Friday, April 22, 2011

Securities Sales by Affiliates under Texas Securities Act

Let's say you are an officer or director of a privately held company in Texas.  Can you sell shares of the Company to another officer or director without registering the sale or otherwise making a filing with the Texas State Securities Board?  Probably so, but the answer is not nearly as obvious as you might think. 

As a reminder, all sales of securities must be registered or exempt from registration.  Even if a sale is exempt from registration under federal securities laws, one must also register or find an exemption from registration under applicable state securities laws, such as the Texas Securities Act.

The Texas Securities Act provides a number of exemptions from registration, but most of the exemptions are not available for affiliates (such as officers and directors) of privately held companies.  Let's walk through some of them. 

Most of the exemptions are available only to the issuer of the securities, so those won't help you. Rule 139.13 provides an exemption for sales of securities that comply with the SEC's Rule 144, but affiliates of the issuer cannot rely on Rule 144 unless "current public information" regarding the issuer of the securities is available - that's virtually never the case for a privately held company.  Rule 139.14 provides an exemption for a limited number of sales of securities by non-issuers, but affiliates of the issuer who wish to rely on this exemption must file a Form 133.34 with the Texas State Securities Board.

Fortunately, we have Section 5.C(1) of the Texas Securities Act, which exempts "[s]ales of securities made by or in behalf of a vendor, whether by dealer or other agent, in the ordinary course of bona fide personal investment of the personal holdings of such vendor, or change in such investment, if such vendor is not engaged in the business of selling securities and the sale or sales are isolated transactions not made in the course of repeated and successive transactions of a like character; provided, that in no event shall such sales or offerings be exempt from the provisions of this Act when made or intended by the vendor or his agent, for the benefit, either directly or indirectly, of any company or corporation except the individual vendor (other than a usual commission to said agent), and provided further, that any person acting as agent for said vendor shall be registered pursuant to this Act;"

The Texas Securities Board has issued several opinions interpreting Section 5.C(1).  Basically, a "vendor" under Section 5.C(1) appears to mean anyone who sells securities held for personal investment.  Unfortunately, the statutory language quoted above is simply not very clear.

Monday, April 18, 2011

Mythbuster: the "Limited Liability Corporation"

Occasionally I'll hear someone describe a company as a "limited liability corporation," and I'll cringe like an English teacher who has just heard a student split an infinitive.  Or like anyone who hears the sound of fingernails on a chalkboard.

An entity can be a limited liability COMPANY (LLC) or a corporation, but not both.  Countless legal treatises have been written comparing and contrasting the LLC, the corporation, and other business entities, so I will not attempt to summarize all of the difference in this blog post, but here are two big differences:

1. Taxes.  Although an LLC can elect to be taxed as a corporation, LLC's typically choose to be taxed as a partnership (if the LLC has more than one member) or as a disregarded entity (if the LLC has a single member) for federal tax purposes.  Generally, that means income generated by the LLC is taxed just once - each member pays tax on the portion of the LLC's income attributable to such member's percentage ownership of the LLC.  Conversely, earnings of a corporation are taxed twice - once to the corporation when it earns the income, and second to the shareholder of the corporation when the shareholder receives dividends from the corporation.

2. Governance Flexibility.  The rules for operating and managing a corporation are very strict and set out in length in the corporate statutes of the corporation's state of incorporation.  Those rules typically can be modified by contract among the shareholder's of the corporation only in limited circumstances.  On the other hand, LLC statutes are typically very flexible and generally permit the members to enter into company agreements which provide for all sorts of operating and management arrangements.  For example, corporations are virtually always managed by the corporation's directors, while an LLC may choose to be mananged by its members or by managers.

Accordingly, an LLC is often the business entity of choice.  Just don't call it a limited liability corporation!         

Friday, April 15, 2011

Is Your Fate "Sealed" in Delaware?

Have you ever seen the word "Seal" on a signature page to a contract?  Have you ever wondered what that word means?  It turns out it means quite a bit under Delaware law.

Stamping a contract with a corpoate seal means that the contract or instrument is extra official.  Contracts "under seal" can subject to a 20-year common law statute of limitations rather than the typical 3-year statutory limitations period in Delaware.  In the case of an individual, merely writing the word "Seal" next to that person's signature is enough to create a sealed contract under Delware law.  That result came as a bit of a surprise to legal practitioners when the Delaware Supreme Court made that decision in the 2009 case of Whittington v. Dragon Group, L.L.C.

The 3-year statute of limitations, which includes a carve out for records or instruments "under seal," can be found in Title 10 (Court and Judicial Procedures), Section 8106 of the Delaware Code.

Parties to contracts governed by Delaware law would be wise to look for the word "Seal" on the signature page of the contract and understand its far-reaching implications.

Wednesday, April 6, 2011

Mythbuster: Dilution is not a 4-letter word

Dilution is not something to be feared.  It is something to be respected.  Let me explain.

Dilution is a much talked-about topic among company founders, angel investors, and venture capitalists.  Founders are understandably fearful of any dilution of their stake in the company.  A company's founder always starts off owning 100% of the company.  Then, the founder may sell off pieces of the company to key executives and employees, strategic partners, sources of equity capital, and others.  Each time a new party gets new shares of stock from the company, all of the existing shareholders get diluted and own less of the company.

At first glance this seems bad - the founder used to own 100% of the company and now he owns less, often much less.  But what did he get in return?  Hopefully, by issuing stock to key executives and employees the founder was able to recruit and retain a highly motivated management team.  By issuing stock to strategic partners the company got access to exciting new markets.  By issuing stock in exchange for equity capital, the company got the funds it needed to complete its prototype, or to build its new factory, or to compensate its sales team. 

Any time a company issues new stock the company's board of directors must evaluate whether or not the issuance will expand the size of the pie (the equity value of the company) enough to justify diluting the amount of the pie held by existing shareholders (their repsective percenatge ownership of the company).  Of course, no company has a crystal ball, and stock issuances do not always benefit the company.  If the board does its job correctly, however, dilution (along with the issuance that caused the dilution) will actually benefit the existing shareholders.

Bill Gates no longer owns 100% of Microsoft, but I imagine that he is quite pleased with the value of the 7% of Microsoft that he owns as of the company's most recent proxy statement!