Bouncing Around the Federal Securities Laws

April 13, 2011

By: Michael H. Altman

As securities lawyers, we get used to proposals by which the whole world changes every few years. In the 1990s, the SEC proposed a set of rule changes so massive that the proposal was quickly dubbed the “aircraft carrier release.” More recently, moves toward company disclosure, modernization of electronic filing, disclosure and proxy delivery rules, the welcome preemption of the most onerous state “blue sky” laws in the private placement contexts and the SEC’s enaction of rules to implement Sarbanes-Oxley and Dodd-Frank have, at times, stood various aspects of this practice on its ear.

One thing hasn’t changed, however. Issue equity to enough holders and you risk triggering the 500 holder threshold, in place since 1964, which would require periodic filings and public disclosure of financial results, executive compensation and other company information. In 2003, Google held its IPO when it crossed that threshold, saying “[b]y law, certain private companies must report as if they were public companies. The deadline imposed by this requirement accelerated our decision [to go public].” The most prominent company to currently face this hurdle is, of course, Facebook, which, instead of going public as Google did, raised money in another private placement which was exempt because it went to non-US investors under Regulation S. Of course, the offering only became foreign-only when the SEC questioned Goldman Sachs’ initially proposed structure for getting around the 500-holder rule.

Well, as of this week, the SEC chairman stated that the commission is “taking a fresh look at” this rule. This would allow Facebook and companies in similar situations to remain “private.” Because they would not be subject to periodic reporting, arguably management could more easily focus on long-term strategy, rather than on the quarter-by-quarter analysis and expectations that public companies must consider. In addition, these companies could continue to avoid the detailed disclosure requirements and costs attendant with compliance with the securities laws, including Sarbanes-Oxley. Finally, the emergence of secondary markets and private exchanges have enabled these companies to provide some liquidity for their equity-holders, even in the absence of a public offering.

This proposal is interesting, because it seems to go directly against the SEC’s often-repeated preference for increased disclosure and transparency. We’ll keep an eye on it.

I’ll end with one unrelated SEC action this week – the arrests of a former Wilson Sonsini lawyer and a Wall Street trader with insider trading in advance of at least 11 merger announcements involving Wilson Sonsini clients. The two individuals had no direct relationship with each other, but were only linked through a mutual friend who passed along the information. All 3 used only public telephones and disposable prepaid phones. Despite all these precautions, they were caught. There is no question that the SEC has stepped up its enforcement efforts in the insider trading realm, and the SEC and US Attorney have sufficient tools to track even sophisticated efforts. Trading while in possession of material non-public information is, of course, illegal, and there is no foolproof way of hiding tipping or trading activities from the authorities.

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Posted by mhaltman

Should employees joining a start-up make a “Section 83(b) election” on restricted stock awards?

April 11, 2011

By: Kelli Toronyi

A “Section 83(b) election” refers to a tax election available under Section 83(b) of the Internal Revenue Code (the “Code”). Generally, employees receiving restricted stock as compensation for services to a company must report income (and pay tax at ordinary income tax rates) when the stock is no longer subject to a substantial risk of forfeiture (i.e. the stock vests). The amount included in income is the difference between the fair market value of the stock upon vesting and the purchase price paid, if any, for the stock. Often restricted stock is granted with no purchase price so the amount taxable to the recipient is the full fair market value at ordinary income tax rates. Once vesting occurs and tax is paid at ordinary rates, if the stock is held and continues to go up in value before it is sold by the recipient, the additional increase in value is taxed at the applicable capital gains rate provided the one-year holding period is met.

However, Section 83(b) of the Code allows employees receiving restricted stock to make an election to recognize income on the restricted stock in the year the restricted stock is awarded rather than wait until the year of vesting when the fair market value of the stock is expected to be greater. In the year of the award, the value of the stock is often nominal and including that nominal value in income when the restricted stock is awarded is often a significant tax savings for the recipient as compared to the tax that would be due on the stock in the year of vesting without the election.

One drawback to making a Section 83(b) election is that since the stock is not vested when the election is made, the stock may be forfeited. The consequence of forfeiting restricted stock with respect to which a Section 83(b) election was made is simply that the recipient paid tax on unrealized income and the tax paid cannot be recouped through a subsequent deduction. Despite this drawback, in instances where the income to be reported if the election is made is small, most recipients of restricted stock make the election.

To make a Section 83(b) election, the election must be filed with the Internal Revenue Service within 30 days of the date the restricted stock is awarded. If this time period is missed, the opportunity to make a Section 83(b) election is lost.

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Posted by jadurant

The Patent Monopoly – More Than The Right To Exclude

April 7, 2011

By: John C. Scheller & Kenneth M. Albridge

Many entrepreneurs often associate the value of patent rights with the ability to protect the patent owner’s position in a given market by demanding royalties from others in the market or excluding them from the market altogether. However, the value of a patent can also be found in its prospective ability to open up doors to other markets and facilitate movement within a given market. This is best exemplified by Google’s recent $900 million acquisition of a family of Nortel patents out of bankruptcy.

For the last several years, Google has been attempting, with some success, to make in-roads into the mobile telecom market. However, in highly contested and patent-cluttered markets such as this, companies, even as large and formidable as Google, are often faced with significant barriers to entry. These barriers include the potential of ending up on the receiving end of a patent infringement lawsuit or paying exorbitant royalties to use a competitor’s patented technology. As Google has realized, though, while patent rights may act as a barrier to entry, they can also hold the key to entry and, once acquired, offer a certain level of freedom to move within the market. In a blog post on April 4, 2011 regarding the acquisition of the Nortel patents, Google explained: “one of a company’s best defenses against . . . litigation is (ironically) to have a formidable patent portfolio, as this helps maintain your freedom to develop new products and services.”

The Nortel patents recently purchased by Google cover two important technologies related to Long Term Evolution networking, which underlies the “4G” technology that many mobile telecom operators are deploying. Holding the patents for this underlying technology provides Google with more than the ability to demand royalties for its use or to exclude competitors from the marketplace. It will also allow Google to gain broader influence in the mobile telecom market through cross-licensing opportunities.

A cross-license is simply a license given to another to use a patent or invention in return for a similar license. Given the importance of the technology covered by the Nortel patents, Google is certain to find some takers willing to license their own patent rights in exchange for the right to use Google’s newly acquired technology. These cross-licenses will provide Google with substantial freedom to develop new products and services in the patent-cluttered mobile telecom market, which it would otherwise be unable to do without the threat of litigation.

Google’s recent acquisition of the Nortel patents demonstrates that patent rights often have value beyond the ability to protect the patent owner’s position in a given market. It is important for entrepreneurs to keep in mind both the potential offensive and defensive uses of patents and to think about what patents they should file or acquire in both contexts.

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Posted by jcscheller

United States Patent Reform Act

April 7, 2011

By: John C. Scheller and Matt Brown

On March 8, 2011, the Senate passed the America Invents Act. The Act’s most significant change to U.S. patent law would be to implement a “first-to-file” system, which gives patent rights to the first inventor who files a patent application for an invention, even if another inventor conceived of the invention prior to the inventor that filed first. This would create greater pressure to file an application for an invention as soon as possible.

Many think a first-to-file system would give bigger companies, such as Apple and Google, a competitive advantage over smaller companies, start ups, and entrepreneurs, because bigger companies inherently have more resources to file patents quicker and with more frequency. Thus, if the Act becomes law, it will be critical for smaller entities, many of which drive innovation in certain technology areas, to ensure they have quick and responsive patent counsel that can file patent applications for inventions as soon as possible.

Recognizing the potential disadvantage for smaller businesses, the Act also includes several provisions that would create new advantages for smaller businesses, start ups, and entrepreneurs. First, the Act would make it more difficult for large patent infringers to harass small business patent owners through continuous administrative challenges of a patent, or through challenges that have no likelihood of success, tactics commonly used to avoid license fees or to discourage an infringement suit. Second, the Act would eliminate interference proceedings as the method for determining the right to a patent between competing inventors, a costly proceeding which is almost always won by larger corporations. Third, because the Act will improve patent quality overall, it will be easier for start ups and entrepreneurs to raise capital from inventors, who would be more confident that an eventual patent would be less likely to be invalidated. Finally, the Act will require the PTO to provide a 50 percent reduction in fees for small businesses and will create a new “micro-entity” designation for truly small and independent inventors. This new micro-entity class will receive a 75 percent reduction in fees, which will greatly benefit start-ups and new inventors.

The America Invents Act, which passed in a bipartisan 95-5 vote in the Senate, still must make its way through the House to become law. Although the House is expected to vote in support of a compromise bill, final passage could be blocked by a late-stage “hold” in the Senate.

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Posted by jcscheller

Grant Money: When “Free” is not “Free”

April 6, 2011

By: Paul A. Jones

In a down VC market, in the heart of flyover country, it is perhaps inevitable that the lure of free money – SBIR grants, stimulus funds, etc. – would be compelling for Wisconsin’s life sciences entrepreneurs. And if “free” meant, well, “free” I suppose that would be a good, as well as inevitable, thing. But, alas, “free” does not always mean “free.” In fact, from a strategic business building perspective “free” all too often means “a lot more costly than you think.” So, before you spend another dollop of time, energy and, yes, even money pursuing the next too-good-to-be-true free money from the good folks in Washington and Madison that dole out all those tax dollars, consider a few things.

  1. What, ultimately, do the vast majority of folks that offer free money to life sciences and other technology companies look for in grant apps? The answer: good science with very early stage commercial potential that consenting adults, with cash to invest, won’t invest in. What, on the other hand, makes for a good commercial project worthy of financing from a business perspective? Projects that can generate products – and revenue – sooner rather than later. You know, the kinds of projects that investors want to fund, rather than the kind that scientific/academic researchers want to fund.
  2. What time does business run on these days? Internet time. What time do public agencies and grant programs run on? Government time (or, worse, academic time). Seriously, how often do grant application, consideration and funding timelines come even close to matching the timelines imposed by financial and consumer markets? Almost never.
  3. Do grants scale? Well, sort of. If your Phase I SBIR goes well, there is a big step-up at Phase II. But seriously, how big? Not relative to the puny Phase I, but relative to how much capital will actually be needed to get something to the market: something that a freely consenting adult will actually pay for?
  4. Just how much bandwidth does your team have? In terms of how much talent/time can you profitably afford chasing grants? And if the answer is “lots of talent/time” is available for hunting down “free” money what does that say about the commercial prospects of where your business is headed?
  5. Just because the academics on the team are good at finding and writing grants is no reason to apply for grants. Indeed, grants too often end up blinding the lab coats running a startup to the realities of the market, to the ultimate regret of all concerned – including even the lab coats themselves when they eventually find out that customers don’t care about peer-reviewed research, they care about value adding products.

Now I am not suggesting that grants shouldn’t be part of a good start-up’s financial model. But the financial model should serve the needs of the business and it’s investors, not the needs of grant writers. So by all means, use grants – sparingly – to establish credibility. And, if from time to time you run across a grant opportunity that actually dovetails nicely with your real business needs and timing, by all means go for it. But if you ever find yourself thinking that getting grants is what your  business is all about – well, don’t tell that to your investors.

2 Comments | start-ups, Venture Capital | Tagged: , , , , , , , | Permalink
Posted by pajones1

Cheaper…but still expensive

April 4, 2011

By: Paul A. Jones

Conventional wisdom has it that it takes a lot less capital to build a startup tech company these days – or at least a web-based startup tech company – than it did say 10 years ago. Many folks think that this should make it easier for flyover country entrepreneurs to compete with their counterparts in the major venture capital centers: that having big VC funds close at hand is no longer a pre-requisite for entrepreneurs in places like Wisconsin to compete with entrepreneurs in places like San Francisco. Well – I am not so sure.

As with much that passes for conventional wisdom, there’s an element of truth in the notion that it takes less capital to build a web-based startup today than it did in the past. The cost of building the tech in these startups is indeed a small fraction of what the cost was a decade back. But there is also an element of naiveté in the conventional wisdom, because while building out the tech may be cheaper, building out the company still takes, in most cases, the kind of capital that is still scarce here in Wisconsin.

These thoughts occurred to me a couple of days back when I saw that San Francisco-based Limos.com recently raised $10 million, courtesy of Austin Ventures, to become the Travelocity (or whatever) of the private limo business. That’s ten million dollars to … build a web site to book limos? Not really. The site was already built (presumably with some of the $5 million previously invested by Canal Partners). The new money will be mostly invested, presumably, in building the brand. Because the idea that “if you build it, they will come” only works, with any regularity, in Hollywood. In most other places, having built it you then have to tell people about it. A lot of people. A lot of times. You have to build a brand, and that still takes real money. It might even take more money today than a decade ago, when the noise level on the web was a small fraction of what it is today. And that’s sobering for entrepreneurs (and angel investors) in places like Wisconsin, where the number of firms that can invest $10 million in a “we have the technology, now let’s build the brand” play like Limos.com can be counted on the fingers of one hand, with digits to spare.

I guess my point here is not that it’s impossible for entrepreneurs in places like Wisconsin to compete, in terms of building meaningful web-based businesses, with places like Silicon Valley, or Boston, or even Austin. We have the technology, so to speak, and we have sufficient (there’s never enough) seed risk capital to make it work.  But we still don’t have regular access to the high seven and eight figure capital rounds that it usually takes to build a world beating brand. Until we do, don’t look for the next Limos.com here in the Badger state.

1 Comment | start-ups, Venture Capital | Tagged: , , , , | Permalink
Posted by pajones1

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