Equity Financing

equity financing
Equity is an ownership interest in a company. In a corporation, it typically takes the form of common stock or preferred stock. In a limited liability company, equity ownership is called a membership unit (or membership interest). In a general or limited partnership, it is termed a partnership interest. The difference between raising capital by selling an ownership interest in your company and by the incurring of debt is that the first is a non repayable capital contribution and debt is a legally binding promise to repay the amount borrowed with interest.

Debt has to be paid back, usually on a prescribed schedule, and negatively impacts the balance sheet (the debt-toequity ratio). Equity, on the other hand, does not have to be paid back. In return, you have given away a portion of the ownership of your company. This is not all bad, however, because it allows your company to grow.
Beginning businesses that need to raise capital should consider the sale of equity for a number of reasons.

The terms of equity financing are more flexible than debt financing and they have a positive effect on the company’s balance sheet. In addition, investors understand that they are entering into a long-term investment and are less likely to expect immediate returns on their investment. Last, but not least, cash flow can be retained by the company for expansion of the business operations, conducting research and development, and obtaining assets, such as intellectual property, rather than servicing a debt.

Raising money from investors can be a daunting task that will require a substantial commitment of time. It can become a second, full-time job apart from developing the products and services that you hope to sell someday. Determining what is attractive to investors is an art more than a science,
and everyone will have an opinion on what works best at any one time. This article informs you of the types of ownership interest that can be used in the various business organizations.

Ownership

What is Equity Financing?

Equity financing involves selling a percentage of ownership in the company to an investor. The advantage of equity financing is that the company does not incur a debt obligation that must be repaid. As the company makes a profit, the investors may be paid dividends and their ownership interest will increase in value. The biggest disadvantage of equity financing is that every
time you sell ownership, your percentage of ownership is diluted or decreased.

Depending on the stage of funding and the amounts involved, you may have to give up varying degrees of control of your company. If things go badly for a company and its assets are liquidated, equity investors are paid back after debt holders. Equity investors realize this going in and therefore usually consider a company’s debt-to-equity ratio—the amount of debt a company has versus the amount of equity or paid-in capital. If a company has too much debt, it may not be able to meet its obligations to pay back debt from revenues, which could result in a foreclosure. On the other hand, if a company has sold too much equity, the return on investment might take a long time. It is all a balancing game.

Understanding Your Repayment

Schedule: It is time and money well spent to forecast how much capital you will need to fund the company and also how long you anticipate it will take to pay lenders back or give investors a return or an exit.

The type of equity securities that a company issues to founders and investors will depend, in part, on the amount of capital needed to be raised and the number and type of investors needed. If the company does not need large amounts of capital to accomplish its goals, one form of securities may
be all that is needed. If the company needs to raise a significant sum of cash, creating different classes of securities could be advisable.

Corporation Equity

The equity of a corporation is called stock. Typically, you will hear the stock in a corporation referred to as shares of stock. A corporation may sell its stock to investors to raise capital for expansion and operations, and once an investor has purchased stock in a corporation, he or she becomes an owner
of part of that corporation. The ownership of stock is perpetual, meaning that there is no maturity date for the stock, and the investor may own the stock until the corporation decides to buy them back or until the investor decides to sell them. Shares of stock of a corporation have a number of terms associated with them.

Authorized stock is the total amount of stock that a corporation possesses. When a corporation is formed, it must state the amount of its authorized stock in its articles of incorporation. That language will read something like the following.

The number of shares that the corporation is authorized to issue is 15,000,000, 10,000,000 of which are common shares at a par value of $0.001 and 5,000,000 of which are preferred shares at a par value of $0.001.Authority shall be vested in the board of directors to change the class, the number of each class of stock and the voting powers, designations,preferences, limitations, restrictions, and relative rights of each class of stock.

By stating its authorized stock, the corporation determines the size of its universe, and it lets investors know where their investment fits into the company. For example, they want to know if the 10,000 shares they are buying represent 1% or 10% of the company. Par value is a nominal value arbitrarily assigned to the shares and bears no relationship to the market value that changes over time.

The next term you need to know is issued stock. Issued stock is the amount of authorized stock that currently is or has been in the hands of the founders, or sold to investors since the beginning of the corporation. Once stock has been issued, it will always be regarded as issued, regardless of its current status (i.e., whether someone currently owns it or if it has been repurchased by the corporation). Closely related to issued stock is the term outstanding stock. Outstanding stock is stock that has been sold or issued that is currently in the hands of the founders and investors.

Treasury stock are those shares that had been issued but have subsequently been returned to the corporation through a redemption, purchase, or other liquidity event. These shares are back in the treasury of the corporation. The corporation may elect to reissue the shares at a later date or it may retire the shares.

To determine the amount of treasury stock, use the following formula:

THE LIFE OF A SHARE OF STOCK
To gain an understanding of the terms just described, an example is helpful. Anderson Industries, Inc. is founded with 10,000,000 authorized shares with a par value of $0.001. The founders want to maintain majority control of the corporation, so they issue 5,000,000 shares amongst themselves,
for which they pay the par value, or $5,000 (5,000,000 x $0.001 = $5,000). At this point, there are 5,000,000 issued and outstanding shares, which is 50% of the authorized shares. The ownership
structure looks like this:

Next, the board of directors of Anderson Industries, Inc. decides that the corporation needs to raise $1,000,000 for operations, and they determine that a fair market value for the shares to be sold will be $1.00 per share. (Do not get too bogged down with how they are going about raising capital or what the value of the shares is here—the finer points of valuation and raising capital are discussed in later articles). The ownership structure now includes the investors and looks like this:


Once the 1,000,000 shares are sold to investors, there are 6,000,000 issued and outstanding shares, or 60% of the authorized shares. Investors will be concerned with two ratios here: the amount of issued and outstanding shares they own in relation to the number of authorized shares, and the amount of shares they own in relation to the total number of issued and outstanding shares in the corporation.
In this example, the investors own 10% of the authorized shares (1,000,000 of the 10,000,000 authorized shares) and they own 16.6% of the issued and outstanding shares (1,000,000 of the 6,000,000 issued and outstanding shares). These values can be expressed like this:

Over the years, the corporation becomes successful and the board of directors decides to redeem the shares it has sold to investors for $5.00 per share, so it creates a plan of redemption and offers it to all of the investors. A number of the investors decide to redeem their shares and the corporation buys back 750,000 of the shares it had sold. At this point, there are still 1,000,000 issued shares, 250,000 of which are outstanding shares and 750,000 are treasury shares. Now the ownership structure looks like this:

With a good grasp of the terms associated with the status of shares of stock, a description of the types of shares that you will typically see in a corporation, their function, and their attributes, is discussed in the following pages.

Common Stock

C corporations can sell equity in two basic forms—common stock and preferred stock. Common stock is voting stock. Typically, it is issued to the founders of a corporation shortly after formation in exchange for the founder’s time and expertise, or perhaps the assignment of intellectual property or other assets. Some common stock may be sold to initial investors and issued to officers, directors, and consultants as incentives. Common stock may also be given as stock options that may be exercised at
a higher price at some future date.

Dividend Rights

Dividends are declared by the board of directors from available after tax earnings and profits. In most states, the company cannot pay a dividend if it would impair the capital of the corporation, which means, in layman’s terms, you cannot pay a dividend unless you have earnings and profits. Directors can be held personally liable under some laws if they impair the capital of a corporation. A board of directors is not under any obligation to declare a dividend at any time. They merely have the right to declare one. The practical reality is that most beginning corporations do not pay dividends and may never pay dividends until they are fully mature. In 2002, Microsoft Corporation paid the first dividend in its history.

Alert!
Common stock can receive dividends, but if there is any outstanding preferred stock that has a dividend preference, it will be entitled to receive dividends first.


Voting Rights. 

Holders of common stock are typically entitled to one vote per share on all matters to be voted on by the shareholders. When holders of common stock vote for directors, the directors with the greatest plurality win. Most states allow common stockholders to cumulate (combine) their votes, if such voting is allowed by the articles of incorporation. The use of cumulative voting should be discouraged, because it concentrates unequal voting power in a few shareholders and can be a negative to new investors. Liquidation Rights. In the event of a liquidation or dissolution of the
corporation, holders of common stock are entitled to share in all assets remaining after creditors and any preferred stockholders are fully repaid.
 

Unfortunately, if liquidation or dissolution of the corporation occurs, it means that things are not going well and probably have not been going well for quite some time. So, there may not be much left in the way of assets to distribute to common stockholders.
Redemption Rights. Redemption is the purchase of issued and outstanding stock by the corporation. There is no inherent right of shareholders to redeem their shares unless it is part of a contract with the corporation. 


The company can attach a right of redemption to a particular class of common shares, and this could create an attractive exit strategy for certain common shareholders. However, a company can voluntarily offer redemption to some or all of its common shareholders. If a right of redemption is part of a stock offering, the company may wish to create a sinking or reserve fund to have the after-tax money available to fund the redemption in the future.
 

Redemption can be at the option of the company, the stockholder, or both. There are a variety of methods to set the redemption price—a fixed price per share, a multiple of the purchase price, market value determined by an appraisal, and other methods. In setting the time for the redemption event, the longer the hold period of the stock, the greater the redemption price.

Preemptive or other Preferential Subscription Rights.

Preemptive rights entitle a current shareholder to purchase additional shares in the event of an ownership percentage dilution due to subsequent rounds of stock offerings. The use of preemptive rights or other preferential subscription rights is not recommended because they can discourage additional investors. By granting a shareholder the right to purchase additional shares of stock when the corporation offers stock to outside investors, funding is often delayed because the stock has to be
offered to existing shareholders first.


Nonvoting Common Stock. Nonvoting common stock can also be used in a stock incentive plan. Such a plan may reward employees with shares in the company as part of their compensation package. In this manner, the company can share ownership with its employees and still maintain
voting control. You may use nonvoting common in both an S corporation and a C corporation
when the voting shareholders do not want to grant voting rights to other shareholders. Family-controlled corporations are another instance where the family members maintain control by issuing nonvoting common stock.


QUICK Tip
The S Corporation: One of the limitations of an S corporation is that it is allowed
only one class of stock. However, S corporations do allow the issuance of nonvoting
common stock in addition to issuing voting common stock. 


Preferred Stock

Preferred stock is the second kind of equity available for sale by a corporation. It entitles its holders to certain preferences that differ from common stock. Investors like preferred stock because dividends are paid before common stock, and if the company is liquidated or dissolved the preferred
stockholders have a preference to the liquidation proceeds ahead of common stock.
 

The board of directors of a corporation is typically authorized in the articles of incorporation to create multiple series of preferred stock. It is allowed to determine the rights, preferences, and privileges of any series of preferred stock, and the number of shares constituting any such series. Pursuant to this authority, the board of directors will adopt a resolution at a board meeting designating a series of preferred stock. The board will then file the preferences with the state through an amendment to the articles of incorporation or a designation of preferences, depending upon the laws of the state of incorporation. 

The language would read something like this.

RESOLVED, that the number of shares that the corporation is authorized to issue is 15,000,000 shares, 10,000,000 of which are common shares and 5,000,000 of which are preferred shares, and


RESOLVED FURTHER, that 750,000 of the 5,000,000 authorized
preferred shares are hereby designated as Series A Preferred Shares, and


RESOLVED FURTHER, that the voting powers, designations, preferences,
limitations, restrictions of Series A Preferred Shares are as follows:
[Details of the preferences would appear here].

 
When amending the articles of incorporation, the board of directors sets forth the proposed amendments in a resolution (like described) and submits it to the shareholders for approval. In most cases, the chairman or president calls a special meeting of the shareholders and the shareholders vote to ratify the amendment to the articles. If there are few shareholders, all shareholders
sign a unanimous written consent and no meeting is necessary. Preferences for preferred stock can include the following.

Dividend Rights. 

Shares of preferred stock will either have a cumulative or noncumulative right to dividends. A cumulative dividend accumulates from year to year if it is not paid. For example, if a corporation
promises to pay a cumulative dividend of ten cents per share every year to each holder of preferred stock, and the corporation was unable to pay one year because it had no available earnings and profits, the dividend would cumulate the next year, so that the corporation would owe twenty cents per share.


A noncumulative dividend does not accrue when unpaid, and it does not roll over to the next year. If dividends are not declared during the year, no dividend is due. Investors realize this, too, and often will want cumulative dividends. It is all about bargaining power.
 

Dividends are calculated by applying a rate percentage to the face value or the purchase price of a share of stock at the time a dividend is declared. In a privately held company, the face value is what the investor paid for the preferred stock. If there was an 8% dividend rate and the face value was $1.00 per share, the dividend would be $0.08 per share multiplied by the  number of preferred shares owned. Whether or not the company declares dividends to shareholders will depend upon a number of factors, including the capital requirements and the financial condition of the company.
 

Voting Rights. 

In exchange for their preferential treatment for dividends, preferred stockholders will usually give up their right to vote on corporate matters, except when it pertains to changes to the preferences of the stock they are holding. They will most likely want to be part of the decision making process if their preferences are going to change. They may also want a voice if the corporation wants to create a series of preferred stock that is senior in preference to their series of preferred stock.
 

If an institutional buyer, an angel, or a venture capitalist is funding the company, they want a designation of an entire series of preferred stock. The stock structure of venture deals usually involves preferred stock that votes and converts to common stock in a variety of circumstances. In addition, the venture funder may demand representation on the board, which is generally
helpful because of their experience and contacts.
 

Liquidation Rights. 

Holders of preferred stock will normally be entitled to receive a certain dollar amount per share (plus declared but unpaid dividends) before any distribution or payment is made to holders of common stock in the event of a dissolution, liquidation, or wind-up of the corporation.
 

If the corporation liquidates, dissolves, or winds up, and the assets of the corporation are insufficient to permit full payment of the amount promised to the preferred stockholders, the holders would then be entitled to a ratable distribution of the available assets and the common stockholders would
get nothing.


Alert!
A consolidation, merger, or sale of all or substantially all of the assets of a corporation
is generally not considered a liquidation, dissolution, or winding up for
these purposes.
 


Conversion and Redemption Rights. 

Preferred stockholders are sometimes granted the right to convert their shares into shares of common
stock of the corporation. Conversion rights can be voluntary or compulsory. The preferred shareholder can exercise voluntary conversion anytime. Compulsory conversion usually occurs on the happening of an event, such as a public offering or merger. When the time comes to convert, the conversion ratio is the paramount concern. 


The conversion ratio is the formula by which you calculate the number of shares of common received by surrendering a certain number of preferred shares. The most straightforward conversion formula is one share of preferred stock for one share of common stock. Other formulas call for a third party appraisal at the time of conversion, which can be expensive.
The conversion rate should be subject to adjustment from time to time if any of the following events occur:



  • • the company splits or combines its common stock or issues dividends to common stock;
  • • the corporation issues other convertible securities at a lower price or with a conversion rate less than the then-current conversion rate for the issued and outstanding preferred stock; or,
  • • the corporation sells its common stock at a price less than the then-current conversion rate of the issued and outstanding preferred stock.

There are a number of different formulas used to safeguard the interests of an investor when calculating how to convert convertible securities. These are called anti dilution provisions and the corporation needs to pay particular attention to these provisions when negotiating with an institutional investor. As a starting point, look at this typical conversion scenario:




 Under this scenario, the original share price and the conversion price would be equal and essentially the investor would be converting at a ratio of one to one. But what happens if the corporation sold a bunch of convertible preferred stock at $2.00 per share and subsequently had to lower their valuation based upon changes in the economic landscape?
 

The corporation would probably have a tough time selling additional shares at $2.00 per share and would probably have to enter into what is called a down round of financing, in which the price per share is lower than had previously been offered.
 

Existing investors do not like down rounds because their ownership in the corporation is diluted. Essentially, their investment is worth less. That is when antidilution provisions come into play. The first and most harsh antidilution provision is called a full-ratchet conversion. A full-ratchet looks at the price per share paid by the investor and compares it to the price paid later on by other investors and compares the two. If the first investor paid $2.00 per share and later investors paid $1.00 per share, the first investor with full-ratchet protection could convert at a 2to 1 ratio. This is harsh because it applies even if the corporation went out and sold just a few shares at $1.00 per share.
 

The second and more preferable antidilution provision is called a weighted-average conversion. A weighted-average takes into account salesprices just like the full-ratchet, but it also takes into account how many shares were sold at the lower price in proportion to the total outstanding shares of the corporation. 

What the investor is trying to accomplish through these antidilution formulas is to safeguard their position in the corporation. If the investor bought their securities at $2.00 per share and the corporation needs to sell securities in a future round at $1.00 per share because the corporation’s valuation will not support a $2.00 per share price, the investor wants some assurance that they will not be left holding the bag. 

They want some assurance that when it comes time to convert, they will get more shares for their money because of the subsequent lower valuation of the corporation. The corporation will also want to maintain automatic conversion rights if the corporation merges with or into any other corporation, if it sells or transfers substantially all its assets, or in the event of an underwritten public offering. Essentially, the corporation wants to have the option to convert everybody over to common stock if a big deal is coming down the pike and it makes a whole lot more sense to be selling apples as opposed to apples, oranges, pears, and mangos.
 

Redemption can go hand in hand with conversion. A series of stock may be redeemable, in whole or in part, at the option of the corporation upon the happening of a specified event such as a public offering or the sale of the corporation’s assets. So, the investor can either convert to common
stock or have their shares redeemed by the corporation.
 

Preemptive or other Subscription Rights. 

Just as with commonstock, preemptive or other preferential subscription rights are discouraged. If an investor already has some antidilution protection, it is unnecessary to add preemptive rights to the package.
 

Other Types of Stock

In addition to common and preferred stock, there are endless variations and hybrids a creative business attorney can design to reflect ownership in your company. For example, some companies have nonvoting common stock, others have convertible preferred stock that converts into common
stock at the option of the holder or when certain events occur (i.e., a public offering) or both.

Warrants

An often overlooked source of equity financing is the issuance of warrants. A warrant is a contractual right to acquire some shares of a corporation at a specified price for a specified period of time. It is similar to a stock option, but warrants are issued to investors while stock options are issued to
employees, officers, and directors.
 

Warrants are often issued to investors as part of the sale of securities as a sweetener or kicker to an offering of securities. For example, an investor purchasing 5,000 shares of common stock at $1.00 per share would receive a warrant to purchase an additional 5,000 share of common stock at a strike
price of $1.00 per share for a three-year period.


QUICK Tip
Warrants and the Right to Purchase: The holder of a warrant is not obligated to purchase the shares in the future—they just have the right to purchase them. If the warrant holder fails to exercise the warrant, it expires. 


 The company must be careful to comply with federal and state securities laws when using warrants. Since the investor will buy the additional shares under the warrant (if they buy them at all), at some point in the future, it is considered a separate offering of securities.

Limited Liability Company and Limited Partnership Equity

As you may recall, limited liability companies (LLCs) and limited partnerships (LPs) are pass-through tax entities. This means that they file tax returns but do not pay any income tax. Instead, the net income and losses of the company flows through to the equity holders (members or limited
partners) and is reported on their individual tax returns.


Alert!
Partnership (pass-through entities) tax law is complex, so check with your
attorney and accountant every step along the way. 


To understand how a pass-through tax entity works, it is helpful to define certain terms. The first term is allocation. Net income and losses of passthrough tax entities are allocated among the equity holders in predetermined percentages. Those percentages can correspond directly with the percentage
of ownership of the company or they could be different. The latter is called a special allocation that can be used to accelerate an investment return to investors. The second term is distribution. After the net profits and
losses have been allocated to the equity holders, some or all of the net profits
can be distributed to them.



The difference between allocation and distribution is important because an equity holder will pay taxes at the end of the year based upon the amount of net income allocated to them and not on the amount that is actually distributed to them. All operating agreements and limited partnership
agreements should have a provision allowing the managers to distribute sufficient monies to pay the taxes on all allocated but undistributed sums for a particular tax year.
 

A number of factors determine how much of the net profits that have been allocated to the equity holders will actually be distributed. The most important factor is the need to retain funds for use in the operation and expansion of the business. A company may need to retain a portion of the
net profits and use them for the operation of the business rather than to raise more capital from new investors. The basic point, however, is that net profits do get distributed eventually. This is a big advantage over a corporation in which common stockholders may have to wait years before seeing
any return on their investment. For this reason alone, pass-through tax entities are an attractive investment vehicle.
 

The complex partnership tax laws that underlie LLCs and LPs allow for a greater amount of flexibility when it comes to creating an attractive return for investors. The company can allocate a disproportionate amount of the net income or loss to investors. For example, investors may only hold 10% of the equity, but they could be allocated 50% of the net profits to create an accelerated return on their investment.
 

While LLCs and LPs are treated the same for tax purposes, there are differences
in the way each is structured and the way in which equity is
offered to investors.


Limited Liability Company Equity

The equity of a limited liability company (LLC) is called a membership unit (or interest). Unlike a limited partnership, every member of an LLC may participate fully in the management of the company. When an LLC is formed, it may elect to be managed by a manager or managers or by
the members themselves. As a practical matter, if an LLC is looking to raise capital from investors, it will more than likely be run by a manager
or group of managers.
 

Limited liability companies are ideally suited for businesses that are looking to focus on the delivery of a few products or services that will produce distributable cash. Also, keep in mind that an LLC can convert to a corporation in a tax-free exchange known as a Section 351 exchange if the
needs of the company change in the future.
 

An LLC is different than a corporation because it does not have to state a maximum amount of membership units. There can be an infinite number of membership units. However, as part of the planning process to make an LLC attractive to investors, the managers of the LLC will often define a
maximum amount of membership units that the LLC can issue in the operating agreement.
 

A number of factors need to be taken into account when deciding the maximum number of membership units in an LLC, including the total amount of money that the company anticipates raising from investors and the valuation of the company.

 

 AN LLC EXAMPLE

Three people meet through a local business networking event. One is a designer of custom jewelry, the second has experience in managing a company, and the third has marketing experience. The three decide to pool their talents to create a line of custom jewelry and market it to wholesale jewelry dealers.
After meeting with an attorney, the three decide to form an LLC in which they will serve as managers. Each person will have an equal amount of decision-making responsibility and equal amounts of membership units in the company. After filing Articles of Organization with the state corporation commission, they work with their attorney to draft an Operating Agreement for the company.
As part of the Operating Agreement, they designate different classes of membership units to be divided among the founders, investors, and principals of the company (managers, officers, directors, employees, and consultants).The different classes of membership units will have vastly differ ent attributes. The class reserved for the founders will have voting rights, while the class to be issued to the investors and principals of the company may not. In addition, the allocation of net income will be weighted heavily in favor of the investors at first and then gradually even out over time.
 

The managers then work with their attorney, accountant, and a business plan writer to draft a business plan and financial projections. The cost estimate for designing, manufacturing, and marketing the jewelry comes in at $350,000. Based on a number of factors, the company can justify a valuation of $1,000,000. Therefore, if the company were to set a maximum limit of 10,000,000 membership units and then sell 3,500,000 membership units at $0.10 per unit, it would raise enough capital to achieve its goals.
 

The membership units will be split up into three classes:
• 6,000,000 Class A membership units will be reserved for issuance to
founders and managers;
• 500,000 Class B membership units will be reserved for issuance to officers,
directors, employees, and consultants; and,
• 3,500,000 Class C membership units will be reserved for issuance to investors.
 

Obviously, the Class A membership units would be issued to the founders first. Over time, some Class B membership units would be issued as incentives (much like stock options in a corporation) to officers, directors, employees, and consultants. Class C membership units would be sold to investors.
A sample breakdown of the three classes of membership units would probably
look like this:


sample ownership equity of an LLC
 Holding 60% or 6,000,000 of the 10,000,000 maximum authorized membership units will ensure that the founders retain decision-making control over the company for quite some time. Issuing up to 5% or 500,000 membership units as incentives will help establish the culture that the officers,
directors, employees, and consultants are valuable members of the team and provide incentive for them to do a good job. Setting aside 35% or 3,500,000 will ensure that the company has enough breathing room to be able to raise the additional capital it will need to set up and expand
its operations.


Most often, an LLC will structure a graduated reduction in the percentage of net profits allocated to investors. For example, even though the investors as a group will only own 35% of the equity, they could be allocated 60-80% of the net profits until they have been allocated an amount equal to their investment in the company. Thereafter, the investors could be allocated an amount that corresponds directly with their percentage of ownership of the company. There are obviously innumerable variations on this theme that will most likely be driven by how fast investors expect a
return on their investment and how large those returns should be.


Limited Partnership Interests

The equity of a limited partnership is called a limited partnership interest. Limited partnership interests are typically designed and marketed to passive investors whose monetary returns are dependent upon the efforts of the general partner. Most investors in limited partnerships invest because of the passive nature of the investment. They neither want nor desire to make decisions for the partnership. In fact, unlike an LLC, if a limited partner takes too much control of the operation of the business, they run the risk of incurring personal liability just like a general partner.
 

The Revised Uniform Limited Partnership Act, which has been adopted by a majority of states, lists a number of activities that a limited partner can engage in without triggering personal liability. Some of those activities include:
• being an officer, director, or shareholder of a corporate general partner;
• consulting with or advising the general partner on business matters; 

• voting on dissolution of the partnership;
• voting on the sale or mortgaging of partnership assets;
• voting on the incurrence of unusual indebtedness;
• voting on the admission or removal of general or limited partners;
• voting on transactions involving potential conflicts of interest; and,
• all other matters required by the partnership agreement.


Limited partnerships are well-suited for investment ventures that are looking for a handful of high net worth investors, like real estate investments. The general partner will solicit the interest of a few investors, form the limited partnership, and have the limited partnership agreement drafted. The investors will then be brought on board by signing the limited partnership agreement and contributing capital to the venture.
 

Just like LLCs, limited partnerships do not have to state a maximum amount of authorized capital. The limited partnership agreement usually limits the number of limited partnership interests to be sold to investors. Typically, the net income and losses of a limited partnership will be split between the general partner and limited partners, with a disproportionate amount being attributed to the limited partners at the beginning and leveling out later on.
 

Allocation of the net income and losses of the limited partnership are typically split between the general partner and limited partners. In the scenario, the three founders formed a corporation that served as the general partner and they also contributed capital as limited partners.
 

However, a general partner is under no obligation to contribute any capital to the venture.
Because the three founders are serving as officers of the corporation, which is the general partner, they will be entitled to receive compensation from the share that is allocated to the general partner. 


Because they also hold 200,000 limited partnership interests, they will be entitled to their percentage of the share that is allocated to the limited partners. The three founders will not run into trouble and risk incurring personal liability, because they are allowed, as officers and directors of corporation
that serves as the general partner, to have decision-making power. 


THE LP EXAMPLE

Three people are interested in purchasing a piece of commercial real estate for investment, but they do not have enough cash to obtain financing. After consulting with an attorney, they decide to form a limited partnership. The three of them intend to share equally in the decision-making power for the limited partnership, but are concerned about being personally liable for the debts and obligations of the limited partnership.
 

Therefore, the three of them form a corporation in which they are the directors and officers, and appoint that new corporation as the general partner of the limited partnership. After filing a Certificate of Limited Partnership with the state corporation commission, they work with their attorney to draft a Limited Partnership Agreement. The three of them together contribute $200,000 to the venture. In order to obtain financing, they calculate that they will need to raise an additional $800,000 from the sale of limited partnership interests.
 

The Limited Partnership Agreement sets the maximum amount of limited partnership to be sold at 1,000,000 and issues the first 200,000 limited partnership interests to the three founders who contributed the first $200,000. The limited partnership then works with their attorney to draft a Private Placement Memorandum to offer $800,000 in limited partnership interests under Rule 506. The limited partnership interests are offered to investors at $1.00 per unit of interest, with a minimum purchase of $50,000. Sixteen investors later, the limited partnership has the capital it needs to obtain its financing. 

Just like an LLC, the limited partnership can allocate the net income and losses of the partnership any way it wants to. Typically, since the limited partners are putting up all of the capital, they will receive the lion’s share of the profits and losses initially. After some time, the allocations can be adjusted. 

QUICK Tip
Protect Yourself with Redundancy: Spell out your allocation amounts and
schedule in both the limited partnership agreement and the private placement
memorandum. 


If the limited partnership was going to acquire multiple properties with the same financing, serious thought might be given to raising its capital through a series of offerings.

Raising Capital in Stages

When you start your company, you may end up having to give away a healthy portion of your company in exchange for little money because you have nothing more than a good idea. As your successes grow, however, you will be able to justify a higher price for the equity of your company. This iswhy young companies should raise capital in stages and accomplish certain goals with the money they raise. 

 SELLING IN STAGES

An inventor came to an investor with a great idea for some software that would also be a video game. For this venture, the inventor needed to write and build the software, test market it, adapt the software to the video game formats that are out there, and finally, manufacture, market, and distribute
the software. To accomplish these goals, it would take quite a chunk of money, so the investor broke it down: raise some capital to write and build the software. 


Raise more capital to test market and adapt the software to video game software formats. Then, raise some final capital to manufacture, market, and distribute the whole thing. All along the way, the successes of the company justified higher share prices for each of the three rounds of capital raising. Consequently, the company ended up selling off less of its equity than if it had tried to raise it all at once.
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