Guidance for Venture-Backed Companies
Venture-backed companies entered a new era of disclosure with the Corporate Transparency Act (“CTA”) taking effect on January 1, 2024. Adopted as part of the Anti-Money Laundering Act of 2020, the CTA requires most privately-owned companies to file beneficial ownership information (“BOI”) reports with the Financial Crimes Enforcement Network (“FinCEN”) of the U.S. Department of Treasury. Moreover, the special economic and governance rights negotiated in venture financing, the CTA can create complex analytical and reporting hurdles for venture investors, startups and other venture-backed companies. With a key reporting date of January 1, 2025, approaching, this article provides an overview of key considerations for venture-backed companies to navigate CTA compliance.
What companies are required to report?
Unless an exemption applies, all privately-owned corporations, partnerships, limited liability companies or any other entity that is created by a state filing (or Indian tribe) are considered “reporting companies” and must comply with the CTA’s disclosure requirements. Non-U.S. companies are also considered reporting companies if registered to do business in any U.S. state (or Indian tribe).
Twenty-three types of entities are exempt from CTA reporting requirements, including publicly traded companies, nonprofits and banking institutions. While certain venture investment advisors and large operating companies are exempt, most startups and venture-backed companies will not qualify for an exemption and will be required to comply with the CTA disclosure requirements.
What information must be reported?
The CTA requires that each reporting company report its full legal name, any trade names or DBAs (whether filed or not), current U.S. address, the state or jurisdiction of formation or registration, and an IRS-issued taxpayer identification number (EIN).
The CTA also requires a reporting company to provide the name, date of birth, address, and unique identifying number from a government-issued document (such as a passport or driver’s license), along with an image of that document, for each “beneficial owner” and “company applicant.”
Beneficial Owners:
The CTA defines a beneficial owner as anyone who, directly or indirectly, either (a) exercises “substantial control” over the company, or (b) owns or controls at least 25% of the ownership interests of the reporting company. Let’s review each of these aspects in more detail.
Substantial Control. An individual exercises substantial control over a reporting company if the individual meets any of four general criteria:
- the individual is a senior officer, including the president, CEO, CFO, COO, general counsel or any other officer (regardless of title) that performs these functions;
- the individual has authority to appoint or remove any senior officers or a majority of directors of the reporting company;
- the individual can direct, determine or have substantial influence over important decisions regarding the company’s business, finances or structure; or
- the individual has any other form of substantial control over the reporting company.
Ownership Interest. Reporting companies are required to identify all individuals who own or control at least 25% of the ownership interests of the company. A reporting company may have multiple types of ownership interests and any of the following may be an ownership interest:
- equity, stock, or voting rights;
- a capital or profit interest;
- convertible instruments;
- options or other non-binding privileges to buy or sell any of the foregoing; and any other instrument, contract, or other mechanism used to establish ownership.
Ownership interests are generally measured in relation to all outstanding ownership interests in the company. For corporations, ownership is measured by either voting power or value. An individual will be deemed a beneficial owner if either (a) its combined voting power of all classes of ownership interests divided by the company’s total outstanding voting power of all classes exceeds 25%, or (b) its combined value of all classes divided by the company’s total outstanding value exceeds 25%. In all cases, a reporting company must identify any individual who owns or controls 25% or more of any class or type of ownership interest in the company.
A reporting company can have multiple beneficial owners, and there is no maximum number of beneficial owners that must be reported.
Company Applicants:
Certain reporting companies are required to report the individual(s) that directly or indirectly files the document that created the domestic reporting company or first registered a foreign reporting company (e.g., certificate of formation). A reporting company is required to report its company applicant(s) if it is either (a) a domestic reporting company created on or after January 1, 2024; or (b) a foreign reporting company first registered to do business in the United States on or after January 1, 2024. A reporting company is not required to report its company applicants if it is either (a) domestic reporting company created before January 1, 2024; or (b) a foreign reporting company first registered to do business in the United States before January 1, 2024.
There are two categories of company applicants: (1) the “direct filer” – the person who directly files the document creating or registering a reporting company (e.g., physically or electronically makes the filing with the secretary of state) and (2) the individual who “directs or controls the filing action” – the person who was primarily responsible for directing or controlling the filing. If a startup uses a third-party registered agent to create the entity, the registered agent must be reported as a company applicant.
Special considerations for venture-backed companies.
The economic and governance rights negotiated in venture financing can create complex analytical and reporting hurdles for venture-backed companies in navigating CTA compliance.
Ownership Considerations:
Most pre-seed and seed funding transactions are structured as SAFEs or convertible notes. Those instruments usually feature a mandatory or optional feature to convert into equity in the startup’s next priced round at a discount or subject to a valuation cap. Thus, the conversion price – and number of shares to be issued – is usually unknown before the instrument converts. This can make it challenging to determine what percentage of ownership a convertible note or SAFE represents with respect to overall capitalization.
Early-stage companies that have not raised capital on a priced round can use the “catch-all” provision to determine who is a beneficial owner. The final rule provides that if the 25% ownership calculations cannot be performed with reasonable certainty, any individual who owns or controls 25% or more of any class of ownership interest of a reporting company is deemed a beneficial owner. For example, a startup that has only common stock and SAFEs on its cap table would report any (1) person(s) who is a beneficial owner of at least 25% of the common stock and (2) any SAFE holder(s) whose SAFEs represent 25% or more of the outstanding SAFEs issued by the company.
Venture-backed companies that have raised capital in priced rounds will have an easier time calculating beneficial ownership, as SAFEs and convertible notes generally convert to equity during priced-round financings. The ownership in each equity class, as well as “fully-diluted” ownership, will be calculated for a financing and the proforma capitalization table can be used as a reference point to determine the reportable beneficial owners.
Substantial Control Considerations:
For early-stage startups raising a priced round and later-stage startups, the equity ownership calculation may become easier, but the substantial control determination may become more complicated. Startups must consider how the governance and control rights granted to venture investors affect the evaluation of substantial control. VC investors insist upon enhanced governance and control rights in exchange for their investment, and these rights often include:
- The right to appoint one or more directors to the board of directors.
- Representation on the board of directors (with the board having the right to appoint and remove senior officers).
- The right to approve (or veto) certain important decisions regarding the company’s business, finances or structure by virtue of “protective provisions” or matters requiring preferred director approval.
All of these rights, and the extent to which an investor controls these rights, must be considered when determining whether an investor has “substantial control” over the company. For example, if Series A investors must consent to the sale of the company’s material assets, certain Series A investors have substantial control over an important company decision and thus may be considered beneficial owners (in particular, investors that hold 25% or more of the Series A shares).
Compliance Considerations:
The consequences of CTA non-compliance could be severe. Failure to timely report or update BOI reports to FinCEN, or willfully providing false beneficial ownership information, is subject to civil or criminal penalties, including civil penalties of up to $500 for each day that the violation continues, or criminal penalties including imprisonment for up to two years and/or a fine of up to $10,000. Senior startup officers who fail to file required BOI reports may be held accountable for that failure. Further, a company would need to disclose any CTA compliance infractions to potential investors or acquirers, which could jeopardize a company’s ability to secure funding or be acquired.
How can my company comply with the Corporate Transparency Act?
FinCEN began accepting beneficial ownership reports on January 1, 2024, but the date of formation of a startup determines the filing deadline:
- If your company was created or registered prior to January 1, 2024, you will have until January 1, 2025 to report BOI.
- If your company is created or registered in 2024, you must report BOI within 90 calendar days after receiving actual or public notice that your company’s creation or registration is effective, whichever is earlier.
- If your company is created or registered on or after January 1, 2025, you must file BOI within 30 calendar days after receiving actual or public notice that its creation or registration is effective.
Reporting companies are also required to submit any updates or corrections to previously filed beneficial ownership information within 30 days of the change. Venture-backed companies should review their CTA filings for potential modifications with each round of financing it accepts.
CLOSING THOUGHTS
Venture-backed companies will need to navigate data protection and privacy concerns in collecting and storing the information required for CTA compliance. As companies prepare CTA reports, they may receive personally identifiable information from officers and stockholders (PII) such as passport or driver’s license numbers from their owners. The company must ensure that such data is protected from unauthorized access and treated in compliance with applicable law. To mitigate this concern, FinCEN allows companies and beneficial owners to create a “FinCEN identifier”, a unique identifying number. FinCEN will issue an identifier to an individual or reporting company upon request after the individual or reporting company provides certain information to FinCEN. An individual or reporting company is not required to obtain a FinCEN identifier, but may only receive one FinCEN identifier. In lieu of a startup collecting PII from each beneficial owner or company applicant, a startup can collect and submit FinCEN identifiers for each beneficial owner or company applicant in its BOI report.
This article is for educational purposes and does not constitute legal advice. However, GwC is happy to assist our clients in preparing for and filing BOI reports. Please get in touch with us for more information or assistance.
