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Corporate Transparency Act Risks for Startups and Venture-Backed Companies

January 08, 2024

Starting January 1, 2024, virtually all private companies will be required to report information about their beneficial owners to the Treasury Department’s Financial Crimes Enforcement Network “FinCEN”) under the Corporate Transparency Act (the “CTA”).  But the CTA presents unique analytical and reporting challenges for startups and venture backed companies because of the special economic and governance rights negotiated with investors in early stage and venture funding rounds.

Beneficial Ownership under the CTA

For each “beneficial owner”, the CTA requires companies to provide the name, date of birth, address, unique identifying number from a government issued document such as a passport or driver’s license and an image of that document. A beneficial owner under the CTA means anyone who, directly or indirectly, either (i) exercises “substantial control” over the company, or (ii) owns or controls at least 25% of the ownership interests of the reporting company. 

“Substantial control” over a reporting company exists if someone serves as a senior officer, has the right to appoint or remove any senior officer or a majority of the directors, directs or influences important decisions of the company or has any other substantial control over the company.

As to the 25% ownership test, ownership interests are generally measured in relation to all outstanding ownership interests in the company.  Ownership interests are defined broadly to include all equity securities, convertible securities, profits and capital interests, options and any other similar contracts, arrangements or understandings with the reporting company.

For corporations, ownership is measured by either voting power or value.  As between voting power and value for the purpose of determining 25% ownership, one would look at the greater of (i) the total combined voting power of all classes of ownership interests of the owner as a percentage of total outstanding voting power of all classes of ownership interests entitled to vote, or (ii) the total combined value of the ownership interests of the owner as a percentage of the total outstanding value of all classes of ownership interests.  An individual will be deemed a beneficial owner if either his combined voting power of all classes of ownership interests divided by the company’s total outstanding voting power of all classes exceeds 25%, or his combined value of all classes divided by the company’s total outstanding value exceeds 25%.

Unique CTA Issues for Startups and Venture Backed Companies

Startups and venture backed companies will need to be mindful of how their unique funding and governance structures will impact the beneficial ownership analysis under the CTA.

Startups with convertible notes and/or SAFEs (simple agreements for future equity) on their cap tables will have particular challenges in determining voting power and value for the purpose of the ownership requirement.  Most early stage funding transactions in startups are structured as either convertible notes or SAFEs because of valuation uncertainty and the need for efficiency and cost effectiveness.  Those instruments typically convert to equity at a discount to the price per share in the company’s next priced round.  But at any given time of calculating beneficial ownership for CTA purposes, the conversion price will be unknown as to any outstanding convertible notes or SAFEs, i.e., before the instrument converts.  The company will not know how many shares will be issued on conversion or what percentage those conversion shares will represent of the overall capitalization.

There is some guidance in how to deal with the above calculation quandary in the final rule issued by FinCen to implement the CTA.  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 would be deemed to own or control 25% or more of the ownership interests of the reporting company (and thus be deemed a beneficial owner).  So, for example, a startup that has only common stock and convertible notes on its cap table would report any person who is a beneficial owner of at least 25% of the common stock, as well as any convertible note holder whose notes represent 25% or more of the outstanding aggregate principal and interest of all convertible notes issued by the company.

In addition, venture backed companies will need to consider carefully how the unique governance rights negotiated with VCs will impact the “substantial control” analysis under the CTA.  As I mentioned above, a person would be deemed to have substantial control over a company (and thus considered a beneficial owner) if that person has the right, among other things, to appoint or remove any senior officer or a majority of the directors, directs or influences important decisions of the company or has any other substantial control over the company.

Venture investors almost always get enhanced governance rights in exchange for their investment.  One of the most common of these is board representation rights found in a company’s amended and restated certificate of incorporation which gives the investor or holders of a series the right to elect a certain number of directors.  Directors are understood to have the right to appoint and remove executive officers.  Where an investor has a right to designate one or more board members, both the investor and the designated director(s) would likely be deemed beneficial owners.  Another example of enhanced governance rights that will impact the substantial control analysis is the collection of protective provisions, also included in a company’s amended and restated certificate of incorporation, which gives the investor or group of investors a veto over major decisions or transactions such as a merger, charter amendment, issuance of a senior class of stock, issuance of dividends, etc.  Anyone given these protective provisions, either individually or as a holder of a particular series of preferred, would likely be considered a beneficial owner as well.

Startups and venture-backed companies will also need to consider data protection and privacy concerns.  As companies prepare CTA ownership reports, they will be receiving personal information such as passport, social security and driver’s license numbers from their owners, and will have to make sure such data is protected from unauthorized access.

The consequences of CTA non-compliance could be severe.  Failure to report complete or updated beneficial ownership information to FinCEN, or willfully providing false beneficial ownership information, may result in 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 officers of an entity that fails to file a required beneficial ownership report may be held accountable for that failure.  As a practical matter, a company would need to disclose any CTA compliance infractions to potential investors or acquirers which could complicate a funding or acquisition transaction or prevent it from occurring at all.