The Death of Stealth Mode

Seeing how attacking startup lawyers seems to be en vogue this month, let's put this post in the category of "Things I wish lawyers told their startup clients."

Here's a situation I see all the time: 

A pre-launch, stealth-mode company just closes a seed round of funding.  Three weeks go by, and the news of the company's funding starts appearing in VentureBeat, PEHub, and Venturewire.  The story is then picked up by mainstream tech bloggers and press.  The CEO starts getting phone calls from journalists.  I then receive frantic, angry phone calls and emails from the CEO that go something like this: "Dude!  Did you announce the funding?  We wanted to stay under the radar..."

I want to reply, "No.  I didn't announce the funding.  Your lawyer did."

The culprit is a little known SEC regulation called "Regulation D".  A basic summary:

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. Regulation D (or Reg D) contains three rules providing exemptions from the registration requirements, allowing some smaller companies to offer and sell their securities without having to register the securities with the SEC.  While companies using a Reg D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a "Form D" after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company.

When a company raises capital, most lawyers fill out the Form D paperwork on the company's behalf and stick it on the pile of papers a CEO has to sign on closing.  (Click here to see the complete form in pdf format).  There's little a company can do to avoid a Form D filing - more than 17,000 companies and partnerships made nearly 28,000 Form D filings in 2007.   I'm continually surprised, however, by the fact that few attorneys actually tell their clients about this public disclosure.  Maybe they don't mention it because they know that people can't access these documents online.  (You can search the SEC database to see if any documents exist, but you can't access the actual content/document.)  This by itself can be pretty revealing.  For example, although Twitter announced their funding today, you could have searched the SEC database and saw that the round closed on June 9th.  It's also a great way to get the address and phone number for stealth mode companies ;-)

In addition, hardcopies of these documents are available to the public (and press) for a limited time.  As Scott Austin of Venturewire writes:

The SEC makes hard copies of these filings available in a series of folders located in a public reference room at their Washington headquarters.  There's about a two-week lag time between when the filings are processed and when they hit this room, and after 30 days they disappear. Also in the room are four computers, but they're without Internet access.  And the staff members that work there are known to shrug their shoulders when asked for help.  In other words, this room appears to be intentionally uncooperative - much like the private companies and partnerships that wish to keep the information contained in these filings under wraps.  At VentureWire, news of start-up financings are our bread and butter, so we send a couple of helpful reporters from our Dow Jones Newswires bureau in Washington to sift through the filings and pull out the most interesting ones...

So it turns out that the SEC is the source of most of these "leaks". 

But, wait, there's more.  A few months ago, the SEC published rule amendments mandating the electronic filing of information required by Securities Act of 1933 Form D through the Internet.  Starting next year, the data filed will be available on the SEC Web site and will be interactive and searchable.  View the Final SEC Rule here.

One small positive change.  While your company name and amount of funding will be public, apparently the forms have been changed so that companies no longer need to disclose names of investors that own more than 10% of a class of securities.

If you're starting a company and want to stay in "stealth mode", make sure you understand the impact of your Form D filing and factor that into your plans.  And if you're a lawyer for a startup company, please tell your clients about the public disclosures you make on their behalf!