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Capital Financing and Syndications

I. Capital Structures and Needs

The lifeblood of business, capital fuels start-ups, company growth and, for the benefit of owners, the sale of the company. To address these different needs, financial markets have developed innumerable products with unique characteristics targeted to the following types of needs.

A. Start-Ups

Start-up companies typically finance development and commercialization through a “seed capital friends and family” round, followed by an angel round, one or more venture capital rounds. Once established, the company may obtain growth capital as described in Corporate Finance below. The final stage of these companies involves the exit of the owners financed by an initial public offering or a sale of the company.

B. Real Estate Syndication

Through real estate syndications, real estate developers finance property acquisitions and development. Real estate syndications (which may also be viewed as serial start-ups) usually allocate returns between the investors and the developer with a “waterfall” approach. Called “waterfalls” based on the analogy of “economic returns” cascading into subsequent pools of cash after filling the previous pool, the developer earns increased carried interests or shares of return as higher investor return levels are achieved. These financial structures are complex and require financial modeling of projected returns. Although numerous financial software models are available, an example of one commercial model is available at https://breakingintowallstreet.com/biws/real-estate-modeling/. Before using any financial model, the software calculations should be examined to confirm proper structure.

C. Corporate Finance

More established businesses obtain debt capital from institutional lenders (such as banks, insurance companies and large private lenders) and equity capital from investment banks, private equity groups, family offices and large private investors. Debt capital may be structured as senior debt, mezzanine debt, convertible debt and exchangeable debt. Stock warrants (right to purchase equity on favorable terms) may be issued to lenders as an “equity sweetener” to increase their return. Equity capital may be raised by the sale of common stock, convertible preferred stock, warrants and various other equity instruments.

II. Common Restrictions and Requirements

While financing structure variations are too numerous to catalogue, securities laws and financial covenants apply to all financings.

A. Securities Laws

In response to fraudulent securities offerings considered to cause the Great Depression, Congress passed federal laws in the 1930s requiring registration of sales of securities (the “registration requirement”) and disclosure of all material facts (the “antifraud requirements”). The states followed suit with their own state securities or “blue sky” laws. These laws apply to “securities” – a term which has been expansively defined beyond traditional concepts (such as stock) to include equity interests other entities such as limited liability companies and limited partnerships), certain debt instruments issued by a borrower for a loan, and even interests in orange groves managed by the promoter.

Without a statutory exemption from the registration requirements, sales of securities must be registered with the U.S. Securities and Exchange Commission (SEC) for review prior to sale. Selling a “security” in violation of the registration requirements is illegal. The issuer (seller) of the securities and its “control persons” (directors, managers and officers) in an illegal offering can be personally liable for the full amount received from investors, even if the business fails for unrelated and unforeseeable reasons. No exemption exists from the antifraud requirements of full disclosure. A violation of the antifraud requirement also results in an illegal offering with liability to the issuer and its control persons.

With registration costs typically being significant six-figures, capital raises are structured to meet registration requirement exemptions when possible. One of the most popular registration exemptions is the “Rule 506” offering because it also overrides state registration requirements.

While not limiting the amount of capital that can be raised or the number of “accredited investors,” no more than 35 nonaccredited investors are permitted. An accredited investor includes certain types of entities as well as an individuals who: (i) is a director/manager or executive officer of the issuing company; (ii) individually or jointly with his or her spouse, has a net worth (excluding primary residence, total assets in excess of total liabilities) in excess of $1,000,000 at the time of purchase; or (iii) had annual income exceeding $200,000 (or $300,000 jointly with his or her spouse) for the two most recent calendar years and reasonably expects the same level of income for the current calendar year. If the offering is limited to “accredited investors,” there is no required disclosure format but an offering circular/private placement memorandum should be prepared to address the antifraud requirement. If any nonaccredited investors are permitted, an offering document satisfying SEC registration requirements becomes necessary which dramatically increases costs. Other requirements to satisfy the Rule 506 exemption exist. As required by the Jumpstart Our Business Startups Act (the JOBS Act), the SEC recently relaxed the prohibition against “general solicitation” activities which severely limited selling activities.

B. Financing Covenants

All financing sources, including institutional, venture capital, private investor and other capital providers, require representations, warranties and covenants to protect their funds. The principal owners may also be required to guarantee certain obligations. While these restrictions and obligations are common to all financings, their scope and extent vary based on the company’s capital structure. The capital structure governs the payment priority among the financing sources. This payment priority, in turn, influences the protective representations, warranties and covenants sought. Even in equity investments, preferred stock (the favored investment form of venture capital and private capital sources) contain protective provisions and preferential payment rights over common stock (typically owned by founders and management) which constitutes the residual economic interest in the company after payment of all debt and senior equity.

This brief overview is only an introduction to the complex issues inherent in financing transactions and this summary belies the complexity of legal issues in this area. No financing transaction should be undertaken without experienced and knowledgeable legal counsel.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts. Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.

Business Arrangements

A. Scope of Business Arrangements

The term “business arrangements” generally describes various business activities of our clients. More specifically, these activities include entity formation, owner buy-sell agreements, admission and withdrawal of owners, purchase and sale of business assets or franchises, obtaining or providing security interests to secure payment or performance obligations, and releases of obligations to settle disputes.

B. Entity Formation

Texas offers several types of entities for liability protection, including corporations, limited liability companies (LLCs), limited partnerships, various professional entities and combinations of the foregoing. Regardless of entity type, the formation process consists generally of the following:

  • confirming name availability by calling or emailing the Texas Secretary of State at 512.463.5555 or corpinfo@sos.state.tx.us. Name approval only determines name availability in the Secretary of State’s records; without a separate trademark search to confirm availability, the name may infringe another’s trademark.
  • engaging a registered agent
  • filing a certificate of formation with the Texas Secretary of State
  • preparing governing documents – bylaws (corporation or association), company agreement (LLC) or partnership agreement (limited partnership)
  • organizing the newly formed entity by issuing ownership interests, adopting the governing documents, and electing governing persons (directors, managers and officers)
  • obtaining an employer identification number from the IRS – https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
  • providing a bank with the entity’s EIN and copies of the filed certificate of formation and governing documents to open a business account.

Series LLCs, popularized by real estate investors and owners of multiple assets desiring lower profiles, require additional formation. A series of an LLC is not a separate entity from the Master LLC and may be best conceptualized as a “cell” of the Master LLC. The certificate of formation and governing documents of Series LLCs establish one or more series of members, managers, membership interests, or assets that have separate rights, obligations and liabilities and business purposes from the Master LLC. Each individual series has the ability to sue and be sued, enter into contracts, hold title to assets, and grant liens or security interests in its assets.

Joint ventures and strategic alliances combine or share joint operating and ownership activities for a specific business objective through contractual arrangements or through partnerships, LLCs or corporate entities.

Entity formation services abound on the internet. Unfortunately, these services require the individual to determine the best type of entity for the particular business and ownership structure. These services also fail to advise the owners of best practices for avoiding personal liability for the entity’s debts and obligations.

C. Owner Buy-Sell Agreements; Admission and Withdrawal of Owners

Ownership changes are inevitable. A buy-sell agreement among owners anticipates these changes at a fraction of the cost of ensuing litigation from disputes regarding these foreseeable changes. Buy-sell agreements should address:

  • business “divorce” & impasse resolution
  • transfer restrictions and rights of first refusal
  • initial capital contributions & ownership vesting
  • withdrawing owner’s equity & purchase rights
  • additional capital contributions – obligations and penalties
  • treatment of deceased owner’s equity
  • representation on the board of directors
  • drag-along right whereby majority owners can require minority owners to join in a sale
  • co-sale right whereby minority owners can elect to join in sales by majority owners
  • permitted transfers for estate planning
  • confidentiality and noncompetition obligations

D. Purchasing or Selling Business Assets

Business assets may be bought and sold in discrete transactions or as part of ongoing supply or distribution arrangements. Confidentiality of these business terms should be considered. Sales involving significant seller-financed amounts should contain protective provisions restricting purchaser’s activities, addressing defaults and acceleration rights for certain events, and requiring collateral (see Security Interests discussed below). In lieu of specified quantities, purchase and sale arrangements may consist of purchaser’s agreement to purchase all of its goods from seller (a “requirements contract”) or of seller’s agreement to sell its entire production to purchaser (an “output contract”). The Uniform Commercial Code (UCC) provides a “default” set of commercial laws which may be modified, for the most part, by written agreement. Unfortunately the UCC default rules regarding these types of contracts are generalized, vague and difficult to apply to particular situations. Contractual terms addressing obligations (while disclaiming others) and contingencies such as unanticipated production problems and demand or price spikes provide greater certainty and minimize disputes with valued trading partners.

Warranties of merchantability, noninfringement and, if applicable, fitness for a particular purpose are implied as a matter of law under the UCC to all goods sold. To avoid the ambiguity and scope of these implied warranties, knowledgeable suppliers adopt express written warranties detailing the scope and limits of their obligations to replace these UCC warranties. If the strict UCC requirements are not satisfied, attempts to limit the damages and remedies for violations of the UCC warranties are unenforceable.

Purchase orders and invoices frequently contain conflicting terms. Deciding which terms are effective involves the dreaded “battle of the forms” triggering the various UCC “knockout” rules. While a favorite of law school professors for law school exams, few businesses want to become the subject of these exam questions. Rather than “after the fact” litigation of this battle, addressing this issue at the outset enhances certainty while saving money.

E. Purchasing (and inadvertently selling) a Franchise

Many of the issues outlined in Business Acquisitions – Part 1 and subsequent articles on this website apply to franchise purchases. Importantly, franchise purchases raise additional issues relating to the nature of a franchise. A franchise is essentially a license to operate a branded and systemized business for a limited time period (typically 10 years). Because the franchisor must protect its brand (trademarks and service marks), franchise agreements impose many financial, operating and quality obligations on the purchaser/franchisee. Just as commercial leases are landlord-biased, franchise agreements are franchisor-biased. When negotiating these agreements, prioritizing issues is critical as it counterproductive to request numerous changes of lesser importance.

Businesses licensing others to use their trademarks in connection with distribution or supply arrangements may be selling an “inadvertent franchise” or “accidental franchise.” Under trademark law, licensing a trademark without retaining adequate quality control results in abandonment or loss of the trademark. However, retaining these quality control rights resemble the operating and quality controls of a franchise. Unlike trademark licenses which are private contractual matters, franchises are heavily regulated by the Federal Trade Commission (FTC) and by many states. Although state definitions vary, the FTC defines a “franchise” as any continuing commercial relationship or arrangement in which:

“(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

After analyzing the licensing arrangement under FTC regulations and applicable state franchising laws, modifying the proposed operations may be necessary to avoid elements of the “franchise” definition or to qualify for an exemption or exception from the definition.

F. Security Interests to Collateralize Payment or Performance Obligations

A promise to pay or perform obligations may become an empty promise without collateral and/or personal guaranties. The UCC sets forth the requirements for security interests on most tangible and intangible assets. Requirements include a written agreement granting the security interest and identifying the collateral followed by “perfecting” the security interest to maintain collection priority over subsequent creditors. Security interests may also be granted on ownership interests in corporations, LLCs and limited partnerships as “general intangibles” under Article 9 of the UCC. However, these types of security interests are inadequately protected unless the issuer corporation, LLC or limited partnership “opts in” to UCC Article 8 (Investment Securities) as part of the collateralization process. The opt-in procedure is simple and prevents unscrupulous debtors from circumventing the perfection (priority protection) of the security interest.

G. Settling Obligations

Not all business arrangements are successful. At times, breached obligations and liabilities must be settled with payments and releases. Releases should extend to affiliates of the parties and waive and release all business obligations (outside of the release agreement) and all known and unknown claims existing as of the release date. Texas courts require releases to have conspicuous language expressly stating any release of negligence claims. Other states have statutes require special language for releases. To be effective, releases of claims arising out of employment relationships must strictly comply with requirements under federal and state anti-discrimination laws.

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