This past month, Pastore LLC assisted a registered investment advisor (RIA) with the filing of its Form ADV. In connection therewith the firm assisted the RIA in its calculation of regulated assets under management (RAUM), which totaled over $1 billion. The Securities and Exchange Commission (SEC) uses RAUM as its measurement of assets for registration purposes. However, RAUM has sometimes been misunderstood as representing total assets under management (AUM) for a company, and based on the firm’s experience the SEC itself has sometimes confused RAUM with AUM. RAUM does not include every type of asset that an RIA may manage, and in particular may not include certain real estate investments or investments in portfolio companies controlled by the fund. When assessing the financial condition of an RIA and its funds, it is important to distinguish between the assets counted under RAUM and the assets counted under AUM. An RIA that appears to manage a small volume of assets based on its RAUM may in fact manage a much larger volume of assets based on total AUM.
Pastore & Dailey successfully concluded a contentious, multi-year litigation, defeating claims of fraudulent inducement and securities fraud brought against two hedge fund executives by a billionaire family office special purpose investment vehicle. The billionaire family office, the heirs to and founders of a well-known apparel store, had invested in the fund’s General Partner limited liability company.
In 2018, The United States District Court for the District of Connecticut granted a summary judgment in favor of the defendants. The summary judgment was subsequently appealed up to the United States Court of Appeals for the 2nd Circuit, before being remanded back to, and concluding with, a jury trial in the United States District Court for the District of Connecticut in New Haven, Connecticut. Pastore & Dailey was hired for the trial. After two weeks of evidence and 7 hours of jury deliberation, Pastore & Dailey was able to secure a favorable jury verdict for the clients.
Pastore & Dailey won a complex securities and M&A appeal taken to the United States Court of Appeals for the Eighth Circuit arising from a derivative rights holder agreement and related investment banking engagement agreements. This matter was an appeal filed by Plaintiff-Appellant after Pastore & Dailey successfully defended this case in the United States District Court for the District of Nebraska.
Plaintiff-Appellants, who were shareholders to a company, brought suit against Pastore & Dailey’s client in the District Court seeking to invalidate investment banking fees owed to Pastore & Dailey’s client following a series of complex insurance corporate mergers, in which the company was acquired and merged with another company. In its appeal to the Eighth Circuit, Plaintiff-Appellants argued that the District Court erred in denying certain Post-Judgment motions made by Plaintiffs arguing their lack of standing. The Eighth Circuit affirmed the District Court ruling in Pastore & Dailey’s favor that Plaintiff-Appellants lacked standing.
Pastore & Dailey attorneys have vast experience arguing and defending matters in various federal courts across the country and are well-situated to handle similar claims involving complex contractual and investment banking issues.
As with most transactions involving buyers and sellers, the valuation of a potential investment in a business is often a matter of perspective. The founder views the business equity as full of promise of future returns. The investor, holding cash and, therefore, access to alternatives as to where to deploy that liquidity, apprehends that same equity as opportunity cost, because his or her election to invest in a given enterprise ends access to alternatives. This opportunity cost looms larger for investors, and larger in proportion to their experience.
Reconciling this tension in valuation perspectives, especially with early stage ventures, between founders and investors is often left to a sort of ersatz market clearing mechanism of road shows and elevator pitches, leaving it to the experienced investors to apply their experienced, if subjective, valuation metrics to an otherwise unknown company. Less confident investors then step in behind the seasoned players to acquire an apparently lower risk, and lower value, portion of the equity.
Investors and their advisors should work with the information they have to evaluate their risk tolerance. Negotiations between the investor and the founder all too often focus on subjective hopes and dreams for the marketplace and overlooks objective calculation of the magnitude of the equity share that a startup investor should seek in exchange for a cash infusion. That is, the metric of equity share should be deployed as part of the discussions between the parties, as a goal, and not merely as an incident, of valuation. These calculations are drawn from the Venture Capital Method of valuation. Here, I briefly review this method.
Simply put, an investor that wants to obtain a desired return is obliged to follow a mathematical map to achieving that return. This calculation is accomplished using the functions of present value, future value, and percentage ownership. Let’s consider an investor who wants to deploy $1 million today in order to participate in a start-up’s anticipated $40 million exit value in five years.
The present value of the proposed $40 million exit value is calculated by discounting $40 million at the rate of 40% per year for five years. The equation for this is:
So, to accomplish the desired return on the initial investment, an investor should obtain an equity interest calculated as the initial investment divided by the present value of the exit value, or:
In other words, the investor should negotiate for about a 13.5% equity interest in order to achieve the desired return. A common way of referring to the present value of the exit value is the postmoney value of the business. We can think of it as the present value of the potential of the business if the investment is made. The term premoney value is the postmoney value less the investment, or $7,437,377 – $1,000,000 = $6,437,377.
Observe that the target rate in our calculations should be distinguished from an expected rate of return. The target rate rests on the presumption that the business grows as planned.
Next, consider what happens to our equity expectation when we raise the exit value of the enterprise to $60M.
The higher exit value raises the present value of the exit figure and reduces the equity percentage the founder will be expected to part with in return for an early stage investment. This relationship calls for both investors and founders to be aware of the incentive to under or over-estimate the likely growth of the company.
To be sure, the valuation of a startup involves as much art as it does science. Additional methods of valuation including, but not limited to, the Berkus Method, Scorecard Valuation Method, and the Risk Factor Summation Method might be productively used in addition to the Venture Capital Method to provide a broad set of metrics for understanding the potential of a new enterprise. The proper use of these tools is necessary for the success of any venture.
These notes are intended to provide a review of general principles only and are not legal or tax advice. The reader is encouraged to discuss his or her particular circumstances with a qualified professional before taking any action.
To date, nearly 18.5 thousand Connecticut businesses have received forgivable loans under the Paycheck Protection Program. This note will briefly review some of the recordkeeping requirements of the program you should keep in mind if you anticipate being able to qualify for loan forgiveness.
The program requires that borrowers meet two tests for loan forgiveness:
- The loan proceeds are used to cover payroll costs, and most mortgage interest, rent, and utility costs over the 8 week period after the loan is made; and
- Employee and compensation levels are maintained
The loan proceeds may only be used for four categories of business expenses:
- Payroll costs, including benefits. Payroll costs include –
- Salary, wages, commissions, or tips (capped at $100,000 on an annualized basis for each employee);
- Employee benefits including costs for vacation, parental, family, medical, or sick leave; allowance for separation or dismissal; payments required for the provisions of group health care benefits including insurance premiums; and payment of any retirement benefit;
- State and local taxes assessed on compensation; and
- For a sole proprietor or independent contractor: wages, commissions, income, or net earnings from self-employment, capped at $100,000 on an annualized basis for each employee
- Interest on mortgage obligations, incurred before February 15, 2020;
- Rent, under lease agreements in force before February 15, 2020; and
- Utilities, for which service began before February 15, 2020
Payroll costs also include employee benefits such as parental leave, family leave, medical leave, and sick leave. Note, however, that the CARES Act, P.L. 116-136, excludes qualified sick and family leave wages for which a credit is allowed under section 7001 and 7003 of the FFCRA, P.L. 116-127. You can read an IRS summary of this credit here.
The CARES Act also excludes from payroll costs the following:
- Any compensation of an employee whose principal place of residence is outside of the United States; and
- Federal employment taxes imposed or withheld between February 15, 2020 and June 30, 2020, including the employer’s share of FICA and Railroad Retirement Act taxes
Mortgage prepayments and principal payments are not permitted uses of PPP loan proceeds. Borrowers will need to request loan forgiveness from their lenders. The request must include:
- Verification of the number of employees and pay rates
- Payments made on eligible mortgage, lease and utilities
- Documentation that you used the forgiven amount to keep employees and make the eligible mortgage, lease, and utility payments
This documentation will generally take the form of:
- Payroll reports from your payroll provider
- Payroll tax filings, including Form 941
- State income, payroll, and unemployment insurance filings
- Documentation of retirement and health insurance contributions
- Documentation of payment of eligible expenses. This documentation should meet the same standards as your documentation of business expenses on your tax return. Invoices matched with cancelled checks, payment receipts, and account information
- Documentation that you used at least 75% of your loan for payroll costs
Lenders are expected to require forgiveness documentation to be provided in digital form, so borrowers should get scanning done in advance.
Lenders must rule on forgiveness within 60 days of the borrower’s request. In some cases, borrowers may be asked to provide additional documentation.
If you are not approved for loan forgiveness, your loan balance will continue to accrue interest at the rate of 1% annually for the remainder of the two-year loan period.
These notes review general principles only and are not intended as tax or legal advice. Readers are cautioned to discuss their specific circumstances with a qualified practitioner before taking any action.
Is a Registered Investment Advisor (“RIA”) eligible to participate in the Payment Protection Program (the “PPP”) administered by the Small Business Administration (“SBA”)? The short answer is “yes.”
The PPP was promulgated as part of the recently enacted Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) which in part set aside hundreds of billions of dollars to help small businesses retain their employees during the COVID-19 crisis and the resultant work from home orders set forth by governors across the country.
We understand that many RIAs applied for and were granted a loan under the CARES act, and that some of these RIAs may be unsure of whether they were granted the loan in error, how they may spend the loan funds or if they can spend the loan funds. The guidance below will hopefully answer some of these questions because applying for and receiving a PPP loan in a knowingly false fashion is a criminal offense, and we strongly encourage any RIA unsure of its PPP eligibility to seek particular legal advice.
The guidance below hinges on whether an RIA engages in speculative operations, holds any securities or other speculative assets, or is simply engaged in financial advisory services.
The SBA published an Interim Final Rule on April 2, 2020 (the “Interim Final Rule”). Specifically, the Interim Final Rule provides that “Businesses that are not eligible for PPP loans are identified in 13 CFR 120.110 and described further in SBA’s Standard Operating Procedure (SOP) 50 10, Subpart B, Chapter 2….” (the “SOP”).
Some of the ineligible financial markets and funds businesses listed in the SOP include, without limitation:
- Life insurance companies (but not independent agents);
- Finance companies;
- Investment companies;
- Certain passive businesses owned by developers and landlords, which do not actively use or occupy the assets acquired or improved with the loan proceeds, and/or which are primarily engaged in owning or purchasing real estate and leasing it for any purpose; and
- Speculative businesses that primarily “purchas[e] and hold[ ] an item until the market price increases” or “engag[e] in a risky business for the chance of an unusually large profit.”
On April 24, 2020, the SBA issued its Fourth Interim Final Rule on the PPP (the “Fourth Interim Final Rule”). The Fourth Interim Final Rule explicitly states that hedge funds and private equity firms are not eligible for a PPP loan.
If the RIA is also a hedge fund or a private equity firm, then it may not be eligible to receive a PPP loan. If, however, the RIA is legally distanced from those entities through appropriate corporate structures, and the loan is only used for the RIA business, then the RIA should be eligible to receive the PPP funds.
Because most RIAs are not also banks or life insurance companies, the exclusions should not apply. However, as some RIAs also sell life insurance products, such individual situations may require more research.
Finance companies are also ineligible under the SBA guidelines to receive PPP funds. The SBA guidelines define a finance company as one “primarily engaged in the business of lending, such as banks, finance companies, and factors.” (Sec. 120.110(b) of the SBA’s Business Loans regulations). Thus, this exclusion should not apply. Similarly, an RIA may not be deemed an investment company, which is a company organized under the Investment Company Act of 1940, unless the RIA was in fact incorporated under that Act.
An RIA also may not meet the definition of a “speculative business” as defined above in the Interim Final Rule. If an RIA does not purchase or hold assets until the market price increases or engage in a risky business for the chance of an unusually large profit, then it will not meet this definition. Speculative businesses may also include: (i) wildcatting in oil, (ii) dealing in stocks, bonds, commodity futures, and other financial instruments, (iii) mining gold or silver in other than established fields, and (iv) building homes for future sale, (v) a shopping center developer, and (vi) research and development. (Sec 120.110(s) of the SBA’s Business Loans regulations, SBA Eligibility Questionnaire for Standard 7(a) Guaranty and SOP Subpart B D (Ineligible Businesses). It is our understanding that an RIA that merely provides portfolio management services would not be deemed to be involved in a “speculative” business based on the examples of such businesses provided by the SBA. If the SBA had taken the position that financial advisory services are speculative, it could easily have so indicated by including such services in its lists of speculative services.
Financial Advisory Services.
Consistent with this view, the SBA has provided clear guidance that financial advisory services are eligible for SBA loans, including loans under the PPP. In the SBA’s SOP, the SBA provides the following: “A business engaged in providing the services of a financial advisor on a fee basis is eligible provided they do not use loan proceeds to invest in their own portfolio of investments.” (SOP Sec III(A)(2)(b)(v) pp.104-105) (emphasis added).
This guidance is clear that the focus of ineligibility is at the portfolio company level, not the advisory level, and this is consistent with the guidance noted above making hedge funds and private equity firms ineligible. Hedge funds and private equity firms make money based upon speculative investments and/or appreciation of the markets. An investment advisor operates at the consulting or services level. In other words, the SBA has distinguished between true speculative operations such as wildcatting, speculative real estate development and investing in securities, and service-based operations such as the investment advisory business. Assuming that an eligible RIA did not use any proceeds of the PPP loan at any investment level, such RIA should not be deemed a speculative business and is eligible for a PPP loan.
SEC guidance affirms that RIAs are eligible for PPP loans. While the SEC imparts certain burdens on RIAs that accept PPP loans, the fact that the SEC even acknowledges such burdens should give most RIAs confidence that a PPP loan is available to them.
For RIAs who are eligible to receive PPP funds under the SBA guidance set forth above, the SEC instructs that they must comply with their fiduciary duty under federal law and make a full and fair disclosure to their clients of all material facts relating to the advisory relationship. The SEC further posits that “If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance.” An example of a situation the SEC would require such disclosures would be an RIA requiring PPP funds to pay the salaries of RIA employees who are primarily responsible for performing advisory functions for clients of the RIA. In this case the SEC would require disclosure as this may materially affect the financial well-being of an RIA’s clients.
The SEC additionally provides that “if your firm is experiencing conditions that are reasonably likely to impair its ability to meet contractual commitments to its clients, you may be required to disclose this financial condition in response to Item 18 (Financial Information) of Part 2A of Form ADV (brochure), or as part of Part 2A, Appendix 1 of Form ADV (wrap fee program brochure). (SEC Division of Investment Management Coronavirus (COVID-19) Response FAQs).
While the Cares Act and PPP are recently enacted, and there is some confusion surrounding the eligibility requirements for the PPP, the SBA had a clear opportunity to deem financial advisors ineligible in the Interim Final Rule and Fourth Interim Final Rule, but specifically chose not to do so. Instead, the SBA followed the direction of its historical eligibility requirements, holding to ineligibility at the fund and portfolio company level, but continuing to permit loans to firms operating at the advisory level.
While it is possible that the SBA could interpret its own rules and regulations inconsistently with the specific guidance provided in the Interim Final Rule and Fourth Interim Final Rule, the weight of the evidence strongly suggests that an investment advisor is eligible for a PPP loan as long as it does not use the proceeds for fund or portfolio company purposes.
It may be worth considering that many non-profits, including churches, might utilize provisions in the new Coronavirus Aid, Relief, and Economic Security Act or CARES Act (P.L. 116-136) to provide some economic relief. Potential applicants should review the new law in detail and discuss its requirements with their attorneys.
The new law sets aside about $349 billion for loans to various nonprofit organizations, including churches. The bridge period is from February 15, 2020 to June 30, 2020. It also includes a provision that can make the loans forgivable. Employers with up to 500 employees are eligible. Availability is first come, first served, so prompt application is recommended.
How the Loan May Be Used
Loan proceeds may be used for:
- Group health insurance, paid sick leave, medical and insurance premiums
- Mortgage or rent payments
- Salary and wages
- Vacation, parental leave, sick leave
- Health benefits
- Salary or wages, payments of a cash tip
- Vacation, parental, family, medical, and sick leave
- Health benefits
- Retirement benefits
- State and local taxes (excludes Federal Taxes)
Limited up to $100K annual salary or wages for each employee
The application to Pastoral housing allowances is presently unclear, so I suggest that this be included in payroll costs.
The lenders will likely include the organization’s current banker, as funding will be routed through the SBA. The term of the loan is two years (unless forgiven) and it has a .5% interest rate.
Maximum loan amount is limited to:
- Total average monthly payroll costs for the preceding 12 months (April 2019 to March 2020) multiplied by 2.5 or
- $10,000,000 if you are a new church plant church or organization, use average payroll costs for January and February 2020 multiplied by 2.5.
No loan payments are due under this program for 6 months. No loan fees apply. No collateral or personal guarantees will be required.
Good Faith Certificate
Applicant organizations will need to provide a Good Faith Certification at Application and after coverage period – post July 2020.
- Organization needs the loan to support ongoing operations during COVID19.
- Support ongoing operations
- Funds used to retain workers and maintain payroll or make mortgage, lease, and utility payments.
- Have not and will not receive another loan under this program.
- Provide lender documentation verifying information of funds used
- Everything is true and accurate.
- Submit tax documents and that they are the same submitted to IRS. Legal counsel should be involved here.
- Lender will share information with the SBA and its agents and representatives.
The entire loan amount loan can be forgiven, if the borrower qualifies. In general, the loan is forgivable if the borrower employed the same number of people during the loan period as it did last year.
- Full-Time Equivalent Employee (FTE) (as defined in section 45R(d)(2) of 11 the Internal Revenue Code of 1986)
- The goal of this loan is for your 2020 FTEs to be equal to or greater than your 2019 FTEs. Essentially, the law provides that you must have equal to or more employees from February. 15, 2020, to June 30, 2020, as you did last year from February 15, 2019, to June 30, 2019.
- If you will have fewer employees in 2020 than in 2019, then you need to complete a calculation:
Average FTEs per month in 2020 from February 15, 2020-June 30, 2020 / (divided by)
Average monthly FTEs from February 15, 2019-June 30, 2019 or Average monthly FTEs from January 1, 2020 to February 29, 2020.
Limitations on Forgiveness
- Only so much of the loan as is used for the payroll costs, benefits, mortgage, rent, or interest on other debt obligations can be forgiven.
- Not more than 25% of the forgiven amount may be for non-payroll costs.
- Loan forgiveness will be reduced if the borrower decreases its full-time employee headcount.
- Loan forgiveness will also be reduced if the borrower decreases salaries by more than 25% for any employee that made less than $100,000 in 2019.
- Borrower has until June 30, 2020 to restore its full-time employment and salary levels for any changes between Feb. 15 to April 26, 2020
No collateral or personal guarantees will be required.
This note is intended only as an illustration of general legal principles and is not legal or tax advice. The reader is directed to discuss his or her specific circumstances with a qualified practitioner before taking any action.
As the cost of legal fees continues to rise, many clients are justifiably concerned about the economic implications of retaining an expensive law firm. According to the legal fee analysis organization NALFA, a not insignificant proportion of the country’s top attorneys have recently begun charging more than one thousand dollars an hour for their services.1 Adding to that the ever-increasing cost of junior associate billings,1 many businesses are facing a conundrum: the price of legal services often exceeds the cost involved with litigating or settling a matter. To fulfill their responsibilities to clients, law firms must move beyond costly price structures and embrace value-added billing – an approach that emphasizes the importance of improving a client’s bottom line by embracing flexible billing rates and alternative fee arrangements.
What value can a law firm legitimately claim to provide when its billings outstrip the cost of a settlement? Despite all the cachet that comes with the retention of a large national firm, common sense dictates that clients are getting a raw deal when law firms cannot add value in the course of their work. If clients do not see their bottom line improve after retaining a certain firm, that firm simply does not deserve their business.
Value-added billing does not just benefits clients, however. In the long run, it may well benefit law firms to make an honest accounting of the cost of legal services – especially because clients may cut and run if they find themselves overpaying for legal fees. Value-added billing may also obviate the newfound preference of many businesses for non-traditional legal services,2 which often prove to be more flexible and economical than the costly billing practices employed by most firms.
To transition from unfair, costly billing practices to value-added billing, firms can make several changes to their fee structures. First, they can adjust their average billing rates in accordance with the estimated cost of litigating or settling a certain matter. If the attorney tasked with handling a certain matter realizes that their usual legal fees will surpass the expected cost of litigation or settlement, he or she should adjust them accordingly. In addition, firms can add value by embracing alternative fee structures. If an attorney determines that taking a matter on a contingency basis is likely to improve their client’s bottom line, he or she should not hesitate to do so.
Obviously, this sort of common-sense calculation can be thrown into confusion by uncertainty as to the final cost of litigation or settlement. The success or failure of legal procedures like litigation or arbitration (not to mention their length) cannot easily be predicted, especially considering that the introduction of new evidence or an unexpected level of intransigence on the part of the opposing party sometimes scramble the contours of a certain matter. But legal expertise and experience can help ameliorate this problem. Presumably, senior partners will have handled similar cases in the past and can extrapolate from the cost of litigating or settling those cases to estimate the potential impact on a client’s bottom line. (This assumes, of course, that firms are keeping close track of their total billings for each matter they handle).
Law is a business like any other, even if many attorneys are loath to admit it. Their primary task should be to add value, not to charge unfair fees. Anything else risks hurting the firms they were hired to represent.
Recently Pastore & Dailey advised clients on complex questions regarding family offices and the compensation of non-family member “key employees” of such offices. Pastore & Dailey referenced the Investment Advisers Act of 1940, Dodd-Frank, and other securities act provisions to help the clients maneuver the complex structure of a family office and how to properly compensate non-family member employees pursuant to these provisions so as to not lose the family office exemption.
The new changes imposed by the Bipartisan Budget Act of 2015 established new rules for how partnerships will be audited and how they are assessed liability for federal taxes due after an examination. These new rules require that every entity that could be treated as a partnership to examine, and when needed, revise its governing documents to be able to comply with the rules. This article delves further into the new BBA rules and how partnerships may opt-out to avoid the full effects of the new consolidated partnership audit rules and push-out the adjustments to income, gain, loss, deduction, or credit to each partner of the partnership for the reviewed year by following a prescribed process. For those considering purchasing or selling partnership interests should be aware of the current responsibilities implemented by these new rules and review their partnership agreements.