Capital Structure For Start-Ups: Part 2

By: Robert Hawn

As a business lawyer in the Silicon Valley area of California, I find that one of the most important issues founders of a high tech start-up company have to consider is its ownership, or capital structure. As you grow your company, it is important to understand your percentage ownership of the company. The different types of equity incentives and funding instruments will have varying impacts to your ownership, and you need to keep this in mind as you grant options to your employees and accept funding from your investors.

In the last blog in this series , I discussed some of the basic concepts of determining the number of shares of outstanding stock, and the number of shares of fully diluted stock, to help explain how investors look at ownership in a company. To summarize, the number of shares of outstanding stock equals the number that are issued and held by a shareholder. The number of fully diluted shares, however, are the number of outstanding shares, PLUS the number of shares that can be issued on exercise of contracts that enable the holder to purchase shares, such as stock options and warrants.

When you are dealing with the typical family business, or owner operated business, outstanding shares and options are about as deep as you need to get. When you are dealing with a typical high tech start-up which has gone through a couple of rounds of financing, the situation can get a bit more complicated.

Let’s first look at how a commonly used angel funding vehicle can affect the process of determining the number of fully diluted shares. In very early stage companies, where there is not even a product, much less revenues or profits, it is almost impossible to determine the value of the company. As a result, angel investors often provide funds through a “convertible note”. In a convertible note, a company borrows money from an investor and provides a note, essentially a promise to repay. The note, however, can convert into shares that are issued in the next round of funding. The rate at which the note converts is based on the value of the shares in the next round. Essentially, the investors forgive their debt under the note in exchange for shares. The idea here is that once the company has some history, it will attract venture investors who know how to value early stage companies. By converting into shares issued in a round led by venture capitalists, the angel investors will piggyback on the valuation determined by the venture investors. To compensate the angels for investing early on, they often receive a discount on the purchase price set in the venture round (although the venture investors may try to limit this).

Using convertible notes creates some difficult issues in calculating the number of fully diluted shares. First, you don’t know how many shares will be issued on the conversion of the notes. This is because the rate at which the notes will be converted into stock is based on the per share price in the next round of financing. The share price, in turn, is based on the value of the Company. Because the venture investors have yet to determine valuation, you don’t know what the purchase price of the next round is. As a result, you don’t know the conversion rate of the note or, correspondingly, the number of shares that will be issued once the note converts.

Second, founders often cannot be convinced that the interest payments under the note should not convert. If interest converts, the number of shares issuable under the note changes daily as interest accrues. This results in the number of shares allocated to the notes to increase slightly each day, and the percentage of shares held by other stockholders, such as the founders, to decrease each day.

Let’s fast forward. You’ve now grown your company and created enough value and buzz to close a serious investment round, and all of your convertible notes have gone away. You now have investors who have purchased stock from your company. The stock they have purchased, known as convertible preferred stock , however, is a little different from the common stock you likely hold. One major difference is that convertible preferred stock can convert into the same kind of common stock you hold. This is convenient, because it allows you to determine the number of fully diluted shares by applying the conversion rate of the preferred stock against the number of outstanding shares of preferred stock, and generate the number of common stock equivalent shares. If you have an option plan, you can assume all of the options are converted into common stock. Once everything is reduced to common stock, you can count up the number of shares and that is your number of fully diluted shares. Pretty easy, huh?

At this stage, yes, but let’s fast forward even more. Because of some misfortunes, you had to take in investment funds as part of a “down round” (so named because the price of the preferred stock was down from the previous round). One common feature of convertible preferred stock in a start-up context is a device that protects the investor if there is a later down round. The device, often referred to as price-based antidilution, will change the conversion rate of the preferred stock issued in the earlier round. The change will, as you might guess, result in relatively more common stock being issued for each share of preferred. So, if there has been a down round, you need to account for the impact of this antidilution feature in determining the number of fully diluted shares. You can imagine this can get pretty complicated if your company has already done a number of investment rounds, each with different purchase prices, some of which may have an antidilution provision triggered in connection with a particular subsequent round, and some of which may not.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

General Partnership – What Is it And Am I In One?

By: Serge Filatov

Working as a business attorney in Silicon Valley, which some consider the start-up capital of the world, I have seen my fair share of different business structures . One structure that people form (most without even realizing it) is a general partnership.

A general partnership is formed when two or more people carry on a business for profit. Interestingly, people do not need to intend to form a general partnership. Simply carrying on a business together is enough to create it. And when that happens, all of a sudden an entire body of law applies to the relationship of the owners of the business – some of whom probably don’t even realize what has happened.

Because two or more people can unknowingly create a general partnership, let’s get into some specifics about what it means to have such a business structure.

One of the big problems of having a general partnership, and a reason I counsel most people away from having this type of entity, is that you are personally responsible for the liabilities of the partnership. This personal responsibility occurs even if your partner, but not you, creates the liability. If your business partner purchases $100,000 in product for the partnership but the partnership cannot afford it, you, personally, will be liable for any amount that is owed. You will be liable even if your partner did not tell you about the purchase of the product. The bottom line is that this entity structure will not protect your personal finances so you are completely exposed as an owner.

Although the lack of liability protection is a major concern, the general partnership structure does have some benefits. It is easy to form and easy to manage. In California, a general partnership can file a “Statement of Partnership Authority”, but this is optional. In fact, no state filing is required in order to have a lawful entity. Moreover, unless there is a partnership agreement between the partners which has language to the contrary, the partners will each have full managerial powers over the business. The ease of formation, control, and lack of corporate formalities may make the general partnership seem like a tempting business structure. However, the lack of protection from personal liability for the debts of the business will often lead a business to choose another form of entity.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

New Partnership Tax Return Filing Deadlines

By: Tamara Pow

Since I started my career as a tax attorney at Price Waterhouse, and have been managing partner at two San Jose law firm limited liability partnerships (LLPs) since then, I am used to being in control of the tax reporting for my business. This is also one of the tasks that falls to me at home thanks to a natural division of labor with my scientist husband who would rather clean the garage than spend a day doing tax forms. I like to have my taxes filed by the original due dates. I find that extending the returns just creates more accounting fees, and more issues during the year when I need to provide returns for various reasons. However, oftentimes when you are a partner in a partnership that you don’t control, you will not get partnership form K-1s for that partnership until just days or hours before the April 15 th deadline. As a result, it may be too late to get into the queue for your accounting firm to get your personal returns done before the deadline and you will have to extend your personal taxes.

Beginning after 2015, the IRS has changed business tax return filing deadlines to supposedly alleviate this problem. Partnership returns will now be due 2 ½ months after year end (March 15 for calendar year partnerships). This is the same as the S corporation deadline. This gives partners time to get their Form K-1s and give them to their personal accountants to transfer the information to their Form 1040s in time for April 15 th . C corporations, which are not flow through tax entities like S corporations and partnerships, will be due 3 ½ months after year end (April 15 for calendar year corporations). Partnerships will be able to extend for six months, still making the partnership returns due a month before the extended due date for personal tax returns. (Source: The Kiplinger Tax Letter , Vol. 90, No. 17, August 14, 2015.)

Keep in mind that many LLC operating agreements and LP and LLP partnership agreements may need to be updated to take these new deadlines into account and to put managers, managing members and general partners on notice that they have earlier tax deadlines to meet, and should therefore provide tax information to the partners earlier. If that does not happen, we may see the opposite effect – a lot more partnership tax return extensions, resulting in more personal tax return extensions.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

For more partnership tax information, see: https://www.irs.gov/businesses/small-businesses-&-self-employed/partnerships

Partnership Alert!

By: Tamara Pow

On November 2, 2015 the Bipartisan Budget Act of 2015 (the “Act”) was enacted, completely transforming partnership audit procedures going forward. The intent was to streamline audit procedures and increase partnership tax compliance. The effect is going to be a lot more scrutiny related to tax terms in partnership agreements , tax issues in partnership mergers and acquisitions, and analyses of tax liability related to individual purchases or transfers of partnership interests.

Although we have some time until these new rules apply to partnerships, the next two years are going to be busy as the Treasury Department provides additional guidance and procedures, and partnerships, partners, and prospective partners work to tailor their agreements to protect themselves from liabilities as a result of the new Act.

Effective Date:

The Act is applicable to taxable years beginning after December 31, 2017, unless a partnership elects to apply the rules earlier.

Who Pays the Partnership Tax Adjustment ?

Under existing audit rules, if a partnership is audited, those persons who were partners in the year being audited (the Reviewed Year) are responsible for any tax deficiency determined on audit. However, under the new Act the partnership itself will be required to pay any amount due. The tax will be calculated at the highest marginal tax rate and will not be offset by any partner level items. This means that partners in the Reviewed Year benefited from the now-disallowed deductions, and partners in the year of assessment (the Adjustment Year) take the hit as a partnership cost.

There will be two ways a partnership could get out of this partner level treatment for past taxes. First, the Act directs the Treasury Department to promulgate rules and procedures for the partnership to have the partners from the Reviewed Years pay for the adjustment, known as a Partner Assessment Election . The partnership can make the Partner Assessment Election within 45 days after the date of the partnership’s receipt of notice of a final partnership adjustment. Second, small partnerships with less than 100 partners, and no partnerships (or LLCs taxed as partnerships) as partners, may opt out of the new audit rules; this is known as the Small Partnership Election . To qualify for the Small Partnership Election all of the partners must be individuals, C corporations, S corporations or an estate of a deceased partner, and the name of each partner and their taxpayer identification number must be disclosed to the IRS in order to make the election.

If a partnership makes a Partner Assessment Election, and shifts the burden of payment for an adjustment to the partners in the Reviewed Year, those partners will have to compute the impact of the adjustment on their tax liability for the Reviewed Year. However, instead of amending that tax return, they will have to pay the tax increase with their tax returns for the Adjustment Year, plus interest on the partnership-related tax at a rate 2% higher than the normal underpayment rate. If the partnership does not have a tax increase, but has a decrease, those partners don’t get to claim the benefit on their own returns. Instead, the benefit is treated as a partnership deduction for the Adjustment Year.

Prospective purchasers of partnership interest should consider:

  1. Carefully reviewing prior period tax returns for any potential liabilities.
  2. Requesting an indemnification from the seller for any losses suffered by them as a result of an audit related to a pre-purchase date taxable period, if a Small Partnership Election has not or cannot be made.
  3. Requesting the Small Partnership Election be made if the partnership is eligible, keeping in mind that electing out of the new Act means that all partnership issues will be examined and adjusted in multiple partner-level deficiency proceedings.
  4. Requesting a representation that no election has been made to apply the Act to taxable periods beginning before 2018.

Partners should consider amending their partnership agreements to:

  1. Require the partnership to maintain the necessary records,
  2. Require the partnership to make Partner Assessment Elections for all relevant periods, and
  3. Prohibit any partnership from becoming a partner.

Partnerships with partnerships as partners should consider eliminating those partnerships.

Statute of Limitations:

Under the new Act, the filing date of a partner’s tax return is no longer relevant to a partnership audit unless the Small Partnership Election is made, or the partnership is terminated. Instead, the statute of limitations will be three years from either the due date of the partnership tax return (without extensions) or the filing of the partnership’s tax return, whichever is later.

Tax Matters Partner :

Currently, each partnership ( or LLC taxed as a partnership ) must have one partner that is chosen to be the Tax Matters Partner to be the contact person for the IRS in the event of a partnership audit. However, the other partners still have statutory rights to notice of, or participation in, any audit of the partnership. Under the new Act, instead of a Tax Matters Partner, each partnership will have a Partnership Representative. The Partnership Representative does not have to be a partner of the partnership, but must have a substantial presence in the United States. This person would have authority to resolve a partnership audit, and that resolution would be binding on all partners. Other partners will have no statutory rights to participate in tax audits or litigation or to opt out of the partnership-level proceedings. If the partnership does not select a Partnership Representative, the IRS may appoint any person to represent the partnership.

As a result, existing partners and potential purchasers should consider rules for appointing or electing their Partnership Representative, and for obtaining additional notice and participation rights regarding the actions of the Partnership Representative. This could be done in the purchase agreement and in the partnership agreement.

Conclusion:

If you are a partner in a partnership, don’t wait. 2018 will be here before you know it, so now is the perfect time to take a closer look at your partnership agreement to determine whether you want to make changes in anticipation of the new Act. And, if you are considering becoming a partner in an existing partnership, your due diligence list just got longer. Make sure you have a qualified accountant assist you in the review of the partnerships past tax returns that are still subject to audit, and that your legal counsel is knowledgeable about the new Act and can protect you accordingly.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Sole Proprietorship – Is it right for me?

By: Serge Filatov

Many people here in San Jose and Silicon Valley have a dream of starting their own small business. Small business owners that are just starting out often come to me and ask if they can simply run their business as a sole proprietor to save on the cost of forming and maintaining an entity such as a corporation or limited liability company. Although there are some cases where it is fine to conduct business as a sole proprietor, the liability exposure to the business owner individually will likely require a business owner to look at creating a formal entity.

What is a sole proprietorship?

A sole proprietorship is a form of business in which the individual (or a married couple as community property) carries on a business as the exclusive owner and decision-maker.

Benefits of a Sole Proprietorship

There are several benefits to having a sole proprietorship.

First, sole proprietorships have low start-up costs. A sole proprietorship exists simply by an individual carrying on a for-profit business. There are no state registrations required for a sole proprietor simply because they are a sole proprietor (unlike corporations and LLCs). Of course, if a sole proprietor uses a business name other than his or her own name, he or she must register that assumed name (usually a DBA at the county level) although the sole proprietor should also consider whether that name is already in use by another business. Also, certain professions require licensing and the sole proprietor will still need to comply with all licensing requirements for him or her.

Second, sole proprietorships have no annual compliance requirements. Unlike LLCs and corporations which have numerous compliance requirements with the state, a sole proprietorship can simply conduct business without worrying about state compliance requirements.

Third, it is easy to keep track of accounting and prepare taxes for sole proprietorships. There are no accounting requirements for sole proprietorships so one must simply keep adequate records for tax purposes. Additionally, there is no need to prepare a tax return solely for the business because there is no separate entity.

Disadvantages of a Sole Proprietorship

There is one major drawback that comes with the simplicity and cost savings of a sole proprietorship. The drawback is personal liability. Unlike an owner of an LLC or a corporation, a sole proprietor is personally liable for all the debts and obligations of the business. This means that a creditor, to satisfy the debts of the sole proprietorship, can go after all of your assets, including your home. For this reason, and this reason alone, many individuals often choose to form a business entity. Without an entity, an individual leaves himself or herself vulnerable to unnecessary liability.

Another drawback for the sole proprietorship is that it is difficult for third parties to invest in the business. This is because there is no separate entity to invest in; the individual is the business. A further drawback is that since the owner and the business are basically one, it can be difficult to accurately establish financial results for the business separate from the individual owner.

Is a Sole Proprietorship Right for Me?

The answer to this question depends on your specific situation. Generally speaking, if you do not expect to grow the business or have investors, and are conducting a business that has minimal liability risk, you might consider a sole proprietorship. Even if there is some liability risk, obtaining insurance on your business could help minimize risk. However, obtaining insurance is not always easy, is not always affordable, and only provides protection up to the coverage limit and then only for items that the policy doesn’t exclude. Because the answer to this question depends so heavily on the exact circumstances of each person and his or her new business, you should contact a business attorney who can guide you through the decision-making process.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

New California Law Allows Finders To Help With Start-up Financing

By: Robert Hawn

In representing start-up companies in Silicon Valley I have found that one of the biggest challenges facing founders is raising early stage capital. Emerging growth companies often do not have the necessary relationships that can lead to investment funding. To find these relationships, the company may retain a finder. A finder is an individual who can introduce the company to funding sources, typically in exchange for a commission. Because these finders were not licensed as broker-dealers of securities (essentially, someone who helps to sell securities of a company to investors), they were frowned upon by the law. A few years ago, stricter laws were enacted that created strong disincentives to start-ups to pay commissions to finders.

On October 10, 2015, the Governor signed into law AB 667 , a bill sponsored by Assembly Member Wagner, which creates exemptions to the broker-dealer laws for finders and their client companies. The act, which added Section 25206.1 to the California Corporations Code, provides a balance between protecting investors while easing requirements for fund raising by small companies. Because the law was passed during regular session and not an urgency measure, it will likely become effective January 1, 2016.

So, What Does The Bill Do?

Before the new law, any finder who was not licensed by the State as a broker-dealer of securities could not introduce any company, start-up or otherwise, to potential investors. If an unlicensed broker-dealer provided an introduction, among other things, the investor could get their money back from the company and from the unlicensed broker-dealer, who would be personally liable for the investor’s money.

Under the new law, an unlicensed finder can make an introduction if certain requirements are met. Among them is the requirement that the finder can only introduce “accredited investors”. These are investors who satisfy income or wealth thresholds, have an executive position with the company, or are certain types of entities. Among other requirements, the finder can’t (i) provide an introduction where the aggregate sale price of the securities is more than fifteen million dollars, (ii) participate in negotiating any of the transaction’s terms, or (iii) provide any advice regarding the value of the securities purchased. The law sets forth the only information the finder can disclose regarding the company. The finder also is required to make a filing with the Department of Business Oversight and pay a $300 filing fee, which must be renewed each year and filed with an additional $275 filing fee. There are other requirements that have to be satisfied, including specific disclosures to be made to the potential investor.

Positive Aspects To The New Law

There are a number of positive aspects to this new law. First, start-up companies can now use finders, and finders can now get some value from the relationships they may have with high net worth individuals, or companies, which may want to invest in start-up companies. Second, lawyers like me who are asked about using finders now have a relatively clear direction of how start-up companies can use them.

As with anything in fundraising, this new law is just one part of a large and somewhat technical body of securities laws that need to be reviewed with your lawyer to make sure your company is in compliance. Failure to comply with these laws can expose anyone who runs one of these companies to personal liability for the amount of the investment. That’s why it’s really important that before you start any kind of fundraising activities, you should confer with a lawyer that works in the fundraising area.

As a former chair of the State Bar’s Business Law Section , I can’t help but note that this bill came about as the result of the hard work of many members of the Section’s Standing Committee on Corporations. They are to be congratulated on their hard work in bringing clarity and rationality to start-up fundraising activities.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

We Are Not Going There! The Limits of Waivers in Loan Guaranties

By: Jack Easterbrook

Question: if a person signs a loan guaranty and it contains a long waiver section in which the signer gives up defenses (and the guaranties all have these sections, right?), is the guaranty still enforceable if the lender breaches the loan agreement? That is, can the lender claim that the guarantor is obligated to pay under the guaranty even though the lender was a cause of the defaults in the loan? That was the question in the DelPonti* case and the court came down on the side of the guarantors. (The case citation and the pertinent facts of the case are discussed below.)

What are the takeaways?

The court in the DelPonti case described two things the lender apparently did, which affected its rights under the guaranties taken from the borrower’s principals:

First, the court said the lender failed to honor approved payment applications (requests for advances) from the borrower on a construction loan. This is a reminder that the lender needs to be very careful that its loan documents thoroughly describe the conditions borrowers must satisfy to obtain advances. Stopping an advance without proper cause under the loan documents may jeopardize the lender’s ability to enforce its guaranties.

Second, in a subsequent loan workout the lender told the guarantors they would be exonerated if they did certain things in connection with the construction project, but later changed its position and tried to enforce the guaranties. The lesson is obvious: the lender needs to be careful about its communications with the borrower and the guarantors but if there is an agreement, stick to it!

Finally, while the guarantor may waive all of its defenses under the terms of the guaranty, the DelPonti court says that the lender continues to have a duty of good faith and fair dealing under the loan documents. The lender, according to the court, cannot sidestep that duty and use the broad waiver language in the guaranty to ensure repayment of a loan. This outcome actually seems rather consistent with the long standing trend in the courts to strictly construe loan documents and demand lender good faith. The DelPonti case addresses an area that the California courts had not previously discussed but the holding likely is not a surprise to those following the issue and familiar with the history of lender liability litigation.

Details of the DelPonti Case:*

The lender in the DelPonti case (a predecessor bank taken over by California Bank & Trust) made a construction loan in the amount of $6 million to an LLC developing a townhome project and took the personal guaranties of the principals. As the first phase of the project was nearing completion, the lender failed to honor requests for advances from the borrower which resulted in the first phase not being completed and sold. This triggered loan defaults by the borrowing LLC. The DelPonti case does not elaborate on the specifics of this; it states, however, that the trial court, after reviewing the evidence, found that lender’s failure to honor the payment applications (for loan advances) was a breach of the loan agreement by the lender. Subsequently the parties entered into a workout agreement, which was spelled out in an email from the lender. The lender agreed to exonerate the guarantors if they performed certain tasks related to the construction project. The guarantors did these things but the lender nevertheless foreclosed on the real estate collateral and pursued the guarantors for the deficiency.

The lender did not dispute the factual findings of the trial court but argued on appeal that even if the guarantor had such defenses, they were waived in the guaranty. The court discussed at length California Civil Code Section 2856, which is broad in scope and provides that a guarantor may waive the rights and defenses that would otherwise be available to the guarantor, including defenses that may exist because the loan is secured by real estate collateral.

The court said that the question of whether the waivers in a guaranty can be enforced under such circumstances had not previously been addressed in California. The lender’s argument, however, did not sway the court, which held that a guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement. The court would not extend this to include “the predefault waiver of the Bank’s own misconduct.”

A Win for Long Guaranty Forms ?

When opining on the waiver’s effectiveness, the court emphasized that “a guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement…” This suggests one additional point of interest to those concerned about the length of commercial loan documents: those long waiver provisions in the guarantees actually serve a purpose if a dispute arises! If a defense otherwise available to a guarantor is not expressly set out in the waiver portion of the guaranty, the courts are likely to narrowly construe the matter and interpret it to the benefit of the guarantor.

*California Bank & Trust v. DelPonti , 232 Cal.App.4 th 162 (2014)

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Loans With High Rates of Interest – Be Careful About Usury

By: Serge Filatov

As a corporate attorney here in Silicon Vall

ey and San Jose, I have numerous clients who need help documenting loan transactions and promissory notes . These clients may be taking on debt or providing a loan to a third party. One area of law that clients are not always familiar with is usury law. The California constitution protects individual borrowers from usury, which in simple terms is the lending of money at very high rates of interest. With some notable exceptions, the general rule is that loans cannot have an interest rate that exceeds 10% per year.

How is it then that your credit card company can charge over 10% interest on your

personal card? The answer to that is that there are numerous exceptions

to the general usury rule. In fact, the general rule is riddled with exceptions that are spread out between sections of the California civil, commercial, corporate, and financial code. Often, an exception concerns a specific item that the legislature was concerned with at the time so the exceptions pop up in random places of the California code.

Examples of common exceptions to the rule include California Civil Code Section 1916.1 which states that usury does not apply to loans made or arranged by a licensed California real estate broker, which are secured by liens on real property. Licensed lending institutions such as banks and credit unions are also exempt from usury laws.

Additional common exceptions, at least for the clients that I work with, are (i) loans made to a business that has $2,000,000 or more in assets at the time of the loan or (ii) loans that are for $300,000 or more. In order to qualify for these exceptions, the borrower must meet the following criteria:

  • The borrower cannot be an individual.
  • The lender must have a pre-existing relationship with the borrower.
  • The borrower must reasonably appear to be able to protect its own interests.
  • The loan must not be primarily for personal, family, or household purposes.

What is the big deal about a usurious loan? The lender could forfeit all interest on the entire loan and may have to pay the borrower 3 times the interest paid during the 12 months prior to the filing of a lawsuit. Also, a lender who willfully and maliciously receives interest in violation of usury law can be found guilty of being a loan shark which is a felony punishable by up to 5 years of jail.

Be careful if you are making a loan with a high rate of interest. If you are considering making such a loan, you should consultant with an attorney to confirm that the loan is not usurious.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Be Careful When Leasing A Home To Relatives

By: Tamara Pow

Many people are very fortunate here in the San Francisco Bay Area to have acquired so much wealth in their real estate, both their homes and their vacation homes, as well as homes held for investment. As a result, I am often asked to assist my business and real estate clients with a personal matter – leasing a home to a family member.

Leasing a residence to a family member can be hazardous in many ways.

Before you do so, you should think carefully about whether you would be willing to enforce the lease or sue your relative if they do not perform under the lease. Think about evicting your family member… then think about what Thanksgiving will be like next year. However, there is also a tax issue to think about – renting to a family member may mean that you cannot take any tax deductions for losses on the property.

The general rule is that if you receive rental income for the use of a dwelling unit, such as a house or an apartment, you may deduct certain expenses such as mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance, and depreciation. These expenses will reduce the amount of rental income that is subject to tax, usually providing tax losses for you as well (subject to certain limitations). However, this is only available if you are renting to make a profit and not if you are using the house as a personal residence.

The IRS says you are using a house as a personal residence if you use it for personal purposes during the tax year for more than the greater of 14 days or 10% of the total days you rent it to others at a fair market rent. You are considered to be using a house if a member of your family is using it, unless they pay fair market rent. A recent tax memo confirms the IRS is enforcing this rule. In Okonkwo (TC Memo, 2015-181), the parents rented out a house to their daughter for $2,000 per month, much lower than the $6,000 fair market rent they had received previously. They deducted the mortgage interest and depreciation. The Tax Court held that the losses are not deductible because the tenant is a family member paying below market rent, so her use is treated as use by the owners, her parents. Because her parents are considered to use the property for more than 14 days or 10% of the total days rented to others, they get no rental loss deductions.

Here are some other special rules you should be aware of:

If you use a house for both rental and personal purposes, you have to divide your expenses based on the amount of rental use and the amount of personal use. Your loss deductions will be limited to the rental income, but you may be able to carry forward some losses to the next year. You may still be able to deduct the personal use portion of expenses such as mortgage interest, and property taxes.

If you rent your personal residence for fewer than 15 days, you do not have to report any of the rental income (and you do not get to deduct any expenses as rental expenses).

Sources:

IRS Topic 415, Renting Residential and Vacation Property, Page Last Reviewed or Updated: August 31, 2015

The Kiplinger Tax Letter, Vol. 90, No. 20, September 25, 2015.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Capital Structure For Start-Ups: Part I

By: Robert V. Hawn

As a corporate attorney in San Jose, California, I help a lot of high tech start-up companies get up and running. One of the major decisions that requires a lot of time and discussion is how the new corporation should set up its capital structure. In this series of blogs, I hope to explain some of the basic issues and concepts to help founders understand how to approach building this important aspect of their new business.

Closely Held Corporations

Corporations are formed to enable founders to accept outside capital by selling ownership interests, or shares, in the corporation. Remember, stock is merely a share of ownership in a corporation. Shares that aren’t sold or otherwise provided to employees, investors, or others are held by the founders. So, one of the basic issues that a founder will want to know and keep track of is how much of their corporation they own. If you own all of the stock of a corporation, you own the entire corporation. If you just own a third of the stock, then you just own a third of the corporation. Simple, right?

The example above is typical of a corporation that is held by very few people. It is what lawyers refer to as a “closely held” corporation. A closely held corporation is typical where the stockholders are actively involved in the business. Stock rarely changes hands, and it is unusual for new stock to be issued. In that situation, it is easy to determine how much of a corporation each person owns.

Outside Investor

Now, let’s make things a bit more complex. Let’s say that our corporation has three equal shareholders, who bought their shares for $1 each, and an investor has agreed to put some money in the company. After discussion, which, of course should include advice from your corporate lawyer , you decide that the corporation is worth $300, and that the investor can hold ¼ of the corporation, or 100 shares, for $100. Before the deal is done, each shareholder owns 1/3 of the corporation or 100 shares each. There are 300 shares outstanding . After the deal is done, there are now 400 shares outstanding and each shareholder now only holds only ¼ of the corporation, although they still each own 100 shares. This reduction in percentage interest is called “dilution”. If it is a very important concept to remember. It is common to say that your interest in the corporation has been diluted from 33% to 25%, even though you hold the same number of shares. Make sure you understand it before you go on.

What is interesting about the dilution example is that the percentage of the old stockholder’s ownership has gone down, but the value of their ownership has remained the same. This is because the addition of the $100 in investment capital has increased the value of the corporation from $300 to $400. The old stockholder now owns ¼ of a corporation worth $400, and the value of the ¼ ownership remains at $100. (despite the “dilution”).

Stock Options to Key People

In a start-up corporation , the structure becomes a bit more complicated because certain types of interests are issued which can convert into stock of the corporation. Let’s see how that impacts the percentage ownership of each stockholder.

In our example, let’s say we want to provide an incentive to a key employee. One common approach is to provide an option. The cool thing about the option is that the employee doesn’t have to buy their stock until they can get some money for it. So, often, employees just hold onto the option and don’t turn it into stock (a process called an “exercise”) until they need to. By then, they hope the value of the stock has increased and they can make some money. One key concept is that if the option is never exercised, you never get stock, and there is no ownership interest in the corporation. In other words, an option does not represent ownership; only stock represents ownership.

You may want to determine ownership, however, if you are selling your corporation and you know the option will be exercised. So, how do you determine ownership where someone holds an option, but not the stock? Very simply, you assume that the person exercises their option and turns it into stock. Once you do that it’s easy to determine the percentages.

In the example above, let’s say our employee is provided an option for 20% of the corporation, or 100 shares. If you look at just the percentage of the ownership before the option is exercised, then each person holds ¼ of the corporation or 100 shares out of 400 shares. When the option is exercised, however, there are now 500 shares outstanding. Each stockholder holds 100 shares, or 20% of the outstanding stock.

The number of shares of stock determined assuming options have been exercised (among other things), is called the fully diluted number of shares. The fully diluted number of shares is an important concept because it is often used to set the value of a single share of stock in an investment deal. In the next blog on capital structure for start-ups, I will discuss how investor stock affects the number of fully diluted shares, and your percentage ownership.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.