Thursday, July 22, 2010

Change in the Accredited Investor Definition

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). Reforms introduced by the Act are broad and will affect many aspects of the operation of the U.S. capital markets. Today, I would like to mention one reform in particular, the new “accredited investor” standard. Only one word has changed, but this change may have an immediate and profound impact on the way small businesses access capital markets.

The Act has amended Rule 501(a)(5) of Regulation D and Section 215(e), both under the Securities Act, to provide that an accredited investor is one whose net worth, individual or joint with the spouse, at the time of purchase, is $1,000,000, excluding the value of a primary residence. Previously, the net worth had to be $1,000,000, including the value of a primary residence. This change is effective immediately upon enactment of the law. When raising a limited amount of capital, Regulation D does not require companies to provide disclosures to accredited investors. However, if offers are made to non-accredited investors, then companies have to provide extended disclosures about their business, industry, risks and also their financial statements.

On one hand, this change has been long overdue. The definition of an “accredited investor” had not been changed since 1982, when it was first adopted. The standard that is supposed to describe high net worth individuals who earn high salaries and can afford the services of a financial representative has lost its purpose as the inflation and rising real estate values made more and more people “accredited”. For example, all those who were fortunate enough to purchase their apartments in Manhattan in the early 1980s have all become “accredited” by the mid-2000s just by virtue of owning apartments, when the real estate boom had quadrupled the prices. However, not all of these individuals have enough other income to afford the services of a financial representative to guide them through the risks of private investments. Therefore, the Congress has decided to protect these individuals by making them “non-accredited”.

On the other hand, this change makes it more difficult for small businesses to raise money. Providing extensive disclosures for non-accredited investors will add up legal fees, as attorneys will have to draft lengthy private placement memorandums. Since the pool of accredited investors has shrunk, raising capital in the initial rounds (in “Family and Friends” or “Angels” rounds) has become more expensive. This comes at a critical time for many businesses that cannot obtain bank financing and whose only option is to resort to raising capital from investors.

Of course, the change is needed, since the definition of “accredited investor” has not been updated in almost 30 years. However, it comes at a cost to small businesses, a high cost, given the current economic environment.

Monday, July 19, 2010

What is Corporate Governance?

I have decided to write a three-part blog about corporate governance. I want to describe what corporate governance is, why it is important for a company to have it, what kind of companies should adopt corporate governance policies and what are the hotly debated issues in corporate governance today. This is the first posting.

Corporate governance is a set of internal rules designed to increase transparency in the management of a company and align the interests of its shareholders, directors, managers, employees and creditors. Even though the concept of corporate governance has existed in some form since the time modern corporations began to form, corporate governance has been in spotlight only since the corporate scandals of the 1990s and 2000s, such as Enron, Worldcom, Arthur Andersen, Global Crossing, Tyco International and others. These scandals ultimately led to the adoption in 2002 of the Sarbanes-Oxley Act and that is when the new era of corporate governance has begun.

In general, corporate governance puts checks and balances on the relationship between the senior management of a company and its board. With corporate governance rules in place, managers have to be accountable for the performance of the company and the board, for example, cannot approve bonuses that are unrelated to the performance of the company. All deals among interested parties (such as between the company and its board members or executive officers) have to be disclosed, pre-approved or ratified and be on arms’-length terms. The scandals of Enron, Worldcom and other companies triggered increased shareholder activism and the desire to add transparency and accountability to the internal corporate governing process.

So, which corporate governance policies should a company have? There are mandatory rules that apply to public companies (or companies with registered debt) that are in the Sarbanes-Oxley Act of 2002 and rules written by the Securities and Exchange Commission to implement the Act. The most important ones, in my opinion, are the requirement to have a set of (1) disclosure controls and procedures to assure the accuracy of financial reports, and (2) internal controls over financial reporting, which require a very thorough (and expensive) analysis and evaluation of all internal accounting controls and risk management systems on a company-wide level. There is also the requirement to have a code of ethics for senior financial officers, to have a financial expert on the audit committee, to adopt a procedure for pre-approval of audit-related services, prohibition of personal loans to executive officers, and the requirement to disclose transactions between senior executives and certain shareholders, among others.

There are policies that the companies can adopt to facilitate their compliance with these rules. Such policies include code of ethics, charters for each of the board committees, whistleblower procedures, corporate governance guidelines, insider trading policy, related person transaction policy, audit committee pre-approval policy and disclosure controls and procedures.

It may seem that a private company with no outstanding public debt or equity and a relatively small number of shareholders (less than 500) does not need to worry about corporate governance. After all, implementation and compliance with all these procedures takes time and money, something that many start-ups and smaller companies do not have a lot of (good topic for another blog). However, it is advisable to start implementing some of these policies early on, so that the employees, executive officers and other stakeholders in the company get used to the way the company is run and adjust their expectations accordingly. It is not uncommon for a private company to adopt all these rules right before going public, as part of the pre-IPO process. However, this is a lot to process. It is not only about having these policies in place (although that’s definitely a step in the right direction), but also about fostering a corporate culture that has learned to respect these policies and operate according to them on a daily basis. Also, knowing in advance that compliance with internal controls over financial reporting may be required, financial executives can centralize the accounting and financial reporting systems ahead of time in order to lessen the cost of compliance with this requirement and to avoid the need to re-adjust the systems once the company is public. This takes time… so, just like with life insurance (the earlier in life you get it, the smaller are the premiums), start early in the life-cycle of the company and let the company grow with the policies in place.

In the next blog, I will discuss what kind of corporate governance policies a small company should adopt.

Thursday, July 15, 2010

Attention Business Owners: What “Buyout” Provisions Are and Why You Should Have These in Your Partnership Agreement?

When starting a new business, the last thing that owners worry about is what happens with their business ownership if one of them becomes disabled, gets divorced, dies or simply decides to get out of the business to start another one or to retire. There is just not enough time to think about all that when you are working around the clock trying to lift your business off the ground. “Let’s deal with this when/if it comes to that” is the common attitude.

Actually, the worst mistake that co-founders can make is to ignore these questions before they arise. After all, if you are the co-owner who wants to get out, you need to ensure that you get bought out by the remaining partners at a fair price (you want to be compensated for all that hard work and time spent building the business). On the other hand, if you are the owner who is staying, the departure of a partner may leave the business vulnerable and you are not sure if you would like working with the new partners. To avoid these tensions, co-owners should think through these questions at the very beginning of their business venture, well before any of these problems come up (you just never know when and how soon this may happen).

So, what can really happen if you don’t have buyout provisions in your partnership agreement? If you want to leave, you may find yourself arguing endlessly and bitterly with your co-owners as to what the fair buyout price should be. If you die, your survivors may be stuck with a share in a business that no one wants to buy or for which the co-owners would not pay a good price. If a co-owner files for personal bankruptcy or has defaulted on a personal secured loan, you may end up sharing the business with a bankruptcy trustee or a creditor. Finally, if a third party buys an interest from the co-owner or a family member of a deceased partner inherits the interest, you may have to work with new co-owners who are inexperienced in running the business or who have different views on how this should be done.

Buyout provisions (also called buy-sell provisions or agreements) cover when and how the owners of a business can sell his or her interest, at what price, and who can or must buy their interest. A buyout agreement may provide for forced buyouts that give owners the right to force the company to purchase their interests in certain circumstances (retirement, death, disability). Also, buyout agreement may prevent the sale of interests to the third parties and provide for a way for co-owners to buyout the owner who wants to get out. Further, buyout agreement can set forth what happens if a co-owner stops fulfilling his or her responsibilities at the company and becomes an inactive partner. Buyout price should be agreed to ahead of time and will depend on whether the co-owners choose a valuation option or a fixed price formula that is right for the business. Finally, buyout agreements address how the buyout price will be paid out (installments or outright) and how it will be funded (common methods include purchasing disability and/or life insurance).

Hopefully, by now, you are already persuaded to insert buyout provisions in your partnership agreement, which are essential to the long lasting success of the business.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.