In my March 26 post “Guarding the Angels?”, I blogged about some troubling provisions in Senator Chris Dodd’s (D-Conn.) financial reform bill that would have subjected private offerings to angel investors to burdensome SEC review and state regulatory compliance obligations. Among other things, these provisions would have drastically raised the $200,000/year income and $1 million net worth thresholds for angels to qualify as “accredited investors,” which assures private offerings to such persons critical exemptions from federal and state securities laws.

No doubt this sounds like legal gobbledygook, but from the standpoint of a tech attorney whose practice is focused on aiding creative startups, the prospect was sobering. Since startup businesses, particularly in risky technology fields, generally do not have access to traditional bank financing, the addition of potentially tens or even hundreds of thousands of dollars in legal and compliance costs as well as 120 days or more of delay to the angel funding process could have devastated innovative startups and job creation at a time of 9.9% national unemployment. This was a classic case of our political aristocracy in Washington not having had the “Mommy, where do jobs come from?” conversation.

Fortunately, Senate Amendment 4056, approved by the Banking Committee on May 17, while not a perfect fix, largely vitiates the problematic anti-angel Sections 412 and 926 of the Dodd bill. For this we have to thank Senator Dodd himself, as well as Senators Scott Brown (R-MA), Maria Cantwell (D-WA), Mark Warner (D-VA), Kit Bond (R-MO) and Mark Begich (D-AK), although the real heroes were the startups themselves (including my colleagues in Philly Startup Leaders), who organized nationally to petition our elected representatives to remember our critical role in the economy at a time of worldwide economic crisis.

S.A. 4056 gets rid of the SEC review requirement and threat of exposure to state securities compliance requirements and keeps the accredited investor income and net worth thresholds fixed at their current levels for a period of four years, after which they will be subject to SEC review and possible adjustment. This eliminates the immediate danger to startup funding.

In their press release, the Senate sponsors of the amendment hit exactly the right note: whatever went wrong with Wall Street in 2008, startups and angel investors had nothing to do with it, so the government should lay off. However, at the same time it is disconcerting to realize how close we came to killing the goose the lays the golden eggs. Venture capitalists are few and highly selective; small angel investments are the primary vehicle for injecting seed capital into startups. How many future Googles, Facebooks and Microsofts might never have gotten off the ground? How much precious development money would have padded the pockets of securities lawyers? It seems that many senators were not even aware of the implications of their monstrosity. True regulatory reform requires transparency and patience for debate, as well as a willingness to forego dramatic political gestures in favor of targeted (i.e., boring) fixes that are narrowly tailored to diagnosable problems. Above all, it involves reading the freakin’ bill. Fortunately, our citizen-capitalists were on the ball.

Angel investors are wealthy individuals who purchase equity or convertible debt securities to contribute much-needed seed capital to startup businesses. Angel investors are different from venture capitalists (VC’s) in that they are individuals rather than professionally managed investment funds and typically invest much smaller sums of money (usually a couple of million dollars or less) than would interest VC’s. (Angels are also less demanding in terms of the economic and participatory rights of ownership, such as liquidation preferences, vesting of entrepreneurs’ equity stakes, seats on the board, etc.) With VC funding virtually non-existent due to the Great Recession, angel investments are the lifeblood for many struggling startups.

Sales of securities to wealthy angel investors normally come under the private placement exemptions to the Securities Act of 1933, which as a general matter requires filing of a registration statement with the Securities and Exchange Commission (SEC) prior to sale (a costly and onerous process). Under the safe harbor granted in Rule 506 of the SEC’s Regulation D (give yourself a pinch if your eyes start to glaze over at this point!), a company can sell securities in a private placement (i.e., without a general solicitation) to accredited investors and certain sophisticated non-accredited investors without filing a registration statement. Compliance with Rule 506 also enables the company to take advantage of exemptions from state securities laws (also known as “blue sky laws”), which otherwise can impose requirements in addition to those in the federal securities laws.

In the context of angels, an “accredited investor” is an individual with more than $1 million net worth or joint net worth with the individual’s spouse (alternatively, there are income tests for determining whether or not someone is an accredited investor). This makes sense in view of the overall purpose of securities regulation – angels are wealthy, savvy individuals who are used to investing, can afford good lawyers and business advisors, and frequently have a prior relationship with the founders of the companies in which they invest. For these reasons, they need less formal disclosure and regulatory protection than, say, a teacher who wants to put the money in her savings account into equities to get a higher rate of return.

Sections 926 and 412-13 of the proposed “Restoring American Financial Stability Act of 2010” would gut the current Rule 506 exemption by opening the door to greater SEC and state regulatory involvement in angel offerings:

• first, the rules would allow the SEC to designate certain securities offerings as not being “covered securities” under the 1933 Securities Act due to their small size (this would have the effect the effect of negating the Rule 506 exemptions from state blue sky laws and forcing companies to comply with differing requirements of individual states – e.g., filing and obtaining state review of a lengthy registration statement).

• third, the bill proposes to roughly double the net worth and income thresholds for accredited investors, meaning that fewer angel investments would qualify for the private placement exemption from SEC registration.

Needless to say, these requirements, if enacted into law, could have a huge impact on the flow of angel funds to cash-starved startups, disqualifying many transactions from favorable securities treatment and vastly increasing transaction time and costs (including legal fees). They could drive a stake through America’s still-beating entrepreneurial heart.

No one has a clear idea exactly how these provisions got into the financial reform bill, the ostensible purpose of which is to address the root causes of the financial collapse of 2008. While these causes are undoubtedly complex, I can safely say that angels run amok is not among them. From conversations with Senator Dodd’s staff, the best that inquirers have been able to discern is that the provisions were intended to deal with Bernie Madoff-type situations and hedge fund abuses. No one appears to have seriously considered the implications for angel investors and startups. Of course, this is an expected problem when, in the name of reform-at-any-cost, you ram through sweeping regulatory overhauls whose drafts consume legions of trees and no has the time to peruse in depth.

Fortunately, the entrepreneurial and angel community, especially the Angel Capital Association, was very much on the ball here, and, as we speak, their representatives are working with Senator Dodd and Senator Richard Shelby (R-Ala.) to make fixes. Hopefully we will have some good news to report on this blog soon. If access to angel funds is choked off, financial reform may turn out to be the “Jobs Prevention Act of 2010,” and we’re going to be enjoying 9.7% unemployment (or higher) for some time to come.

With a report released today showing unemployment in Philadelphia now at 11.4%, one thing we DON’T need is government guarding millionaire angels – from themselves.

On a legal note, one of the tidbits that VC’s have for startups is … make sure you have the proper intellectual property assignments in place with founders, employees and consultants (for my PANMA and PSL friends, that means: DEVELOPERS) to transfer ownership of all intellectual property rights to the startup entity. VC’s look for this when they do their due diligence for funding transactions, and you can bet your startup keister on the fact that everything will be given an even more penetrating once-over at the time of an exit event like an acquisition or IPO. If these assignments are not in place, your startup could end up being an unintentional co-owner of its product with someone else, who may be able to sell or license it independently as they see fit. In fact, I blogged about the need to nail down ownership last May, so you know how near and dear this issue is to my heart.

Someone else co-owning your patents or copyrights is NOT good for your valuation! If you need an IP audit or want to get IP ownership buttoned up, please give me a call. I always have time for startups.

Not that I don’t understand. If the startup is your brainchild, you want to get a prototype in the works, move ahead with alpha and beta testing, and start to market the product and talk to investors at the earliest possible date. You can’t allow yourself to be distracted setting up a payroll, talking to accountants or doing all of the coding yourself. Furthermore, if you’re like 99.9% of startups, you don’t have a lot of cash, which seems to make giving out something other than dead United States presidents an attractive option. Plus, your prospective partners may be your co-workers or roommates, and you want to do right by them. Right? Right?

Unfortunately, being too generous with equity is a common mistake made by startups. Naturally, it seems like an effortless and expedient way to get the ball rolling. Remember, though, that when you give out equity, you make partners of people whose commitment to the startup and time horizon may not be the same as yours, and whose contributions, while genuinely needed, may be more generic and easily replaceable than what you’re contributing (money, patentable ideas, reputation and stature as an innovator, connections with investors, etc.) Another risk is that the potential partner who seemed cool and focused at the last Philly Startup Leaders happy hour may turn out to be a certifiable flake who sees kabbalistic messages in Drupal.

These partners may lose interest in a few months, fail to perform as anticipated or hold different views from yours on the management and goals of your startup. Yet, being partners, they have legal claims on the assets of the startup, the right to access business records, and the right to have a say in (or even block) certain strategic decisions. Or they may want to sell their equity to third parties with whom you’d rather NOT be in business. The situation gets even messier and more unpredictable when (as frequently happens) the initial buy-in transactions and the partners’ rights and obligations with respect to their equity stakes and their roles in the startup are not well documented (or documented at all) in, say, an LLC operating agreement.

As with romance, it’s easier to get married than divorced. In my own legal practice I’ve seen a steady flow of what I call “app divorces” — that’s when two people without a long prior working relationship form an LLC to develop iPhone or Facebook apps, quickly encounter irreconcilable differences and decide to part ways. The story normally goes like this: one partner just is not putting his all into the relationship (”you’re not there for me!”). The other partner comes to me, and I have to figure out a way to unwind the partnership and cash out the wayward partner while keeping the intellectual property (ownership and practical control of the app) and as much cash as possible in the hands of my client.

So be stingy with your equity, dear startups. If you’re the primary innovator and/or source of funding, and the other guy is basically bringing labor and moxie, ask yourself how well you know him, how well you work together and whether a strict pay-for-services or commission-based relationship might be better. If the skill set you need is not particularly unique (say, coding or website design), could you get a freelancer or other independent contractor to do it under an agreement where they assign all intellectual property rights in the work product to your company? Or, as with payroll, is there an affordable third-party turnkey solution on the market?

Of course, sometimes you have no choice but to give out equity in order to get the services and skill sets you need, particularly where they’re not all that fungible or require a high degree of trust and comfort. In these situations, give out as little equity as possible, both to preserve your control as well as your ability to bring in other investors without diminishing your ownership stake too much. Don’t immediately offer 50-50 because it seems fair.

You could also create two classes of equity, one for yourself and other investors, and the other for service providers you need to woo. The first class of equity could have an exclusive claim to all distributions from the startup entity up to $XX, with holders of the second equity class only being entitled to their proportionate share of distribution proceeds over and above $XX. This is a good way of ensuring that a service provider partner doesn’t end up claiming a share in the investors’ money.

App divorces handled with sensitivity here

Performance vesting is tied to achievement of certain milestones — for example, 25% of the shares vest on successful testing of a prototype, another 25% on sales reaching $XX, etc. Combinations of time and performance vesting are also possible, so that, for example, 25% of the shares would vest if the holder is still employed after one year AND has successfully tested a prototype.

Where equity is shared among multiple partners, transferability and exit issues (if someone wants to get rid of their shares, to whom may be they be sold and how should they be priced?) also need to be carefully discussed and dealt with in a legal document such as an LLC operating agreement. Having multiple owners means you will need more legal consultation in the startup process, yet another reason to be stingy with your equity. (And don’t try to draft the documents yourself to save on legal fees; if your startup ends up doing well, that’s a great way to buy a litigator a new yacht.)

Don’t get me wrong — I’m not saying NEVER hand out equity. Just be cautious and, if you have questions or reservations, talk to a business lawyer. When you give equity for services, you’re buying more than those services; you’re also buying the service provider.