California Conforms to New Tax Due Dates – Update your Agreements!

By: Tamara B. Pow, Esq.

On December 8, 2015 I published a blog about new federal partnership tax return filing deadlines . At that time, the IRS had just announced that partnership and S corporation returns will be due 2 ½ months after year end, or on March 15 th if the partnership is on the calendar tax year. C corporation returns will be due 3 ½ months after year end, or on April 15 th for calendar year corporations. California has now conformed to these due dates (AB 1775, Ch. 16-348). (Note: California has not conformed to the federal delay in changing the due date for C corporations with fiscal years ending on June 30 th .)

Federal extensions (based on requests) of time to file partnership returns have changed – from five months to six months, same as S corporations. C corporation extensions depend on the taxable year, with some being reduced from six months to five months. California (automatic) extensions of time to file may change as well from the current six months for partnerships and seven months for corporations to six months for both ( Spidell’s California Taxletter, Volume 38.10, p.4).

Don’t forget to update LLC operating agreements and LP and LLP partnership agreements, as well as corporate shareholder agreements if necessary to make sure the requirements are in line with these new deadlines. Often these agreements have particular time periods for management to provide tax reporting documents to owners, which may need to be changed. For example, the partnership tax return deadline for a calendar year partnership is now March 15 th . If your partnership agreement still says the managing partner shall prepare tax information by the 90 th day of the tax year, it should be changed to the 60 th day (or thereabouts) to meet the new requirements.

Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including limited liability company and other business entity formations, operations, transfers, conversions and dissolutions. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her stay apprised of these items when advising owners of LLCs and other business entities.

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.

Crowdfunding – Is this the deal for you?

By: Robert Hawn

If you are an emerging growth high technology start-up , or a closely-held small business, you’ve heard of crowdfunding. Crowdfunding is commonly used to describe an approach to fund raising over the internet, often characterized by small investment amounts by large numbers of people. Recently, the Securities and Exchange Commission enacted its Regulation Crowdfunding. You can find all 685 pages of the release discussing the Regulation, and the Regulation itself, at https://www.sec.gov/rules/final/2015/33-9974.pdf . In this blog, we’ll focus on the requirements concerning issuers.

Under the Regulation, an issuer can raise a maximum of $1,000,000 through crowdfunding in any 12-month period from any person. The offering can’t be conducted by your company directly, however. Instead, it has to be conducted through a broker-dealer or online portal registered with the SEC and a member of the Financial Industry Authority, or FINRA, or other national securities association registered with the SEC. To see if a broker-dealer is properly registered with FINRA, check http://brokercheck.finra.org/ , and to check if a portal is properly registered with FINRA, check http://www.finra.org/about/funding-portals-we-regulate .

There are some eligibility requirements that can disqualify an issuer. These include, among others, companies that don’t have a specific business plan (or whose plan is to engage in a merger or acquisition with an unidentified company), issuers that violate so called “bad boy” rules, and companies that have failed to satisfy annual reporting required by Regulation Crowdfunding.

One major requirement facing issuers under the Regulation is the need to prepare a disclosure statement. Although not as extensive as the type of statement required for an SEC registered offering, the requirements are significant. Items that must be disclosed pertain to the offering itself as well as the issuer. Offering related items include, among other things, the desired amount of the offering, the deadline for reaching it, whether investments over the desired offering amount will be accepted, the price of the securities, how the proceeds will be used, and material risks associated with the investment. Issuer related items include, among other things, a description of the business and its financial condition, information about 20% owners, members of the Board of Directors of the issuer, and officers, information concerning transactions between the issuer and related parties, and a description of the issuer’s ownership and capital structure.

The disclosure statement must also include financial statements prepared in accordance with generally accepted accounting principles as applied in the US. The financials must cover the shorter of the immediately preceding two fiscal years or the period since inception. The review the financials have to undergo depends on the amount of the offering:

  • If the current offering plus previous offerings under the Regulation are $100,000 or less, the financials must be certified by the principal executive officer and accompanied by certain information from the issuer’s tax returns (but need not include the tax returns themselves.
  • If the current offering, plus previous offerings under the Regulation, are more than $100,000 but less than $500,000, the financials must be reviewed by a CPA.
  • If the current offering, plus previous offerings under the Regulation, are over $500,000, the financials must be audited. If, however, the issuer has not previously sold securities in reliance under the Regulation, the financials must be reviewed by a CPA.

Keep in mind that there are no exceptions to these requirements, even for very early stage companies. So, if your company has just been formed, and you want to raise over $500,000, you’ll need to provide audited financials.

The amount the issuer can sell to an individual investor is limited. My next blog will discuss the specific investor limitations.

Advertising the offering is, not surprisingly, very limited. An issuer can publish a notice advertising the offering terms similar to “tombstone” ads. The notice must include the address of the funding portal or broker-dealer who is assisting with the offering.

In addition to the initial disclosure documentation, an issuer must file annual reports with the SEC and provide them to investors. The annual reports must contain much of the same information required under the initial disclosure document. Once the issuer becomes a reporting company under the Exchange Act, there is no further need to provide the annual reports required by the Regulation. The rules under which a crowdfunding issuer becomes subject to the reporting obligations under the Exchange Act have been relaxed if the issuer is current on its annual reporting obligations, uses a registered transfer agent, and has less than $25 million in total assets.

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.

LLC Members – Ignoring Self-Employment Taxes When Choosing Your Business Entity Can Be A Costly Mistake

By: Tamara Pow

In addition to income tax considerations on forming a limited liability company (“LLC”) in California and making contributions to the LLC, potential LLC members should keep in mind that income they receive from their LLC may be subject to self-employment tax, and that self-employment tax treatment may be different if the LLC is taxed as a corporation or a partnership.

LLC Taxed as a Corporation

For an LLC taxed as a corporation , if a member is active in the business of the company, payments to the member may be taxed as compensation which is deductible by the corporation and subject to employment taxes. Other amounts, and possibly excessive compensation, will be characterized as a dividend.

LLC Taxed as a Partnership

For an LLC taxed as a partnership , if a member is active in the business of the company, payments to the member may be self-employment earnings, salary or wages, or simply a distribution based on the member’s percentage interest. A member’s distributive share of LLC income is self-employment income if the business of the company is a trade or business that the member is active in. A member is considered active in the business if she has personal liability for claims against the LLC, has authority to contract on behalf of the LLC, or participated in the LLC’s trade or business for more than 500 hours in a tax year. On the other hand, if the member is not active (like a limited partner) then the income is generally not treated as self-employment income.

For certain professions, including health, law, engineering, architecture, accounting and others, if a member is providing professional services, that member will be considered active and all income from a partnership will be subject to self-employment tax. In California, most professionals are not eligible to practice in a limited liability company, but this rule would apply to a limited liability partnership (“LLP”) as well.

One other California difference to note is that for California state tax withholding purposes, a member of an LLC that is taxed as a partnership cannot be an “employee.”

Self-Employment tax and other individual taxes are one of many tax and other considerations to be taken into account in determining the right form of entity for your business. If you are active in your business, or are planning to practice a profession in a partnership, make sure to discuss these implications with your tax advisor prior to forming a business entity to avoid the hassle and cost of an entity conversion later.

Tamara Pow is an LLC attorney who also has an MBA, a California real estate broker’s license and experience in public accounting. She understands the importance tax planning plays in choosing an LLC as the proper form of entity for business and real estate investments.

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.

Using LLCs For Estate Planning

By: Tamara Pow

Although I do not practice estate planning law, as a limited liability company lawyer (“LLC lawyer”) in San Jose, I have worked with estate planning attorneys to form many LLCs for families that want to include them in their estate plan. Traditionally, the entity of choice for estate planning was the Family Limited Partnership (“FLP”). Once LLCs were introduced in California, attorneys began using an LLC to be the general partner in the Family Limited Partnership. The parents would contribute assets (often income producing real estate) to a Family Limited Partnership in exchange for limited partnership interests which would be gifted to the next generation, and a general partner interest which would be retained by the parents in their wholly owned LLC. This maintained control with the parents, but unlike holding the general partnership interest in their individual names, it provided them with a layer of liability protection as well.

Gifting of limited partnership interests is more attractive than outright gifting of the underlying asset for two reasons: First, the donor can retain control in the form of the general partnership interest. Second, the gifted limited partnership interest can get a valuation discount for terms in the partnership agreement such as lack of control and lack of marketability of the interest. In other words, a parent can gift her child 50% of a property worth $1,000,000, making the gift worth $500,000; or a parent can gift her child a 50% limited partnership interest in a partnership that owns the $1,000,000 property, making the gift worth approximately $350,000 because the partnership interest is not a controlling interest and cannot be easily transferred. LLCs are entitled to this same valuation discount so long as the transferee has limited rights.

Over time, estate planning attorneys have become more comfortable with using Family Limited Liability Companies in place of Family Limited Partnerships, rather than just as their general partners. Using one entity instead of two can sometimes reduce the amount of California franchise taxes paid by the family to maintain the entities and can simplify the annual reporting requirements for the family. Also, the transfer of assets to a Family LLC can avoid the potential of a gift occurring when parents transfer assets to an FLP and take limited partnership interests but give the next generation the general partnership interest (the IRS sees this as a transfer of control resulting in a gift without valuation discounts). This same argument against valuation discounts does not apply to LLCs because the transfer of assets to an LLC with one class of members does not involve the same disproportionate transfer of control.

There are many more business and real estate considerations to an operating LLC than just the estate planning considerations. A good LLC attorney is critical to drafting an operating agreement for the LLC that will both satisfy the family’s estate planning intentions and satisfy its business protection needs, management needs and other tax requirements. A trust and estates attorney can set up trusts for the members to hold the LLC interests and work with the LLC attorney to make sure the ownership and control succession plan dictated by the operating agreement is in line with the succession plan for the family.

As an LLC attorney with an MBA, a California real estate broker’s license and experience in public accounting, I cannot overemphasize the importance good planning plays in choosing an LLC, LP or corporation as the proper form of entity for business and real estate investments, including those involved in family estate planning.

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.

Business Contracts – Beware of Third Party Beneficiaries -They May Not Be Missing Persons

By: Robert Hawn

As a business attorney with a Silicon Valley practice, I create a lot of contracts for many different kinds of companies. It never gets boring! One of the issues we sometimes worry about is whether there are any other parties that might have rights under these contracts. This concept, which lawyers refer to as a “third party beneficiary right,” is often disclaimed in the agreement. Job done, right? Well maybe not.

In January of this year, a Ninth Circuit Court of Appeals looked at whether third party rights exist where they have been expressly disclaimed in an agreement and decided that, the facts need to be examined further. Whether this case will expand third party rights, or will just be limited to its particular facts, remains to be seen. It does, however, caution business people to make sure of the deals they cut so that only the parties with whom they deal with in the contract will be the parties they have to deal with in court if the deal goes sideways.

For you fans of 80s Rock, this case involved the lead singer of the band, Missing Persons. The facts, however, are not just a simple case of walking in L.A., so pay attention.

Dale Bozzio, the lead singer of the band, brought suit against Capitol Records, and its corporate parent, EMI, to collect royalties based on what was argued to be a mischaracterization of the source of the record company’s revenue for the band. Like many bands, Missing Persons had created a “loan-out corporation.” This is a corporation that is used to cut deals with, among others, record companies. Under the contract, Bozzio, along with her other band mates, agreed that they would not bring any claims for royalties individually against the record company, but only against the loan out corporation. Problem was, the corporation was suspended when the band broke up and therefor had no standing to sue. So, a lower court looked at the contract and said no corporation, no lawsuit, and besides you agreed not to sue, so go away. Bummer. Bozzio appealed.

The Ninth Circuit looked a bit closer at the contract, and said not so fast. To make a long song into radio format, the Ninth Circuit looked at some other parts of the law and the contract and said that Bozzio could have her day in court. They were swayed by prior case law that seemed to imply that the fact that the corporation could not sue did not necessarily mean that someone claiming third party beneficiary rights under that corporation could not sue. They were also swayed by a clause, presumably created to protect the record company, that said that if the loan out corporation could not provide Bozzio’s services, that she would provide them directly. In addition, the Agreement provided for royalty payments individually under certain circumstances, which allowed the court to conclude that the record company may have accepted the concept of individual rights for Bozzio under the agreement, and that her standing as a third party beneficiary of the loan out corporation’s rights against the record company existed, notwithstanding her promise not to sue the record company directly.

So what is the takeaway? First, just excluding a person as a third party beneficiary might not do the trick. You need to look and see if there are any other provisions affecting those shareholders that might allow them to assert rights sufficient to allow them to sue you. This case is particularly interesting because a clause that was, in my opinion, created to help the record company (i.e., the clause that allowed the record company to get Bozzio’s services when the loan out corporation would not provide them) was used against the record company. Second, and probably most important, you need to keep in mind that the law in this area is fuzzy and fact dependent, and you have to consider these types of rights as you evaluate the risk of any deal.

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.

Limited Liability Companies, California Real Property And Property Taxes

By: Tamara Pow

As a real estate attorney in Silicon Valley, I represent a lot of real estate investors that hold their properties in LLCs. One of the biggest and most expensive mistakes LLC members can make when transferring property to or from an LLC is triggering a reassessment of their real property, yet this complex area of taxation is often not well understood by real estate owners or even accountants or attorneys that do not specialize in this area. The general rule is that any transfer of real estate is an event causing both transfer taxes and the reassessment of the property for property taxes. The role of the tax advisor, whether a CPA or real estate or business entity attorney, is to either prepare the client for this eventuality in advance so they can decide whether or not to proceed, or to structure the transaction to fall into one of the exceptions.

A contribution of real property to an LLC on the formation of an LLC is a change of ownership, triggering reassessment for California property tax purposes, unless all of the following three circumstances apply :

  1. The transfer is between legal entities or between one or more individuals and an entity;
  2. The transfer is solely a change in the method of holding title; and
  3. The proportional interests in the property (directly or through the entity) remain the same before and after the transfer.

This means that one or more owners of real property can transfer the real property to an LLC and take membership interests in the LLC in the same percentages in which they previously owned the property directly and there will be no change in ownership, and therefore no reassessment for property tax purposes and no transfer taxes. Be very careful with percentages – they must be identical. I recently had to argue a case with the Santa Clara County Tax Assessor’s Office in which an attorney helped two co-owners of real estate transfer their property to an LLC. One owned one-third of the property, which was noted on the deed as 33 1/3%, and the other owned two thirds of the property, noted on the deed as 66 2/3%. However, when the attorney drafted the LLC operating agreement, he rounded the percentage interests to give the first owner 33% and the second owner 67%. The result was that the property was reassessed and the partners could not claim that the indirect ownership percentages were identical before and after the transfer to the LLC.

Even though the contribution to the LLC may not be a change of ownership, the property could still be reassessed later as a result of a member’s transfer of an interest in the LLC resulting in either a change in ownership or a change in control. A change of ownership results when more than 50% of the total interests in the LLC are transferred by the original co-owners. A change in control results whenever a person or entity obtains direct or indirect ownership of more than 50% of the total membership interests in the LLC. One of the many reasons experienced real estate attorneys encourage their clients to take title to property from the beginning in the name of the LLC (rather than taking title in their own names and then transferring to an LLC) is to avoid the change of ownership risk.

If title to the property is being transferred by deed, the County receives a “PCOR” or preliminary change of ownership report form whereby the transferee reports the new ownership and claims any exclusions from reassessment. If LLC membership interests are being transferred, the property remains titled in the LLC, so no deed or PCOR is filed. Instead, the members are required to file a change of ownership of real property form with the State Board of Equalization within 90 days of any change of more than 50% of the original co-owners (cumulatively – in one or more transaction) or any change in control. Failure to timely file the Form BOE-100 can result in a significant penalty. For more information on the change of ownership form go to the BOE website .

Once a property has been reassessed it is usually impossible to reverse unless a mistake was made, and it is difficult and expensive to argue for a reversal even for a mistake. Before transferring real property into an LLC or from an LLC out to its members, and before transferring membership interests in an LLC, be sure to consider the potential property tax implications.

I am one of the very few LLC attorneys that has an MBA, my real estate broker’s license and experience in public accounting. I therefore understand the importance tax planning plays in choosing an LLC as the proper form of entity for business and real estate investments.

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.

Doing Online Business With Europe? New Shield to Replace Your Safe Harbor?

By: Robert Hawn

As a business attorney practicing in the San Francisco Bay Area working with start-up companies , I often represent companies which are pursuing market opportunities in the European Community. Many of these companies, especially “software as a service” companies, offer apps and other services which process data and personal information of individuals who live in Europe. As a result, these companies are required to comply with European Union directed privacy laws. Up until recently, complying with these laws was possible by taking advantage of a “safe harbor” that allowed US companies to process personal data of individuals in EU member countries.

Last October, a European Union Court threw into disarray this “safe harbor,” and invalidated this relatively long standing information sharing framework. Since then, many companies receiving information from EU country citizens have operated in an uncertain environment regarding privacy matters. A ray of hope arose, however, in the last few weeks with the adoption of a new approach to enable U.S. companies to gather European originated personal data.

A Little History

The European Community has traditionally been highly protective of the personal information of the citizens of its member states. This has often clashed with the relatively more business oriented approach taken in the United States. This conflict, and the highly protective privacy rules of the EU, made it almost impossible for US companies to comply with EU related rules when dealing with personal data of EU citizens. In the early 2000’s, the United States and the EU agreed on a self-certification framework, referred to as the “ Safe Harbor Privacy Principles,” to allow personal data to be transferred to US companies. The Safe Harbor allowed a U.S. company to self-certify that its privacy practices satisfied certain enumerated standards.

Last October, the European Court of Justice held that the Safe Harbor was invalid because, among other things, the revelations by former National Security Agency contractor Edward Snowden showed that U.S. authorities could access EU citizen data in the U.S., and that there was no means for redress. Without the Safe Harbor, only expensive and time-consuming approaches under the EU directives were available for those U.S. companies that wanted to comply. Most commentators believe these alternate approaches may be available to larger companies, but won’t be available, at least quickly and economically, to smaller emerging growth companies. They fear that lack of easy compliance will prevent small and emerging growth companies from expanding their operations into Europe.

On February 2, 2016, a new framework was announced by the U.S. and European Union to replace the Safe Harbor. The announcement released by the European Commission states that the new framework, referred to as the “EU-US Privacy Shield” will provide stronger obligations on companies in the U.S. to protect the personal data of Europeans. It also requires stronger monitoring and enforcement by the U.S. and increased cooperation with European Data Protection Authorities. Access to European citizen data will be subject to clear conditions, limitations, and oversight to prevent “generalized access”, according to the announcement. The U.S. will also be required to appoint an Ombudsperson to receive inquiries or complaints from European citizens. Formal adoption by the EU, and implementation by the U.S., will likely occur over the next few months.

Implications

There are a number of implications, particularly for smaller companies. First, the Privacy Shield will likely be more difficult to comply with than the Safe Harbor, resulting in relatively more resources being devoted to protection of personal data from European citizens. Second, the trend of companies maintaining servers in the EU to manage European citizen data will probably continue, if not accelerate. Third, more companies will explore anonymizing their EU-originated data before it is transferred to the US. Fourth, until the Privacy Shield is implemented, there will continue to be a great deal of uncertainty over how personal data can be transferred to the U.S.

What’s a small U.S. company to do?

Pending clarification from our friends in the European Union, there are two actions that can be taken now. First, from a legal standpoint, make sure your privacy policy is updated, i.e., it reflects your current practices. Second, from a practical standpoint, make sure that you consider all of your privacy practices and ask yourself whether you would be irritated if your own personal information were treated in a similar manner.

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.

2016 Standard Mileage Reimbursement Rates

By: Tamara Pow

IRS Announces 2016 Standard Mileage Reimbursement Rates

The Internal Revenue Service has issued the 2016 optional standard mileage rates ( IR-2015-137, Dec. 17, 2015 ):

As of January 1, 2016, the rates for the use of a car, van, pickup or panel truck will be:

54 cents per mile for business miles driven (down 3.5 cents per mile from last year);

19 cents per mile for miles drives for medical or moving purposes (down 4 cents from last year);

14 cents per mile for charitable organizations (this rate is fixed by law).

Of course, taxpayers have the option of calculating the actual costs of using a vehicle rather than using these standard rates. However, if the taxpayer is claiming depreciation under MACRS (Modified Accelerated Cost Recovery System) or is claiming a Section 179 deduction for the vehicle, it may no longer use the business standard mileage rate for that vehicle. Also, the business standard mileage rate cannot be used for more than four vehicles simultaneously. Companies with four or fewer vehicles may use this rate, with the vehicles’ basis reduced by 24 cents a mile, which is the depreciation component of the rate.

A taxpayer may also claim parking costs and tolls, as well as state and local personal property taxes paid on a vehicle. (Kiplinger Tax Letter, Vol. 90, No. 26, December 18, 2015.)

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.

Show Me The Money – And Start With Your Revenue!

By: Jack Easterbrook

Technology lenders, asset based lenders, commercial lenders and factors always pay attention to a borrower’s revenue line – obviously the revenue line is critical for determining the income of the company and the amount and quality of the accounts receivable and contracts receivable collateral that will be available to secure a line of credit or loan. Many deals involving companies in the Silicon Valley and the San Francisco Bay Area now peg advance rates to revenue formulas or, alternatively, contain loan covenants that use the monthly or quarterly revenue numbers as key factors in the formulas for calculating compliance. Against this backdrop the Financial Accounting Standards Board issued ASC 606, which significantly changes the way many companies will recognize revenue in the future.** Although full implementation is still a few years out, the action begins in 2016 and may affect the credit analysis of lenders and the covenants and requirements in loan agreements. More is said about these points below.

ASC 606 and Changes in Revenue Recognition

Revenue recognition is presently a heavily rules driven process which can, depending on the accounting standards used, lead to different reporting results. In an attempt to narrow the differences between US GAAP reporting and IFRS revenue standards, ASC 606 was issued. It seeks to establish a principles-based approach to recognizing revenue using a multi-step process. While this process is still a work in progress, it will require companies to more clearly identify performance obligations under contracts, show how the contract price relates to the required activities under the contract and explain the assumptions being used in recognizing or deferring revenue in various accounting periods. ASC 606 also requires a significant amount of additional disclosure by management, allowing those reviewing financial information to assess the revenue recognition principles utilized by the company. Company management will exercise more judgment over the process but will need to explain itself.

Complete implementation of the new reporting under ASC 606 is required for 2018 financial reports for public companies and 2019 financial reports for private companies. However, companies will also need to look back and restate revenues consistent with ASC 606 principles for prior years beginning in 2016.

The Takeaways – the Potential Effects of the Changes in Revenue Recognition

So what does this mean to the lender? The pending implementation of ASC 606 potentially means material changes in revenue reporting by new and existing borrowers. Depending on their type of business, the effects on the lender may include the following:

● For growth companies with contract revenue, reported revenue is expected to adjust upward, at least initially, while deferred revenue diminishes, which means advance rates or financial covenants may need to be adjusted accordingly. A lender will need to understand how changes in revenue recognition principles affect each borrower, as it will affect them differently. If ASC 606 is going to have a material impact on a borrower, it inevitably means that more in-depth analysis of management’s underlying assumptions concerning future revenue will be required as they will have more latitude to make these determinations.

● If a loan extends into 2018 (2019 for private companies), lenders will want to consider whether the loan documents executed prior to that time need to provide for adjustments to loan covenants or advance rates to reflect the changes in revenue recognition. As many credit facilities are structured to mature in 1-2 years, this will become a larger issue as those dates get closer.

● The increased data collection, accounting costs and disclosures required of the company may materially impact the borrower’s administrative expense line. Lenders will want to determine what effect this might have on the company’s profitability and related effects on cash flow and any loan agreement financial covenants.

● Is the borrower on top of this? Company disclosures about the expected impact of ASC 606 are required going forward. Initially a company may be able to simply say it is evaluating the impact but that position can only be taken for a limited period of time.

Because revenue recognition is so critical in measuring the well-being of any business, lenders will want to assess how the pending changes caused by ASC 606 will affect the health of new borrowers as well as existing companies in their loan portfolio and begin to pro-actively plan whether any changes in the management of such credits are needed.

** The author is indebted to Rick Brounstein of CFO Network LLC for introducing him to ASC 606 and the issues potentially created by this new standard. The contents of this article, however, are solely the responsibility of the author.

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.

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.