Tuesday, January 13, 2009

Stealth Mode Resurrected?

Often, when a start-up company is in an emerging growth field, it will spend as long as possible in “stealth mode.” That is, the company will purposefully avoid disclosure of its existence, purpose, products, personnel, funding, brand name or other attributes so that it can avoid alerting potential competitors to what it is up to. This is especially the case in industries where products are not easily patentable and trade secrets or programming execution are the primary way to gain a competitive advantage. A head start may make the difference between success and failure. The greater the head start, the better jump the start-up will have on its competition. It can wait to enter the market with a splash and a fully developed product.

As has been noted before Link, raising capital while in stealth mode can be tricky. All offerings of securities must be either registered with the SEC (i.e a public offering) or exempt from registration with the SEC. The easiest way to ensure that your private offering is exempt from registration is to comply with the SEC’s safe harbor under Reg. D. Unfortunately for stealth mode companies, a central component of the Reg. D safe harbor is the requirement that a company file with the SEC a Form D. These Form Ds were required to contain (among other things) the amount raised, the identity of any person controlling 10% or more of the company’s stock, a description of the company’s business and a relatively detailed ‘use of proceeds’ analysis. Typically, any VC investment would exceed the 10% threshold, thus requiring disclosure of the names and addresses of a company’s VC investors.

Below I will discuss some changes at the SEC that may make stealth mode easier to maintain.

The reason a Form D filing often jeopardized a company’s stealth mode is that the SEC makes Form Ds available to the public in a central data room. (Unlike most items filed with the SEC, these forms were not posted online.) Any enterprising news service could regularly monitor the paper filings in these data rooms and thus would be able to “out” the stealth company.

While it is possible to complete a private placement without relying on Form D and thus maintaining secrecy, the benefit of having a very solid safe harbor often prevails over consideration of maintaining stealth mode – this is especially true for companies contemplating an IPO, as IPO diligence typically requires a very in-depth review of the company’s past securities offerings.

However, the dynamics of this quandary have been altered. The SEC has amended the Form D rules so that these Form D filings are available to anyone online. A company has been able to opt for its Form D to be available online on a voluntary basis since September 15, 2008. After March 16, 2009, all Form Ds will be available online. For more info on the mechanics of filing your Form D online, see my release on this subject here.

While at first it would seem that stealth mode will now be even harder to maintain if a company needs to rely on the Reg. D safe harbor, there is more to the story. When the SEC mandated electronic filing, it also amended the requirements of Form D. A company is no longer required to describe its business – instead it can refer to its very general “industry group.” A few examples are “Computers,” “Telecommunications,” and “Other Technology.” Also, a company is no longer required to disclose the names and addresses of shareholders controlling greater than 10% of its stock. Thus, the names of the VC funds backing a stealth company can be kept out of the newsfeeds. In addition, the Company is no longer required to give a ‘use of proceeds’ analysis. Finally, depending on a company’s circumstances, if the total amount of the offer is not set at the time the offer is made and if no sales have closed, it may be possible to not disclose the total amount of funds to be raised.

The net result of all this is that, although a company in stealth mode would have to disclose publicly the fact that it is trying to raise money, it may be possible to avoid disclosing virtually all other interesting information. The SEC has made it so that less information will be more widely available. A company in stealth mode that carefully plans its offering timing and terms could for the most part avoid losing its mantle of secrecy. Further, through use of a temporary ‘dummy’ name, the company could even make the fact that it is raising money have no real significance to its competitors.

Reports of the demise of stealth mode are greatly exaggerated!


  1. In the right situation, the new Form D might make a near-complete stealth mode possible by allowing the company to hide the identity of certain key individuals. Item 3 of the new Form D requires only the disclosure of "related persons", or directors, executive officers and promoters. The key entrepreneur behind the stealth mode company could restrict his association with the company to consulting/advisory agreements and to future-vesting equity holdings (i.e. vesting on the occurrence of a milestone event), and avoid any director or officer positions. The entrepreneur wouldn’t be picked up by any of Form D’s reporting requirements (not a "related person") but could maintain a strong enough association with the company to hopefully satisfy the VCs. In this way, the entrepreneur and the company can carefully control the company’s emergence from stealth mode.

  2. Interesting post. Quick question: How exactly do companies making private placements avoid having publicly available Form D filings construed as offers to sell securities?

  3. Seth -- You make a good point. If stealth mode is of vital importance to a company, with sufficient pre-planning it could avoid revealing all meaningful information publicly. One trick would be to ensure that the "prominent person" is not otherwise regarded as a promoter.

    The 33 Act defines a promoter as:

    "Any person who, acting alone or in conjunction with one or more other persons, directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer; or

    Any person who, in connection with the founding and organizing of the business or enterprise of an issuer, directly or indirectly receives in consideration of services or property, or both services and property, 10 percent or more of any class of securities of the issuer or 10 percent or more of the proceeds from the sale of any class of such securities. However, a person who receives such securities or proceeds either solely as underwriting commissions or solely in consideration of property shall not be deemed a promoter within the meaning of this paragraph if such person does not otherwise take part in founding and organizing the enterprise.

    All persons coming within the definition of promoter in paragraph 1 of this definition may be referred to as founders or organizers or by another term provided that such term is reasonably descriptive of those persons' activities with respect to the issuer."

    This is a relatively broad definition with some ambiguity -- for example, you would want to ensure that the "prominent person" is not centrally involved in the founding of the company. Also, you would want to think hard about the consulting arrangement and how the equity vests to ensure the "prominent founder" was not a promoter. But, I do think it could be possible to set up a start-up and avoid disclosing a "prominent founder" as a promoter in the stealth mode companies Form D filing.

  4. JD -- The question you raise is very interesting. Without guidance from the SEC, I think this would be a real problem. Fortunately, the staff gave guidance on this issue in the adopting release (http://www.sec.gov/rules/final/2008/33-8891.pdf) and amended Rule 502(c) to specifically exempt Form D filings made in good faith and with a reasonable effort to comply with the requirements of Form D. An issuer that complies with these requirements can avail itself of a safe harbor from the prohibition on "general solicitation" and "general advertising" for the information provided in the Form D.


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