Capitalizing a Small Business

1. Capitalizing a Small Business Kimberly A. Lowe Avisen Legal, P.A. klowe@avisenlegal.com Winter of 2013 * The law changes regularly. The information in this document is current as of the date listed.

2. Overview • Introduction • Capitalization Options • Equity • Debt • Equity Compensation • Questions

3. Classic Financing Life Cycle • Founders • Friends and Family • Angel Investors • Venture Capitalist/Private Equity • Mezzanine Financing • Public Offering/Acquisition • Debt (can happen at any stage)

4. Realistic Small Business Financing Cycle • Founders • Founders • Generate revenue • Founders/Friends and Family • Generate a little more revenue • Bank loan guaranteed by founders who pledge their houses and their retirement • Founders make loan to business subordinate to bank loan • Employees (can happen at any point in the cycle)

5. Entity Basics • Corporations: • Subchapter C (double taxation) • Subchapter S (“pass through”) • Limited Liability Companies • Subchapter K (generally partnership taxation – pass through) • Subchapter S • Subchapter C

6. Entity Matters for Capitalization • The myth among lawyers who work primarily with large companies is that corporate finance and LLC finance is the same with just a few differences. • Owners capitalize the business. • 322B based on 302A. Only corporate based LLC statute. Most states are based on partnership statute

7. Capitalization Basics • Investment Capital • Retained Earnings • Borrowed Funds

8. Investment Capital • Capital that comes from founders or some other “investors” • “Capital” can be in the form of cash, assets, or some other form of value (note or services) • In exchange for capital, entity issues stock (or equity) to the investor • Entity can also issue rights to purchase equity as well

9. Retained Earnings • Retained Earnings: profit that the business has made that has been left in the business. • Profit = revenue - expenses (sometimes referred to as income) • profit that is still left in the business after salaries and bonus have been paid, dividends or other distributions have been made. • For purposes of this discussion we are not going to focus on retained earnings

10. Borrowed Funds • Borrowed Funds is debt or money that is borrowed from a bank or an individual. • Currently borrowed funds from banks not readily available • In small business context banks often require owners to guarantee debt and with the loss of personal wealth caused by the issues with the housing market it is hard for guarantors to qualify

11. Equity Terminology by Entity • Partnerships: • Partnership Interests • Limited Liability Companies: • Membership Interests (units) • Corporations: • Stock (shares) • Common stock • Preferred stock* • Options or warrants (rights to purchase stock) * Not allowed in S Corporations

12. Membership Interests • Financial and governance rights issued by an LLC in exchange for value • Right to be allocated a percentage of the LLC’s profits and losses and a right to receive a percentage of distributions • Allocation = annual; income and losses to members for income tax purposes • Distributions = cash or other value distributed to members; whenever

13. Membership Interests • Percentage ownership based on amount of capital contributed by the member on the books • Capital: Cash, property or services • Tax consequences to members when use LLC so be careful if contributed capital is anything other than cash or property. • Governed by Member Control Agreement (versus Articles of Incorporation)

14. Stock • Ownership interest in a corporation • Stock entitles the holders to the specified voting rights and preferences • Must be set forth in Articles of Incorporation (authorized capital section required for valid corporation) • S Corporation one class -- can be voting and nonvoting • Must treat all holders of class or series of stock the same

15. Preferred Stock • Statutorily – something other than common stock with the rights and preferences set forth in the Articles of Incorporation • All stock is common unless otherwise set forth in the Articles of Incorporation! • The sky’s the limit and is really dictated by what the parties want to do

16. Equity Compensation • Equity or rights to purchase equity issued in exchange for services rendered – options or warrants • Employee or contractor is agreeing to receive equity instead of cash • “Payment” for work = income (ordinary) • Certain Options have special tax treatment so that it is not treated as compensation to employee who receives it

17. Debt • Bank Loans • Term Loans • Line of Credit (Revolver) • SBA (loan backed by government but still a bank loan) • Investor Debt • Loans by founders/shareholders • Loans by investors (note purchase)

18. Bank Loans • Term Loan • Promissory Note due upon maturity and payable over time – like a home loan • Line of Credit • Like a credit card • Business borrows the money and pays it back up to a limit • Borrowing Base

19. Bank Loans • Typically secured by assets of business which may include accounts receivable • Security Agreement • Guarantee • Subordination • Financial Covenants and reporting requirements • Bank’s measure of financial soundness of business

20. Investor Debt • Loans made by individuals • May or may not be secured • If secured and there is also bank debt more than likely subordinated • Rounds of financing in the financing life cycle can be in the form of debt or equity –who not what

21. Let’s Capitalize a Business! • Typical small business client • Device or product business • Founders • Friends and Family

22. Product Business • Three founders: • Inventor – has patented a product and now wants to bring it to market. W-2 employee before • Business Guy – has money and business expertise • Marketing Guy – has no money; buddy of the 2 other guys; they are sick of listening to him talk about camp life and income disparity

23. Contributed Capital • Inventor will contribute IP • Business Guy is willing to contribute an amount of cash equal to the value of the IP • Marketing Guy has $100 that he has been carrying around since he closed his bank account in protest and an MBA from Harvard B School

24. Capital Needs (burn) • Need about $50,000 to get started • Will need about $500,000 to take the product to market in about 6 months • Money needed to gear up production • Inventor thinks will generate revenue in one year and income in two years and go public in five years

25. Capitalization Options – Founders • Stock • Investor Debt • Equity Compensation • Bank loan really not an option here

26. C Corporation – Lovefest • Authorized capital of the corporation is 10,000 shares of common stock • Contributed Capital: • IP Value = $50,000 • Cash = $50,000 • Service = $100 • Each founder contributes their respective capital and receives 1,000 shares of common stock each

27. How to Issue a Stock? • Subscription Agreement sets forth what is contributed and what is received in return – need contract to pass the “title” to the capital • Entity issues a stock certificate and keeps a stock ledger

28. C Corporation – Fairness • Authorized capital of the corporation is 10,000 shares of common stock • Contributed Capital: • IP Value = $50,000 • Cash = $50,000 • Service = $100 • 49:49:2 common stock voting

29. C Corporation – Middle Ground • Contributed Capital: • IP Value = $50,000 • Cash = $50,000 • Service = $100 plus issues a promissory note that he will pay over time – he is going to earn it going forward. • 33:33:33 common stock voting

30. C Corporation – Debt Option Plus Option Plan • Contributed Capital: • IP Value = $10,000 • Cash = $10,000 • Service = $100 • 49:49:1 common stock voting • Investor makes a $40,000 unsecured loan to the company payable over time • Equity compensation plan for all

31. C Corporation – Preferred Stock Option • Contributed Capital: • IP Value = $10,000 • Cash = $10,000 • Service = $100 • 49:49:1 common stock voting • $40,000 for preferred stock with a dividend and liquidation preference • Would only do this if could not use debt option

32. Equity Compensation • Incentive Stock Options • Nonqualified Stock Options or Warrants • Exercise Price • Term • Number of Shares • ISOs have specific rules to follow in order for the recipient to delay tax consequences • Percentage of authorized shares reserved for Options and Warrants

33. C Corp Capitalization • Economics don’t necessarily have to track the shares issued in founder round • As a lawyer you should be aware of who your client is how to handle the “inequities” that arise in these sort of situations

34. S Corporation • 3 founders contribute various capital to the business and receive coming voting shares “equal” in value to what gave: 45:45:10 • Going forward shareholders will be allocated profits and losses pro rata based on percentage ownership • Can do some equity compensation as well but does not impact allocation until exercise

35. LLC – Lovefest • Each founder contributes their respective capital and receives a 33% membership interest in the LLC (done by units) • Profits and losses allocated based on percentage ownership • This creates a tax problem for the service member because his capital account is $100 (basically 0) so its all income to him with no losses

36. LLC - Fairness • Contributed Capital: • IP Value = $50,000 • Cash = $50,000 • Service = $100 • 49:49:2 percentage ownership with profits and losses allocated based on percentage ownership • If founders are employees of LLC and draw a salary that is a guaranteed payment

37. LLC – Fairness • Economics of ownership and allocation based on real economics of the deal. • Easy to do but the inequity issue will rear its head

38. C Corp – Middle Ground (Recall) • Contributed Capital: • IP Value = $50,000 • Cash = $50,000 • Service = $100 plus issues a promissory note that he will pay over time – he is going to earn it going forward. • 33:33:33 common stock voting

39. LLC – Middle Ground • Contributed Capital: • IP Value = $50,000 • Cash = $50,000 • Service = $100 plus issues a promissory note that he will pay over time – he is going to earn it going forward. THIS IS DICEY! IRS knows this scheme • 33:33:33 percentage ownership. NO!

40. LLC – Preferred Membership Option • Contributed Capital: • IP Value = $10,000 • Cash = $10,000 • Service = $100 • 49:49:1 common membership interests • $40,000 for preferred membership interests with a dividend and liquidation preference • This can get complicated to draft!

41. Friends and Family • Can do whatever you want • Consider securities laws • Regulation D • State Securities Laws