One of the most crucial aspects of any new venture is the initial financing. The venture's lawyer should be involved in the planning of such financing since the structure of the initial financing has so many implications for the new company later on, as to the amount of dilution that the founders must accept as well as tax and other matters.
Many new companies are initially financed by the founders, their families, friends and business associates. This informal financing is effected through advances by the founders, deferral of payment of salaries to the founders, informal ownership which is not formalized by issuance of stock or other securities, or through informal partnerships, prior to the incorporation of the venture. These informal financing arrangements may not be adequately documented and can create legal problems later on if the venture is not successful. Investors may lose money, and even though they may be relatives, friends and neighbours of the founders, they may claim that misrepresentations were made to induce them to invest, and attempt to rescind such financing and demand a return of the monies they advanced. If the financing was not properly effected in compliance with the federal and provincial securities laws, investors may well be entitled to such rescission.
The venture's lawyer may not be consulted until after the initial financing has been consummated. If the financing failed to comply with corporation and securities laws, he or she may then be faced with a choice of either effecting a rescission or waiting the running of the statute of limitations (started by notice to the investors of the possible failure to comply with the applicable corporate or securities laws). During this period of uncertainty as to whether investors will claim rescission, disclosure of the potential rescission liability must be made to any potential investors in any subsequent offerings during this period. A rescission may be difficult to do unless the company has funds to refund the investors and start over by properly structuring the financing.
2. Sale of Equity – Common Shares
Since most investors willing to accept the high risks of investment in a start-up or new company wish to obtain the rewards derived from equity ownership, a common method of initial financing is through the sale of an equity security: common shares, preferred shares or convertible preferred shares. Since the common shares usually carry the full right to participate in earnings and thus increases proportionately in value as the company grows in earnings and net worth, common shares are the usual method of investment for the founders and sometimes the initial outside investors.
3. Sale of Equity – Preferred Shares
On the other hand, the initial outside investors may wish to own a security senior to the common insofar as liquidation and dividend preferences are concerned. Often preferred shares are sold to the outside investors with the right to convert such preferred shares into common stock. In addition, many venture capital funds require some income from their investment, particularly those funds that need investment income to defray the funds' operating costs. However, since most new companies do not have the earnings to pay preferred stock dividends, payment of such dividends would constitute a return of capital rather than of earnings. The investors may accordingly be funding their own dividends until the venture has sufficient earnings to cover the dividends.
A technique which may be considered as a compromise between payment of cash dividends and no accrual of dividends would be payment-in-kind (PIK) dividends. A PIK dividend accumulates, usually whether or not earned, and is added on to the par value and/or the liquidation preference of the preferred stock and is payable by issuance of additional common stock in an amount equal to the PIK dividend. Thus, if the company is liquidated or recapitalized in a manner that requires a payment to the preferred equal to its liquidation preference, the aggregate amount of the PIK dividends would be included in such par value and/or liquidation preference. Also, if the preferred is convertible, the conversion price, when divided into the par value or liquidation preference, including the PIK dividends, will provide the convertible preferred stockholder with additional common shares equal to the dollar amount of the PIK dividends divided by the conversion price. To the extent that the company has earnings and profits, the PIK dividends will be taxable. If not, the PIK dividends will be deemed to be a return of capital and not taxable as income unless and until the basis of the preferred is reduced to zero.
4. Sale of Equity – Convertible Preferred Shares
In addition to being commonly used for venture capital investors, convertible preferred shares might be used where there is a substantial difference in the price per share of equity securities issued to the founders as compared to that sold to the outside investors. Instead of issuing common shares, for example, at $1.00 a share to the founders, and $5.00 a share to the outside investors (which bargain element of $4.00 a share might be viewed as taxable compensation to the founders for services rendered), the venture could issue convertible preferred shares to the outside investors, convertible at $5.00 per share or, even up to $10.00 per share without creating adverse tax consequences to the founders for having received common shares at $1.00 per share.
5. Sale of Equity—Hybrid Preferred Shares
These are preferred shares with provisions more common to debt securities, as for example, a provision allowing the holder to exchange the preferred into debentures, which are in turn convertible into common stock.
6. Sale of Equity – Tax Considerations
In most instances a contribution of property to a corporation for shares may be structured to avoid taxation at the shareholder level. The potential adverse tax consequences referred to above result by virtue of the Income Tax Act, which treats a transfer of property (including stock) in connection with the performance of services as taxable compensation. Thus, the unrestricted receipt of shares by a founder in whole or in part for the performance of past or future services is taxable to the recipient. Although not as clear, the receipt of a partnership interest for services may also result in compensation income.
If a shareholder recognizes income on the receipt of shares for services, the amount taxable is the difference between the fair market value of the shares and the fair value of any consideration given for the shares. The amount is taxable at the time the recipient acquires a beneficial interest in the property, disregarding any restriction which by its terms will never lapse. An example of a non-lapse restriction is a requirement that the employee/shareholder sell the stock back to the company at book value on termination of employment. Another example is a permanent right of first refusal to the corporation on sale of the employee's shares. Lapse restrictions that delay recognition of the income are restrictions that raise a substantial risk of forfeiture or that make the shares non-transferable. If the shares issued subject to a lapse restriction, the time of recognition of taxable gain occurs when the property is transferable or is no longer subject to a substantial risk of forfeiture. The fair market value is determined at the time of the lapse of restrictions and the amount of gain is based on that value.
7. Sale of Debt
The founders may prefer to loan sums to the new company in exchange for debt securities, so that repayments of such capital may be made when the company's operations and financial condition permit. Such amounts would not be taxable as dividends if they are properly structured as debt repayments, whereas any amounts invested by the founders in exchange for common stock would be locked in as equity capital and could not be taken out without being taxed as ordinary income dividends if the company had earnings and profits.
Outside investors may prefer to advance funds in exchange for debt securities which are senior to the equity securities issued to the founders. In a high risk start-up venture, this distinction may not be meaningful, since if the company fails or becomes insolvent, there will not likely be sufficient assets to repay the debt. Hence, the difference in equity securities and debt securities may not be meaningful if the business fails. However, venture capital investors may wish to create a security interest in the assets of the venture, e.g., the intellectual property representing the technology being financed. Thus, in an insolvency situation, the venture investors may be able to recover by foreclosure the intellectual property in priority over the unsecured creditors of the venture.
Since many venture capital funds require some income from their venture investments to defray their own operating expenses, the use of convertible debentures allows the venture to pay such amounts as interest on a tax deductible basis. However, until the enterprise has taxable income, whether the payments are deemed to be interest on convertible debt or dividends on convertible preferred stock will not affect the company's current tax liability.
For tax purposes it now makes a substantial difference to an individual investor (as opposed to a corporate investor) whether he receives distributions from the corporation as payment of dividends or a payment of interest, since the tax rate on qualified dividends is 15%, while the maximum rate on interest is 35%. The difference to the corporation paying the dividends, however, is also substantial. Dividends are not deductible by the corporation and thus must be paid with after-tax dollars. Interest payments, on the other hand, are deductible within limits and therefore reduce the taxable income and amount of taxes that the corporation must pay. Furthermore, repayment of a loan to an investor should be treated as a return of capital and not result in taxable income to the investor. On the other hand, repurchase by a corporation of its shares may result in dividend income to the shareholder.
Because of the lower rate on dividends to individual investors, the tax advantage for issuing debt rather than stock has considerably lessened for years after the Jobs and Growth Tax Relief Reconciliation Act of 2003. In connection with capitalizing the corporation, therefore, shareholders should consider whether the corporation needs additional deductions provided by interest payments on a shareholder note, since the shareholder will be foregoing the preferred 15% rate on dividends for a 35% rate on interest payments. Because of the tax advantages of using debt, many small corporations attempt to maximize the amount of debt as opposed to invested equity capital. That fact pattern may cause Internal Revenue Service scrutiny of the debt to determine whether, in fact, it should be treated as equity. The Service is authorized by statute to prescribe regulations to determine whether an interest should be treated as stock or indebtedness or as a hybrid. There are currently no regulations in effect. Among the factors that the Service may consider in the regulation are: (1) Whether the "debt" is supported by a written unconditional promise to pay on demand or on a specified date a sum certain in money for an adequate consideration in money or money's worth, and to pay a fixed rate of interest; (2) Whether the debt is subordinate to or preferred over any other indebtedness; (3) The ratio of debt to equity of the corporation; (4) Whether the debt is convertible into stock; and (5) Whether the debt is issued proportionately to the stockholdings in the corporation. Debt instruments of a corporation are also subject to some fairly complex provisions relating to below-market interest loans between corporations and shareholders and rules relating to original issue discount on corporate obligations.
8. Debt/Equity Combination – Convertible Debentures
Since most risk investors wish to have an equity interest, convertible notes or debentures offer investors a senior security with preferences on liquidation, payment of interest and other rights senior to common and preferred stock, while offering the investor the right to convert such debentures into common stock at his or her election at a time when the conversion equity security is more valuable than the principal amount of the convertible debentures. It has been suggested that convertible notes are the ideal structure for angel investments with the following provisions: The convertible notes would compulsory convert into a qualifying venture capital round, with a discount, and a default provision allowing the notes to be converted into common or series A preferred at a multiple of earnings or revenues, with a floor and/or a cap for the valuation amount, at maturity or upon a liquidity event. The argument here is that such a structure would tend to protect the angel investors from being crammed down as they would be if they held a simple series A preferred invested at a higher valuation.
9. Debt/Equity Combination – Debentures with Warrants
Debentures with detachable warrants offer the same election to the holder, except that the warrants may have a longer term than the debentures so that investor could obtain repayment of the debentures but continue to hold warrants to purchase common stock after the maturity of the debentures. If the warrants are coterminous with the debentures, there is no real difference in such a security as compared with convertible debentures unless the debentures with warrants are prepaid before the warrants expire.
10. Debt/Equity Combination – Tax Considerations
Debentures generally carry the same tax characteristics as other debt, unless the instrument as a whole represents an equity investment rather than true debt. In determining whether a hybrid security is true debt, the courts normally look at such things as the intent of the parties, whether there is a common identity between the creditor and shareholders, whether and to what extent the creditor participates in the management of the corporation, the ability of the corporation to obtain funds from outside sources, the debt-equity ratio, risk, formality of the arrangement, whether the obligation is subordinate to or preferred over other creditors, voting power, whether the instrument provides a fixed rate of interest, whether there is any contingency on the obligation to repay, the likely source of the interest payments, whether there is a fixed maturity date, whether there is a redemption feature, whether the holder has any input, and whether the instrument was issued in connection with the organization of the corporation.
If the instrument is determined to be debt, the holder's conversion of the instrument into common stock under a conversion privilege is treated as a non-taxable event. A debt instrument that is a contingent debt instrument is subject to a special set of regulations. Interest must be accrued and taken into account by the issuer and the holders on the entire issue price based upon a determined anticipated yield, and a constructed “projected payment schedule.”