We sure have a lot of shareholders – do we need to start reporting to the SEC? – JOBS Act, Section 12(g) and Record Keeping

by Buchanan Ingersoll & Rooney PC

After several rounds of financing, many equity awards to employees and maybe a couple of acquisitions (using company stock for payment), some late stage start-up companies end up with very large cap tables.  At some point, the number of stockholders on your cap table could conceivably trigger public company reporting obligations (for example, 10-Ks and Qs) under Section12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”).  Changes under the JOBS Act and related Securities and Exchange Commission (“SEC”) rules may make it less likely that you will trigger public company reporting obligations, but some late stage start-up companies may have additional record keeping obligations.

“Backing into” Public Company Reporting.

Section 12(g) of the Exchange Act set a maximum number of “holders of record” of a single class of equity that a company can have before it must start making periodic reports under the Exchange Act if it also has more than $10 million in assets (if a private company does not have more than the minimum $10 million in assets, the number of stockholders it has is irrelevant).

In 2012, with the passage of the JOBS Act the asset test stayed the same, but the record holder threshold for reporting was changed to securities “held of record” by either:

(Again, companies with less than $10 million in assets are not required to make periodic reports under the Exchange Act, even if they have record holders in excess of the thresholds above).

Who counts toward the “held of record” number?

  • “Held of record” – This is the Exchange Act rules terminology for how many shareholders you have that count toward the reporting thresholds. Generally, each person or entity that is listed as a shareholder in the company’s records counts toward the reporting thresholds.  Start-up companies typically list the “beneficial owners” of its shares in its records (unlike publicly traded companies which record only the “street name” of the brokerage firm which holds the shares as nominee for the beneficial owners), so the company’s records accurately reflect the shareholders that count towards the reporting thresholds.  In rare circumstances, the SEC may look through an entity (such as a special purpose vehicle) listed on the company’s records if it believes the entity was created to circumvent the requirements of Section 12(g), but typically the SEC’s rules require start-up companies to analyze its shareholder records for purposes of complying with Section 12(g).
    • Employee Equity: Significantly, the JOBS Act and related rules updates exclude from the “held of record” test securities issued to employees and other service providers under compensation plans that did not have to be registered with the SEC, such as under Rule 701. As part of the rules updates that became effective in June, the SEC adopted a non-exclusive safe harbor, which provides that if a company has a reasonable belief at the time a security is issued that a person received securities pursuant to a plan that meets the conditions of Securities Act Rule 701(c), such person may be deemed to have received the securities pursuant to an employee compensation plan with respect to Section 12(g).
    • Prior Acquisitions: In response to concern from the legal community, the SEC also broadened the employee exclusion from the “held of record” in certain business combination transactions. So if your company acquires another company in a stock deal, any current or former employee/service provider of the target company who initially received equity from the target company in compliance with Rule 701(c), and receives securities of your company in exchange (that are exempt from, or issued under a transaction that is exempt from, the registration requirements of the Securities Act) would also be excluded from your company’s “held of record” test.
      • This could be an important diligence question to investigate as part of doing an acquisition, and keeping track of your own company’s 701 issuances could help make things easier for a potential acquirer (as well as helping you keep overall track of your own Rule 701 compliance).
  • “Accredited Investors” – The term “accredited investor” for purposes of the “held of record” standard means basically the same as under Rule 501(a) of Regulation D, and is based on the company’s reasonable belief of such person’s status as of the last day of the company’s fiscal year.

Who is impacted by these changes to Section 12(g)?

The short answer, is that the amendments Section 12(g) and rules changes make the risk of ‘backing into” public company reporting requirements even more remote. Prior to these changes, only a handful of late stage venture-backed companies had enough holders of record to be at risk of exceeding the old thresholds and following the changes, even fewer companies will be at risk.  Nevertheless, companies that approach 500 holders of record will have additional record keeping obligations to determine which holders may be excluded from the “held of record” test.  Below is a summary of steps that all start-up companies with large cap tables should take to ensure compliance with the new thresholds.

What should start-up companies do to comply with the amendments to Section 12(g) and SEC rules?

  • It is important for start-up companies to create and maintain reliable record keeping systems early in the company’s existence (or face a big catch-up project down the road). The number of record holders for purposes of Section 12(g) is measured on the last day of each fiscal year for the company and, if the thresholds are crossed, the reporting obligations under the Exchange Act start 120 days after that last day.
  • Keeping your records updated (which we have discussed before) will also benefit your company during due diligence preparation for each venture financing and your company’s exit, along with calculating voting control for approving shareholder resolutions, and many other calculations associated with the shareholders’ economic interest in the company.
  • Start-up companies should pay particular attention to securities issued pursuant to an employee compensation plan. Accurately tracking awards will allow start-ups to take advantage of the exception described above, as well as the more tangible benefit of knowing who is in your pool and when they leave. While the exception for securities issued pursuant to an employee compensation plan is broad, if these securities are transferred, the recipient may be deemed to be a holder of record for purposes of Section 12(g).
  • Tracking Accredited Investor status: In theory, the threshold change that effectively says that you can have up to 2,000 holders of record so long as fewer than 500 of them are non-accredited is helpful, but in reality, the rules would require the company to have a contemporaneous reasonable belief of that status at the end of each of its fiscal years for that rule to matter much to you (meaning, per the SEC’s own commentary, the company cannot rely solely on the accredited investor determination made back when the stockholder first invested in the company).  The SEC has not embraced a single approach to confirming a shareholder’s status as accredited or nonaccredited, but several reasonable approaches have been suggested, including:
    • Annual affirmations from the shareholder in response to questionnaires;
    • Confirmation from a reliable intermediary, such as a registered broker-dealer, registered investment advisor, auditor or law firm; and
    • Information obtained by a shareholder in connection with an investment shortly before the end of the company’s fiscal year (typically less than three months prior).

Companies that are approaching, or have more than 500 holders of record should consult with counsel about the best way (or combination of ways) to verify shareholders’ status as an accredited investor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Buchanan Ingersoll & Rooney PC | Attorney Advertising

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