Dispense with the jargon: Go cut deals.

I have a client who called me saying he wanted to bring in an investor who is contributing $150,000 to my client’s LLC.  Once a particular project is done a few years down the road, that investor gets their money back.  My client was so confident that he would do well, that he guaranteed the investor a 12% return on the investment.  And not just a friendly verbal guarantee.  My client was willing to put it in writing and pay it annually.

To my client, this person coming in was an investor and would own part of my client’s LLC.  But I asked him, “So this guy gives you $150,000.  For one year he gets nothing.  But after that you guarantee him a payment of 12% of his investment, paid annually.  After five years, you can pay it off or just keep paying his return of 12% each year.  Right?”

“Yes, that’s exactly right.”

“Okay, well…. that sounds to me like a loan.  Not an equity investment.  Do you mind if I just document it as a promissory note?”  His response was funny.  “Yeah, I don’t care.”  That response sounds so informal, but it’s actually the best possible perspective to take. So many entrepreneurs pour over industry terminology to the point that they are experts at investment jargon, perhaps more than being an expert at earning a profit.

I’m not saying this is a total waste of time.  It’s important to know some technicalities on how investments are structured.  And it helps to speak the language when dealing with VC and other investors.  But an investor generally doesn’t care if you don’t know the securities industry lingo inside and out.  The investor wants to know that you know how to make money in your business.

My client is the perfect example.  While his competitors were out there reading yet another copy of Fortune cover-to-cover, my client found a guy willing to part with $150,000 without even realizing that the investment he scored was a loan.  Who cares?  He scored a deal.  It’s my job to sort out the details, figure out how to label it, and document the deal.  My client just spends his time knocking down more and more deals.

If you find yourself spending more time becoming an expert on investing lingo as you do actually attracting investors, you may want to back off from the jargon for a bit and focus on some old-fashioned deal-making regardless of what your lawyer ends up calling the document that comes out of it.

Go make today amazing,

JDV

9 Business Records You Should Always Have on Hand.

Below is a list of documents every company should keep in one place, probably a three ring binder.  In the old days, this used to be called a “Corporate Book” and you can still use one of the fancy ones you get from an online service like Atlas Corporate and Notary Supply, etc.  But nowadays, most people just use a three ring binder.  The main rule to follow is that this book should contain actual filed and signed documents ONLY.  No letters.  No drafts without signatures.   No notes.  The purpose of this binder is to have the ability to trace back every legal change that has actually occurred in the ownership and management of your company.  So unsigned documents don’t count, and hence don’t make it into the book.  It helps immensely to keep them in chronological order so someone later on will be able to piece together your full corporate history very easily.

Terminology is a little bit different for LLCs versus corporations, so I’ve listed both.  Your corporate book should include:

  • Articles of Incorporation (corp) or Articles of Organization (LLC)
  • Shareholder Agreement (corp) or Operating Agreement (LLC)
  • Subscription Agreement (same name for LLC or corp)
  • Stock Certificates (corp) or Membership Interest Certificates (LLC).
  • Any amendments to any document on this list.
  • Stock Register (corp) or Capitalization Table (LLC, but LLCs can call this just about anything).  Whatever it is labelled as, this is just a list of owners and a record of every transfer of ownership interest to anyone (or anything, like a trust).
  • Any document which is filed with the Secretary of State.
  • Corporate shareholder and board minutes.  LLCs are not required to maintain meeting minutes in all states, so check your local statutes.  But if you do keep minutes, they should be in the book (only if signed).
  • Board and shareholder resolutions (corp) or manager and member authorizations (LLC).

I recommend against keeping financial statements and tax returns in the corporate book.  The idea behind the book is to create a history of ownership and control, and not a financial history.  But this is more my personal opinion than a legal opinion.  I’m fussy about what I put into corporate books.

That’s it for today.  Make it an awesome day.

JDV

Control at Only 1%? Yes.

Can you sell so much equity in your business that you’re left with literally 0.51% but still retain control?  Yes.  As long as we structure your company to allow for control at even extremely low ownership percentages.

Control at 100% Ownership. The most iron-clad method of maintaining control of your business is to be a sole-owner.  Obviously, if you control all of the stock you can vote off any officer or board member who makes a power-play.  But being a sole owner does not prevent you from bringing on investors.  Instead of selling stock, the company borrows from investors.  Some investors have no interest in the day-to-day operations of the business and would actually prefer to lend.  The investors may bring requirements like security interests against company assets, etc. but they do not gain any control over the business by way of simply being a lender.  Properly documenting these lender relationships is critical.

Control at 51% Ownership. A second option is to maintain a 51% majority ownership.  This way you can still outvote all other investors combined but you are able to bring in at least some capital without borrowing.  You need to use caution in this strategy, though, because certain decisions (like the decision to amend articles of incorporation or dissolution) require a greater majority than just 51%.  Also, depending on the number of directors you have in a corporation, you will not be able to control the entire board with just a 51% majority because of a concept known as cumulative voting.  Each of these issues can be addressed in a good set of by-laws and a shareholder agreement.  So the 51% majority is a good strategy, avoids borrowing, but requires good documentation to keep you in control.

Control at 1% Ownership. A third option is to create a non-voting class of stock.  This is easily done in a limited liability company (LLC), but requires care in a corporation.  Most small businesses formed as corporations have made an S-Corp election.  This provides significant tax benefits to the business owners.  But you will lose your S-Corp status (and the tax benefits) if you create two classes of stock with different economic rights.  Voting stock and non-voting stock are allowed, but each class of stock must have equal rights to profits, losses, distributions, etc.  The main advantage of non-voting stock is that you can maintain a 1% ownership and still control the entire company as long as the other 99% is non-voting.  This option requires careful documentation just like the 51% option, and may require amending your articles of incorporation on file with the state.

Each of the options above carries with it certain benefits and certain drawbacks. Ultimately, if you are seeking investors, the plan you go with is the plan that attracts the right investors.  The best plan in the world means little if you can’t get investors to buy shares.  There are many options available to a small business owner seeking to bring in additional capital without losing control of the small business.  When choosing an attorney to help you, it is important that you work with someone who has experience in both corporate formation and corporate litigation.  An attorney who has fought through a power play is much better equipped to help you avoid one.

Have a great day.

JDV

 

Getting ownership percentages right.

This questions comes up frequently, and is a simple misunderstanding that is easy to clear up.  It primarily pertains to corporations, but can apply to LLCs as well depending on how they are set up.

Rule #1: Your percentage ownership in a company is not based on the number of shares that are authorized.  It is based on the number of shares that are issued.  Corporations always issue ownership in terms of “shares” and the Articles of Incorporation set a maximum on the number of shares the company can “issue” and we call this the number of “authorized” shares.  The company can issue fewer than this number.  But it can’t issue more.  Your percentage ownership of the company is based on the number of issued shares, not the number of authorized shares.  For example, a company may be authorized to issue 100,000 shares.  But right now, there is one shareholder who only holds 20,000 shares.  Even though more shares could be issued, so far this one owner holds all of the issued shares, and she owns 100% of the company.  If you are then issued 20,000 shares you own 50% of the company.  Why?  Because you have the same number of shares as the original shareholder.  The fact that there are more shares authorized doesn’t mean anything until those “available” shares are actually issued to someone.  For now, you hold 50% of the company because each of you owns 20,000 shares.  Your percentage is calculated by dividing the number of shares you hold (20,000) by the total number of shares everyone holds, including you (40,000 total).

Rule #2: Watch out for “dilution”.  In the example above, it’s true that you own 50% of the company right now.  So if that’s the case, then why bother setting a specific number of “authorized” shares if that number doesn’t actually affect the percentage of the company that I own?  The reason is that there may be more shareholders coming in the future.  If the company eventually issues the full 100,000 it has authority to issue, your same 20,000 shares you’ve always held are now only 20% of the company.  This is because your 20,000 didn’t change, but the number of total issued shares (including yours) has risen to 100,000 total.  So the number of authorized shares is very important.  It tells you how much your ownership can be “diluted” if the company issues that maximum number of shares.  When buying your 20,000 shares, if staying at 50% is important to you, you need to enter into an agreement with the other shareholder that the company will not issue more shares.

Rule #3: Five-percent isn’t as simple as it looks.  Consider business owner “Steve” who runs a software company, and he’s always been the only shareholder.  Steve holds 1,000 shares in his company.  He has a great employee, Alex, and wants to give him 5% of the company.  Simple, right?  5% of 1,000 is 50 shares.  But this is not correct.  Steve wants to keep his whole 1,000 shares.  If he issued 50 shares to Alex, and reduced his own shares to 950 then the percentage would be right, and Alex would have 5% of the company.  But this would technically be a sale of shares by Steve to Alex.  And Steve doesn’t want to report a sale of stock on his tax return.  He just wants the company to issue new, never-before-issued-shares to Alex.  This is a better tax result for Steve.

Why is this more complicated?  Can’t we just issue 50 shares from the company instead of “selling” them out of Steve’s shares?  No.  The number 50 doesn’t work anymore.  If Alex received 50 shares, we would calculate his percentage by dividing 50 into the total number of issued shares including the 50 he just received.  So Alex’s percentage would actually be 4.8% (50 divided by 1,050 equals .0476).  This is too far from 5% to allow for rounding.  To get Alex the 5% he has been promised, you would need to issue him 52.6 shares.  52.6 divided by 1,052.6 equals .0499 which can be properly rounded to 5%.

That’s all for today.  Have an excellent day.

Launch Strong.  Build Strong.  Exit Strong.

JDV

Notice: Details such as the amount of the transaction, the location of the property, dates and other information have been modified for confidentiality.