The following article was written by Daniel DeWolf, chair of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC's technology practice and co-chair of the firm's venture capital and emerging companies practice; and Joseph Wallin, a partner at Carney Badley Spellman PS who focuses on early-stage and growth companies.
As published in the Deal on October 6, 2022.
Emerging companies are a critical source of growth for our economy. Startup enterprises generate many new jobs, and new jobs are a prime accelerator of economic growth. Additionally, and most importantly, new jobs provide financial security to many families and communities. This is where it all starts.
In this time of economic uncertainty, it is imperative that we encourage and support a strong ecosystem for emerging companies. Having practiced law in the emerging companies space for several decades, we see some easy fixes to help promote the growth of emerging companies. Here is our list of the top five ways to accelerate the growth of emerging companies:
1. Broaden the definition of accredited investors. The vast majority of capitalraising events for emerging companies is limited to “accredited investors.” This is done for ease of regulatory compliance with the exemption provided in Regulation D under the Securities Act of 1933. Historically, with respect to individual investors, the term is an income or net worth test under the theory that if you earn more than $200,000 annually or have a net worth in excess of $1 million, you are sophisticated and have the ability to fend for oneself. In August 2020, the Securities and Exchange Commission expanded the definition to include certain professional criteria such as being a registered financial representative in good standing who passed the Series 7, 65, or 82 examinations. While the SEC expansion of the definition is helpful, it does not go far enough. The accredited investor definition should be expanded to include any individual who passes an examination established by the SEC pursuant to which an individual could be certified as a sophisticated investor and therefor deemed to be an accredited investor.
2. Increase the number of angel investors who can invest in pooled investment vehicles. Many angel investments in emerging companies are structured as pooled investment vehicles that are exempt from registration under Section 3(c)(1) of the Investment Company Act of 1940. Under current law, the number of investors who may invest in such a pooled vehicle is limited to 250 investors and the aggregate sum of $10 million if the investment is in a “qualified venture capital fund,” or not more than 100 investors. We think these limits are arbitrary and severely restrict the ability of emerging companies to work with angel associations that invest through pooled investment vehicles. We see no reason why the number of investors cannot be increased to 500 and the aggregate sum of $50 million for “qualified venture capital funds.” This simple change would facilitate increased investment by angel associations.
3. Shorten the holding period for qualified small business stock. Section 1202 of the Internal Revenue Code has received broad bipartisan support across the board since its inception in 1993 and its subsequent amendments including most recently in 2015 to increase the tax exemption to 100%. In essence, if you are an investor in what is deemed to be “qualified small business stock” and you hold the stock for five or more years, then generally you are exempt from federal taxation on the sale of such stock up to the greater of $10 million or 10 times your basis in such stock. This tax exemption has been a great benefit to taxpayers who take the significant risk of investing in early-stage emerging companies. It could be a far greater accelerator of the growth of young companies, however, if the holding period was reduced from five years to two or three years. Additionally, we also believe that the definition of qualified small business stock should include interests in limited liability companies.
4. Lengthen the rollover period for investing in qualified small businesses. Section 1045 of the IRC provides that if you sell qualified small business stock, you have a period of 60 days to roll over that gain into another investment in other qualified small business stock. Any smart investor will tell you, however, that it is highly unlikely one can find a compelling investment in a startup company in a mere 60 days. This rule is simply impractical. A simple change of extending the rollover period to 180 days would do wonders for the amount of capital invested in emerging companies.
5. Modify the 83(b) filing rules. It is common for emerging companies to provide that stock issued to founders will vest over time, typically over a three- or four-year period. This provides significant protection for investors, as it insures the founders stay involved in the company for several years until the entire value of their stock fully vests. The IRS permits founders to file what is commonly known as an 83(b) election within a strict 30-day period after the initial grant of such vesting stock and pay the tax on the then-current value of such stock, which is often de minimis. We believe this filing period for private companies should be more flexible and extended to the earlier of 180 days or April 15 of the next tax filing year. Additionally, this filing should be permitted to be accomplished electronically. Surprisingly, under current law, the form actually has to be mailed to the IRS. This is certainly quaint but not a good indication of an economy focused on the growth of new enterprises.