BOI Part Deux: Who Is a Beneficial Owner? A straightforward exercise for most; an administrative headache for some.

For many, January 1^st was a time to reflect on the previous year’s successes and pivot to new resolutions and goals for 2024. For entrepreneurs, January 1, 2024, marked the start of a new compliance regime that has the potential to create administrative headaches. As we discuss in a previous blog post, the Financial Crimes Enforcement Network (FinCEN) implemented a new rule regarding beneficial ownership reporting effective January 1, 2024. While the roll-out and evolution of the rule remains to be seen, the rule will alter current practices and may even impact fundraising. At the very least, the new rule will re-focus the spotlight on capitalization tables and who owns or controls a company.

The rule requires reporting companies to report everyone who is a beneficial owner, but who falls under that umbrella? The answer is anyone who exercises substantial control over the company or who owns or controls at least 25% of the ownership interests in a company. These are not as simple as they appear on their face, so it makes sense to understand how the rule views both aspects.

Substantial Control

An individual exercises substantial control over a reporting company under any the following instances:

• • The individual is a senior officer, such as a president, CEO, CFO, COO, general counsel and any other officer regardless of official title, who performs a similar function as these officers;
  • The individual has authority to appoint or remove certain officers or a majority of directors of the reporting company;
  • The individual is an important decision-maker; or
  • The individual has any other form of substantial control over the reporting company.

The first two items are relatively straightforward, but the third is where the number of individuals who exercise substantial control may blossom, and the fourth is an even broader catchall designed to allow the rule to maintain pace with any future changes to corporate structure. Understanding who is an important decision-maker will be key to completing the form.

FinCEN views an important decision-maker as an individual who “directs, determines, or has substantial influence over important decisions” including decisions relating to a company’s business, finances, and structure. And substantial control can occur either directly as an individual or indirectly, through control of an entity who wields substantial control over the reporting company. The definition creates a potentially large umbrella where investors may qualify as beneficial owners because of rights negotiated into investment documents.

Companies, especially those looking for early traction, sometimes accept contractual clauses that cede power to investors. If investors have negotiated rights to approve or reject things like business direction, certain expenditures, and mergers then those investors could be deemed to have substantial control under the rule.

An expansive reading of this requirement could obligate a company to include many employees since things like contract negotiations, sales, and certain business decisions are often delegated out from the executive suite as part of the natural scaling of a company. However, there is an exception to the rule that carves out employees from the reporting requirements to the extent that they have decision-making power and influence as a result of his or her employment with the company. This exception does not include contractors, so those contractors who meet one of the definitions of substantial control would likely need to be included in the business ownership information report.

At the end of the day, reporting companies will need to examine their decision makers and who may have rights associated with a financial interest to determine who may or may not have substantial control over a reporting company’s operations.

Ownership Interest

The second prong of determining beneficial owners seeks to understand who holds at least 25% ownership interests of a company. Initially this seems like a quick glance at a cap table will solve the issue, but the rule is potentially more complex than first blush suggests.

An Ownership Interest means any:

• • Any equity, stock, or similar instrument; preorganization certificate or subscription; or transferable share of, or voting trust certificate or certificate of deposit for, an equity security, interest in a joint venture, or certificate of interest in a business trust; in each such case, without regard to whether any such instrument is transferable, is classified as stock or anything similar, or confers voting power or voting rights;
  • Any capital or profit interest in an entity;
  • Any instrument convertible, with or without consideration, into any share or instrument like equity or a profit interest, any future on any such instrument, or any warrant or right to purchase, sell, or subscribe to a share or interest like equity or a profit interest, regardless of whether characterized as debt;
  • Any put, call, straddle, or other option or privilege of buying or selling any of the items described in 13 above without being bound to do so, except to the extent that such option or privilege is created and held by a third party or third parties without the knowledge or involvement of the reporting company; or
  • Any other instrument, contract, arrangement, understanding, relationship, or mechanism used to establish ownership.

A glimpse at a cap table will indicate who owns more or less than 25% of a company, but where ownership reporting becomes complicated is when a company issues convertible instruments like SAFEs and convertible notes. Determining ownership of a convertible note is a fluid exercise and is based on future conditions which may never occur, in which case, the note holder never actually owns a part of the company.

Despite this, the rule still requires a calculation exercise in an attempt to discern whether convertible instrument holders reach or exceed the 25% reporting threshold. For the purposes of the calculation convertible instruments and options should be treated as exercised and then ownership interests calculated accordingly. The rule does not delve into details around things like valuation caps and discount rates, so a company is left to reasonably ascertain the variables in order to derive ownership percentages for holders of convertible instruments, options, and the like. Without further clarification from FinCEN, reporting companies will need to make a judgment call when it comes time to calculate ownership of conditional instruments. As a result, the rule directs reporting companies to focus on who is and who could be the holder of a 25% ownership interest. For many reporting companies, probably most, instrument holders will not rise to meet the ownership threshold, but each reporting company must still perform the due diligence to ensure investors can be excluded from the definition of beneficial owner.

Potential Pitfalls

Because the rule obligates reporting companies to report individuals who directly or indirectly meet the substantial control or ownership interest requirement, companies may face administrative challenges finding and obtaining the information. Companies may need to conduct due diligence to uncover an indirect owner if a beneficial owner is an entity as opposed to an individual. This could entail peeling back multiple layers of corporate entity structure to determine whether an individual ultimately is a beneficial owner or not of a reporting company. If for example, an individual owns 75% of an entity that owns 40% of a reporting company, absent an exemption or exclusion, the induvial would need to be reported as a beneficial owner of the company since the individual indirectly owns 30% of the reporting company. Add a few more entities between the reporting company and an individual and the calculation becomes more complex. Additionally, the information needed to perform the calculation increases and could implicate privacy concerns for the entities and the individual.

While beneficial owners have the option of entering their own information into the FinCEN portal, some may be hesitant to provide such information. Entities are established for various reasons including liability limitations and privacy concerns. Beneficial owners may be hesitant to provide personal information as a result of an investment made prior to the enactment of the rule. Without an exception or exemption, the reporting company faces a risk of fines and penalties if the individual elects not to comply. The risk can be mitigated by amending existing agreements and including language in future contracts obligating beneficial owners to provide the information necessary to meet reporting obligations.

For reporting companies with a tight-knit cap table and a small cadre of decision makers, filing a beneficial ownership information report will be quick and straightforward. However, for reporting companies, like some startups, who may have different classes of stock, voting rights agreements, options, SAFEs, convertible notes, and similar instruments calculating who is a beneficial owner through substantial control or ownership of 25% or more of the reporting company may be time consuming and involve significant due diligence.

If you have any questions on the new regulations or with filing a beneficial ownership information report or just want to learn more about beneficial ownership, Peak attorneys are here to assist.

This article is for informational purposes only, and may not be considered legal advice.