The Business Plan And Private Placement Memo

Since a private placement memorandum, usually abbreviated as the PPM, is the norm in most deals, the founder should familiarize himself with the standards for memorandum preparation, keeping in mind that, like any legal document, there are various audiences. The audience composed of potential plaintiffs (and, theoretically at least, the SEC enforcement staff) will read the document against the requirements contained in the cases imposing liability. The audience composed of investors will read the document for its substantive content: “What are the terms of the deal?” To professional investors interested enough to become potential buyers, the private placement memorandum is a handy collection of only some of the information they are interested in, plus a lot of surplus verbiage (the empty language about suitability standards, for example). To the issuer, it is a sales document, putting the best face possible on the company and its prospects. To the managers, the memorandum is a summary of the business plan. Indeed, it may incorporate the business plan as an exhibit or be “wrapped around” the plan itself—a memorialization of how the business is to be conducted.

The first page of the PPM, the cover page, contains some of the information one might see on the front of a statutory prospectus: name of the issuer, summary description of the securities to be sold, whether the issue is primary (proceeds to the issuer) and/or secondary (proceeds to selling shareholders), the price per share, the gross and net proceeds (minus selling commissions and expenses), and a risk factor or two (that is, the offering is “highly speculative” and the securities will not be liquid). Some would argue a date is important, because, legally, the document speaks as of a certain date. However, if the memo becomes substantively stale between the offer and the closing, it is critical that the issuer update and circulate it; omission of material information as of the closing is not excusable on the theory that the memo displays an earlier date. Moreover, a dated memorandum will appear just that—dated—if a few months elapse and the issue is still unsold. A related issue is whether to specify a minimum amount of proceeds that must be subscribed if the offering is to go forward. If the financing is subject to a “minimum,” a reference belongs on the cover page. It makes common sense that there be a critical mass in most placements; however, a stated requirement that X dollars be raised or all subscriptions returned inhibits an early-closing strategy—the ability to “close,” if only in escrow—with the most eager of the issuer‘s potential investors. Such “closings ” may not be substantively meaningful; the deal may be that the “closing” will be revisited if more money is not raised. However, a first closing can have a salubrious shock effect on the overall financing; it can bring to a halt ongoing (sometimes interminable) negotiations on the terms of the deal and create a bandwagon effect.

The cover page should be notated, a handwritten number inscribed to help record the destination of each private placement memorandum. It is also customary to reflect self-serving, exculpatory language (of varying effectiveness in protecting the issuer), that is:

1. The offer is only an offer in jurisdictions where it can be legally made and then only to persons meeting suitability standards imposed by state and federal law. (The offer is, in fact, an “offer” whenever and to whomsoever a court designates.)

2. The memorandum is not to be reproduced (about the same effectiveness as stamping Department of Defense papers “Eyes Only,” a legend understood in bureaucratese to mean, “may be important … make several copies”).

3. No person is authorized to give out any information other than that contained in the memo. (Since the frequent practice is for selling agents to expand liberally on the memo’s contents, it would be extraordinary if extraneous statements by an authorized agent of the issuer were not allowed in evidence against the issuer, unless perhaps they are expressly inconsistent with the language of the memo.)

4. The private placement memorandum contains summaries of important documents (a statement of the obvious), and the summaries are “qualified by reference” to the full documentation. (A materially inaccurate summary is unlikely to be excused simply because investors were cautioned to read the entire instrument.)

5. Each investor is urged to consult his own attorney and accountant. (No one knows what this means; if the legally expertised portions of the private placement memorandum are otherwise actionably false, it would take an unusually forgiving judge to decide the plaintiff should have obeyed the command and hired personal counsel.)

6. The offering has not been registered under the ’33 Act and the SEC has not approved it.

The foregoing is not meant as an exercise in fine legal writing and the avoidance of excess verbiage. Certain legends are mandatory as a matter of good lawyering—a summary of the “risk factors”; a statement that investors may ask questions and review answers and obtain additional information (an imperative of Reg. D); and, of course, the language required by various state securities administrators. A recitation tipping investors that they will be required in the subscription documents to make representations about their wealth and experience is generally desirable, particularly in light of cases finding against plaintiffs who falsified their representation. However, in my opinion, a cover page loaded with superfluous exculpations may cheapen a venture financing, signaling to readers that the deal is borderline, in a league with “double write-off” offerings in the real estate and tax-shelter areas.

A well-written private placement memorandum will follow the cover page with a summary of the offering. This section corresponds to a term sheet, except that the language is usually spelled out, not abbreviated. The important points are covered briefly: a description of the terms of the offering, the company’s business, risk factors, additional terms (i.e., anti-dilution protection, registration rights, control features), expenses of the transaction and summary financial information. The purpose of the summary is to make the offering easy to read and understand. As stated, suppliers of capital are inundated with business plans and private placement memoranda; the sales-conscious issuer must get all the salient facts in as conspicuous a position as possible if he hopes to have them noticed.

At this juncture, it is customary to reproduce investor suitability standards, identifying and flagging the principal requirements for a Reg. D offering, that is, the definition of “accredited investor.”

Issuers should approach offerings that have stated maximums and minimums with caution. The SEC has made its position clear. If the issuer elects to increase or decrease the size of the offering above the stated maximum/minimum, each of the investors who have signed subscription agreements must consent to the change in writing. It is not open to the issuer to send out a notice to the effect that “We are raising or lowering the minimum and, if we do not hear from you, we assume you consent.” The issuer must obtain the affirmative consent of each investor, which may be a bit difficult if the investor is, at that point, somewhere in Katmandu.

Investors should be aware that issuers sometimes do not want the investors to know certain information. For example, some issuers elect to code the numbers on the private placement memorandum so that no investor knows he is receiving, say, number 140; he is, instead, receiving “14-G.”

Finally, the current trend is to prepare both a full placement memo as well as a brief summary, such as the so-called “elevator pitch”, a concise summary that can be read while riding in an elevator. Venture capitalists are chronically short on time and a 40-page document is likely to be left unread if this is the only pitch material available.

Are You Savvy on Restricted Stock Units?

Written by: Joseph W. Bartlett, Co-Chair of VC Experts

A structure is creeping into the process of rewarding and motivating managements of public and private companies with equity awards. [1]

Although the subject of discussion in this article is not new, nonetheless my experience is that a significant percentage of the parties involved in the capital markets … particularly the private capital markets where emerging growth companies are organized to travel the Conveyor Belt, [2] from the embryo to the IPO … are unfamiliar with restricted stock units (“RSUs”).

The grant of a restricted stock unit (“RSU”) by a corporation to an employee gives the employee the right to receive a share of the corporation‘s stock, or if the RSU agreement so provides, its cash value equivalent, upon satisfaction of one or more specified vesting conditions.

The vesting conditions may be either time-based (completion of a specified period of employment following the date of grant) or performance based (achievement of performance goals over a specified measurement period), or both.

To the extent the RSUs granted to the employee become vested, the employee will receive either the number of shares that have vested, or if the RSU agreement so provides, a cash amount equal to the shares’ fair market value.

In the usual case, the RSU’s are “settled” by the delivery of the shares or payment of the cash amount at the time the RSUs vest. However, an RSU agreement can, and often does, provide for the payment or delivery of shares to be deferred until the occurrence of some later specified date or event; but if payment is to be delayed beyond March 15 of the year following vesting, then the payment-triggering event must be one permitted under Section 409A of the Internal Revenue Code.

Under Section 409A rules, the payment event could be termination of employment, or it could be the occurrence of a change in control , as defined for Section 409A purposes [3], which would be a typical private company exit event when cash can be realized to enable the employee to sell enough shares to pay the tax … and keep the rest. An IPO, another typical exit event, would not be a 409A-permissible payment event for an already vested RSU. But an RSU agreement could provide for the RSUs to both become vested and payable upon the first to occur of an IPO, a change in control (including one not meeting the Section 409A definition), termination of employment, or at some specified date corresponding to the investors’ expected exit and realization date, e.g., the 7th anniversary of the date of grant.

For federal income tax purposes, an employee is not taxed with respect to a grant of RSUs either at the time of grant or at the time of vesting. He is subject to tax only upon his receipt of the shares or their cash equivalent at the time the RSUs are settled. At that time, he is taxed, at ordinary income rates, on the then fair market value of the shares he receives, or the amount of the cash he receives.

In a number of respects, RSUs compare favorably with other forms of equity grants, as a medium for delivering incentive compensation to a private company’s employees.

    • A grant of RSUs delivers full share value to the employee. It provides him not only with upside potential but also downside protection. He can realize value from the grant even if the date of grant value of the RSUs should later decline. In contrast, with an option grant the employee will realize value only if and to the extent that the shares covered by the option increase in value after the grant date.


    • A grant of restricted shares also delivers full share value to the employee, and in addition, provides the employee with an opportunity for capital gains treatment on eventual sale of the shares. In contrast, when RSUs are settled, the then value of the shares is subject to tax at ordinary income rates. But as indicated above, RSUs are not taxed at the time of grant, nor at the time of vesting if settlement of the RSUs does not occur until a later date. As a result, it should be possible in most cases to structure an RSU grant so as to delay settlement, and thus, taxation, until a realization event occurs. This may not be the case with a restricted stock grant. The employee would have to pay tax, at ordinary income rates, on the value of his restricted shares either at the time of grant if he makes a Code section 83(b) election, or at the time the shares vest if he doesn’t make the election. He may therefore be subject to tax, at ordinary income rates, with respect to a substantial portion of the ultimate value of his restricted shares well before an exit event occurs permitting a sale of the shares.


  • Like an RSU grant, an employee is not taxed with respect to a stock option at the time of grant or at the time of vesting. He is subject to tax at the time he exercises the option, if it is a nonqualified stock option (“NQSO”), or if it is an incentive stock option (“ISO”), at the time he sells the shares acquired on exercise of the option. [4] In either case, the grant of a stock option, whether an NQSO or an ISO, would permit tax to be delayed until the occurrence of a realization event, since a stock option grant can permit the option to be exercised at any time during its term after it becomes vested. Although in the case of an NQSO, tax would be at ordinary income rates, as is so with an RSU, in the case of an ISO, the increase in value of the shares from date of grant to date of sale could qualify for tax at capital gains rates, subject to certain limits and conditions. However, there are several negatives to be considered in connection with a stock option grant.

(i) Valuation Issues. Tax law requirements [5] mandate that the exercise price of a stock option not be less than the fair market value of the underlying shares at date of grant. Failure to comply with this requirement could result in significant adverse tax consequences for the employee under Section 409A. Share valuations for a private company are an inherently uncertain matter. To minimize the exposure to adverse treatment under Section 409A, the exercise price for the option usually would be established based on an independent third party valuation.

(ii) Dilution. Because an option delivers value to the employee only to the extent that the fair market value of the shares at the time of exercise exceeds the option exercise price, it would be necessary for an option grant to cover a greater number of shares than a grant of RSUs or restricted stock, in order to deliver an equivalent economic value to the employee. As a result, an option grant would mean more dilution for the investors as compared with an economically equivalent grant of RSUs or restricted stock.

(iii) Limits on Capital Gain treatment for ISOs. Capital gain treatment for an ISO is available only if the shares acquired on exercise are held for at least 1 year following the date of exercise of the option, and 2 years following the date of grant of the option. In the usual case, an employee holding an option on shares of a private company would not want to exercise his option until there is an IPO or other realization event, and will want to sell the shares he acquires on exercise of the option as soon as practicable after that event occurs, in order to (a) fund his payment of the exercise price for the shares, and (b) avoid loss of value in the shares in a highly volatile market that could bring a significant drop in share price prior to the end of the ISO-required holding periods. If the employee does sell the shares before the end of the ISO required holding periods, the increase in value of the shares since date of grant will be taxed at ordinary income rates, instead of capital gain rates. [6]

All things considered, for many private companies the grant of RSUs may be the best vehicle for delivering incentive compensation to the company’s executives, despite the fact that the values so delivered will be subject to tax at ordinary income rates.

After all, the objective is to give an incentive to the executives which pays them for navigating the company’s trip from “the embryo to the IPO” or to a trade sale. And, if the tax is at ordinary income rates the answer is ‘so what?’… as long as the executives receive and are able to sell enough shares to make a big difference in the executive’s life.

[1] See, Perkins, “Equity Compensation Alphabet Soup- ISO, NSO, RSA, RSU and More,” Contributing Author, the Venture Alley at DLA Piper, LLP, Buzz, on VC Experts (

[2] Bartlett, “From the Embryo to the IPO, Courtesy of the Conveyor Belt (Plus a Tax-Efficient Alternative to the Carried Interest), ” The Journal of Private Equity Winter 2011, Copyright (c) 2011, Institutional Investor, Inc.

[3] The definition would include the acquisition by a third party of more than 50% of the total fair market value or voting power of the company’s shares, or more than 40% of the total gross fair market value of the company’s assets.

[4] However, the “spread” at the time of exercise of an ISO might be subject to the alternative minimum tax (“AMT”) in the year of exercise.

[5] Code section 409A and the regulations issued thereunder in the case of a nonqualified stock option, and Code section 422(b)(4) in the case of an incentive stock option (“ISO”).

[6] Other limits on capital gains treatment for ISOs: (i) ISO treatment is available only for shares with a total grant date value of up to $100,000, in respect of all of the employee’s ISOs that first become exercisable in any calendar year; and (ii) ISO treatment is available for an option only if exercised by the employee during employment or by the end of the 3rd month following termination of employment. If an exit event has not occurred before the end of the 3 month post-termination exercise period and the employee wants to wait until an exit event does occur to exercise his option, doing so will result in loss of ISO status for his option and taxation at ordinary income rates, instead of capital gain rates, for the “spread” when he does exercise the option.

Let’s Finally Fix Crowdfunding!

Guest Post by: Christopher G. Froelich of Sheppard Mullin

On April 5, 2012, President Obama signed into law the landmark Jumpstart Our Business Startups Act (JOBS Act), for the purpose of encouraging the funding of startups and small businesses throughout the United States.  Title III of the JOBS Act, otherwise known as Regulation Crowdfunding or Reg CF, received the most attention because it legalized investment crowdfunding.  The purpose of Reg CF was to make it easier for startups and small businesses to access capital, to give more people the ability to participate in investment opportunities, and ultimately, to create jobs and stimulate economic growth. Crowdfunding is the practice of funding a business by raising small amounts of money from a large number of investors, typically via the Internet.  Prior to Reg CF, generally only accredited investors – those who earn an annual income of at least $200,000 (or $300,000 if married), or those with a net worth of at least $1 million (excluding one’s primary residence) – could invest in startups and small businesses, usually through Rule 506 of Regulation D.  Reg CF created a new exemption to the Securities Act of 1933 that allows ordinary people the opportunity to invest in startups and small businesses alongside angel investors and venture capitalists.
So how does Reg CF work?  In general, Reg CF allows startups and small businesses to raise up to $1 million in a rolling 12-month period from any investor, including non-accredited investors.  Issuers are required to use online intermediaries known as “funding portals.”

Reg CF officially went into effect in May 2016, but has been off to a slow start.  This is due to several factors that make it difficult for potential issuers to utilize the new law.  The primary difficulty is that  Reg CF imposes high regulatory burdens and costs on startups and businesses attempting to raise funds.  For example, Reg CF requires that businesses raising more than $500,000 have GAAP standard financial statements ready to share with potential investors.  While transparency in investing is important, few startups and small businesses have funds available to pay the accountant fees necessary to prepare GAAP financials.

Moreover, Reg CF requires issuers to file a Form C with the SEC prior to raising funds.  Form C is a complicated document that in most cases requires legal review.  The fact is that very few startups and small businesses have the money to cover the legal fees associated with such review.  Reg CF itself is long and complex, requiring further expensive legal assistance to make sure its requirements are followed.  To make matters worse, Reg CF prohibits issuers from making any offering, or any announcement about an offering (including any general announcement or tombstone statement), without first making the required disclosures with the SEC, including Form C.  This rule prohibits potential issuers from “testing the waters” – i.e., from soliciting non-binding indications of interest from potential investors prior to an issuance, thereby minimizing the risk of paying accounting and legal fees, among other expenses, for an offering that may turn out to be unsuccessful.

There are additional problems with Reg CF.  The $1 million cap on yearly fundraising is a nonstarter for small businesses in industries that require larger sums of startup capital.

There have been efforts to make Regulation Crowdfunding more useful to issuers.  In June 2016, the House of Representatives approved the “Fix Crowdfunding Act” bill (HR 4855).  While the original bill sought to remedy the shortcomings discussed above, the legislation was significantly amended prior to being passed by the House.  HR 4855, however, died in the Senate.

Any new bill should try to address the following issues.

First, the issuer cap should be raised from $1 million to $5 million and the investor caps should be modified by basing the percentage caps on the “greater of” net worth/income, not the “lesser of.”  These higher caps would vastly improve the capital raising capabilities of startups and small businesses.

Second, potential issuers should be able to “test the waters,” permitting them to solicit interest before actually spending money on accountants and lawyers.  Allowing potential issuers to test the waters would reduce the upfront cost of conducting a Reg CF offering and the risk of paying accounting and legal fees for an unsuccessful offering.

Finally, the burden on funding portals to vet the Reg CF offerings they post should be reduced to encourage the development of these new facilities.  Currently, Reg CF requires portals to act as gatekeepers of the offerings they post by imposing significant liability on portals for misstatements or omissions of the issuer, even if the portals are not aware that the information is false.  While the due diligence obligations of the portals should be retained, the new rule should clarify that portals would not be liable under Reg CF unless they knowingly allowed material issuer misstatements or omissions or otherwise engaged in or aided fraud.

It has been nearly 5 years since the passage of the JOBS Act, and the most anticipated portion of the landmark legislation, crowdfunding, has been a bust.  It is finally time to fix the problem, make it easier for startups and small businesses to access capital and democratize access to startup investment opportunities for the every-day investor.

Christopher G. Froelich, Special Counsel at Sheppard Mullin

Chris advises public and private companies and private equity funds in domestic and cross-border transactions, including mergers and acquisitions, private equity investments, joint ventures, divestitures, restructurings, recapitalizations and transactions involving distressed or bankrupt targets or sellers. He counsels clients through all stages of the deal process, including drafting and negotiating letters of intent, stock and asset purchase agreements, merger agreements, shareholder and joint venture agreements, partnership agreements, financing documents, confidentiality agreements, escrow agreements, due diligence reports and corporate governance documents.

 Sheppard Mullin is a full service Global 100 firm with 750 attorneys in 15 offices located in the United States, Europe and Asia. Since 1927, companies have turned to Sheppard Mullin to handle corporate and technology matters, high stakes litigation and complex financial and property transactions. In the U.S., the firm’s clients include half of the Fortune 100. For more information, please visit

What are Registration Rights?

To many investors, registration rights are one of the most important issues in a financing. If an investor is in a minority position in a nonpublic company, his exit possibilities depend on decisions made by others. Thus, some founders are proud that they have turned down entreaties from investment bankers to take their companies public. They claim that public shareholders might cramp their style and interfere with their ability to run the company according to their own tastes. Well and good for the founder, but not so comforting to a minority investor locked into the founder’s company. Even if the investors as a group are in control of the company, there may be differences of opinion as to when an exit strategy should be implemented; indeed, each investor may have a different sense of timing on the issue, based on facts peculiar to that investor.

The decision to sell the company as a whole is almost always dependent on at least a majority of the shareholders approving the sale. To be sure, the shareholders could by contract agree to sell out at the election of the minority, but such contracts, while common in Shareholders Agreements styled on drag-along rights, are seldom enforced in practice, in accordance with their terms. [1] The shareholders, however, can implement one primary exit strategy, in theory at least, singly and seriatim. The company can only sell its assets once, but it can have as many public offerings of its securities as the market will bear, and a public offering will eventually make the investors liquid.

However, the decision to go public in the first instance is often difficult; there are considerations on both sides. Moreover, even if a company is already public, the election to float another offering requires thought and discussion; any offering “dilutes” existing shareholders. Some shareholders may feel the currently obtainable price accurately reflects value and some may violently disagree.

As a technically legal matter, the decision to affect an IPO is a majority decision. Even if the company is not planning to sell any stock, only the company can file a registration statement; [2] a minority shareholder cannot register his stock for sale without the company’s consent. As the registrant, [3] the company sets the terms of the offering, including the question of how many insider shares to include. Accordingly, investors seek to bolster their position by securing that consent in advance, by insisting that there exist, as part of or allied to the Stock Purchase Agreement, an agreement called the Registration Rights Agreement. It is important to recall that a company “going public” does not undergo an instant transformation, with all its stock ipso facto turned into liquid instruments; the only shares which become truly public-that is, are released from resale restrictions [4] -are those registered for sale [5] and sold at the time. And the company ordinarily issues those shares; the investors’ share of the “action” in an IPO is severely limited because the market’s appetite for stock in an IPO is generally confined to those transactions in which most of the money raised is going to work inside the company. Nonetheless, an IPO is the most significant step on the road to liquidity, even for those investors not selling in the offering.

[2]-Categories of Registration Rights

Registration rights fall into two categories: “demand” and “piggyback.” Piggyback rights, as the name implies, give the shareholders a right to have their shares included in a registration the company is currently planning on behalf of itself (a “primary” offering) or other shareholders (a “secondary” offering). [6] Demand rights, as the name implies, contemplate that the company must initiate and pursue the registration of an offering including, although not necessarily limited to, the shares proffered by the requesting shareholder(s). Since demand rights are more controversial, the following discussion focuses principally (but not exclusively) on that variety.

It should be noted that there are various types of stock issuances, albeit registered, which should not be subject to piggyback rights by their nature-that is, issuance of shares in the course of acquiring another company or the registration of shares pursuant to an employee stock benefit plan. Moreover, the practical difference between demand and piggyback rights can be slight; the investors make a noise about demanding an IPO, the issuer (thus prodded) elects to go forward on its own and then the investors seek to piggyback on what has been, in effect, an offering they “demanded.” Thus, the discussion of “haircuts,” stand asides,” and “lock-ups” applies to all types of registration rights, not just demand rights.

[3]-The Principles Underlying Registration Rights

To comprehend adequately the various issues involved, a discussion of basic principles is in order. The first is that registration rights are seldom used in accordance with their terms, and yet some investors and their counsel view them as a central element of the deal. The actual use of the demand rights, for example, could prove very awkward: a group of minority shareholders insisting on registration, the CEO agreeing only because he has to, but saying, in effect, to the minority, “Find your own underwriter; conduct your own road shows; [7] do not bother me with questions from large institutional purchasers; in a word, sell the stock yourself.” Such would make for a disorderly marketing effort, and the price per share would suffer.

On the other hand, as stated, registration rights are often the only exit vehicle, which, as a practical matter, the minority shareholders can compel. A start-up may issue shares redeemable at the option of the holder, but the instances in which that privilege has been successfully exercised are few. A company still in the development stage may not have the legal power, let alone the cash and/or the agreement of its creditors, to redeem stock. If a controlling founder is content to sit in his office, play with his high-tech toys and does not need more money from his investors, the investors need leverage. Other than through the threat of enforcing the registration rights agreement, there is no legal way to compel the company to go public. Therefore, it is important to keep in mind that liquidating the investors’ shares through a public offering can be not only a promise but also a benchmark, meaning that the remedy, if the founder refuses to cooperate, need not be a lawsuit. Reallocation of stock interests can be triggered if an IPO fails to materialize on time.

The second interesting feature of the registration rights agreement is that it is a three-way agreement, but only two of the three parties negotiate and sign it. With a minor exception for “self-underwritten offerings,” a primary or secondary offering of securities requires an issuer, selling shareholders and an underwriter, either on a “firm” or “best-efforts” basis. However, the underwriter is usually not present when the registration rights agreement is signed, and the parties themselves have to anticipate what the underwriter will require. Following that point, underwriters as a rule do not favor secondary offerings for early-stage companies.

Given a choice, the market likes to see the proceeds of the sale go into the company’s treasury to be used for productive purposes, rather than released to outsiders. Moreover, whenever stock is being sold, the underwriter wants the number of shares issued to be slightly less than its calculation of the market’s appetite. An underwriting is deemed successful if the stock price moves up a bit in the after-market. If the price goes down, the buyers brought in by the underwriter are unhappy; if it moves up smartly, the company is upset because the underwriter underpriced the deal. Consequently, the underwriter does not want to see new shares coming into the market shortly after the underwritten offering is sold, creating more supply than demand. These imperatives account for terms in the registration rights agreement known as the “haircut” and the “hold back.”

Finally, including one’s shares in a publicly underwritten offering is not the only way shares can be sold. A holder of restricted securities can sell his shares, albeit at a discount attributable to illiquidity, in a private transaction; more importantly, he can “dribble” out the shares into the market once the company has become public, under Rule 144. Registration rights for the holder of restricted shares in an already public company are, therefore, redundant unless the holder wants to sell before the required holding period in Rule 144 has expired or the block is so large that it cannot be “dribbled” out under the “volume” or “manner of sale” restrictions set out in that Rule.

The “points” in a registration rights negotiation (points being a slang term for contested issues) [8] are of varying degrees of intensity. Some are standard. Thus, the issuer rarely agrees to register convertible preferred stock, convertible debt or other rights to purchase common stock. The market in the hybrid securities themselves can be messy and confusing to analysts of an emerging-stage issuer‘s IPO; indeed, the mere existence of a class of senior security may cloud the outlook for the common stock‘s participation in future earnings. [9] Hence, the holders of convertible securities must convert before they can include their stock in the offering and/or must convert in any event so as to “clean up” the balance sheet. Some “points” on the other hand, are potential battlefields. For example, a minority shareholder will want the right to threaten exercise of his rights (and thus bully the company into registration) at any time of his choosing. The company will fight to limit the permissible timing of the shareholder’s election-no less than, say, five nor more than seven years after he makes his investment. The shareholder will want to be able to transfer his registration rights if he transfers his shares-they are part of the bundle of rights for which he bargained. The company will fight to keep the rights personal to the holder-a right to force registration is a formidable weapon if the timing is totally inappropriate. A disgruntled shareholder-for example, a founder recently terminated as president-may wave the rights around like a club to win some unrelated concession.

Following that thought, the company needs to limit the number of fingers on the trigger, so to speak. Assume, for example, 10 investors who each hold 10 percent of the class of convertible preferred stock. If each investor enjoyed his personal trigger-that is, could demand registration-the company might find itself in the path of a stampede, helping neither itself nor the investors generally. Moreover, if the company agrees to pay all or a part of the cost of the registration, multiple demands could be expensive. It is, therefore, in the interest of the company and the major investors to vest control of the trigger in the shareholders acting in concert, at least to insist that most of them agree internally before the issue is brought before the company. In addition, the amount of stock they are willing to sell should also be substantial, both because of expense (a small registration is almost as expensive as a large one) and because a buoyant public market depends on “float,” enough shares in circulation to interest institutional investors. From the investor’s standpoint, of course, the situation is reversed. He wants the trigger to be one share less than the shares he holds. This issue becomes more difficult when an issuer goes through multiple rounds of financing, selling off registration rights in each round. If all the shares are of the same class and series, what does one do with a 51 percent shareholder in round one who becomes a 35 percent shareholder when round two is completed? Does he “lose” his solo finger on the trigger because he did not elect to participate in the second round or because the second round involved the acquisition of another company for stock in a transaction in which he was not eligible to participate?

Indeed, the question of inconsistent registration rights provisions occasioned by separate agreements for each round is a thorny one. If the company’s norm is that the rights are not meant to mature for three years from the date of investment, what is to be done with investors in earlier rounds who have held shares for almost three years? Will they have first and exclusive chance at the gateway to public securities? If series A preferred was sold last year (with a 51 percent trigger) and series B preferred is being sold currently, is there any way to compel the series A holders to join in with the series B (assuming the number of shares in each series is the same) to avoid a situation in which the trigger is suddenly held by 25.1 percent (versus 51 percent) of the outstanding preferred stock? Is the language of the agreement such that investors in the earlier rounds can claim to have a first priority for including their shares in a piggyback registration?

The fact is, when the later round occurs, most practitioners attempt to induce the prior holders (who often overlap with the investors in the later round) [10] to cancel the earlier agreement and accept a new provision that affects all the existing holders, old and new, equally. Alternatively, counsel for the early-round investors may bargain for provisions that constrain the issuer in agreeing to register shares of subsequent purchasers-either an absolute prohibition without the consent of the earlier investors or a priority in their favor.

[1] There is nothing conceptually impossible in the notion of “drag along” rights. If all the stockholders agree in advance, the board could be bound, at the instigation of the minority, to retain an agent and authorize it to negotiate the best terms possible for a sale or merger of the entire company. There could be problems in binding the board in advance to vote for a transaction to occur well in the future-one which passes a given hurdle, for example-but, if the majority refuses the agent’s recommendations, there could be other remedies: a control “flip,” for example, or more stock for the minority.

[2] Section 6(a) of the ’33 Act provides that the issuer, the CEO, the CFO, the comptroller or principal accounting officer, and a majority of the board must sign the registration statement.

[3] The term ‘Registrant’ means the issuer of the securities for which the registration statement is filed. ’33 Act, Rule 405.

[4] Even publicly registered shares may not be freely resold; the privilege of investors holding nonregistered shares in a public company to “dribble” out shares pursuant to Rule 144 is limited by the provisions of that Rule and may be further limited by a “hold back” imposed by underwriters, the NASD, and/or state securities administrators.

[5] ’33 Act, Rule 415, adopted in November 1983, permits underwritten shelf registrations, i.e., the registration of shares for later sale at the option of the holder for (1) mature public companies and (2) for secondary issues. See, e.g., Palm, “Registration Statement Preparation and Related Matters,” in Mechanics of Underwriting (PLI Course Handbook Series No. 547, 1987). The problem is that underwriters are reluctant to allow investors to include their shares in the registration statement for delayed sale under Rule 415 since that creates an “overhang” over the market. If the investor’s stock is registered “on the shelf” under Rule 415, it must be “reasonably expected” it will be sold within two years. Rule 415(a)(2).

[6] A “reverse piggyback” right occurs when the investors exercise a demand right, compel a registration that (under the agreement) is at their expense, and the company seeks the right to “piggyback” some newly issued shares on the investors’ registration. See Frome & Max, Raising Capital: Private Placement Forms and Techniques, 673 (1981).

[7] Road shows are meetings between the company, the underwriters, and potential buyers of the company’s stock held around the country after the registration statement has been filed and before it becomes effective. If a CEO wants to be obstreperous, not agreeing with the concept of an IPO, he can be less than enthusiastic about the company’s near-term prospects at the road show, thereby effectively chilling the offering.

[8] When negotiators want to show an increase in the fervor that they or their clients feel about a given issue, they label it a “deal point” or a “deal breaker.” The way experienced negotiators respond to a litany of “deal points” is to create an “escrow file,” meaning that the issue is left for later consideration. After a deal point sits in the escrow file for a bit, it often defuses itself. See generally, Fisher & Ury, Getting to Yes: Negotiating Agreements Without Giving In (1981).

[9] Since the existence of a convertible senior security can muddy the investing public’s perception of the common stock, conversion is usually mandated no later than the evening of an IPO.

[10] Investors in the early rounds are expected to follow on with fresh capital in late rounds to show their faith in the company; however, the existing investors often insist that the founder find at least one new investor, “new blood,” to join in late rounds, if only to avoid a situation in which the investors are negotiating on price and other issues with themselves.

Should You Pay Someone Else’s Tax?

Guest Post by Sung Hyun Hwang, Partner, Venable LLP

The answer is a resounding yes under the new U.S. tax audit rules applicable to VC funds organized as partnerships (including LLCs treated as partnerships) for U.S. federal income tax purposes, and this article explores steps a VC fund may consider taking to mitigate this draconian outcome.

Background: A partnership is a “flow-through” or “pass-through” entity for U.S. federal income tax purposes. This means that the partnership does not pay income tax itself. Instead, for each taxable year, it will determine the character and amount of its items of income, gain, loss, deduction, and credit, and allocate them among its partners, who will take them into account when they determine their own income tax liability for the same taxable year.

For decades, the U.S. tax audit of most partnership matters has been handled at the partnership level, where the partnership items and their allocations were reviewed, with the resulting adjustments flowing to the partners, who would pick up the tab by amending their own tax returns and pay additional taxes owed.

The IRS has not been happy with this two-tiered system of partnership audits because, often, an audit takes place a long time after a tax return is filed and, by the time the audit is completed, either the statute of limitations has run on assessing taxes at the partner level, the agency had to start new proceedings against the individual partners, or the partners were simply nowhere to be found, given the lapse of time.

This practical difficulty has been keenly felt, especially in the case of tiered partnerships in the investment space, where multiple tiers of partnerships are common, because of the layers of the partnerships that need to be looked at, and because the many changes in the ownership of each partnership in the chain have discouraged IRS auditors. A good example of a tiered partnership in the VC space would be a fund-of-funds investing in a VC fund, or a VC fund investing in a portfolio company through a partnership.

New Partnership Audit Rules: In late 2015, Congress passed a law changing the existing partnership tax audit rules effective with taxable years beginning after 2017 (with limited elective retroactive application), aiming to significantly improve the IRS’s ability to handle partnership tax audits by centralizing both audit and collection at the same partnership-level. There is a fair amount of uncertainty regarding the application of the new law because it is new and was passed in haste.

A “technical corrections act” is currently pending in Congress to improve certain aspects of the new law, but, given the current political excitement about revamping the tax law, it is not clear whether the technical corrections act will pass in its current form in the near future. The IRS proposed a set of regulations to implement the new law and to clarify its scope, but it was withdrawn because of the new administration’s executive order temporarily freezing new regulatory guidance actions. To make the matter more complicated, a few states have already started adopting similar changes to their partnership audit regimes, while others are taking a wait-and-see approach.

In the short term at least, VC funds will have to deal with a new, centralized partnership audit and collection regime, with looming uncertainty and potential changes in the background. One key aspect of the new law in particular warrants the VC community’s attention now: the “collection” feature of the new audit rules (i.e., imposition of entity-level taxation for adjustments arising from VC fund tax audits). Under the new law, at the conclusion of a VC fund audit, the IRS will determine tax liability at the fund level, by solely taking into account all adjustments of the fund’s items of income, gain, loss, and deduction, in a manner similar to how funds calculate tax distributions. If the IRS determines that taxes are owned based on this determination, the tax will be payable by the partnership at the highest individual and corporate tax rates in the year of the adjustment (as opposed to allocating the adjustments to the investors who were partners in the year under audit (the “Audit-Year”)).

This clearly can lead to a result where one investor makes money in one year and a different investor picks up the tab in a later year. This also raises many technical questions without ready answers: among others, do the investors who are the partners in the year of adjustment (the “Adjustment Year”) get credit for their allocable share of the adjusted partnership items, or for tax paid by the partnership for purposes of calculating their own income tax? How will it affect the capital accounts of these partners? This will be especially relevant for VC funds using the “forced allocation” or “target allocation” or any tiered or special allocation regime for allocating items of income, gain, loss, deduction, and credit.

The new law provides certain mitigating options that would allow a VC fund to either keep the old audit regime (i.e., investors who were Audit-Year partners pick up the tab in the Audit Year) or “push out” the tax liability to the Audit-Year partners in the Adjustment Year, as follows:

Opting Out: A VC Fund can opt out of the new audit regime with respect to a taxable year if, for that taxable year: (i) it issues no more than 100 Schedule K-1s, and (ii) its partners are only individuals, C corporations, S corporations, estates of deceased partners, or foreign entities that would be C corporations if they were domestic entities. Thus, if a VC fund can limit its partner count to 100 or less, and is closed to investors organized as partnerships, LLCs, trusts, mutual funds (taxed as “regulated investment companies”), or REITs, it will enjoy the greener pasture of the old audit regime, in which the Audit-Year partners pick up the tab as of the Audit Year.

Second Bite at the Old Regime: The VC fund will not be subject to the entity-level tax to the extent of adjustments allocated to any Audit-Year partner if such investor files an amended return for the Audit Year taking into account its allocable share of the adjustments and pays the tax in full. If the audit results in reallocation of the partnership items among the partners, all Audit-Year partners must file amended returns and pay taxes for this to work. The technical corrections act was aimed, in part, at improving the taste of this second bite. While it is hard to rely on the good nature of investors alone, adding a provision in the operating agreement to this effect may prompt some (and, hopefully, all) investors if that provision is backed by an indemnity provision and survives the investors’ redemption or transfer of their interests in the VC fund, and the dissolution of the VC fund.

Third Bite at the Old Regime: The VC fund will have one last chance to shift the tax to the Audit-Year partners if it makes an election, within 45 days of the receipt of the notice of the proposed adjustments at the end of the audit, to “push out” the adjustments to the Audit-Year partners. In such case, the Audit-Year partners will be treated as if they have reported the adjustments in the Audit Report but paying tax when they actually pay (most likely in the Adjustment Year), including by paying penalties, additions, interest, etc. The fund’s general partner or managing member, as applicable, should be given the discretion (but should not be compelled) to make this election.

More Ways to Reduce the Pain: If all else fails, the VC fund can still reduce the tax bill to the extent of adjustments allocable to C corporations or individuals (with respect to capital gains and qualified dividend income) and tax-exempt investors (with respect to their income and gain not taxed as unrelated business taxable income). Therefore, a VC fund may consider adding to its existing tax information reporting provisions a concept to the effect that the partners would provide such information as is necessary or appropriate for reducing the partnership-level tax resulting from a tax audit.

Tax Indemnity: Last, VC funds may review and amend their existing operating agreements to include concepts such as (i) adding tax audit costs to the existing tax indemnity provision (e.g., for withholding tax) and (ii) the obligation to re-contribute or “claw back” prior distributions in their operating agreement that survive the transfer or redemption of an investor’s interest or dissolution of the fund.

**This article was prepared for marketing purposes and does not constitute tax opinion or advice to any taxpayer. Each taxpayer should consult its own tax advisor for the application of the tax laws to its own facts. In addition, this article is based on current U.S. federal income tax law, and the author will not update any reader on any future changes, including those with retroactive effect, in U.S. federal income tax law.


Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. For more information, visit

Venable LLP

Venable ( has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

Structuring a U.S. Real Estate Fund: A How-To Guide for Emerging Managers – Part Three

By Michael A. Bloom and Sung H. Hwang – Venable LLP (New York)

Read Parts One and Two.

C.   Corporate Blocker with Leverage.

Often a corporate blocker will be funded with a combination of debt and equity from the foreign investors.  U.S. tax-exempt investors avoid this form because this can easily turn their investment income into UBTI for technical reasons beyond the scope of this article.  This debt-equity package (often known as “interest stripping”) is still popular with foreign investors, because interest on debt can be used to offset the taxable income of the corporate blocker at the federal, state, and local levels, which, when combined, represents a significantly higher tax rate than the withholding tax on interest paid to the foreign investor.  In other words, the U.S. tax benefit of the interest expense deduction often exceeds the U.S. tax cost on the corresponding interest income.  If the foreign investor qualifies for an exemption from, or reduction of, the withholding tax on the interest, this tax arbitrage can result in even higher savings for foreign investors.

However, because of a series of rules enacted and adopted to curb interest stripping, as well as significantly enhanced documentation and reporting requirements, this form of interest stripping is not as popular as it once was.  As a general rule, foreign investors cannot leverage the corporate blocker to an extent greater than a loan an unrelated lender would have made against the same assets of the corporate blocker.

In our example, Maple Leaf Pension ultimately decides against an interest stripping strategy because the tax savings are not significant enough to justify the leverage, because of limitations on interest deductions under U.S. tax rules.

D.   REIT.

A U.S. real estate fund often invests with a real estate investment trust (REIT) or uses a REIT as a legal vehicle for a joint venture with a tax-exempt investor or a foreign investor.  A REIT is, in summary, any U.S. business entity that acts like a mutual fund with a real estate concentration.  To qualify as a REIT, the U.S. business entity has to make an election to be taxed as a REIT, and satisfy on an ongoing basis a number of ownership diversification, real estate asset and income concentration, active business prohibition, and distribution requirements, among others.  When it does, just like a mutual fund, it will be treated as a corporation that does not pay corporate income tax on its distributed income.

A REIT is generally not suitable as the primary vehicle for a U.S. real estate investment fund because of the numerous and technically difficult qualification requirements.  For example, the rigid distribution rules applicable to a REIT will be inconsistent with the flexibility required of a typical real estate fund distribution waterfall.

Instead, a REIT is often used to create investment opportunities with tax-exempt investors and foreign investors because, like a corporation generally, it can serve the function of a corporate blocker or reduce the tax cost from investment in significant ways.  For example, a REIT may be a suitable joint venture vehicle for a real estate fund that seeks to team up with a pension fund to acquire a large hotel that the fund could not acquire alone because of its size, whereas a pension fund will shy away from direct investment in a hotel because of the UBTI concerns.  Properly structured, a hotel REIT will shield the pension fund from UBTI concerns while allowing the real estate fund to make an investment that it otherwise could not have made.

Similarly, a REIT will be an enticing opportunity for a foreign investor if the U.S. real estate fund does not have significant foreign investor ownership and is willing to take more than a 50% interest in the REIT.  In such case, again, properly structured, the foreign investor will be able to take advantage of a special rule that allows it to exit its investment tax-free through the sale of its REIT stock (the so-called domestically controlled REIT rule), while allowing its U.S. real estate fund partner an investment opportunity that it otherwise would not have been able to close.

In our example, the Coffee Fund most likely will not be interested in teaming up with a REIT, because it has sufficient funds raised from the seed investors for its intended investment goal: to acquire a 30-property Dunkin Donuts portfolio in the first 3 years of its life.  Moreover, because the Coffee Fund has significant foreign investor ownership (i.e., more than 50%), it would not qualify for the “domestically controlled REIT” rule noted above.

Thus, one can see from this example how a structuring analysis is highly fact-dependent, and it is difficult to distill general rules of thumb.

5 Tax Law Changes.

Tax law will undergo many changes this year and in the near future, as the new administration and new Congress will try to “fix” laws and regulations that are perceived as “unfair” or “not working.”  For example, there is a great debate regarding how a carried interest is taxed, while an entirely new idea of creating a new tax rate for income earned through flow-through entities is also being entertained.  Thus, the way a U.S. real estate fund is structured may change soon, in reaction to how tax law changes.

6 Conclusion.

The aggregation of triple-net leased real estate can produce a very attractive real estate fund model.  As illustrated by the Coffee Fund example, there is no “one size fits all” approach to structuring a U.S. real estate fund.  The proper fund structure will depend on the facts and circumstances.  As indicated above, the key facts and circumstances include (i) investor type (e.g., taxable versus tax-exempt), and (ii) the business strategy of the fund.  In addition, compliance with applicable securities laws is a critical component of a successful fund launch.  Although launching your first real estate fund in the U.S. is an extremely complex process, we hope that this article gives the reader a better understanding of the analysis that goes into structuring a U.S. real estate fund.


Michael Bloom is counsel in Venable’s Tax and Wealth Planning Group, where he provides tax advice on all types of corporate transactions, such as mergers & acquisitions, restructurings, and venture capital investments. He is based in New York. In particular, Michael’s tax practice focuses on advising emerging fund managers on fund formation and portfolio acquisitions.

Sung H. Hwang

Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice, based in New York. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. Mr. Hwang has significant experience in domestic and cross-border transactions involving real estate partnerships and funds, private equity funds, hedge funds, asset managers, family offices, and financial institutions. Mr. Hwang also has significant experience in the tax credit space, including the energy-based tax credit area.

Venable LLP

Venable ( has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.

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