National Business Incubation Association; Your source for knowledge and networks in business incubation

Staying on the right side of the SEC

by Meredith Erlewine

February 2001

Most professionals involved in incubation focus on selecting clients, identifying their needs, and developing ways to best serve them. Developers of for-profit incubators also must decide how much equity to take in client firms, how to compensate incubator staff in relation to the upside that the most successful client companies may realize, and how to generate revenue and guarantee a return on investment. Many factors figure into the final equation – including compliance with rules and regulations of the U.S. Securities and Exchange Commission (SEC). To find out exactly what the dynamic is between U.S.-based for-profit incubators and the SEC, NBIA interviewed Christopher Wilson, a partner at longtime member Pillsbury Madison & Sutro LLP, in Costa Mesa, Calif. Wilson specializes in securities law and counsels for-profit incubators.

According to Wilson, if a for-profit incubator does not act prudently and work closely with an attorney who is versed in key securities issues, the incubator may inadvertently be an investment company and thus be forced to comply with the Investment Company Act of 1940 – the same rules, regulations and laws applicable to mutual funds. That "mutual fund" designation brings burdensome requirements that may limit an incubator's business operations and impose additional costs.

According to Wilson, two things can cause the SEC to consider an incubator an investment company: 1) if the incubator is or holds itself out as being primarily engaged in the business of investing, reinvesting or trading in securities; or, 2) if the incubator owns or proposes to acquire "investment securities" having a value exceeding 40 percent of its total assets.

"Generally, incubators are operating businesses, not engaged in the business of investing in securities," Wilson says. However, many for-profit incubators take an equity stake in their clients' companies. When the value of the equity securities owned by an incubator exceeds 40 percent of the incubator's total assets, the incubator inadvertently may become an investment company.

Fortunately, there are several exemptions from the 1940 Act's regulations (the exemptions are outlined below). In order to make sure your incubator meets one or more of the exemptions, you'll need the guidance of a competent attorney who specializes in securities law. Describe your incubator's long-term plans, individual business model, capital structure and future capital-raising plans.

It's imperative to touch base with your attorney regularly, because as your incubator evolves and changes, so may its ability to comply with one or more of the critical SEC exemptions. Should noncompliance become an issue, your attorney can make sure you are one step ahead of the game (and an SEC investigation). Work with your attorney to chart a course that ensures that your incubator always carries out one of the following suggestions that will keep it in compliance with the '40 Act.

Own a controlling interest in client companies. One exemption from the definition of investment company permits an incubator to have up to 45 percent of its assets composed of "controlled" securities. Controlled securities are those securities of companies in which the incubator has a 25 percent or greater stake. However, Wilson cautions, few incubators can command such a hefty share. "Even if they could, such an ownership position cannot be perpetually guaranteed," Wilson says, "particularly when the portfolio company seeks and accepts subsequent rounds of private funding or if it ultimately undertakes a public offering." When that happens, the incubator's equity percentage will be diluted below 25 percent or it may have to purchase additional securities (to maintain its 25 percent ownership) or divest itself of the investment. That divestment can itself trigger a closer look by the SEC if the incubator's investment income is too large a proportion of its own internal operating income.

Limit the incubator's shareholders to 100. The '40 Act provides that companies with fewer than 100 shareholders that do not make public offerings will not be considered investment companies. "However," Wilson says, "the 100 shareholder rule may limit an incubator's ability to raise capital or prevent a public offering exit strategy." Moreover, incubators relying on this exemption may not be able to attract employees since their ability to grant options as part of a compensation package will be restricted to 100 employees. On the other hand, as a practical matter, most incubators – even the oldest members of NBIA – can mount very effective programs without ever exceeding the 100-employee level.

Own some revenue-generating companies. Some incubators that intend to do a public offering acquire operating businesses so that their investment securities represent less than 45 percent of their assets and net income after taxes. "CMGI is one example of this approach," Wilson says. "CMGI acquired operating businesses to ensure its revenue is predominantly from operations and not from investment securities."

Ask for permission … don't wait to beg for forgiveness. If no other exemptions are available, an incubator may apply to the SEC for a "no-action letter" – an exclusion order specifically acknowledging that the incubator is not in the business of investing in securities. Internet Capital Group, idealab! and others have taken this approach, according to Wilson. The SEC considers five factors when reviewing applications for exclusion orders. "We encourage clients to address the issue early, before any violation occurs," Wilson says. It is important for an incubator to initiate the no-action letter process with the SEC before the SEC discovers that the company may be in violation of the '40 Act and initiates an investigation of its own.

Register as a Business Development Company (BDC). If your attorney cannot structure your incubator so that it meets one of the SEC's exemptions and if your attorney does not think the incubator is a good candidate for a no-action letter, consider registering as a BDC. As BDCs, incubators are exempt from many – but not all – of the '40 Act requirements. For example, unlike investment companies, BDCs are permitted to compensate managers and advisors based on company performance – an incentive program that can assist BDCs in attracting qualified management. However, BDCs still are subject to certain '40 Act requirements that may restrict their business operations. To qualify as a BDC, an incubator must have 70 percent of its investments in eligible assets (there are several ways to meet the eligibility requirements) and it must provide or make available to its portfolio companies significant management assistance.

Note: None of the information above is intended to replace the services and advice of a competent attorney. For comprehensive advice tailored to the specific situation, anyone forming an incubator or any other company should consult an attorney who is specifically qualified to provide professional counsel on both business and SEC issues.

Keywords: equity and royalty agreements, for-profit incubators, regulatory compliance -- incubator

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