Taking Outside Capital

Today s entrepreneur dreams have shifted to building the business to a certain scale and selling for a large multiple. The path to the dream seems easy: find an investor or investor group, use the capital to grow the business and capture market faster than by organic growth, and position the company for sale at a high multiple. Reality is more complicated than the perception.

Outside investor money can spur growth. At the same time, taking in outside investment has significant consequences. Investors do extensive due diligence on candidates, closely checking everything. Issues coming out of due diligence often have a great impact on the terms of investment proposals. Good planning can resolve or minimize problems before due diligence starts.

This memo focuses on what to address in considering your first outside investment and the steps to take in anticipation of pursuing capital from third parties.

THE RIGHT LEGAL STRUCTURE

The type and structure of the business materially impacts both the economics and management controls required by investors. Structure also impacts the range of solutions available to address outside capital provider concerns. A substantial amount of time is frequently spent addressing issues resulting from the company s legal structure and making changes to elements of the structure that do not work well for outside investors.

Corporations have been the most common form of entity used by operating businesses. Corporations are established and governed by state corporation laws, most of which are based on similar models. The corporation has been around for over a century and a large body of law has developed to define the rules applied to it. Investors and public markets are familiar and comfortable with corporations.

S Corporations

S corporations are passthrough entities that flow through income and loss to shareholders. No federal tax is imposed at the entity level; however, some states impose tax at that level. Income flows through to shareholders regardless whether cash is actually distributed. Shareholders may have phantom income or taxation without a cash distribution. Shareholders may get the tax benefit of taking the losses that often exist in early stage entities.

To get the benefits of the passthrough tax treatment given an S corporation, it must comply with some rigid requirements. It may only have a single class of stock identical in all economic respects. Voting and nonvoting stock is permitted provided the shares are otherwise identical. It may not have more than 100 shareholders understanding there are attribution rules which effectively allow for many more than 100 shareholders if there are family groups in the shareholder base. S corporations are limited to certain types of shareholders individuals and certain trusts and may not have any shareholders that are corporations, partnerships, pensions, charitable organizations, complex trusts or nonresident aliens. Not satisfying any one requirement, intentionally or by mistake, means the loss of the S corporation status.

Although the economic benefits of passthrough taxation are significant, S corporations are not ideal vehicles for taking in outside capital. Prohibiting multiple equity classes precludes establishing the distribution, liquidation, voting and other preferences frequently used in venture capital and private equity deals. The restriction on the type of shareholders eliminates funds, institutions, and pension funds as investors. The company and its shareholders should expect to terminate the S election when closing any investment transaction.

C Corporations

C corporations are the most common form used by businesses getting venture or private equity. There is extensive precedent and investor comfort in terms of transaction structures, documentation, and solutions to issues. C corporations are taxed both at entity and shareholder levels. The double taxation has a significant economic effect on the amounts ultimately realized by shareholders from corporate distributions. While C corporations do not have the benefit of passthrough tax treatment, they are also not subject to the burdens on S corporations. There is no restriction on the classes of stock. C corporations can have multiple classes of common and preferred stock with a variety of voting, liquidation, and distribution preferences. Likewise, C corporations are not subject to any limitations on the number or types of investors that may own equity. Complex trusts, corporations, partnerships, limited liability companies, pensions, charitable organizations and foreign entities may hold stock in a C corporation. The C status remains except by affirmative action by the shareholders to change it.

Although the lack of flowthrough tax treatment may mean higher taxes, there are benefits that usually more than offset the double tax. Investment funds are often averse to flowing through or reporting losses to their limited partners or passive members before exit transactions. C corporations also block unrelated business taxable income, or UBTI, from flowing through to pensions and other tax exempt investors. C corporation shareholders have no tax reporting requirements unless or until distributions are made from the corporation. No limitation on shareholders opens the door to prospective investors regardless of legal structure or status, expanding the pool of prospective capital providers.

Other Benefits of Corporations

Corporations have several benefits to entities that are also attractive to outside investors. Section 368 of the IRC allows corporations and their shareholders to take advantage of partial income tax deferral on exit transactions involving another corporation. A 368 transaction is a merger where a portion of the price received by the exiting shareholders is stock. The selling shareholder pays no income tax on the part that is stock until the stock is sold. All other consideration is taxed on receipt. The deferral from a 368 transaction can materially increase the value of the transaction to the selling shareholders and allow continued participation in the business.

IRC Section 338 allows buyers and sellers of corporations to treat the sale of stock, solely for income tax purposes, as though the transaction was a sale of assets. These transactions may have significant value to a buyer by allocating the purchase price to the acquired assets with resulting depreciation or amortization of them for tax purposes. Sharing the value created by structuring a deal as a 338(h)(10) transaction can be a winwin for the buyer and seller. Structuring the deal legally as a stock transaction with taxation as an asset deal may allow the parties to get aound the delay caused by consent requirements and termination rights of contracting parties.

LLC s & LP s

Over the past 20 years, limited liability companies (LLC) have become frequent. LLCs are very different from corporations. LLC statutes are based on freedom of contract whereas corporation statutes are prescriptive. LLC statutes are mostly default rules that apply only if the members do not otherwise address a topic. Parties have great flexibility to tailor the organization to fit owner needs. Creative distribution layers, management structures, and other mechanisms are easily created and managed in an LLC structure compared to the corporate form.

Like S corporations, LLCs are usually flowthrough entities. There is generally no federal taxation at the entity level and operating results flow directly through to the owners. An LLC is usually taxed as a partnership, but the members can elect to have it taxed as a corporation (either S or C). Unlike S corporation shareholders, LLC owners may step up basis with respect to certain nonrecourse indebtedness, enhancing the ability to deduct losses and get tax benefits in the early years of operation. This passthrough tax treatment is not based on complying with strict rules. There are no restrictions on classes of equity or the number or type of owners in an LLC. Consequently, LLCs have a lot of flexibility, a single level of taxation, and lack of restrictions the most attractive attributes of both S and C corporations.

They are not a cure all. Typically, neither a 368 transaction nor a 338(h)(10) transaction is available. LLCs have been around for more a while and case law has evolved interpreting the LLC statutes and defining the attributes and governance of the entity. Many important issues remain unsettled or untested. Consequently, LLCs and the issues related to them are subject to much greater uncertainty than businesses in the corporate form.

Limited partnerships (LP) are most like LLCs. The similarity results from the substantial degree to which LLC statutes use the concepts in LP statutes and the similar federal tax treatment of LLCs and partnerships. There are meaningful distinctions between LLCs and LPs. Legally, LPs have general partners with management authority but no liability protection and limited partners that play no role in management but have limited liability. Limited partners jeopardize their liability protection by participating in management. LLC members have management authority (unless they choose to delegate to managers) and liability protection is not conditioned on remaining passive. Taxwise, limited partners typically cannot take nonrecourse debt into basis like members of an LLC. Largely because of these differences and because LLCs offer most benefits of limited partnerships, LLCs are usually more attractive for operating businesses than LPs.

LLCs have significant positive and negative attributes for taking in outside capital. Passthrough taxation increases return rates to owners. The availability of multiple classes of equity allows for complex structures tailored to suit the specific needs of the company and investors. The lack of restrictions on the type and number of owners allows any prospective investor. On the other hand, the flowthrough taxation is often unattractive to investment funds and LLCs cannot use section 368 or section 338 to minimize income taxes in an exit transaction. Also, LLCs have been less commonly used for venture and private equity portfolio companies, making investors less familiar and less comfortable.

JURISDICTION

Regardless of entity type, the state of formation may be a subject of discussion in capital infusion transactions. Although many corporation and LLC acts are similar, Delaware law clearly stands out. The proentity environment in Delaware means many businesses are formed there with no other contact with the state. The concentration means Delaware has developed a highly sophisticated and welldefined set of legal rules that give guidance and predictability for business owners and operators. While other states have significant positive attributes, most investors will be familiar with Delaware law, its effect on equity transactions, and governance of Delaware enterprises with outside investors.

THE CAPITAL STRUCTURE

Few issues have greater importance to investors than capital structure. Not being able to adequately explain a capital structure tells investors that the most basic element of an organization, its ownership, is unsettled.

The Cap Table

Step one in mastering the equity structure is an organized capitalization table. A wellcrafted, easytounderstand, uptodate cap table should be available with a list of holders, equity ownership, paid in capital and other relevant information. A complete cap table should also show all options, warrants and other equity rights, documented or not. Quick and easy access to a cap table shows command of the ownership structure and helps investors efforts to structure the investment transaction to address all equity issues. Not having a cap table creates a negative perception and complicates, lengthens, and increases due diligence cost.

Documenting Equity Holdings & Rights

Properly documenting ownership is critical. Stock certificates or other ownership documents should be created, copies should be retained by the organization, and all equity transfers should be documented and recorded. Undocumented ownership claims are among the most serious concerns of prospective investors in due diligence. Thoroughly documented ownership kills these concerns. Comprehensive documentation not only gets rid of uncertainty about ownership and provides easy verification of the cap table, it also eliminates expensive cleanup projects and uncomfortable interaction with existing holders who are going to be diluted. Ownership related rights, like options, warrants, and appreciation rights, should be fully documented. The agreements should fully address all exercise, price, vesting, termination, and repurchase issues, rights, and obligations.

Holder Agreements

From an investor perspective, holder agreements create a perception that the owners have thought about and planned for the changing nature of the business and the relationships among the principals. The agreement is particularly important where all owners participate in the business. In these cases, the agreement should provide for rights to purchase or sell when an owner ceases to be active in the business. Mandatory purchase and sale provisions cut risks associated with renegade owners after separation. From an individual perspective, these provisions ensure the departing owner gets value from an entity they no longer control. These concerns are less pressing when dealing with passive owners.

Other topics that may be addressed in these agreements are restrictions on transfer, defining any permitted transferees like family members or estate planning vehicles, and limitations or provisions about governance. For example, the agreement may have requirements to vote for certain individuals as directors or provide supermajority approval for some actions.

PROTECTING ASSETS

Managing and protecting assets are often overlooked by growing businesses where the owners are so busy doing business that they do not have enough time to manage the business. Understanding the nature and vulnerability of business assets is central. For example, in a software business, maintenance and protection of source code is critical to preserving enterprise value and combating competitive threats.

Getting Title in Order

During the early days of a business, key assets may be titled in the name of a principal or key employee. It is forgotten until a major transaction. The cost and effort of fixing title may be substantial, especially if key people have left the organization. Investor confidence may be rattled discovering the company s key assets might be subject to claims by others. To avoid unnecessary cost, all assets used by the business should be titled or registered in the name of or licensed by the entity. To the extent title can be made of record with a government body, the company should strongly consider doing it.

Written evidence of title and transfers should be maintained. Personal assets should not be mixed with business assets. Nonessential assets used by the owners should be transferred out of the entity to the individuals in order to avoid issues later. Maintaining nonessential assets in the company s name clutters financial statements and increases the risk of distracting disputes when an individual separates from the business. If an owner s personal assets are needed for the business, such as office space, written agreements on market terms should be in place. In this way, the true costs of the company s operations are reflected in financial statements.

Steps should also be taken to ensure third parties have no claims against business assets. Employees should sign agreements before starting work acknowledging all inventions, innovations, ideas and other concepts related to the business are its property and the employees have no interest in any of the assets. Independent contractors and vendors should sign agreements making clear all work product resulting from any services is the sole and exclusive property of the business. If the business requires the use of proprietary assets of others, a license or other agreement should be put in place to ensure availability. The agreements should clearly spell out the business rights to use the assets and address ownership of derivative works, modifications, enhancements or byproducts of the relationship between the parties as well as renewal terms, purchase rights, fees and royalties, exclusivity and payment terms.

Keeping A Secret

Confidentiality is another critical element to protecting business assets. Investors want to be comfortable that the unique elements of the enterprises are protected from competitors and preserved for the company s growth. By maintaining confidentiality, barriers to entry are created and the company s value proposition is maintained. The company should establish clear guidelines for handling confidential information to ensure it is not used to its disadvantage. In particular, the company should identify items that constitute trade secrets so that applicable legal protections are preserved. Limiting disclosure of information to those who need to know and protecting disclosed information are the main elements of an asset protection strategy. To the extent possible, trade secret information should be disclosed in segments with as few people as possible having all segments. Files with trade secret information should be encrypted or locked and access should be monitored. Employees and third parties doing business with the company should sign nondisclosure agreements that require all information be returned or destroyed following use.

EMPLOYEES

The investment decision often turns on the strength of the staff. Identifying the critical members of the management team is necessary when preparing to take in thirdparty investment. Investors recognize not all critical roles will be filled and the funding may be the vehicle that enables the company to make essential hires. However, before starting a fundraising process, the business should have identified and defined the key roles and developed a game plan for filling them.

Defining Roles

Creating detailed job descriptions not only helps define the skill sets for personnel, but also clarifies expectations for employees. Welldefined roles allow establishing bases for evaluation and bonuses and identifying gaps in the organization. Finally, the company can use the job descriptions to establish goals and foster growth and development for employees.

The Carrot

Incentive plans are part of an overall compensations package that, if properly structured, will provide the financial incentives necessary to attract and retain qualified, key personnel. Incentive plans can also preserve working capital by shifting the payment of a portion of employee compensation to the future. Incentive compensation consists primarily of performance bonuses and participation in equity or quasiequity plans.

Bonus criteria should be tied to relevant performance standards for each employee. For example, the bonus for the head of sales should be tied to sales growth or volume. Incentives with no relation to employee performance can create frustration because the employee has no ability to control what is needed to get to bonus. Tying bonuses to metrics unrelated to performance and outside the employee s control does little to create incentives and creates a risk of undesirable results, frustrating the employee or thwarting the goals. If possible, the bonus plans should include deferred payments to strengthen incentives to stay with the company and increase the cost to others attempting to hire them away. Bonuses should be earned only if employees are employed on the date of payment.

Equity and quasiequity incentive compensation plans like option plans and appreciation rights provide rewards over a long period of time. They typically provide compensation as the value of the business increases over time. To realize value, employees must remain with the business, creating an incentive to contribute to the business s wellbeing and aligning owner and employee incentives. Long term incentive plans should include provisions addressing vesting, employment termination, and exit transactions such as sales or mergers.

Having A Stick

Noncompete covenants are always controversial. Prospective employees are reluctant to limit their alternatives if the business is unsuccessful or the employment fit is poor. They provide meaningful protection for the business and are significant to investors. Capital providers not only want assurance employees are appropriately motivated to enhance the value of the investment, but also are precluded from conduct that would impair the business value. Agreements regarding noncompetition, nonsolicitation and nonhiring employees, nonsolicitation of customers, noninterference with other business relationships, and nondisparagement all have this effect. While courts closely scrutinize and are generally skeptical of restrictive covenants, wellcrafted, narrowly tailored, and meaningful restrictive covenants are often enforced. Severance payments may further enhance the enforceability of restrictive covenants.

LENDERS

Companies that do not have outside equity capital frequently have several layers of debt, ranging from commercial banks to loans from shareholders. Use of funds and debt repayment are often among the biggest issues in taking in outside equity. Thirdparty investors want their capital used to grow the business, improve products, expand services or pursue opportunities, and are not generally willing to having the money immediately exit the business to repay loans. Loans made by principals are seen by investors as equivalent to equity. Subordination agreements may be required, repayment may be substantially delayed or loans may be converted into equity to ensure principals do not cash out before investors or before the company is performing. Friends and family are not likely to fare much better, and conversion, restructuring, or subordination are often required.

Bridge loans are frequently put in place before an equity financing is completed. They often have conversion features that convert the debt into equity on the closing of the equity raise. The conversion often provides for a discount to the conversion price of the next equity round. For example, the conversion feature may say the conversion price will be 80 percent of the per unit price in any subsequent equity financing. This creates several issues. First, allowing a lender to convert at a discount to the equity price in the next round results in a higher effective coupon for bridge lenders than realized by the equity providers. Prospective capital providers are unlikely to permit bridge lenders to acquire the same class of equity on superior terms. Discounts are generally more burden than benefit. An alternative is to provide warrant coverage or issue junior equity to bridge lenders and require the bridge lender to convert at the same price as the equity investors.



OTHER HOUSEKEEPING

Other housekeeping items should also be attended to before looking for investment capital from third parties. Nonmarketbased compensation and perks should be reset to market levels. Personal expenses run through the business that are common to privately owned companies should be eliminated. Failure to clean up these items complicates due diligence, distorts financial statements, and creates a perception the business is a personal piggy bank not suited for thirdparty capital.

Other housekeeping items include documenting thirdparty arrangements that have not been reduced to writing like customer arrangements, vendor agreements and other party relationships. Each of these items preserves the enterprise value of the organization and facilitates investor transactions.

BUSINESS PLAN

A key component in getting equity capital is a clear and focused business plan. A good business plan reveals an understanding of the business, industry, related trends, competitive threats, and obstacles to the success of the business. It should identify each critical growth factor and show how the organization will address and overcome obstacles to success. The business plan may provide insights and identify growth paths not readily apparent to investors. Besides describing the business, industry and competitive landscape, the plan should include historical financial statements and projections of future results. Investors recognize projections are speculative; however, they reveal management s expectations and understanding of business realities. The financial statements also give an opportunity to explain, adjust, or recast nonrecurring or extraordinary items to accurately reflect operating results and review projections.

Developing the business plan should include all senior managers to ensure focus. The singular focus also helps consistency in discussions with prospective investors. The business plan should be reviewed and updated periodically so management can evaluate successes and failures and make adjustments as the business evolves.

HOW MUCH MONEY?

How much money is a byproduct of the business plan. The plan should show how the capital will be used and the results that should be attained. Uncertainties and contingencies should be factored into use of funds. Companies frequently pursue inadequate funding because management underestimates sales cycles, lead and development times, or does not account for unexpected costs or delays. As a result, many companies are forced to return to the capital markets earlier than anticipated. Failure to adequately anticipate the amount of money and time needed hurts in several ways. First, management credibility with investors is damaged because there is a gap between management s expectations and actual results. The company will be required to answer questions as to why current forecasts should be trusted when past projections were off the mark. Harsher terms are likely to be imposed on the organization in the next round. Most important, failure to adequately anticipate time or funding amounts diverts management time and energy away from growing the business.

Companies often go for less capital to avoid giving up a large chunk of equity. That mindset often distracts from the ultimate goal of getting enough money to properly grow the business and wastes time and energy on negotiations over valuation. Owners forget whether a large piece of a small business is more valuable than a smaller piece of a significantly larger one. Alternative approaches can be used. Transactions can be structured such that accretive or dilutive provisions are triggered by actual operating results like increased sales or net income. Management can also participate in incentive plans that recapture ownership over time based on increased enterprise value or that provide special bonuses based on outstanding company performance. Before engaging in battles over valuation, the company should consider the projected internal rate of return received by investors from the investment. Equity investments are subject to significant risks and equity investors demand meaningful returns as compensation for assuming them.

THE RIGHT INVESTOR

The nature of the investors factors into capital raising. Identifying the value needed from investors is a first step in fundraising. In addition to money, investors can contribute financial knowledge, industry connections, management expertise and other resources, or be a potential exit for the company. Identifying the needs defines the appropriate investors. Also, the characteristics of the capital providers significantly impacts transaction structure, restrictions and provisions in transaction documents, interaction required between management and investors and the time horizon for growth and exit. Consequently, the company and its principals should do due diligence on prospective investors to understand the goals and needs of each and compare the pros and cons of various investor groups before taking in capital.

Investors are generally in three broad categories: financial, strategic, and high net worth individuals. Financial investors include private equity and venture funds and institutions. Typically, these are not in the company s industry and say they provide value in excess of money invested. They may bring management or board experience, acquisition experience, financial knowledge and the ability to open doors to new opportunities. Strategic investors are entities within the company s vertical with related or synergistic businesses. Investing by a strategic investor is often a precursor to acquisition of the entire company. The strategic relationship may create revenue growth or costcutting opportunities. On the other hand, taking capital from a strategic investor may limit the universe of potential acquirers down the road.

These classes of investors differ in how they evaluate and structure investments, interact with companies and pursue exit strategies. Understanding investor expectations and goals is necessary to determine the appropriate equity provider. Financial investors are focused on internal rate of return and exit. The transaction structure, restrictive covenants and repurchase provisions are generally set up to maximize growth and position the company for the highest value exit that can be attained in five to seven years. Extensive approval rights are common to ensure the company goes down a narrow path to the desired exit. Redemption rights and price protection for the investors are common if an exit transaction does not occur within the financial investor s time horizon.

Strategic investors look to economies of scale and synergies with existing businesses. For these entities, investing in the company may be a faster, more costeffective approach than developing the business from scratch. Exit and tight controls may be less of a concern than developing and exploiting synergies. Controlling administrative and overhead costs issues that adversely affect earnings and exit price may be less important because they are seen as redundant and are typically eliminated on acquisition. Controlling strategic direction may be more of a focus than daytoday operations. Options to purchase are more likely in transaction documents with strategic investors than financial investors.

Less formally organized investment groups like family and wealthy individuals are usually more flexible than financial and strategic investors. They can often be more patient than other investors. They are not subject to the pressure of reporting internal rates of return, attracting investors to new funds, or public reporting requirements. They may be concerned about keeping in touch with the business and participating in discussions about larger decisions like financings or strategic initiatives but may be less interested in the daytoday operation. On the other hand, this class of investor may not add the incremental value provided by financial and strategic investors. Accordingly, the transaction documents and due diligence process may be less onerous and cumbersome.