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5. FINANCIAL MATTERS

e. Distributions

Obligations

Distributions are usually left to the discretion of the board of directors of a corporation, or the managers of an LLC or LP. However, the governing documents of an entity may require distributions under certain circumstances. For example, the operating agreement of a private equity fund may require distributions of 40% of the net income allocated to the investors and manager in order to cover estimated tax liabilities caused by the allocations.

Applicable law may also require distributions under certain circumstances. For example, California requires the distribution of net assets to shareholders upon the dissolution of their corporation.

Limitations

Any distributions should be made only from net available cash. Net available cash is the cash left over after paying business expenses and setting aside reasonable reserves for future expenses. Cash flow is different from “income”. “Income” is calculated for tax purposes and takes into account the depreciation and amortization of assets. As a result, an entity may have net cash flow but not taxable income.

State law may prohibit distributions under certain circumstances. For example, California prohibits distributions that would make the entity insolvent, meaning unable to pay off creditors or those owners with preferential rights. Similarly, Delaware law prohibits distributions that would make the liabilities of the entity exceed the fair value of the assets. Investors and managers who vote in favor of or receive improper distributions may be personally liable to the entity for the amount of those distributions.

Loans from banks and other persons are business expenses of the borrowing entity. Lenders usually have priority rights over the owners, which means that the entity must make its scheduled loan payments prior to making distributions. Loan agreements often impose additional restrictions on the payment of distributions.

Timing

Managers usually have flexibility in choosing the timing of distributions. Distributions may follow a periodic schedule (annual, semi-annual, or quarterly), or the managers may make distributions at an intermediate time – usually in connection with a sale of capital assets (as opposed to inventory). The operating agreement may specify the distribution schedule.

Start-up companies often defer distributions to professional investors until a liquidity event, meaning an IPO, company sale, or liquidation.

Amounts

The amount of the distributions will depend on the amount of net available cash, limitations imposed by applicable law and governing documents, and the need to maintain reasonable reserves for future expenses.

In the case of a California LLC, the default rules are the following: (i) distributions that are a return of capital must correspond to the capital contributions; and (ii) other distributions must correspond to the allocation of profits (but not losses). The operating agreement of the LLC may vary these default rules, subject to applicable law.

If an owner of your company provides more services than the other owners, you may be tempted to compensate the owner with extra distributions. However, this solution is not available to corporations. LLC's have more flexibility to make “special allocations” of profits, but tax authorities may challenge such allocations due to the risk of tax evasion. Safer methods for rewarding disproportionate services include paying a higher salary and awarding a cash bonus to the overachiever.