) during private placements of securities in certain cases, and make it easier for retail investors to participate in investments through crowdfunding with Regulation CF (companies can raise up to $1 million) and other limited unregistered equity offerings (JOBS).
The JOBS Act significantly changed the regulatory environment under which startups can raise capital. So far it has been successful in providing them with easier access to capital (Ivanov).
Prior to 2012, retail investors were generally unable to participate in unregistered offerings, which were reserved almost exclusively for accredited investors. The JOBS Act leveled the playing field by allowing retail investors to be involved in private issuings.
What is an Accredited Investor?
The “accredited investor” is a well-specified entity in the SEC code. An accredited investor is an entity (person or business) allowed to deal in securities unregistered with the SEC.
Investors are considered accredited if they meet one or more requirements concerning their “income, net worth, asset size, governance status [in the case of businesses], or professional experience,” (Rowley).
SEC Rule of 501 D
SEC Rule 501 of Regulation D puts forth the requirements for accredited investor status as (Hayes):
- A person with annual income over $200,000 (or $300,000 joint income) for the past two years and for the next year, or whose net worth exceeds $1 million (individually or jointly with a spouse, excluding primary place of residence)
- A general partner, executive officer or director of the issuing company
- A registered broker, or someone with sufficient academic or professional expertise regarding unregistered securities
- Businesses with assets exceeding $5 million, or if the equity owners are accredited investors
Accredited investors do not hold any formal certification, and while the SEC offers the aforementioned guidelines to determine eligibility, the burden of proof is on the issuers of the securities to confirm that the buyers are in fact accredited.
"Angel investor" is a common term entrepreneurs will hear when looking for early investors. Angel investors are wealthy individuals who invest in early-stage startups, and they usually offer more favorable terms than other capital providers (Ganti). Angel investors are usually qualified as accredited investors due to their wealth and sophistication.
Given the high qualifications for “accredited investors,” there has been a push to modify the standard’s definition. The original intent behind the Acts of ’33 and ’34, as well as that of the standard itself, was to protect unsophisticated investors from making financially risky investments. The issue is that under the current legal interpretation, wealth serves as a proxy for sophistication. This does not, however, truly align with the original intent of the Securities Act nor that of the Securities and Exchange Act.
New standards should perhaps take into account multiple features of a potential investor, such as knowledge, wealth level, and the path to their own capital formation (Haq). The SEC’s proposed expansion of the “accredited investor” standard would increase the pool of people that could participate in risky private markets by adding a process through which those with certain educational or professional credentials could be designated as accredited investors (Lee).
Regulation D Accredited Investor
Other recent changes are also relevant to founders looking to raise private capital. Private offerings through Form D were both large and on the rise in the late 2000s and early 2010s ($905 billion in 2010). 14 Regulation D managed to target the facilitation of small companies’ private offerings. The phenomenon of companies staying private longer (not going public for a decade or more) could partly be caused by the heavy regulatory burdens imposed on companies going public and partly by the existence of perceived “cold issue markets,” (Ivanov). However, Form D required companies to publicly disclose information that they may want to keep private (Herrfeldt). The JOBS Act loosened these reporting and disclosure requirements and gave founders more fundraising options, thus fueling the shift toward private issues that began under Regulation D.
LPs and LLCs: Legal structures for funds and startups
In terms of legal structures, both startups and venture capital (VC) funds can vary significantly. In this context, legal structure refers to the organizational structure of the fund or the company. For funds, this involves the internal hierarchical and reporting relationships, while for startups this mainly concerns incorporation matters. Understanding these differences will help explain the rationale behind the incentives and actions on both sides.
VC funds are usually organized as Limited Partnerships (LPs), which need to have two or more partners, including at least one managing general partner and at least one limited partner.
Uniform Limited Partnership Act
The main body of legislation regulating LPs is the Uniform Limited Partnership Act (ULPA). Introduced in 1916, it set organizational guidelines, defined rights and liabilities of limited partners and general partners, and outlined registration requirements with the appropriate authorities (Tarner).
Usually in a limited partnership, general partners have decision-making authority within the ordinary course of business to act in the best interests of the partnership. Limited partners are generally the ones who enjoy limited liability, meaning they are not liable for the debts of the partnership, but usually have no decision-making power.
The LP structure provides limited partners with an attractive return on their money as a passive investment while shielding them from personal liability. On the contrary, general partners tend to be personally liable for the debts accumulated by the partnership.
In recent years, the law has changed to adapt to current times and practices, and the environment allows for greater flexibility and protection for general partners (GPs) in some cases.
Venture Capital Firms
“VC firm” usually refers to the mix of structured entities that together comprise the firm. VC fund structures can get fairly complicated, but at a basic level, the roles and functions of each actor are fairly standard (Takatkah). Funds typically have a hierarchical and vertical structure with many layers.
GPs usually form a Limited Liability Company (LLC) in charge of managing the investors’ money to curb their liability, which is one of the reasons legislators made the ULPA more flexible. Additionally, the management company can manage multiple parallel funds at the same time with the same Limited Partners (Takatkah).
Lower-ranking roles in a fund include principals (who have the power to make investments but must follow firm strategy), associates (who oversee analysts), and finally analysts (junior employees tasked with market research, company analysis, due diligence, and deal scouting) (Cremades). People in each of these roles can get a founder’s foot in the door.
While organizational structure for VC firms tends to be fairly standard across the board, startups can organize in a number of ways. The most common solutions are Limited Liability Companies, C Corporations, and S Corporations.
Limited Liability Companies
LLCs offer some of the typical characteristics of both a corporation and of a partnership. Members of an LLC are not personally liable for debts accrued by the company. Additionally, LLCs can have some tax benefits: members can choose “pass-through taxation,” whereby the company’s losses and profits are listed on the personal tax returns of the owner(s), thus avoiding corporate federal taxes (Kenton). Another benefit of LLCs is that they are easy to set up and afford a high degree of flexibility to the owners.
S Corporations present some restrictions as they are only allowed 100 or fewer shareholders and one class of stock. They also present interesting tax benefits by avoiding double taxation (corporate income is split into salary and distributions.) Finally, C Corporations, and more specifically those incorporated in Delaware, are a VC fund favorite.
The main reason is that VCs won't get a yearly tax form from C Corps, like they would with an LLC. Additionally, C Corporations offer limited liability protection for an unlimited number of owners.
Ownership is represented by stock shares and, while a common class is required, multiple stock classes are allowed.
C Corps also tend to have more defined organizational structures and roles with three main tiers of actors: shareholders, directors, and officers. However, they present owners with the issue of double taxation, as both company profits and shareholder dividends are taxed.
C Corporations and LLCs can be optimal in different settings. C Corporations present investors with easy transfer of ownership, without limitation on status, nature, or number of shareholders (HBS). C Corporations are a better choice if the company is set to scale up, as governance structures are standardized for all sizes, and because scaling up LLCs requires hefty legal work.
Additionally, it is easier to raise capital thanks to stock issuance, which is not possible with an LLC. If the objective is to rake in steady profits, the LLC solution might be better; however, if the objective is to grow the company and operate on a larger scale, the C Corporation solution works best.
Delaware Limited Partnership Act
One of the main reasons VCs tend to prefer companies incorporated in Delaware is the Delaware Court of Chancery. It is a court of equity in Delaware with a long tradition and a high level of expertise when it comes to corporate law. Another benefit to corporations is that this court uses expert judges instead of juries (Akalp).
The State of Delaware also permits multiple classes of stock (HBS). This allows C Corporations to issue a customizable Preferred Stock, the “Delaware Blank Check Preferred Stock,” which is attractive for investors and VCs (C Corporation). With this type of preferred stock, investors can tailor their investment to their needs.
State law also affords C Corporations benefits in terms of employee compensation: Corporations can reward employees with stock options, which incentivize early employees to work towards growth. They can also deduct employee benefits as business expenses for tax purposes (HBS).
Another benefit of incorporating in Delaware is low income taxes on retained earnings. However, Akalp argues that incorporation in Delaware might not be cost-efficient for smaller companies that do not intend to operate in the state as it would add expenses and layers of bureaucracy (Akalp).
Preferred Stock vs Common Stock
In terms of stock preferences, there are 2 widely used classes: common stock and preferred stock.
Common stock is usually held by founders and issued when the company is formed. It can also be awarded to employees through stock option pools. In the U.S., investors usually receive convertible preferred with a liquidation preference, meaning that it can be converted into common stockat the investor's discretion. In case of a liquidation, the preferred stockholder will receive a specified amount before the common holders receive anything (Korsmo).
Investors tend to favor preferred stock as it can offer dividends and fixed returns, or otherwise reduce the investment risk to the VCs since they can benefit from anti-dilution and other provisions and take precedence over common stockholders’ claims (Cremades).
Investors can negotiate ad hoc terms for their preferred stock regarding ownership and involvement, which is significant since independent VCs tend to be active investors (Korsmo). For this reason, in many cases when investors obtain preferred stock, they are taking more control of the company than they are taking ownership of it.
Founders might fail to realize exactly how much they are giving up in terms of control and financial returns in case of new rounds, exits, or liquidation.
Preferred stock does offer some advantages to the company as well since it is considered equity (and thus does not increase the company’s leverage), but the “dividends” are deductible for tax purposes, which is a characteristic of debt (Korsmo).
Preferred affords investors greater leverage, greater control, and greater protection while providing tax benefits and lower compensation costs for the company. This dual-class system, however, can create conflict between different groups, as the interests of each group are not always aligned.
How Legal Structures Impact Incentives and Governance
Governance in startups is different than in public companies. This is because different shareholders have different rights, diverging interests, and often shifting and overlapping roles.
Startups have fundamentally different goals than mature companies. While the goal of the latter is to profit the owner(s), the goal of the former is to grow and scale its business offerings, often meaning a negative cash flow. These factors increase the chances for conflicts (Pollman).
VCs are active investors. They select the companies they think have the best chances of offering high returns and often push for board representation to have a say in company decisions.
Their participation as active investors, however, can be highly beneficial to a startup. VCs who are on the Board of Directors (BoDs) are likely to help the company in ways other than providing capital. They are likely to hire management and directors from their network, providing the startup with proven expertise. They also use their networks to provide exit opportunities, as relationship-based acquisitions become more likely with active investors.
VCs are more likely to be on BoDs if they are the lead investor in a funding round, but whether they are on a board also depends on what stage the company is in, existing relationships between the startup team and VCs, geographical proximity (Amornsiripanitch), and other factors (Allen).
What is Ownership and Control?
An important point to keep in mind for the VC-startup relationship is that control and ownership differ. Ownership refers to the actual percentage ownership of the company, while control refers to how much influence one actor has on the decisions a company makes.
In mature public companies, control and ownership usually are well-aligned. In startups, this is not always the case. Investors can leverage their way into obtaining more control than they have ownership in the business through a high number of board seats or provisions and clauses (Kaplan).
Nivi suggests that founders should create boards that reflect the real percentage ownership of the company so that control is well-distributed and so that the board can act in the best interests of the common shareholders (Nivi).
There are several mechanisms for founders to retain control over their companies, and the more leverage founders have going into investment rounds the more control they can retain. Some founders manage to create super-voting stock, while others use a variety of legal strategies (Young).
Another source of conflict can be the allocation of stock to early contributors. When deciding on grants to these early contributors, founders should keep future financing and their future ownership dilution in mind, working backward each round and coming up with a reasonable stock grant (Medearis).
Difference Between Ownership and Control
The differences between control and ownership, as well as problems that can arise from early share allocation, make it important for founders to establish early on a way to distribute stock and rights to investors, amongst themselves, and amongst other early team members.
The mix of control and relationships, as well as decisional power and execution, fall under the realm of governance. Governance is important because it dictates what direction a company will take in any and all matters. Many founders instead focus all of their attention and efforts on valuation, while ceding control and governance power to the investors.
Investors, on the other hand, are experienced and have long-term objectives and their own interests in mind. Since there are many contrasting groups with diverging interests, governance in a startup determines who gets their way. Because of this asymmetry, investors at times show opportunistic behavior if they are not confronted with a system of checks and balances (Broughman).
Governance matters because there needs to be a certain functional balance in order for the company to grow. If the owners and investors are expending all of their time and effort in power struggles, the company will suffocate.
Board of Directors Structure
The Board of Directors is a tool to exercise control and make strategic decisions. Its responsibilities include: crafting a general strategy and making large budgetary decisions; voting and approving key managerial decisions; and overseeing, compensating, and hiring executives (Suster).
Board structures can vary but there are some standards across companies. Companies tend to prefer having an odd number of directors, and it is common for startups to give seats to those who led the initial investing rounds and eventually hire independent directors as well (Hamadeh).
Since new board seats are typically allocated to new, large lead investors (in the form of preferred seats), founders who want to retain control need to add more common seats to the board. Finally, the BoD is bound by fiduciary duty to the company’s shareholders, meaning it must protect the shareholders’ best interests (Hamadeh).
However, given that startups have multiple classes of stock, there are different classes of shareholders with different interests, and directors represent these various classes.
Usually, the board structure is dominated by founders at the seed stage, founder-lenient after round A (2:1 or 3:2 founder to investor and independent ratio), and becomes investor-lenient after round B (unless the founders have a lot of leverage and can create a high degree of competition among investors) (Suster).
Founders should also aim at creating a highly functional board to make sure it can help the company grow and not stifle its potential. High-functioning boards have common characteristics (tight relationships, shared responsibilities, collective decision-making), just as low functioning boards do (not engaged in strategic discussion either because of the BoD itself or the managers, misaligned incentives, lack of accountability) (Suster).
To create effective boards it is important not to make common mistakes, like waiting for VCs to initiate the BoD set-up, having a board that is too small to offer viewpoints or too large to be flexible and make decisions or failing to establish adequate structures and processes (Zwilling).
Big picture decisions are made by the Board of Directors, which is why it is so important to carefully consider who you will give a board seat to. Giving up a board seat can happen in a variety of ways, but it always means that control is slipping away from the founders.
As investing rounds progress, control may slowly shift along a one-way path toward investors (Nivi). To counter this trend, founders should create the board before or at the seed round so that as investing rounds progress it has a well-established structure. In early rounds, founders should push to maintain control of the board; but as the rounds progress, founders should not necessarily walk away from good deals just because of board governance matters (Suster).
It’s also important to note that outside CEOs are often hired from the VCs' network, and this means they are likely to side with VCs during board disputes. Generally, CEOs of public companies hold a common seat on the board. It follows that if an outside CEO is hired at a private company, they would likely be assigned one of the common seats. As a preemptive measure, founders should be careful to create a new seat for a new non-founder CEO, so as to not lose common seats (Nivi).
Capital Investment Incentive
Because founders and investors represent two distinct interest groups, incentives are distinct as well. These incentives, which are either spelled out or implied in investment agreements in the form of provisions and clauses, can serve to regulate the relationship between the two groups.
Governance impacts incentives, as groups with more power tend to strike more favorable terms for their agreements. The incentive for investors is a potential exit, and thus their goal is to protect their investment (Feld). Ultimately, their objective is to be able to sell their stake, either through an IPO or through the sale of the business to another firm, and to achieve significant returns in doing so. They are motivated by this long-term goal and by their fund’s interests. After all, VCs have a fiduciary duty towards their Limited Partners (Cremades), and the decisions they make — or push the company to make — are aligned with the fund.
Another incentive for investors is to gain a positive reputation among the founder community, lawyers, and other investors. The VC industry, at this point in time, is highly reputational because information about VC behavior is easily shared within communities (Gilson). If VCs want to keep attracting deal flow, they need a strong reputation as respectable and knowledgeable people with excellent networks and expertise. For these reasons, VCs often bring additional value when they are on the board (Amornsiripanitch).
On the other hand, founders' interests lie more in remaining engaged in the success of the company. Thus, they are incentivized to retain as much control and leverage as possible. This determines what works for them as incentives.
One such incentive is accelerated vesting at termination. Vesting simply refers to the conveyance of unconditional rights to the ownership of shares. It is usually a provision that keeps founders from leaving, as their shares have a vesting schedule throughout the life of the startup, and many times vesting is canceled if the founder abandons the company.
Some argue that since founders usually accept vesting provisions in order to prove their commitment to the company, they should also push for accelerated vesting at termination, which would prove the company and investors’ commitment to them.
This would incentivize founders to work but also disincentivize investors from terminating them without good reason, thus giving founders not merely a financial incentive, but also a personal commitment (Nivi). In the case of accelerated vesting upon termination, a founder fired by the board will obtain the unconditional rights to their ownership immediately.
Because investors are accustomed to striking deals, they plan for the long haul with provisions and rights in their term sheets and strategy for board control. Founders need to do the same to preserve and protect their interests. Founders should use the same contractual tools (accelerated vesting, preventive measures to avoid the company being sold too cheaply, and board control and influence) to counteract and balance the advantages investors seek (Nivi).
Other measures founders might take are the creation of supervoting stock and proxy voting from certain investors (Young).
The relationship between stakeholders is complex and potentially riddled with conflicts created by diverging interests. While the VCs look to a medium-term investment that can be quickly liquidated, the founder has a longer-term perspective.
The fundamental tool of Venture Capital that helps manage the relationship and regulate incentives is staged financing. This tool allows investors to directly and constantly reevaluate the startup project through the right-of-first-refusal provision.
Conversely, investors are expected to contribute to future financing rounds. This explicit-implicit process attempts to manage the differing interests of VCs and founders and offers insight into how that complex relationship is regulated (Gilson).
The explicit aspect has contractual and legal consequences, but the implicit aspect has important reputational ones. Investors seek to protect their investment through control thanks to covenants and provisions. However, there is a fundamental information asymmetry between investors and founders. Founders have a better understanding of the product, the research, and potentially the market. Investors have an advantage when it comes to agreements, financing structure, provisions, and control, given their expertise (Kaplan).
This informational asymmetry, coupled with diverging interests, can lead to opportunistic behaviors, especially on the investor side, as mentioned before. Since it is likely that VCs will achieve a high degree of control (and VC control can be beneficial for the company through their non-economic value-add), they are more likely to show opportunistic behavior, (Broughman) and founders should be prepared to fight back.