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5. FINANCIAL MATTERS
a. Capitalization
Initial Requirements
Many new companies fail due to lack of sufficient capital to cover the start-up period. To avoid this situation, create a budget of the initial expenses of your company. Make the budget as detailed as possible, then add an extra amount (for example, 10%) to cover unforeseen contingencies. “Capitalize” the company by arranging for founders or investors to contribute cash in an amount sufficient to cover the budget. If the amount is insufficient, you create the risk of a court holding you personally liable for the debts and obligations of your company based on an “undercapitalization” theory for "piercing the company veil”.
Debt vs. Equity
Capitalization may take the form of debt or equity. If the capital comes from the founders themselves, it is typical to treat a portion as equity and the balance as debt. The debt portion should have a specified interest rate, compounding schedule, and repayment period – for example, 10% per annum, compounding annually, with a one-year term. Your company may also seek a loan from a bank or other financial institution, but such loans are usually not available to start-up companies in the formation phase.
The specific ratio of debt-to-equity varies by company. Work with your CPA to determine an appropriate ratio. Note that the larger the debt percentage, the greater the risk of recharacterization by tax authorities on grounds of “thin capitalization”. The traditional ratio is 1:1 -- in other words, 50% debt and 50% equity.
Equity Investors
During the formation phase, the equity investors usually consist of the founders themselves and perhaps their friends and relatives. Occasionally, unaffiliated “angel investors” are also willing to provide seed capital.
The typical angel investor has years of experience in the same industry as the company. Angel investors usually provide capital for personal reasons as well as financial returns. They may also provide advice and assistance, such as referrals to potential suppliers, officers, and customers. For more information, see the websites of Active Capital (formerly ACE-Net) and SCORE (formerly the Service Corps of Retired Executives).
Venture capitalists are another type of investor. Venture capitalists (VC's) are professional investors that pool capital from other investors to finance start-up companies. Because VC's manage other people's money, they usually prefer to reduce their risk by investing at a later stage.
As a general rule, venture capitalists care more about financial returns than angel investors. This is often a source of conflict between VC's and the founders of their portfolio companies. For example, the VC's may push hard for a company sale or IPO while the founders wish to maintain ownership and control. Keep this in mind as your company grows and you contemplate approaching VC's for expansion capital.
Investor Rights
Outside investors often demand preferential economic and governance rights. The typical solution is to create a second class of ownership interests. If your company is a corporation, it must be a “C corporation” and not an “S corporation” because federal tax law prohibits “S corporations” from having more than one class of stock. (In this regard, shares are different classes only if they have different economic rights.) In addition, California law prohibits statutory “close” corporations from having more than one class of stock.
In California, "C corporations" and LLC's may have an unlimited number of classes unless their governing documents provide otherwise.
In the typical structure, the founders own “common stock” of their corporation or “Class A membership interests” of their LLC. Outside investors receive “preferred stock” or “Class B membership interests”. The outside investors have priority rights to distributions (dividends) and the rights to receive information, vote on certain major decisions, and audit the books and records of the company.
California companies are generally free to prohibit investors from participating in management. However, certain information and inspection rights are mandatory. These rights may also apply to certain “foreign” companies registered to do business in California.
Investment Documentation
Debt and equity are both treated as “securities” under state and federal law. If your company offers or sells securities to outside investors, you should “paper the deal” properly. That means executing written documents between the company and investors. The documentation will provide various benefits, such as avoiding misunderstandings among the parties, reducing the risk of liability for misrepresentations, and persuading tax authorities to allow deductions of interest payments (in the case of debt).
Debt transactions may require the following documents, among others:
• non-disclosure agreement (NDA)
• business plan
• investor questionnaire
• loan agreement
• amended articles and bylaws, or LLC operating agreement
Equity transactions usually require a combination of the following documents:
• non-disclosure agreement (NDA)
• private placement memorandum (PPM)
• investor questionnaire
• subscription agreement
• purchase agreement
• investor rights agreements or “side letters”
• amended articles and bylaws, or LLC operating agreement
In addition, you may need to file notices with government agencies. Securities laws require registration of all securities offerings unless exemptions apply at both the state and federal levels. Exemptions typically relate to the amount of capital being raised, the locations of the investors, the wealth and “sophistication” of the investors, and other factors. Many start-up companies raise capital under the exemptions for “private offerings”, “limited offerings”, or “intrastate offerings”. Other exemptions may apply.
Even if an offering is exempt from registration, the issuer of securities must still comply with disclosure requirements. In general, the securities laws require the accurate disclosure of all “material” (important) information regarding the offering and issuer.
Securities offerings are very complicated and require the assistance of experienced counsel. Legal violations may result in civil and criminal liabilities. At a minimum, investors usually have the right to get their money back, perhaps with interest. In California, the current interest rate is 7%. Applicable law may also require reimbursement of attorney fees and other litigation costs. If the violations were intentional, punitive damages may also be available. In California, for example, investors may recover treble damages for securities fraud. The individuals responsible for the fraud may incur personal liability.
Finders
If your company needs outside capital, you may consider hiring someone to assist with fund-raising. Such persons are known as “finders” or “placement agents”. For small offerings, they usually charge a fee in the range of 4-7% of capital raised. They may also demand a piece of the equity of the client company. The typical amount is 2-5% of the equity of the offering or the company. Together, the fee and equity percentages should fall in the range of 6-10%.
Applicable law may require the finder to register as a licensed “broker-dealer” with FINRA (formerly NASD). If your company uses an unlicensed broker-dealer, the legal violation may give rise to the same civil and criminal liabilities discussed above in regards to registration and disclosure violations.
Transfer Restrictions
If your company sells equity to investors in an exempt offering, the securities laws will restrict resales of the equity interests. First, the resale must comply with exemptions from registration. Second, the resale may not occur until the expiration of the period required by law (six months or one year, in the case of federal law).
The governing documents of a company may impose further restrictions on resales. For example, investors may need the prior written consent of the founders to any transfers. Also, the owners and the company itself may have preferential rights to purchase the equity being sold ("rights of first refusal").
