Investors in privately held companies face new legal considerations due to the Corporate Transparency Act (CTA), a new federal law taking effect January 1, 2024. This article recommends approaches that investors can use to protect their investments as well as their portfolio companies. These investors include angel investors, participants in friends-and-family rounds and others.
The Corporate Transparency Act in a Nutshell
The CTA will require most privately-held American companies to report the names of their “Beneficial Owners” to the Financial Crimes Enforcement Network (“FinCEN,” a part of the U.S. Treasury Department). “Beneficial Owner” is something of a misnomer, as it includes certain company owners as well as some non-owners who have positions of significant control relating to companies. A company’s Beneficial Owners will generally include:
- at least some of its senior executives, at least some members of its Board of Directors (or managers, in the case of a limited liability company), and sometimes higher-level employees (the “Control Test”); and
- individuals who hold or control 25% or more of the company’s equity or rights that may convert to 25% or more of the company’s equity (the “Ownership Test”). The Ownership Test takes an as-converted, as-exercised approach to convertible promissory notes, Simple Agreements for Future Equity (SAFEs), stock options and similar instruments and arrangements.
Companies subject to the CTA[1] will need to make an initial report soon: by January 2025 for companies formed before January 2024, and for companies formed in 2024, within 90 days after formation. The company must also then file updated reports anytime its last-reported Beneficial Owner information changes. A company that fails to make a CTA report when due, or which knowingly reports incorrect information, is subject to civil fines and even criminal penalties.
Our previous articles discuss the CTA and its requirements in more detail, both as they affect banks and other financial institutions and American companies more generally.
Why Corporate Transparency Act Compliance Matters for Outside Investors
As noted above, a company that violates the CTA risks civil or criminal penalties. These fines and penalties would fall on the company making the reporting errors, not the investor (unless the investor herself causes the company’s error by providing incorrect information to the company).
Nonetheless, CTA non-compliance is a significant risk for investors even if a company never receives a civil or criminal penalty. The mere fact of the company’s non-compliance can jeopardize the investor’s future return on the investment. Many investment deals produce returns only when the company is acquired or closes a future financing round. In both of those cases, the company generally needs to disclose to potential investors or acquirers any legal compliance missteps the company has made in the past. When an investor or acquirer stands ready to wire funds, the prospect of disclosing past violations of a federal anti-money laundering law is not a happy one for the company. That disclosure may not scuttle a deal, but it is always better to have no missteps to disclose in the first place.
How Angel Investors May be Named as Beneficial Owners
Any particular investor may, depending on the terms of their investment, be a “Beneficial Owner” whose name the company must report to FinCEN.
For example, investors with negotiated rights to sit on a company’s Board may satisfy the Control Test described above. (Directors are not always Beneficial Owners, but will be in many cases.) Similarly, where an investor has a right to appoint another person to the Board, both the investor and the designated Board member may qualify as Beneficial Owners.
An investor may also be a Beneficial Owner by virtue of their deal documents (stock purchase agreements, subscription agreements, investors’ rights agreements). Many such agreements give investors veto power over key company actions like issuing stock, buying other companies, being acquired by other companies, changing executive compensation levels, launching new product lines or laying out large expenses. An investor may be a Beneficial Owners if they hold any of these rights – either individually or as part of a syndicate that holds the right collectively.
Finally, all of an investor’s equity and equity-related rights in a company are aggregated for purposes of the 25% Ownership Test. If an investor holds 20% of a company’s stock as well as options to buy 6% more, the investor is treated as a 26% holder. The as-converted values of SAFEs and convertible notes are difficult to predict in most cases, but the CTA does count those as-converted equity positions toward the 25% threshold.
How Corporate Transparency Act Reporting Will Work for Angel Investors
When a company reports a Beneficial Owner to FinCEN, the information reported is substantial. The company will report the person’s full legal name and date of birth; their current home address; and a unique identifying number (for example, a Social Security Number). The company must also send FinCEN a photocopy of the person’s U.S. passport, driver’s license or similar government identification document.
Many investors invest through vehicles such as trusts or companies. In these cases, the reporting company will be reporting the name of the individual investor controlling that company or trust. In other words, the use of a company or trust as a vehicle does not shield the individual investor from the report.
FinCEN will allow any Beneficial Owner to obtain a “FinCEN Identifier,” a unique identifying number that companies may submit in lieu of the detailed data described above. This will allow a Beneficial Owner to submit the detailed information just once rather than with every new investment or with every updated CTA report a company makes.
Best Practices for Investors Regarding the Corporate Transparency Act
We recommend investors consider these steps to prepare for the CTA:
1. Going forward, add CTA-related language to your investment documents. Many investors have preferred deal documents that they dust off for each new investment. Update them now to add a promise by the company that it will always ensure its own compliance with the CTA. Consider requiring the company before or shortly after a deal’s closing to designate an individual to handle this task. You might even require input over who that individual will be.
2. Talk to your existing portfolio companies. As noted above, companies in existence before January 2024 will need to file their first CTA reports by January 2025. Yet many U.S. companies still have not yet heard of the CTA, let alone prepared for it. Make sure companies that you have funded understand the law. You can start by simply forwarding them this article.
Encourage these companies to consider privacy and data protection issues. As the companies receive drivers’ licenses and Social Security Numbers from ever-growing numbers of Beneficial Owners, they will accumulate personal data that they should protect from unauthorized access. In some cases, companies should simply delete this personal information as soon as their CTA reports are made.
3. With companies you have already funded, consider amending your deal documents to promote CTA compliance. Deal documents signed in the past can be amended to add robust CTA compliance obligations such as the going-forward provisions described above. Easier still: simply ask the company now to adopt an internal resolution accomplishing the same goals.
4. Consider changing control or equity positions to avoid the reporting obligation entirely. An investor who would be deemed a CTA Beneficial Owner may prefer not to have their name reported to FinCEN at all. In these cases, the company and the investor could agree to restructure their deal to remove any rights that would trigger the CTA’s Control Test. Likewise, they could agree that the investor may sell enough of its equity to fall below the 25% Ownership Test threshold.
Any such restructurings would presumably entail changes to deals’ economic terms as well and may have tax consequences for the investor. They should be done in consultation with an accountant and legal counsel.
[1] Most but not all U.S. corporations and limited liability companies must make CTA reports. Please see our earlier article for more detail on exemptions that may spare companies from reporting.
