Mind Your Business: Part 2 – Initial Financing and Capital Structure

Once you have selected and formed your business entity by filing the necessary documents with the Secretary of State, the next most obvious questions are: how does the company get money and how do I secure my piece of it?

There are a myriad of options for financing your business depending on your particular needs. It is crucial to work with your accountant and attorney to fully understand the implications of the various options. If you have additional concerns, it is prudent to hire an attorney who specializes in taxation to advise.

Interest in the company is referred to as a “security.” There are two basic ways to acquire a security in the company – equity and debt. Equity is basically an ownership interest in the company. In a corporation, equity can be common stock, preferred stock, or a hybrid of both. Preferred stock has a senior position to common stock and has a liquidation preference, meaning the holders of preferred stock get their money out first in the event of dissolution.

Equity

In an LLC, the equity is referred to as “membership interests.” These can have similar characteristics to common and preferred stock with the creation of classes of membership interest (e.g. Class A and Class B).

Partnership equity is the percentage ownership interest a partner has in the partnership.

Anytime you are issuing security to a founder or future investor, you must be sure to comply with the federal and state securities laws. For small businesses and start-ups, there will often be an exemption to registration, but, at least in California, you still have to file a notice of issuance.

The Cheap Stock Problem

Every new company faces the cheap stock problem. To illustrate by example, imagine Carter and Preacher form a fishing company, each investing $500 for 50% each of the company. The value of the fishing company at that point is $1,000. Carter and Preacher then bring in Russell, an outside investor, who will invest $500,000 for 10% of the company. This values the company at $5 million. The problem arises where Carter and Preacher issue their initial stock (the “cheap stock”) at about the same time as they issue the expensive stock to Russell. The IRS has a habit of treating the discount in valuation (the difference between a $1,000 valuation and a $5MM valuation) as services rendered to build up the value and tax it at ordinary income rates.

There are two mechanisms for avoiding this problem. One, have a period of time between the issuance to the founders (here, Carter and Preacher) and the issuance to outside investors (here, Russell) (the longer the better) so the difference in value is not deemed to be taxable. Two, issue a senior security (e.g. preferred stock) to outside investors and common stock to the founders, thereby creating a difference in value.

Debt Securities

In addition to raising additional capital from outside investors to finance the company, it is wise to explore the use of debt to finance. The benefits of using debt are obvious: there is no dilution of the percentage ownership of founders or other existing investors; the debt holder has no ownership interest in the company; the lender has no claim for future profits of the business, only repayment of principal and interest; and the debt is a known equation, meaning the company can budget for it. Additionally, interest on debt can be deductible for tax purposes. Furthermore, raising debt can sometimes be simpler than equity because you don’t have to be concerned with state and federal securities laws.

The disadvantages of using debt to finance the company are equally obvious: debt has to be repaid while common stock does not; debt requires cash flow, so you have to know the company will create enough cash flow to repay debts.

Furthermore, covenants and restrictions built in by lenders can impair the flexibility and ability to conduct business.

Conclusion

The choice of capital structure and how you initially finance your business is of critical importance. Be sure to work closely with a CPA or other financial professional and your attorney to make the choices that will allow your business to thrive.

By Jessica B. Coffield