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What is Form D and what information gets publicly disclosed to the SEC regarding a financing?

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The SEC adopted new rules regarding Form D, which is routinely filed by companies for venture financings relying on one of the securities exemptions under Regulation D of the Securities Act. Regulation D is a exemption from the onerous registration requirements (i.e. a Form S-1 registration statement) of the Securities Act for a private placement of securities.

Form D is currently filed in paper format and must be filed within 15 days of the first sale of securities in the offering. Paper filings can be accessed through the SEC public reference room, and some third-party services provide information on Form Ds by scanning the paper filings. Some publications covering private company financings routinely monitor information on Form D filings from these third-party services, and often announce details of venture financings discovered in Form D filings.

Effective March 15, 2009, the old paper version of Form D will be eliminated, and electronic filing of the new version of Form D will be mandatory. The SEC’s new online filing system for Form D is expected to be available September 15, 2008, after which there will be a six-month transition period during which companies will have three options for filing a Form D: (i) filing the old version of Form D on paper; (ii) filing the new version of Form D on paper or (iii) filing the new version of Form D electronically.

Once Form Ds are filed electronically under the new rules, they will be available to anyone via the SEC’s EDGAR website.  Start-up companies that are operating in “stealth” mode or have otherwise made no public announcement of their financings should be aware that Form Ds will be more readily available once electronic filing becomes mandatory. Thus, some venture funds have requested that company counsel in venture financings avoid filing Form Ds.

Failure to file a Form D complicates the ability of the company to comply with state securities laws.  Unfortunately, one of the benefits of filing a Form D and complying with Regulation D is that the company does not need to separately comply with a securities law exemption in each state where the securities are offered. Compliance in each state requires company counsel to confirm that an exemption is available, which may increase costs in a financing if offers are made in multiple states. In addition, exemptions may not be available in certain states based on the fact pattern unless the offering also complies with Regulation D. Thus, any decision to affirmatively avoid a Form D filing should be carefully discussed with counsel.

Please refer to the existing version of Form D for the information that must be disclosed.  Among other things, the amount of the financing, the names of executive officers and directors, and the names of 10% stockholders must be disclosed.  The new rules eliminate some of the disclosure required by the current version of Form D. In particular, companies will no longer be required to identify 10% stockholders by name, or to provide detailed information on the use of offering proceeds. The new Form D will require some new disclosure in other areas, however, including a requirement to provide information on the recipients of sales commissions or finders fees.  In addition, the new rules also clarify when amendments to Form D are required.

[Update:  PEHub, which regularly uses Form D filings to report on venture financing, notes that the new rules require less information that the old rules, and that they will not cite information from the revised form without corroboration.]

What is par value?

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Par value is the minimum price per share that shares must be issued for in order to be fully paid. I typically recommend that par value be set at $0.001 or $0.0001 per share.  Thus, if a founder purchases 8,000,000 shares of common stock, the minimum price that the founder has to pay is $8,000 at $0.001 per share or $800 at $0.0001 per share.  Par value can even be set lower, such as $0.00001 per share, in order to minimize the amount paid for founders.  Some states, like California, allow for no par value shares.

What is the California Finance Lenders Law?

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Under the California Finance Lenders Law (the “CFLL”), a person engaged “in the business of a finance lender or broker” within California generally must obtain a license from the California Department of Corporations.  The law provides a number of exemptions from this requirement, including exemptions available for small business investment companies and persons that limit their lending activities to no more than one loan in any 12-month period.

However, the licensing requirements of the CFLL are not triggered by a qualified bridge loan (“QBL”), which is defined as a “commercial bridge loan” made by a “venture capital company” to an “operating company.”  Thus, a venture capital fund that made only QBLs would not be required to obtain a license under the CFLL.  However, a fund that makes other types of loans should be subject to licensing requirements only if those loans cause the fund to be engaged in the business of a finance lender or broker.

In general, a “commercial bridge loan” is any loan that: 

1.         Has a principal amount of $5,000 or more;

2.         The proceeds of which are intended to be used by the borrower other than for personal, family or household purposes;

3.         Matures in one year or less;

4.         Is made in connection with, or in contemplation of, an equity investment in the borrower;

5.         Is secured, if at all, solely by the borrower’s business assets (but not by real property); and

6.         Is subject to the implied covenant of good faith and fair dealing arising under Section 1655 of the California Civil Code.

A venture capital fund generally will be a “venture capital company” if it: 

1.         Engages primarily in the business of promoting economic, business, or industrial development through “venture capital investments” or the provision of financial or management assistance to operating companies;

2.         At all times maintains at least 50 percent of its assets in venture capital investments or commitments to make venture capital investments;

3.         Maintains or, assuming consummation of the equity investment to which a commercial bridge loan relates, will maintain a material equity interest in the borrower;

4.         Approves each loan made to an operating company through the fund’s board of directors, executive committee, or similar policy body, based on a reasonable belief that the loan is appropriate for the operating company after reasonable inquiry concerning the operating company’s financing objectives and financial situation; and

5.         Complies, when making the loan, with all applicable federal and state securities laws.

A “venture capital investment” is “an acquisition of securities in an operating company that a person, an investment adviser of the person, or an affiliated person of either, has or obtains management rights to.”  The statute provides no definition of the term “management rights,” but the term is well defined in other places.  The first is the definition of “venture capital operating company” under the Employee Retirement Income Security Act of 1974 (“ERISA”).  The second is Rule 260.204.9 of the California Code of Regulations, which deals with the regulation of investment advisors.

In general, a borrower is an “operating company” if it: 

1.         Engages (directly or through subsidiaries) in the production or sale, or the research or development, of a product or service other than the management or investment of capital;

2.         Uses all of the bridge loan proceeds for the operations of its business; and

3.         Approves the bridge loan through its board of directors, executive committee, or similar policy board, based on a reasonable belief that the loan is appropriate for the borrower after reasonable inquiry concerning the borrower’s financing objectives and financial situation.

What are directors’ duties and what can they do to protect themselves in a sale of company?

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[The following post is courtesy of Priya Cherian Huskins, Esq., a partner and senior vice president at Woodruff-Sawyer & Co., an insurance brokerage headquartered in San Francisco, California.  Priya specializes in director and officer liability and its mitigation through both insurance and corporate governance solutions.  This article was first published in the 2008 edition of Boardroom Briefings: Mergers and Acquisitions, and has been republished here with Priya’s permission.  Priya was previously an attorney at WSGR.]

Consider this scenario: a company’s CEO tells his board that he has received a compelling offer for the sale of the company.  Upon reviewing the offer, the directors agree that the offer is attractive, and think that the shareholders would be well-served to accept the offer.  However, as experienced board members, they know that the potential sale of a company is an inflection point for litigation.  After all, 24% of securities class action law suits include merger-and-acquisition-related allegations[1], and shareholders often bring breach-of-fiduciary duty suits in connection with M&A activities.

The board’s next steps are critical, both to maximize shareholder value and to avoid litigation that may result from failing to do so.  This article outlines the fundamental duties of a board considering the sale of a company.  The article also details what a board can do – beyond diligently fulfilling its duties – to protect itself from liability and thereby focus entirely on promoting the interest of shareholders.

What Are a Director’s Duties under the Law?

When it comes to directors’ duties, it is always useful to think in terms of the golden triad of the duties (1) care, (2) loyalty, and (3) appropriate disclosure.  As is the case in other situations that call for director action, this triad provides a useful framework for thinking about the sale of a company.

1.  Duty of Care.  The duty of care requires that directors diligently pursue the interests of the shareholders who elected them.  Consistent with this duty, and articulated in the well-known Revlon[2] case and its progeny, once a company is up for sale directors of the company must “undertake reasonable efforts to secure the highest price realistically achievable given the market for the company.”[3]

If the board’s efforts are subsequently challenged, the court will review the process set up by the directors for reasonableness.  This is a tougher standard of review than the usual “bare rationality” standard that courts apply to other board decisions, referred to commonly as the business judgment rule.  As one Delaware Chancery Court opinion described it, “this reasonableness review is more searching than [the business judgment rule’s] rationality review, and there is less tolerance for slack by the directors [emphasis added].”[4]

Recognizing that one size will not fit all, Delaware courts have declined to provide boards with the comfort of a “judicially prescribed checklist of sales activities.”[5] Instead, directors must use sound business judgment to construct a deliberate, systematic sale process reasonably designed to maximize shareholder value.

One sale process that most would agree is designed to maximize shareholder value is to conduct an auction of a company.  There is, however, no requirement to conduct an auction of the company.  In the June 2007 Delaware Chancery Court decision concerning the sale of the baseball card maker Topps Company, Inc., the Court noted that in light of a failed auction attempt two years earlier there was no need for the company to conduct an auction when it decided to sell itself.  The Court ruled this way in part because Topps did not have a poison pill in place that would otherwise discourage other buyers from approaching the company.[6]

Nevertheless, companies should be on guard against prematurely cutting off alternative buyers.  Consider, for example, the proposed sale of Netsmart Technologies, Inc.  In its March 2007 decision concerning that company’s sale process, the Delaware Chancery Court was unimpressed by the board’s consideration of only private equity buyers.  The Chancery Court took special note of the board’s failure to consider strategic buyers when it decided to sell the company.  In the words of the Chancery Court “it was incumbent upon the board to make a reasonable effort to maximize the return to Netsmart’s investors. On the existing record [which supports no serious consideration of strategic buyers], I cannot conclude that their approach to this issue is indicative of such an effort.”[7]

Part of a board’s ability to put together a reasonable sale process will depend on the board’s familiarity with a variety of sophisticated deal-protection devices such as no-shop provisions, break-up or termination fees, matching or topping rights, and the like.  In addition to understanding the mechanics of these types of provisions, a board must also understand the impact these types of provisions will have on the board’s ability to maximize value for its shareholders.

This is an area where the board is well-served by seeking advice from independent litigation counsel and having its discussions with counsel protected by the attorney-client privilege.  Consistent with the public policy that supports attorney-client privilege, a board will want an opportunity to freely ask questions about the proposed transaction and to debate the merits of the deal.  The possibility of future litigation can chill this kind of back and forth.  Directors may fear that in future litigation their genuine and sincere questions will be misconstrued as evidence of nefarious intent.  In light of all of this concern, the board should ask outside counsel specific questions about how to protect the privilege, and then to follow the protocol outside counsel recommends.

Finally, in addition to having a good sale process, a board is well-served by documenting its sale process in a timely and diligent manner.  A too-casual approach can result in few formal meeting minutes or worse still the exercise of approving minutes after litigation has commenced.  The board will not want to appear casual if it finds itself in the midst of hotly contested litigation over the adequacy and diligence of its efforts.

2.  Duty of Loyalty.  The duty of loyalty requires that directors act in an independent manner and with regard only to the concerns of the shareholders.  In the context of the sale of company, it is inappropriate to favor one buyer over another for reasons other than the maximization of shareholder value.

One way to violate the duty of loyalty is to give preferential treatment to a buyer that plans to keep current management and/or board members around after the sale has closed.  The possibility that a potential buyer was treated more favorably by management due to promises made to keep management in place post-closing was exactly the conflict of interest issue that was brought to the Delaware Chancery court’s attention in the earlier-described Topps transaction.  In reviewing the facts of the case, the Chancery Court found that the bid of a potential acquirer that would likely have replaced management was treated less favorably compared to the treatment accorded another bidder that had promised to retain management.[8] This was part of the reason that the Court was unwilling to allow the merger vote to move forward without giving the badly treated potential buyer an opportunity to communicate directly with Topps’ shareholders.

Forming a Special Committee of the board composed of outside directors to drive the sale process is a way to mitigate the potential conflict-of-interest issues with respect to incumbent management.  If the board decides to go in this direction, the board should form the Special Committee sooner rather than later to get the maximum benefit of the Committee.  One decision early in the process that is best undertaken by a Special Committee-and not management-is the scope of the types of offers and buyers the board will entertain.[9]

The Special Committee should avoid delegating too much authority to any member of the management team who has a conflict of interest.  Doing so considerably weakens the protection that the formation of a Special Committee can offer.  In its June 2007 decision concerning the sale of the Lear Corporation, the Delaware Chancery Court specifically addressed the issue of putting in charge of negotiations a CEO who had a clear personal interest in having a sale consummated.  Although the Court ultimately decided that there was no evidence that putting this CEO in charge of negotiating this particular sale “adversely affected the overall reasonableness of the board’s efforts to secure the highest possible value,” the court still referred to the Special Committee’s decision in this matter as ” infelicitous.”[10] In other words, the Special Committee got lucky with the Court’s “no harm, no foul” ruling.

3.  Appropriate Disclosure.  It is uncontroversial that directors have a duty to disclose to shareholders all information that is material to a shareholder’s decision to vote on the sale of a company.[11] More specifically, directors are required to disclose balanced, truthful, and materially complete information.[12] In the heat of a sale transaction, it can be all too easy for management and boards to neglect to adhere fully to this requirement.

This was an issue raised in the 2007 Netsmart Technology decision.  The board and management’s failure in this regard caused the court to require the company to provide more information to shareholders prior to holding a vote on a proposed merger. Specifically, the Chancery Court wanted to make sure that the shareholders had a chance to review the discounted cash flow analysis that the company’s investment bankers prepared because the shareholders were being asked to rely on a fairness opinion that itself relied on these projections.  In the words of the court, “[o]nce a board broaches a topic in its disclosures, a duty attaches to provide information that is materially complete and unbiased by the omission of material facts.”[13]

What Else Can Directors Do to Protect Themselves?

Even the best board with a laser-like focus on its duties of care, loyalty and disclosure may find itself the target of a suit brought by disgruntled shareholders or perhaps a disgruntled bidder.  A board’s concern over such suits can result in excessive caution, which is not in the best interest of shareholders.  Consequently, the natural next question is “what can board members do to protect themselves from personal liability?”

First and foremost – and well before any potential sale event – directors should update their personal indemnification agreements with their companies.  Rather than rely on a contract that may be many years old, directors should ask someone who represents the board to review the indemnification agreement to ensure that they have the most protective language possible.  This review should pay special attention to change-of-control provisions.  For example, indemnification agreements should expressly require an acquiring company to assume the selling company’s indemnification obligations in writing.  This exercise of updating the board’s indemnification agreements ultimately inures to the benefit of the company’s shareholders by allowing the directors to put concerns of personal liability aside and focus instead on the business at hand.  It is also consistent with public policy position expressed by Delaware corporate law.  Delaware’s corporate law allows companies to protect their directors with expansive indemnification protections.

Next, and again well before any potential sales event, directors should confirm that their D&O insurance policies are well-designed.  If there has not been an independent check of the D&O policies for a number of years, conduct one.  D&O policies are highly technical contracts, and can be properly analyzed only by an expert in the field.  Among the provisions that should be analyzed are the change-of-control provisions, as well as provisions that prevent the knowledge and acts of another person – an officer, for example – from being attributed to a board member to his or her detriment.

Finally, when a company is ultimately acquired, the company’s board will want to make sure that a “tail policy” is purchased for the acquired company’s D&O insurance policy.  Typically six years in duration, a tail policy holds open the acquired company’s current D&O policy so that it will respond to new claims that are made against the acquired company’s directors after the sales transaction has closed.  The directors of the acquired company may not be in a position to demand protection from the acquiring company after the sale is closed.  Consequently, it is essential that the board of the selling company put this protection in place before the sale is consummated.  One way to do this is to have the directors’ personal indemnification agreements include the right to a tail policy should the company be acquired.

Serving Your Shareholders, Protecting Yourself.  In summary, the sale of a company is a high stakes event for shareholders, management, and directors.  The role of the board is to seek an outcome that is the best available to the shareholders.  To meet the demands of this role, directors must understand what is required with respect to the duties of (1) care, (2) loyalty, and (3) appropriate disclosure.  In exercising their duties, shareholders are not served when directors act with excessive caution.  Instead, shareholders are best served when directors can exercise judgment that is unclouded by the concern that, notwithstanding their good faith efforts, they will be faced with a shareholder suit.  To alleviate this concern, directors should take proactive steps before a sale is even on the horizon to obtain state-of-art indemnification agreements and D&O insurance policies.  With advance planning, a board will be well positioned to handle a sale in a way that effectively and properly promotes the interests of shareholders.

[1] Woodruff-Sawyer & Co. Proprietary Securities Class Action Litigation Database.

[2] Revlon, Inc. v. MacAndrew & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1985).

[3] In re Netsmart Technologies, Inc. Shareholder Litigation, 2007 WL 1576151 (Del. Ch.).

[4] Netsmart at *15.

[5] Ibid.

[6] In re The Topps Company Shareholder Litigation, 2007 WL 1732586 (Del. Ch.) at 50.

[7] Netsmart at *18.

[8] Topps at 61 and 62.

[9] Netsmart at *21.

[10] In re Lear Corporation Shareholder Litigation, 2007 WL 1732588 (Del. Ch.).

[11] Arnold v. Society for Savings Bancorp., Inc., 650 A.2d 1270, 1277 (Del. 1994).

[12] Netsmart at *21

[13] Netsmart at *24.

Filed Under: M&A

What is important in a confidentiality agreement or non-disclosure agreement (NDA)?

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There are various factors to consider when reviewing or drafting a confidentiality or non-disclosure agreement (NDA). Obviously, your perspective on the agreement depends on whether you are primarily disclosing or receiving confidential information. The following points should be kept in mind:

  • Need for an agreement. Entering into an NDA increases the risk that the recipient may face charges of trade secret misappropriation if it develops similar information in the future or inadvertently discloses or uses the information. This is the primary reason that VCs will not enter into NDAs.
  • Mutual versus one-way. Some agreements only cover disclosure of confidential information by one party. Other agreements are mutual and cover disclosures by both parties. Generally speaking, mutual agreements are less likely to have provisions that are one-sided.
  • Non-disclosure and non-use. There are two important restrictions in an NDA. The non-disclosure provision prevents the recipient from disclosing the confidential information to third parties. The non-use provision prevents the recipient from using the information other than for a specified purpose. Occasionally, an NDA may not have a non-use provision. This would allow the receiving party to use the information for its own purposes as long as it did not disclose the information
  • Definition of confidential information. The discloser will want a broad definition of confidential information and may also want third party confidential information to be deemed confidential. The receiver will want to narrow the definition of confidential information in order to avoid being “tainted” by the information. The definition can be narrowed by (i) limiting it to information disclosed in writing (or oral disclosures reduced to writing within a certain time frame), (ii) specifically marking the information confidential, (iii) specifying the information that is deemed confidential or (iv) specifying the dates of disclosure. The discloser will want to avoid some of the limitations because of the possibility or inadvertent disclosure or over-marking information as confidential, which may impair the ability to enforce the agreement with respect to genuine trade secrets.
  • Exceptions to confidential information. The recipient will want broad exceptions to the definition of confidential information. Typical exceptions to the definition of confidential information include (i) information publicly known or in the public domain prior to the time of disclosure, (ii) information publicly known and made generally available after disclosure through no action or inaction of the recipient, (ii) information already in the possession of recipient, without confidentiality restrictions, (iv) information obtained by the receiver from a third party without a breach of confidentiality, and (v) information independently developed by the recipient. The discloser will try to limit the exceptions or add qualifiers such as the discloser must prove the exception with contemporaneous written records. Please note that the typical exception for information required to be disclosed by law should be an exception to the duty to not disclose, as opposed to an exception from the definition of confidential information (which would allow the recipient to disclose the information to anyone).
  • Residual information. The recipient will want to include a clause that allows the recipient to use the discloser’s information that is retained in its employees’ memory. The recipient will want to avoid being “tainted” by receiving the information. This is often strongly rejected by the discloser. In the event the residuals clause is included, the discloser may try to limit it to (i) use of general skills and knowledge, (ii) information retained in the unaided memory of employees after a certain amount of time after access to the confidential information, and (iii) explicitly noting that the discloser is not granting any license to the recipient.
  • Permitted disclosures. The discloser will want to limit disclosures to employees and contractors on a need to know basis with similar non-disclosure obligations. In addition, if disclosure is required by law, the discloser will want the recipient to notify the discloser in advance and provide the opportunity to obtain a protective order or otherwise maintain the confidentiality of the information.
  • Term. NDAs commonly have terms of three to five years. The period of time depends the strategic value of the information to the discloser and how quickly the information may become obsolete.

What trademark and other legal issues are involved in selecting a company name?

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[The following post is courtesy of John Slafsky and Aaron Hendelman in WSGR’s Trademarks and Advertising Practices Group.]

Among the most important tasks in the founding of a new company are the development and clearance of a company name.  There are two very different sets of legal issues, and a host of business issues, involved in the process.

Legal Issues

One set of legal issues concerns availability of the name under state law relating to entity names.  In the case of corporations or limited partnerships, this involves checking with the Secretary of State of the states where they are formed and where they must “qualify” to do business (usually where they have offices or resident employees or a sales force).

The Secretary of State checks the state records to ensure that there is no other corporation or limited partnership with an identical or closely similar name; if one is found, the new name is generally not permitted.  This happens even if the two companies are in vastly different lines of commerce; the sheer similarity of the name bars the second name.  (On some occasions, consent of the earlier company or a relatively minor alteration of the name, such as “ULTIGRA, INC.” to “ULTIGRA SOFTWARE, INC.,” may increase the chances that the state will allow the new name.)

The second set of legal issues concerns trademark law.  The Secretary of State’s approval of a business name does not grant trademark rights or authorize a company to use a particular business name in commercial activities.  (Nor does registration of a corresponding domain name result in any significant legal rights.)  A company may have incorporated under a name but find itself liable for trademark infringement or dilution — with potential risks of an injunction, disgorgement of profits, payment of damages, and more — for use of the name.

Trademark infringement occurs when a person or company uses a name or mark in a way that causes a likelihood of confusion with another person or company with respect to source, sponsorship, or affiliation of products, services, or commercial activities.  Thus, “McCoffee” may infringe upon the marks of McDonald’s Corporation by leading the public to believe that “McCoffee” is a product or an affiliated company of McDonald’s.  A company also may be liable for trademark dilution by using the famous mark of another company even if there is no competitive overlap or likelihood of confusion. For example, the name “Pentium Petroleum Corporation” may well dilute the PENTIUM trademark of Intel Corporation.  It therefore is important to assess the potential trademark law risks of a name before adopting it as a company name.

The fact that a company still has a low public profile, or does not yet have products on the market and does not yet have a website, does not immunize it from challenges.  Some companies have been sued for allegedly causing confusion through their financing activities or for use of a pre-release code name for a new product.

Some companies, in a rush to form a company, devise names in a hurry and do not clear them for trademark purposes.  Often, they consider the name a “place holder” until a later time when they can invest the money and effort to attend to a new name.  This creates a number of risks.  First, there is the risk of liability.  Second, management may “fall in love” with the placeholder name and become unwilling to give it up later.  Third, the company may develop goodwill under the placeholder name that will be lost upon a name change.  Fourth, the company may incur significant legal and administrative costs when it later undergoes a name change.

Our Assessment

Legal assessment of a business name involves several steps.

We check the availability of the name with the Secretary of State for the relevant states; if the name is available with the Secretary of State, we reserve it pending an in-depth search.  The Secretary of State availability check and reservation require only nominal fees.

We also perform searches of trademark databases in-house using on-line services or other research materials.  The purpose of the searches is to determine whether a name is so likely to be unavailable that a more comprehensive search would be wasteful.  A preliminary screening search is not sufficient diligence to assess the real issues in adoption of the name.

After the screening search, we obtain an in-depth trademark search from an outside search company.  It examines federal and state trademark registers and a large number of sources of unofficial information about company and product names in relevant fields.  We obtain an extra copy of the search report for our client and expect it to review the report carefully for potential conflicts; we then discuss our assessment with the client. 

Once a company is comfortable with the level of risk of its chosen name, it is important to find ways to protect the name.  If the name will be used on products, or in connection with the advertising or promotion of services, it often is a good idea to file an application for federal registration of the name based on the company’s intent to use the mark.  This will help establish rights to the name; more importantly, it gives early notice to others who might otherwise overlook the company’s name when they do searches to develop their own names.

For further information, please contact John Slafsky or Aaron Hendelman in WSGR’s Trademarks and Advertising Practices Group. 

What’s the difference between an ISO and an NSO?

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[The following is not intended to be comprehensive answer. Please consult your own tax advisors and don’t expect me to answer specific questions in the comments.]

Incentive stock options (“ISOs”) can only be granted to employees.  Non-qualified stock options (“NSOs”) can be granted to anyone, including employees, consultants and directors. 

No regular federal income tax is recognized upon exercise of an ISO, while ordinary income is recognized upon exercise of an NSO based on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. NSO exercises by employees are subject to tax withholding. However, alternative minimum tax may apply to the exercise of an ISO.

If shares acquired upon exercise of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss. An earlier sale or other disposition (a “disqualifying disposition”) will disqualify the ISO and cause it to be treated as an NSO, which will result in ordinary income tax on the excess, if any, of the lesser of (1) the fair market value of the shares on the date of exercise, or (2) the proceeds from the sale or other disposition, over the purchase price.

A company may generally take a deduction for the compensation deemed paid upon exercise of an NSO.  Similarly, to the extent that the employee realizes ordinary income in connection with a disqualifying disposition of shares received upon exercise of an ISO, the company may take a corresponding deduction for compensation deemed paid. If an optionee holds an ISO for the full statutory holding period, the company will not then be entitled to any tax deduction.

Below is a table summarizing the principal differences between an ISO and an NSO.

  ISO NSO
 Tax Qualification Requirements: * The option price must at least equal the fair market value of the stock at the time of grant.

* The option cannot be transferable, except at death.

* There is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a NSO).

* All options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier.

* The options must be exercised within 10 years of grant.

* The options must be exercised within three months of termination of employment (extended to one year for disability, with no time limit in the case of death).

 None, but an NSO granted with an option price less than the fair market value of the stock at the time of grant will be subject to taxation on vesting and penalty taxes under Section 409A.
Who Can Receive: Employees only Anyone
How Taxed for Employee: * There is no taxable income to the employee at the time of grant or timely exercise.

* However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax.

* Gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise).

* Disqualifying disposition destroys favorable tax treatment.

 * The difference between the value of the stock at exercise and the exercise price is ordinary income.

* The income recognized on exercise is subject to income tax withholding and to employment taxes.

* When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

What is qualified small business stock?

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Under Internal Revenue Code Section 1202 , a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of “qualified small business stock” held for more than five years may exclude 50% of such gain from gross income for regular income tax purposes.  The amount of gain that may be taken into account for purposes of the exclusion is subject to a limitation equal to the greater of: (i) $10,000,000 (less previ­ously excluded gain attributable to the disposition of other shares issued by the company), or (ii) 10 times the aggregate adjusted basis of the shares. In addition, a portion of the excluded gain is included in the calculation of alternative minimum taxable income.

Under IRC Section 1045, an individual may roll over proceeds from the sale of a qualified small business stock held for at least six months, when the proceeds are used to purchase qualified small business stock in another company. This effectively defers the tax due on any gain on the stock.

However, the maximum tax on long-term capital gains is 15% for most taxpayers and a 28% rate applies to gain on qualified small business stock.  The effective tax rate after the 50% exclusion is 14%.  Therefore, there is no substantial benefit to qualified small business stock unless the gain is rolled over into other qualified small business stock.

Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements. 

Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify.

In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time.

Please note that certain redemptions, including (i) redemptions of stock from the holder of qualified small business stock (or a related person) and (ii) certain significant redemptions occurring within one year before or after a stock issuance may disqualify any newly issued stock.

[Note: please go ask your own tax advisors any questions about qualified small business stock because I will not answer technical questions in the comments.]

What is an 83(b) election?

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Failing to make a timely 83(b) election with the IRS is something that could lead to disastrous tax consequences for a startup company founder or employee.

Founders typically purchase stock pursuant to restricted stock purchase agreements that allow the company to repurchase “unvested” stock upon termination of employment. Similarly, employees may “early” exercise options subject to the company’s ability to repurchase “unvested” shares upon termination of employment.

Under Section 83 of the Internal Revenue Code, the founder/employee would not recognize income (the difference between fair market value and the price paid) until the stock vests. However, if a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock.

Typically, the purchase price for the stock and the fair market value are the same. Therefore, if an 83(b) election is made, there is no income recognized. Thus, a founder/employee should almost always make an 83(b) election. The benefits of an 83(b) election generally are starting the one year capital gain holding period and freezing ordinary income (or alternative minimum tax) recognition to the purchase date.

If the founder/employee does not make the 83(b) election, then he or she may have income at the stock “vests.” The income will be substantial if the value of the shares increases substantially over time.

For example, assume that a founder purchases stock for $0.01 per share (fair market value is $0.01) and the stock is subject to four year vesting with a one year cliff. The founder does not make an 83(b) election. At the end of the one year cliff, if the stock is worth $1.00/share, then the founder would recognize $0.99/share of income. As the remaining stock vests each month, the founder would recognize income equal to the difference between the fair market value and $0.01/share. In addition, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.

If the founder had made an 83(b) election, the founder would not recognize any income as the stock vests, as the 83(b) election accelerates the timing of recognition of income to the purchase date.

In order for an 83(b) election to be effective, the individual must file the election with the IRS prior to the date of the stock purchase or within 30 days after the purchase date. There are no exceptions to this timely filing rule. The last possible day for filing is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. For example, if the stock is purchased on May 16, the last possible day for filing is June 15. The official postmark date of mailing is deemed to be the date of filing. The election should be filed by mailing a signed election form by certified mail, return receipt requested to the IRS Service Center where the individual files his or her tax returns. If the election is mailed after the 27th day, the individual should hand deliver the letter to the post office to obtain an official date-stamp on the certified mail receipt. A copy of the election should be provided to the company, and another copy should be attached to taxpayer’s federal income tax return for the year in which the property is acquired.

What inspection and information rights does a stockholder have?

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Most states allow stockholders to demand access to a corporation’s books and records, and a stockholder list, as long as the stockholder has a proper purpose and meets certain procedural requirements.

Delaware General Corporation Law Section 220(b) provides that “Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from … [t]he corporation’s stock ledger, a list of its stockholders, and its other books and records …”

A stockholder that wants to exercise inspection rights should probably engage an experienced attorney because a corporation can reject the request for failure to comply with procedural requirements.

If the corporation refuses to permit an inspection or does not reply to the demand within 5 business days, the stockholder may apply to the Delaware Court of Chancery for an order to compel such inspection.

One requirement for exercising inspection rights is a proper purpose for the demand.  Section 220(b) provides that “[a] proper purpose shall mean a purpose reasonably related to such person’s interest as a stockholder.”

Delaware courts have held that the following purposes, among others, are proper:  gather information prior to filing a stockholder derivative suit, communication with other stockholders regarding a solicitation of proxies, communication with other stockholders regarding a stockholder class action against the corporation, communication with other stockholders for the purpose of influencing management to change its policies, communication with other stockholders to encourage them to dissent from merger and seek appraisal, valuation of one’s stockholdings, and investigation of suspected mismanagement where some credible basis for the stockholder’s suspicions is shown to exist.

Courts have rejected inspections for purposes such as:  gaining information to facilitate a tender offer when the stockholder has already been enjoined from pursuing a tender offer, valuing the company as a whole in order to determine whether to increase one’s bid in a tender offer, gathering information for use in a stockholder’s individual employment-related claims against the corporation, obtaining information to use to exert economic pressure upon a third party in connection with a labor union’s strike, or satisfying idle curiosity.

If a stockholder seeks to inspect only the corporation’s stock ledger or list of stockholders, the burden of proof is on the corporation to establish that the inspection if for an improper purpose.  If the stockholder seeks to inspect the corporation’s books and records, other than its stock ledger or list of stockholders, then the burden of proof is on the stockholder to show a proper purpose.

A stockholder will be entitled to inspect documents that are essential and sufficient to the accomplishment of the proper purpose.  The Court of Chancery may “prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper.” A stockholder may be required to execute a confidentiality agreement in order to exercise inspection rights.

Given that disgruntled stockholders can create problems by exercising inspection rights, companies should be careful about their stockholder base.