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:

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.


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.