More Paperwork: Beneficial Ownership Information Reporting
What investors, startups, and SMBs need to know about Beneficial Ownership Information reporting
As the venture community experienced new regulations to end 2023, this year is off to a bang with more paperwork for founders and funders alike. This time, in the form of the Corporate Transparency Act (“CTA”) and its rules requiring the reporting of certain beneficial ownership information (“BOI”) to the U.S. Department of Treasury’s Financial Crimes Enforcement Network (“FinCEN”). Let’s dive into how this legislation impacts investors, startups, and SMBs.
In 2021, Congress enacted legislation under the National Defense Authorization Act, requiring most private companies to report their "beneficial ownership" to FinCEN starting January 1, 2024. And, if you’ve been on X over the last few months, you’ve probably seen posts like this . . .
For good reason, as this BOI reporting obligation is far-reaching, and companies formed on or after January 1, 2024, already have to report.
What?
Under the CTA, covered companies (that are not exempt) must:
File an annual report with FinCEN (electronic filing link here), providing information regarding:
Who created the entity (known as a “Company Applicant”);
Basic entity information (e.g., legal name, ITIN, address); and
Detailed information about its “beneficial owners” such as legal name, date of birth, residential address, driver's license or passport number (and image).
Report changes to previously reported information. For instance, if a “beneficial owner” changes their current residential address, that will require an updated filing.
When?
There are some caveats, but generally, the initial BOI report is due:
For entities formed on or after January 1, 2024, 90 days from the date of formation.
For entities formed before January 1, 2024, then by January 1, 2025.
For entities formed on or after January 1, 2025, within 30 days.
Who?
Generally, every entity, whether domestic or foreign (if registered to do business in the US), created by filing a document with a State office (e.g., Secretary of State) is covered and must report its BOI to FinCEN unless covered by an exemption.
Before jumping to the 23 exemptions, let's discuss one interesting issue for SPVs and other pooled investment vehicles organized as Series LLCs.
Series LLCs are usually created by forming a “master” series LLC (“Master”) with a State (e.g., Delaware, Tennessee). Although the Master is registered with the State, the individual series LLCs under the Master are not ordinarily registered with the State (some states allow these individual series to choose to register).
Are these individual series LLCs under a Master covered and obligated to report BOI even though they are not formed by filing with a State? As of now, that is not entirely clear, but given the limited guidance, the CTA intends to cover every type of business (despite its legal form) unless exempt. So, individual series LLCs would likewise need to report unless an exemption applies.
Notable Exemptions
The 23 categories of exemptions generally apply to large or highly regulated businesses that already report to a state or federal regulatory body (e.g., SEC). We will focus on the exemptions most likely relevant to U.S.-based investors, startups, and SMBs.
“Large” Operating Company Exemption (Startups and SMBs)
Startups and SMBs with fairly significant revenue and employee counts may qualify for the “large” operating company exemption, which requires the company to have all of the following:
More than 20 full-time employees;
A physical operation presence in the US (e.g., an office); and
More than $5M in gross receipts on its prior year federal tax return.
We are looking at fairly established SMBs and startups with traction (e.g., Series A). So, small companies will need to report BOI unless another exemption applies.
Investment Companies, Investment Advisers, and Venture Capital Advisers Exemption (Funds and Advisers)
This exemption essentially covers two types of investor entities: (i) the fund itself (which might be considered an investment company) and (ii) the investment adviser to the fund (e.g., a Management Company). At first glance, this seems to present a nice exemption for investors, but on closer examination, this exemption is quite narrow.
Investment Companies and Investment Advisers
Only registered investment advisers (“RIAs”) and registered investment companies can take advantage of this exemption. Read the rule carefully:
“Investment company or investment adviser. Any entity that is:
(A) An investment company as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), or is an investment adviser as defined in section 202 of the Investment Advisers Act of 1940 (15 U.S.C. 80b–2); and
(B) Registered with the Securities and Exchange Commission under the Investment Company Act of 1940 (15 U.S.C. 80a–1 et seq.) or the Investment Advisers Act of 1940 (15 U.S.C. 80b–1 et seq.).”
An “investment adviser” is a person or firm who provides advice to others or issues reports or analyses regarding securities for compensation. Similarly, an “investment company” is an issuer of securities that is or holds itself out as being engaged primarily in investing, reinvesting, or trading securities.
These definitions are quite broad, such that most private funds and advisers to those funds would be included in the definition. However, this exemption only covers investment companies and advisers registered with the SEC under the Investment Company Act or Investment Adviser Act.
Most funds that are “investment companies” are exempt from registration via Section 3(c)(1) or Section 3(c)(7), which we discuss in more detail here. So, they are not exempt from BOI reporting (i.e., because they usually do not choose to register with the SEC).
Similarly, many investment advisers are either exempt from registration or prohibited from registration with the SEC. For instance, most small advisers (less than $25M in AUM) and “mid-sized advisers” (between $25M and $100M in AUM) are prohibited from registering with the SEC and, instead, must either register with the State in which they conduct business or are otherwise exempt. Mid-sized advisers must register in the State in which they do business and may not register with the SEC unless it is not registered with the State because it has taken advantage of an exemption from State registration, and in such case, it may be required to register with the SEC, unless it would otherwise be exempt from registration (which is often the case).
However, even if an adviser could register with the SEC, many take advantage of an exemption from registration, such as the Private Fund Exemption or the Venture Capital Exemption. You can learn more about those here.
The Private Fund Exemption allows advisers to claim an exemption under Section 203(m) if such adviser acts solely as an adviser to private funds and has assets under management in the U.S. of less than $150M.
Venture Capital Advisers
Unlike advisers to private funds under the Private Fund Exemption, advisers to venture capital funds have their own exemption under the CTA, which reads:
“Venture capital fund adviser. Any investment adviser that:
(A) Is described in section 203(l) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3(l)); and
(B) Has filed Item 10, Schedule A, and Schedule B of Part 1A of Form ADV, or any successor thereto, with the Securities and Exchange Commission.”
Section 203(l) of the Adviser Act is known as the VC Exemption. To qualify under the VC Exemption, you must have ALL of the following:
Must be a private adviser to a “venture capital fund” under Section 203(l), which generally requires the fund:
Pursues a venture capital strategy;
Invests no more than 20% of the fund's capital contributions in non-qualifying venture capital investments (e.g., at least 80% of the portfolio is initial issuance equity and convertible equity (e.g., not secondaries));
Is not significantly leveraged (e.g., does not borrow 15% of fund assets);
Only issues illiquid securities, except in extraordinary circumstances (e.g., not redeemable except in extraordinary circumstances); and
Is not registered under the Investment Company Act and is not a “business development company”.
Must have filed Part 1A of Form ADV with the SEC.
Again, this exemption only applies to advisers of private “venture capital funds” who meet the requirements for the Venture Capital Exemption AND have filed Part 1A of Form ADV. But remember, many small and mid-sized advisers are governed by State law and may not be eligible to file Form ADV with the SEC. So, even though many advisers structure their funds to meet the Venture Capital Exemption, they may be unable to take advantage of this exemption unless they have filed Part 1A of Form ADV.
recently highlighted this on X:
The CTA exemptions are not as simple as qualifying under the VC Exemption. Instead, thoughtful analysis is necessary to determine whether an adviser is properly classified as a “venture capital adviser” and can (and, in fact, has) filed Part 1A of Form ADV.
Pooled Investment Vehicles Exemption (Funds and SPVs)
Pooled investment vehicles like private funds and SPVs are exempt to the extent they are operated or advised by an investment adviser exempt from the BOI reporting (see the narrow applications above). The obvious issue is that many advisers are not exempt because they are not registered with the SEC or cannot otherwise meet the VC Exemption and file Part 1A of Form ADV. If the adviser fails to meet the exemptions above, the adviser isn’t exempt, so neither is the fund or SPV unless another exemption applies. This will be an incredible burden for large syndicates that invest through many SPVs.
Subsidiaries of certain Exempt Entities
Entities 100% owned and controlled by exempt entities are also exempt. Note that this doesn’t mean a single exempt entity must wholly own it; it means exempt entities hold 100% of their ownership. This area requires a detailed analysis of organizational structures (e.g., how does this work with sidecars, feeder funds, and other alternative investment vehicles).
Beneficial Ownership?
This one varies greatly in complexity because it covers significant equity owners (at least 25%) and those who can exercise substantial control.
“Beneficial owner. For purposes of this section, the term ‘beneficial owner,’ with respect to a reporting company, means any individual who, directly or indirectly, either exercises substantial control over such reporting company or owns or controls at least 25 percent of the ownership interests of such reporting company.”
You need to report the information we discussed above for individuals that directly or indirectly qualify as “beneficial owners,” which does (or could) include the following:
Equity Owners who own 25% or more of the equity.
Although the 25% threshold seems simple, the rule includes nuances that expand the scope of the analysis. Equity will include other instruments like options, convertibles (e.g., SAFES), warrants, preferred equity, and profits units. Again, this is another fairly fact-intensive area, but assume you will treat instruments capable of converting into equity as if they have been converted to the extent it could push someone to the 25% threshold.
Another important caveat is if someone holds their ownership through another entity, which is often the case for investors. In that situation, you need to calculate the individual owners of that entity and use their ownership percentage in that entity in combination with that entity's holdings in the reporting company.
For example, if Sarah is the 80% owner of ABC Ventures, LP, which owns 30% of XYZ, Inc., you need to multiply Sarah’s 80% stake in ABC Ventures by ABC’s 30% ownership in XYZ, Inc., which would equal 24% (i.e., .80 x .30). Sarah would not need to be reported in XYZ’s BOI report unless she can exert substantial control over XYZ, Inc.
Substantial Control
Individuals are also considered “beneficial owners” if they exercise substantial control over the reporting company. The CTA describes several categories, including executive officers, board members, managers (e.g., managers of an LLC), or even investors with significant control rights. However, there is little guidance on complicated situations that usually apply to venture-backed startups.
For instance, how do we view an investor with protective provisions around employee compensation, spending or borrowing, change of control transactions, or other standard protective provisions? The CTA doesn’t provide much guidance, so we are stuck with a highly fact-intensive analysis.
What if I don’t?
The CTA provides for civil and criminal penalties, including a fine of up to $10,000, imprisonment for up to 2 years, or both, for someone who willfully provides false information or fails to report complete and updated information. Yikes.
What’s our take?
The online portal is intuitive and easy to navigate. For many startups and SMBs, the applicable exemption is relatively straightforward (look at your employee and revenue counts), and the realm of beneficial owners is probably relatively narrow unless investors have a significant stake or control. It includes the founders, the board, officers, and substantial investor/employee stockholders. For pooled investment vehicles and their advisers (and even SMBs or startups with multi-entity structures), a few boxes need to be checked before you can determine if the adviser and/or the fund/SPV is exempt.
Even if you can determine that you are not exempt and are savvy enough to navigate the filing database, knowing who is a “beneficial owner” and assuring the “beneficial owner” provides timely and accurate information is quite burdensome (a potential SaaS idea for the entrepreneurs). For instance, if a startup has entity investors, they must ensure they get the relevant information about that entity’s beneficial owners. This may not be something those investors will so willingly disclose–especially if they are not obligated to file BOI reports. This is another significant burden on startups and SMBs.
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Disclaimer: While I am a lawyer who enjoys operating outside the traditional lawyer and law firm “box,” I am not your lawyer. Nothing in this post should be construed as legal advice, nor does it create an attorney-client relationship. The material published above is only intended for informational, educational, and entertainment purposes. Please seek the advice of counsel, and do not apply any of the generalized material above to your facts or circumstances without speaking to an attorney.