User:CheshireKatz/Planning

For the Charts Appendix, go here

Read business section of a reputable paper for current business events, such as options backdating.

How is Business Planning different from typical legal advocacy?

Normally, legal counsel represents X against Y.

In Business Planning, legal counsel represents X & Y against all Zs and each other.

eg. X (capital investor) & Y (idea man with a plan) want you to help them form a business enterprise.

Why go this way as opposed to each hiring their own attorney?

Advantages: Cost efficient, simpler, & cooperative

Risks: Favoring, limited expertise, only one set of eyes on transaction

Professional Conduct

Conflict of interest is the biggest concern in Business Planning ethics.

Write very careful engagement, Tell clients to get counsel, Remind not representing them, getting confirmation that waived,

RPC 1.7 Conflict of Interest - General Rule

(a) Except as provided in paragraph (b), a lawyer shall not represent a client if the representation involves a concurrent conflict of interest. A concurrent conflict of interest exists if:

(1) the representation of one client will be directly adverse to another client; or

(2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer's responsibilities to another client, a former client, or a third person or by a personal interest of the lawyer.

(b) Notwithstanding the existence of a concurrent conflict of interest under paragraph (a), a lawyer may represent a client if:

(1) each affected client gives informed consent, confirmed in writing, after full disclosure and consultation, provided, however, that a public entity cannot consent to any such representation. When the lawyer represents multiple clients in a single matter, the consultation shall include an explanation of the common representation and the advantages and risks involved;

(2) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client;

(3) the representation is not prohibited by law; and

(4) the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal.

RPC 1.8 Conflict of Interest: Current Clients - Specific Rules

(a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client unless:

(1) the transaction and terms in which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing to the client in a manner that can be understood by the client;

(2) the client is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent legal counsel of the client's choice concerning the transaction; and

(3) the client gives informed consent, in a writing signed by the client, to the essential terms of the transaction and the lawyer's role in the transaction, including whether the lawyer is representing the client in the transaction.

(b) Except as permitted or required by these rules, a lawyer shall not use information relating to representation of a client to the disadvantage of the client unless the client after full disclosure and consultation, gives informed consent.

(c) A lawyer shall not solicit any substantial gift from a client, including a testamentary gift, or prepare on behalf of a client an instrument giving the lawyer or a person related to the lawyer any substantial gift unless the lawyer or other recipient of the gift is related to the client. For purposes of this paragraph, related persons include a spouse, child, grandchild, parent, grandparent, or other relative or individual with whom the lawyer or the client maintains a close, familial relationship.

(d) Prior to the conclusion of representation of a client, a lawyer shall not make or negotiate an agreement giving the lawyer literary or media rights to a portrayal or account based in substantial part on information relating to the representation.

(e) A lawyer shall not provide financial assistance to a client in connection with pending or contemplated litigation, except that:

(1) a lawyer may advance court costs and expenses of litigation, the repayment of which may be contingent on the outcome of the matter; and

(2) a lawyer representing an indigent client may pay court costs and expenses of litigation on behalf of the client; and

(3) A non-profit organization authorized under R. 1:21-1(e) may provide financial assistance to indigent clients whom it is representing without fee.

(f) A lawyer shall not accept compensation for representing a client from one other than the client unless:

(1) the client gives informed consent;

(2) there is no interference with the lawyer's independence of professional judgment or with the lawyer-client relationship; and

(3) information relating to representation of a client is protected as required by RPC 1.6 .

(g) A lawyer who represents two or more clients shall not participate in making an aggregate settlement of the claims of or against the clients, or in a criminal case an aggregated agreement as to guilty or no contest pleas, unless each client gives informed consent after a consultation that shall include disclosure of the existence and nature of all the claims or pleas involved and of the participation of each person in the settlement. (h) A lawyer shall not:

(1) make an agreement prospectively limiting the lawyer's liability to a client for malpractice unless the client fails to act in accordance with the lawyer's advice and the lawyer nevertheless continues to represent the client at the client's request. Notwithstanding the existence of those two conditions, the lawyer shall not make such an agreement unless permitted by law and the client is independently represented in making the agreement; or

(2) settle a claim or potential claim for such liability with an unrepresented client or former client unless that person is advised in writing of the desirability of seeking and is given a reasonable opportunity to seek the advise of independent legal counsel in connection therewith.

(i) A lawyer shall not acquire a proprietary interest in the cause of action or subject matter of litigation the lawyer is conducting for a client, except that the lawyer may: (1) acquire a lien granted by law to secure the lawyer's fee or expenses, (2) contract with a client for a reasonable contingent fee in a civil case.

(j) While lawyers are associated in a firm, a prohibition in the foregoing paragraphs (a) through (i) that applies to any one of them shall apply to all of them.

(k) A lawyer employed by a public entity, either as a lawyer or in some other role, shall not undertake the representation of another client if the representation presents a substantial risk that the lawyer's responsibilities to the public entity would limit the lawyer's ability to provide independent advice or diligent and competent representation to either the public entity or the client.

(l) A public entity cannot consent to a representation otherwise prohibited by this Rule.

Basics

Explain to clients that you are representing the enterprise, not the individuals.

Retainer Letter Requirement

You are contracting with the entity to create the entity...wait what?

Clients may collaboratively sign a document describing themselves as representing an enterprise "in formation"

Traditionally, it's a bad idea to take stock in lieu of fees, because it skews the judgment of the attorneys.

Know your customer

Problem is very very few attorneys give a rat's ass

Business Enterprises

Chart

	Partnership	Limited Partnership	Limited Liability Company (LLC)	Corporation
Governing Law?	RUPA	RULPA	State LLC Law	State Corp Law (NJBCA, DGCL, NYBCL)
Formation?	- by actions - by express agreement	- by filing Limited Partnership	- by filing Cert of Formation (brief)	- by filing Articles or Cert of Inspection
Constituent Documents	- none required usually p'ship act	- Cert. of LP - LP Agrmt.	- Cert. of Form. Operating Agrmt	- Cert of Inc. - Bylaws - SH Agrmt
Ownership Interests	- General Partners	- GP Interests - LP Units	- Membership Interests	- Capital Stock - Common or Preferred
Initial & annual franchise or license tax	No	No	Yes	Yes but diff for "C" than "S"
Individual liability for business debts	Partners	Only General Partners	None	None
Judicial proceedings in the name of:	Partners	Only General Partners	LLCompany	Corporation
Transfer of ownership	Requires consent of the partners	May be done freely and informally	Shares may or may not be freely negotiable	Public: freely negotiable Close: some restrictions
Life of entity terminates at	Withdrawal of a Partner	Withdrawal of a General Partner	Depends?	Formal Withdrawal
Authority and ownership	Impaired at death	Impaired at death of a general partner	May be impaired at death or otherwise limited	Unaffected by death
Distributed profits taxed	As member income	As member income	As member income	As corporate income & again as member income
Undistributed profits taxed	Yes	Yes	Yes	Only as corporate income
Losses offset against individual taxable incomes	Yes	Yes	Yes	No
Centralized Management	May or may not	May or may not	May or may not	Must

Liability of Limited Partners

Investments
Committed Capital
Certain Prior Distributions

Taxes

Tax basis: Raised by capital contributions, Lowered by capital withdrawals & depreciation

Eg. Borrow 100% of Capital from Bank, use to purchase widget machine, each year 1/5 of widget machine value is loss, reducing taxable capital gains.

Important: Now that we have LLCs, there's no point in starting an "S" Corp. However, if you already are a "C" Corp, you can elect to become an "S" Corp (subject to lots of regulations) without all the taxable income realized by trying to shift to LLC.

2 Types of TP: 1) Individual or 2) "C" Corporation

[A]     [B]
 \       /
 50%   50%
   \   /
  [ LLC ]

LLC issues K-1 reporting gains & losses of LLC and how those losses are allocated to its owners. If LLC had $100 in gains, K-1 allocates $50 of tax liability to A & B each.

Nomenclature:

K-1 "allocates" income & loss (tax responsibility) among the owners

This is not to be confused with "distributions" of cash

Consider this clause: TI/L will be allocated in accord with the percentage interest of partnership

Always be certain that members are assured distributions sufficient to cover their tax liability on allocable income

Eg. "We will only distribute enough money to you to satisfy your tax liability"

Major diff between pass-thru & "C" corps; by contrast, nothing a "C" corps does translates to individual tax liability

Fed tax rates (max)
	Ordinary income (OI)	Short-term (STCG)	Long-term (LTCG)
Individuals	35%	35%	15%
"C" Corps	35%	35%	35%

SO the whole game is moving "C" Corp LTCGs to Individual LTCGs.

[A]50s  [B]50s                                [A]50u  [B]50u
 \$50     /$50                                   \$50     /$50
 50%    50%                                      50%    50%  
   \    /                                          \    /
  [X Corp]                                        [X Corp] 
    $100 Interest Income                           $100 Interest Income ($50 each)
    -$35 C Corp Tax                                -$35 Individual income (35%) ($17.5 each)
  -------                                        -------
     $65 Dividends ($32.5 each)                     $65 Total Profits ($32.5 each)
    -$10 Individual LTCG Tax (10%) ($5 each)        
  -------
     $55 Total profits ($27.5/SH)

Can we get to that income without paying taxes?

What about distributing through salary bonuses? Taxed as OI, but IRS is on to this & limits to reasonable compensation

How can A & B get this $65 profit?

Declare $32.50 dividend to each shareholder (taxable payment at shareholder level)

Dividends are normally taxed as OI, however Bush amendment currently in effect taxes them as LTCGs

X CCorp of $100 value (two SHs investing 50 each) buys GreenAcre

10 years later GreenAcre's FMV = $500

In order to transfer X CCorp to X LLC, must liquidate

X CCorp sells GreenAcre & pays tax of 35% on FMV less basis ($400) equaling $140

X CCorp's value ($360) is distributed evenly to A & B (180 each) and pay 15% tax on LTCGs (value less basis of 50 = 130) equaling $20

Total taxes paid $160 (~1/3 of X CCorp's value); way too great a loss for LLC benefits

X LLC of $100 value (two members investing 50 each) buys GreenAcre

Assets	Liability
100(GA)	1000
1000ag
	OE 100
1100	1100

Why isn't every Enterprise an LLC? LLCs cannot:

BE PUBLICLY TRADED

80's Tax Shelters operating on the premise that real

   A    B        C     D
    \    \      /     /
   100  100   100   100
     \    \    /     /
      [ L  P ($400) ]
             |
Bank loan -> | $10,000,000 (interest free b/c Real Estate only goes up in value...but not really)
             |
   [Office Buiding]

Thus increasing ABC&D's basis dramatically which they used to offset their year-to-year losses

Congress saw tons of such empty office buildings going up throughout the US and said this is bad for economy

and declared active income cannot be offset by passive losses

Capitalization

General rule: Raising one's basis is good. Increases amount of allocable losses & untaxed distribution.

Some quick notes: If single member LLC, by default, disregarded entity for federal tax purposes and therefore sole proprietors should always form LLCs.

LLCs owned by C Corps sometimes elect to be taxed as C corps to take advantage of corporate consolidation. Always check for this election.

Capitalization
	CCorp	SCorp	LLC/LP/GP
Cash	Generally no tax consequences, but test disprob with deemed liqu ( = was there shift in value )
Appreciated Property	§351		each partner's tax liability remains with that partner
Encumbered Property	§357(c)		each partner's tax liability remains with that partner

X CCorp is worth 1,000,010 (A invests $1,000,000 for 50 shares, B bought $10 for 50 shares)

Liquidates the next day: $500,005 distributed evenly to A & B

Imagine A & B are relatives → treated as gift, A must pay gift tax on that illusory transaction

Imagine A & B are employer-employee → treated as compensation, A must pay ordinary income tax, but B may get deduction

Imagine A & B are just mutual stockholders → treated as capital gain

X CCorp is capitalized by A's $100 cash & B's GreenAcre (Bas$50/FMV$100)

A receives 100Ss (Bas$100) & B receives 100Ss (Bas$50)

B's contribution has built-in tax consequences and if he sold it & contributed cash he would only have $92.50 (15% of FMV less basis)

If instead X CCorp has to sell GAcre, it's only worth $82.50 (35% of FMV less basis) and upon liquidation that loss is distributed evenly among the SHs.

Wait! But why didn't B have to recognize gain when he swapped land for Ss? Code§351 No recognized gain on property traded for stock in (S or C) Corp so long as immediately after contribution all contributors "control" the Corp (hold 80%+ Corp stock). Since A & B (the initial co-capitalizers) own 100% of Corp S, they meet the standard.

However! If C later on contributes BlackAcre (Bas$50/FMV$100), a separate capitalization event, he only holds 33% of X CCorp and the exchange is fully taxable, unless enough other contributions are being made simultaneously to earn 80%+ Corp stock in aggregate.

Criminal Workaround to Defer! A & B simultaneously with C's contribution put in nominal capital and claim to collectively hold 100% of Corp stock. But the IRS knows this trick, so don't even try.

Non-Criminal Workaround to Defer! C & X CCorp create N CCorp, capitalized by C's BlackAcre & X CCorp's cash. Unfortunately C only gets N CCorp stock not X CCorp stock.

Alternative! Distribute to cash contributor Preferred stock and a single share of common stock to each.

A contributes $1M in xchange for 999,999S of Liq Preferred stock & 1S of Common stock and B contributes $1 in xchange for 1S of Common stock. At Liq, $999,999 to A, and then 50/50 split of remainder.

Another Alternative! Corporate reorganizations, but that comes later.

So why would any cash contributor tolerate a land contribution? Because cash barely appreciates at 1%, while land can easily appreciate at 10% and be used, improved, et al.

Code§721 extends the 351 privilege to Partnerships & LLCs, but without control requirement.

Code§704(c) - when you contribute appreciated property with built-in gain, the tax consequences of the built-in gain are specially allocated to the contributor, though additional gain is distributed evenly. Cannot be contracted around (superceded by tax code)!

§357(c) - not a taxable event unless the amount of liability exceeds adjusted tax basis of the contributor in the element

A & B invest in X Corp; A invests $50 cash & B invests GA (with $50 basis, $150 FMV, $100 Liab)

How does B have 50 basis & yet 100 liab? Well he could've reduced his basis by depreciation or cashed out by taking out debt on that property.

Are the liabilities in excess of basis? Yes, thus B has inadvertently triggered $50 of taxable gain, due in the year of investment.

When a partnership borrows money, indebtedness is equally distributed among partners (boosting each partner's basis by their fraction). If Bank loan came with joint & several liability, and one partner is out of the country, bank can go after whoever is available (domestic), leaving that individual to chase down his partner and fight it out in foreign courts. However, if A rights B a note promising to make B whole, A gets entirety of indebtedness basis. Why want more basis? Can draw out more cash from the entity without tax liability. Basis also defines amount of loss earned (to offset other passive income).

When a Partnership (made up of A & B) takes out a $1000 loan, A & B increase their basis by $500.

See Chart Handout → Capital Accounts & Tax Basis in Partnerships

Common law right of contribution, one partner cannot guarantee the loan (& claim the full basis) without creating an agreement with his fellow partners to do so.

When capital contributions are disproportionate to desired distributions, preferred stock can be used to compensate. The difference in capital contributions between the shareholders can be compensated for with preferred stock and then the rest of the capital (equally distributed out to the SHs) can be compensated with equal distributions of common stock.

Profit Allocaiton

In corps it is strictly in accordance of capital structure (distributions of categories of stock held).

In partnerships & LLC, determined by allocation scheme in agreement, so long as in accordance with IRS reqs (handout)

1) Maintain Cap Accts throughout

2) Liquidate Positive Cap Accts

3) Must restore negative Cap Accts balances to zero

Number of Equity Holders?

In corp or LLC? No

In S corp? 100

Type of investor?

In corps & partnerships, anyone real or artificial

In S corp, LOTS of restrictions, excluding corps, foreigners, many trusts, et al.

Type of activity?

In corp, NR

In S Corp? Can't engage in passive activities (investment companies)

Classes of equity? In S corp no pref stock. Only voting or non-voting

To the extent entity level debt increases, partners basis increases

Not true for S-Corp

Corporate Control

Voting (Shareholders/Members)
Directing (Board of Directors/Managers)
Management (Officers/Managers)

Sites for allocating control

Certificate of Incorporation (Corps only)

Advantages - Organic document, superceding all other corp agreements, binds SH w/o notice, bankruptcy-proof.

Disadvantages - Public document

Subsites

Different Classes of Stock

Non-voting vs. voting common stock

Supervoting common stock (eg. 10 votes per share)

Non-voting preferred stock with contingent voting rights (on sales, liquidation, dividends)

Super majority voting rights (eg. 66%, 75%, 80%) (must match with votes necessary to Amend)

Sale or liquidation

Borrowing Money

Choosing Management (CEO, CFO, et al)

[Licensing Technology]

Cumulative voting

Not necessary, have to have been provided for in Cert of Inc

Bylaws (Corps only)

Advantages - 2nd most organic document, but non-public)

Disadvantages - Does not bind without notice

Procedural safeguards: Majority of Directors w/at least...

Quorum - minimum number of present SHs or Directors

Notice - reasonable notification of upcoming vote

SH Agmt / Operating Agmt / Part Agmt

Advantages - Very flexible, non public document

Disadvantages - Does not bind without notice & may be superceded by Cert of Inc or Bylaws

Subsites:

Restrictions on Transfer

No Transfer w/o consent of BoD (51%)

Right of First Refusal (RoFR) - Fair, Potent, but disfavored by prof'l investors

Groups RoFR → 50% Management/founders - 50% by investors

Right of First Offer → sets floor price - Fair, Weak, and favored by prof'l investors

Formula Price Provisions

Calc respective to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)

eg. EBITDA * 10 = Value of Company

Shareholder rights to 1) Force Sale or 2) Participate in Sale

"Drag Along" Rights → Majority/SuperMajority forces a (merger) sale by all equity holders

"Tag Along" Rights → SH oppty to sell at time of a fellow SH's sale

Death or Disability → Mandatory

Formula

Arbitration / Valuation by 3rd Party

Specialized Insurance bought by company on each SH

Another Chart

Based upon 3 hypoth investors, what are their interests and what form would best suit?

Susie Starbucks	$50k	Business Expertise	Guaranty of Bank Loan	Guaranty of Lease Payments
Amalgamated	$100k	Antique Coffee Decoratives	Coffee Supplies	Management & Operational Assistance
Jeff	Goodwill	Day-to-Day Management

	Income	Distribution	Liquidation	Redemption	Conversion	Voting/Management	Risk	Interests
Susie Starbucks	1	2	5	2	5	1 (only major decisions)	2	Long-term investment cash out at liquidation
Amalgamated	3	3	1	5		3 (assurance of supply contracts)	4	Risky venture
Jeff	5	4	3	N/A		1 (minor day-to-day)	3

Susie Starbucks	(For her 50k) PrefEquity Interest → Liquid Pref → 10% Accruing Dividend → Convertible into ComEquity	(For her Guarantys) Warrant → To Purchase ComEquity at initial FMV	(For her Expertise) Nothing → Already in her interest
Amalgamated	(For their $100k) Bond/Note → 10% Int Distributed Currently → Maturity date in 5yrs → Subordinated to Bank Loan	(For their Antiques) Lease → Monthly Rental	(For their Supplies) Sale → Regular Price → Exclusive Supplier Agmt
Jeff

Transfer Tax

Only 16% of family businesses are passed on to beneficiaries, due to insufficient estate planning requiring the liquidation of the business to pay off estate taxes.

A buys GA for $1m

The next day, A gives GA to B, triggering $1m of Gift tax based upon GA's basis.

The next day, A dies, leaving GA to B, triggering $1m of Estate tax based upon GA's FMV.

What's gonna happen in 2010?

Bush administration currently has it set up that the estate tax will disappear for the year of 2010.

Only one year b/c the tax system has a condition that taxes can be cut only so long as the budget remains balanced.

After 2010, the 55% rate will automatically be reinstated.

In all likelihood, Congress will act to implement a 2010 estate tax raising exemption over $3m.

Savings from Transfer Taxes

Lifetime credit
Gift tax $1m aggregate

Estate tax $1m aggregate
Annual exclusion
$12k per donee per year gift tax exclusion
Marital Exclusion
Pre- & Post-death
Basis Step-up on death
Installment Option on CloseCorps
Only if closely held business equals 35%+ of gross estate

Non-formation Concerns

Entity Law
Tax Law
Securities Law
Accounting

Equity Issuance: an opportunity to give value/incentive at no actual expense

Equity Dilution: as more equity is issued, previously issued equity lowers in its proportional value.

Stock Option Plan:
Award
1. Exercise Price → FMV or higher on date of grant
2. Number of Shares
3. Vesting provisions → 4 or 5 years
  Time-vesting → 20% per year
  
  Performance-vesting → 20% per achievement
4. Expiration provisions → Termination and Death/disability → must exercise or forfeit
5. No cash until exercise → "Cashless exercise"
  100 shares (worth $1/share) at $0.25/share
Restricted Equity Plan
Actual Equityholder
1. Usually granted → no purchase price
2. Number of shares
3. Vesting/Forfeiture → time-vested or performance vested
Phantom Equity Plan
Cash bonus plan

Unit = value of 1 share of stock
100 units → $1 units / 100 units → $10 units

Tax & Equity

What are stock options? They are rights to purchase stock at a predetermined value without an obligation to purchase. Though this right might never be exercised, prior to its expiration it still holds some value. When should the receipt of that value be taxed as income?

Incentive (aka Statutory/Qualified) Stock Options (ISO)

Must be approved unanimously be SHs ±12 months of adopting plan
Options must be granted (distributed) within 10 years of later of adoption or SH approval
Options must be exercised by holders within 10 years of grant
May only be granted to employees
Strike / Option at FMV at Date of Grants
Non-transferable except by will
Must be exercised within 3 months of termination
Can't be issued to a 10%+ SH (prior to receipt)
Value of stock of any given year can't exceed $100,000 (thus over 10 years, no greater than $1M)
Holding Reqs: Cannot dispose of stock received through ISO
- Earlier than two years following grant or one year following exercise

Taxed When?	Stock (Equity) Options		Restricted Equity	Phantom Equity
Taxed When?	ISO	Other stock options	Restricted Equity	Phantom Equity
Grant of Option? (eg. $10/Sh)	NO	NO**	N/A	N/A
Exercise of Option? (eg. $20/Sh)	NO	LIKELY, as Ordinary Income***	DITTO	YES, when cash received, as Ordinary Income
Deferred after Exercise? (eg. $30/Sh)	YES, as LTCG (15%)*, at disposition of Option Property,	IF SO, as OrdInc, at the earlier of the stock becoming transferable or the risk of forfeiture lapsing****
*No deduction for employer. **Well...virtually never, only if option has ascertainable FMV, based upon a theoretical market for them. ***Except if stock is non-transferable or subject to substantial risk of forfeiture (termination, performance threshholds, other employment reqs, not withstanding 83(b) election. ****Employer gets deduction relative to employees taxable income from this transaction.

83(b) Election: Within 30 days of exercise, can irrevocably elect to pay tax at ordinary income rate on stock value at time of election. If stock forfeited subsequent to taking the election, screwed.

Amalg (33%)   Starbucks (33%)   Maxwell (33%)
      \              |                 /
       \             |                /
              [ X - C O R P ]


Reasonable compensation payable only as ordinary & necessary 
1) Reasonable in light of services provided
2) Intended to pay for services

Where lacking, appears more like a dividend than compensation, for example:
- If history of no dividend distribution, but annual bonus.
- If disproportionate to employee's pay scale without alternative convincing explanation.
- If disproportionate to comparable employees' bonuses.
- If given without corporate formalities.

NEVER BACKDATE DOCUMENTS FOR ANOTHER TAX YEAR! SOMEONE WILL APPROACH REQUESTING! ABJECTLY REFUSE!

Golden Parachutes

Age of the Leveraged Buyout
- People with no money, borrowing against the target's balance sheet, offering twice the stock price forcing offer acceptance.
To fund off, executives created GParacs: If I lose my job ±12 months after change in control, then I receive 50xAnnualSalary
- Like a poison pill
IRS responds by making any departure severance in excess of 3xAvgAnnualCompensation, non-deductable + subject to 35% Ordinary Income + 20% Excise Tax
- Exception if approved by 75% of ShareHolders (only ever happens in small closely held corps)

§162(m) CEO comp in excess over $1M is non-deduct

Treasury Reg §1.162-7 - Salary deducted must be reasonable and for services rendered (no > $1M salaries for CEOs, though performance-based pay is)

Growth financing

→ Seed Capital / Friends & Family
→ Early stage / 1st Round
→ Growth stage / 2nd Round

                 Pension Funds
       Wealthy   Universities      Public
       Families  ( TIAA-CREF )  Corporations 
               \       |       /
                \      |      /
                 ( LP or LLC )  ———  GP or MM "Promoters" (only about 1% investors)
                /
               /
      Sovereign
    Wealth  Funds

           1st 5yrs → $100M
           2nd 5yrs → "Harvesting"

When company sold, investors are paid back first

then profits are distributed - 80% investors, 20% promoters (gravy at LTCG tax rate)

- Time frame for investment = about 5 yrs / Redemption at 5 yrs
- Exit strategy / Liquidity
- Portfolio - 10 investments of approx $10M/each

- 3 to 4 will go bankrupt → $0-40M loss

- 3 to 4 will probably be "living dead" → Break even

- 2 companies will be home runs → $20M becomes $200M

- Total return: $100M Investment became $240M ( 28% annualized return )

How to draw in growth investors

Prepare a business plan

Executive Summary
Simplified description of product/service differentiating it from competitors
Management, in particular sales experience
Market analysis (preferably growing w/no need to displace a competing standard (disruptive tech? or evolutionary?)
Execution strategy (plan of action once funds received)
Financial matters (historical practices / 5 yrs of projections → 1st yr CRITICAL)
Success factors/milestones - ie. FDA approval, 1st commercial sale, timeline
Description of Industry - trends & how you are fitting in
Exit strategy

Business Value Calculation

Public Comparables

EBITDA * [x multiplier x] = Market Capitalization
Multiplier fits in a range of 5-20 relatively consistently with other public comparables in its field
Truck axle manufacturer has 5-7 multiplier, highest multipliers for fads (today alt-energy, past biotech)
- eg. EBITDA = $1M; Multiplier = 10; Thus, market value = $10M; investment of $5M (gains 1/3 equity interest);

	Investment	Equity held	Sale for $8M	Sale for $100M
Common + $0.50/sh		1M	$500K + (1/3 of $500K)	Convert all sh to common: $33M
Series A	$2M	1M sh @ $2/sh	$2M + (1/3 of 500K)	Convert all sh to common: $33M
Series B	$5M	1M sh @ $5/sh	$5M + (1/3 of 500K)	Convert all sh to common: $33M

Exit Strategies

IPO → Rare (takes an uncommon collection of traits for a company to make an attractive IPO)
Recapitalization / Redemption 5-yrs
- Borrowing to buyout investors at a profit.
- Hard to borrow money today
  Imagine two identical companies each asking for a $10M loan. A wants to use it to buyout investors. B wants to use it to invest in new equipment. Obviously the bank would rather loan to B, because it has the opportunity for high yield returns.
Sale of Company → 90%
- Two kinds of Buyers
  1. Strategic → similar industry players (manufacturers of like products)
    - Interested in the raw materials: Products, Services, IP, et al. to incorporate into their business
    - Most important factor is the product or service and its potential for incorporation
    - Less concerned about current management, sales/EBITDA, financial performance
    - Financed by cash, acquirer's stock, and sell stock elsewhere for more cash
  2. Financial → Private Equity/LBO Funds/Hedge Funds (made up of financial industry businessman)
    - Interested in keeping company as is, leaving a stand-alone company
    - Equal importance are quality of product or service, current management, sales/EBITDA, financial performance
    - Vital to persuade management to stay with company, incentivized with equity ownership (15-20% in aggregate)
    - Financed by equity investment & borrowing

Company A capitalized with $100 cash. Company B capitalized with $10 cash + $90 loan. If both companies gain 10x value, A gives 10x return, but B gives 90x return (after paying back loan)

(60% of financing) Senior Debt (Bank or Financial institution) → 6% rate
- First security interest (mortgage) on all assets
(30% of financing) Mezzanine Debt → In between EI & SD (12-14%), High risk, high potential return
- Second security interest (mortgage) on all assets
  (After first security holder is paid back, second security holder seizes whatever's left)
- PLUS equity kicker (usually warrant/option worth approx 10% of all equity)
(10% of financing) Equity Investors → Preferred equity <3

Final equity ownership tally

10% Mezzanine Debt
20% Management
70% left for LBO Investors

New Example - The Sale of Target-Corp to a Financial Buyer

T-Corp (FMV = $100M) → T-Family owns 90shares & Management owns 10shares (may be restricted/outstanding options)
Deal Points →
1. $100M FMV → $90M to T-Family
2. Management-retention → Increase ownership from 10% to 25%

Player	Investment	Return	% of Equity	# of Shares
LBO Fund, LP	$10M	Conv. Preferred Stock	65%	26s
Mezzanine Lender	$20M	Note at 14% interest w/2nd Security in all assets plus warrant for common stock	10%	4s
Senior Bank, NA	$60M	Note at 6% interest w/1st Security in all assets	n/a	n/a
Management	n/a	n/a	25%	10s (fixed)

Leveraged buyout results

LBO Fund, LP purchased a 65% interest in T-Corp for $10M
T-Family redeemed $90M (of LTCG) for their shares
Management received +15% increase in their interest

Balance Sheet Comparison
Pre-Buyout		Post-Buyout		After Market Dip		After Market Boom
Assets	Liabilities	Assets	Liabilities	Assets	Liabilities	Assets	Liabilities
$120M	$20M to Constits	$120M	$20M to Constits $80M Debt	$80M FMV	$20M to Constits $80M Debt	$160M FMV	$20M to Constits $80M Debt
Net Worth = $100M		Net Worth = $20M		Net Worth = -$20M ML & LBO get nothing		Net Worth = $60M

Thus the leveraged buyout dramatically reduces the value of T-Corp at the peril of investors plus other constituencies (Suppliers, Employees, Landlords, & the Community). Since leveraged buyouts imperil creditors ability to collect, since Senior Bank has 1st Security making T-Corp indirectly judgment proof. Courts addressed this by creatively applying Fraudulent Transfer doctrine.

Fraudulent Transfer doctrine: A doctor can't transfer all money to his wife in anticipation of malpractice claims, thus making himself judgment-proof. Likewise, courts opine that companies can no longer promise 1st Security to Senior Bank (must get in line with other creditors).

Goodwill (Non-balance sheet assets) → only valued at acquisition/liquidation

Self-created IP (Patents, Copyrights, Trademarks)
Reputation
Brand Recognition
Workforce in place
Customer list/client base

Another Example → Goodwill-LLC v. Goodwill-Corp

G-LLC (FMV = $1000) → A owns 50% ($50 Basis) & B owns 50% ($50 Basis)
L-Corp buys G-LLC for $1000 ($100 basis)
G-LLC pays NO Corp Tax on $900 Gain

G-LLC distributes $900 Gain to A & B ($100 basis)
A & B pay 15% LTCG Tax on $900 Gain of $135

For $100 investment in G-LLC, return of $865 to A & B ($432.50/SH)
G-Corp (FMV = $1000) → A owns 50shares ($50 Basis) & B owns 50shares ($50 Basis)
L-Corp buys G-Corp for $1000 ($100 basis)
G-Corp pays 35% Corp Tax on $900 Gain of $315

G-Corp distributes remaining $685 to A & B ($100 basis)
A & B pay 15% LTCG Tax on $585 Gain of $87.75

For $100 investment in G-Corp, return of $597.25 to A & B ($298.63/SH)

But What If L-Corp bought out stock instead of assets?

G-Corp (FMV = $1000) → A owns 50shares ($50 Basis) & B owns 50shares ($50 Basis)
L-Corp buys shares from A & B for $1000 ($100 basis)
A & B pay 15% LTCG Tax on $900 Gain of $135

For $100 investment in G-Corp, return of $865 to A & B ($432.50/SH)

Why wouldn't L-Corp do this?

Depreciation: Buyers always want to buy assets, Sellers always want to sell equity
- Widget Machine depreciates over time from $1000 basis to $100 adjusted tax basis. Purchased for $1000 by L-Corp, WM begins depreciating again.
Also buying equity opens them up to inheriting liability

Tax Disposition Decision Tree

Reorganization (Merger)
- It is possible to dispose of assets & stock, but consideration received must be equity in buyer
  - Similar to contributing assets to a Corp or LLC (GM or M$) for an equity interest
Otherwise Equity and Assets will be taxable
- Equity → Entity irrelevant, Adjusted Basis in Equity, LTCG 15% (>20% next year) if in holding period
- Assets → (AcctRec & Invnty) = OI and (RealProp, Machinery, IP, Goodwill) = CG
  - Section 1060: Buyer and seller must allocate assets
    - Buyer wants to allocate purchase price to AcctRec & Invnty, such that there is no OI gain
  - If selling an asset (eg. IP), remember 704c, contributor's appreciation tags back to him.
  - If C-corp swaps to S-corp, for next 10 years, sale of assets still subject to C-corp tax

If trouble with assets, think of a balance sheet (Liabilities + assets = value of equity). *Sale of a company is collective sale of each of these assets

Under 1060, IRS makes you allocate collective sale price to various parts.
Seller is going to recognize ordinary income for sale of Inventory & Accts Recvs, but capital gains for sale of Machinery/Equipment, IP, Goodwill, etc. So seller wants to allocate lowest price to Inventory & Accts Recvs as possible.
However, Buyer wants to allocate highest price towards most quickly depreciable (so money goes back in their pocket. (Real estate takes 39 years, IP may only take 3 years)

Frequently, what happens is buyer wants to buy assets, seller wants to sell stock. Are you willing to pay more for the opportunity to collect off depreciable assets, if I structure as asset sale?

Random Review

LLCs are liquidated in accordance with positive capital account balances.

If A owns GA w/ $1000FMV. A has full unfettered value control to take out loans on GA, build on GA, rent out GA.

If A is a 1/3 member (having contributed $1k) with two other equal members of an LLC in which a majority vote is needed to sell. So if there are $3k in assets, A's 1/3 interest is actually only worth around $600, b/c of lack of market freedom. At death, less interest is transferred reducing estate tax liability.

There are worse way to practice law than being a business planner.

NJ Jumpstart