Structuring Deals with Angel Investors

We are only going to scratch the surface on the types of deals and arrangements you might see out there. Our intent with this section is to illustrate some of the considerations. One of the common statements we get from clients at WCG CPAs & Advisors is, “I have a guy who is giving me $100,000 to help me start my business.” Our next question is, “Will the guy be an investor, a lender or both?” Then your response is stunned silence… which is certainly reassuring. Not!

There are many ways to handle this, and no one way is always the best. It depends on humans, emotions and personal objectives. Don’t forget the golden rule, where the person with the gold makes the rules (you hear this often in our book, but it is so true).

Here are some ideas and various considerations-

Investor Is Truly a Lender

If the investor wants to get paid back first with interest, then make them a bank, with a promissory note, a commercially supportable interest rate and a repayment schedule. If the loan falls under the related-party or below-market loan rules, the applicable federal rate (AFR) becomes important (IRC Section 7872). Done.

Better yet, a lender doesn’t get a vote. As long as the payments show up on time, they have no say in how you run the business, who you hire or what color you paint the lobby. The loan documents might carry a few covenants, but that’s a far cry from a partner second-guessing every decision. This is also finite, right? After the loan is paid back, the cord is cut, and everyone lives on like perfect strangers.

Then again, if the bank of Mom and Dad is the lender, they will certainly act like an investor. Good luck with that. And family loans are exactly where those AFR rules come into play.

Investor Is a Lender With an Economic Interest

Same as above, but once the loan is paid back, the investor continues in an economic interest capacity and has a claim to some of the business profits. Perhaps this claim expires at a predetermined time, such as five years following loan repayment. This is tricky, since the investor is both a lender and an owner of sorts, which could be conflicted.

This is a cousin of the profits interest in our Economic Versus Equity Interests section, with one difference. The investor earned it by lending money rather than by providing services, so the tax treatment that makes a service partner’s profits interest tax-free on receipt doesn’t apply. Depending on how it is structured, the IRS can view the investor’s profit share as additional interest on the loan, which is ordinary income to the investor and deductible to you, or as a true partnership interest (IRC Section 385 and Notice 94-47 list the factors). Decide which arrangement you actually want, and structure the documents and economics accordingly.

Investor Is a Lender With an Interest Upon Sale

Similar to above, but the lender gets a piece of the action upon sale. Perhaps the loan is paid back as agreed, with the sale option enduring into perpetuity. The thought process is, “Hey, I helped you get off the ground, and now you owe me beyond the 8% interest I charged.” Surely these are your inside words, presented in a softer way to others.

Some caution is in order too. You might not have any control regarding the sale, such as terms, timing and so on. For example, you have an agreement that upon sale the investor gets 10% of the proceeds. Great! What constitutes a sale? What if a 100% owner sells 60% of the business but retains the remaining 40%? Hmmm. In these cases, you could draft the agreement to read that upon a sale, partial sale or change in control, there is a payout.

That change in control is a big deal, since you probably have a personal connection with the owner, and now you are tethered to someone else. People are pro-marriage, but they generally do not want to be told who to marry.

Back to the original idea. The investor is initially the lender but has a contractual interest should an event occur, regardless of the current loan status (paid off or not). These arrangements need to be stress tested with various scenarios and contingencies.

Investor Is an Owner

Rather than recording a loan on the books, the injected cash is credited to the investor’s capital account. The investor may get a return of capital prior to other owners per an agreement. In other words, distributable cash goes to the investor first as a return of their original investment. The splits can vary. For example, the investor contributed $90,000 and you contributed $10,000. You could still own 90% of the entity while the investor only owns 10% (an exact flip-flop). We call this special allocation, and it holds up only if the Operating Agreement makes the economics real under IRC Section 704(b), which is why an attorney who does this for a living drafts it.

Loans Versus Capital

Most lenders want some sort of guarantee from the owners. As such, the angel investor might demand that you guarantee the loan personally, which can make a failed business or real estate venture a messy one, causing ruined friendships, awkward Thanksgivings and all that fun stuff. Conversely, an investor who wants to be an owner (versus a lender) and injects capital now has a seat at the table, so to speak, and might not fully let you run the venture the way you see fit.

S Corp Rigidity

As we have explored in other parts of our book, S corporations can be super rigid with the splitting of distributable cash. At times you also want a cut of the action ahead of others. Partnerships have much more flexibility, including preferred distributions, special allocations and guaranteed payments for services or the use of capital. An S Corp generally cannot provide preferential distribution rights, although differing shareholder salaries can create some economic flexibility, often at the expense of additional payroll taxes.

What if you’re the one bringing most of the money? We cover how to put your own cash into the business, and how to get it back out, in our Funding Your Own Business section.

Ineffective S Corp Elections

Limited liability companies are amazingly flexible in structuring a deal. As mentioned elsewhere, you can build an LLC with all kinds of deal structures, such as-

• Special allocations of income and losses (including qualified income offsets to maintain compliance).
• Liquidating distributions made in accordance with positive capital account balances.
• Employment agreements.
• Buy-sell and redemption agreements.
• Options and warrants, including convertible debt.

And anything that walks and talks like the above without the headline.

This list isn’t exhaustive, but what it tells us is that certain agreements inside and outside the Operating Agreement might make the S Corp election ineffective. Why? Special allocations are simply not allowed in an S Corp. That’s easy. The outside agreements are a judgment call. Employment agreements and buy-sell or redemption agreements at fair market value are generally fine. Options, warrants and convertible debt can create a second class of stock, especially when they’re priced to shift value among owners. As you might recall, an S corporation can only have one class of stock (voting and non-voting are allowed, however) according to Treas. Reg. 1.1361-1(l). Recall? Of course you do!

We talk more about this in a later chapter.

Front-End or Back-End Money

There are two things to consider when bringing in another owner or becoming that new owner yourself. Do you want to make money on the front end, the back end or both? In other words, do you want to make money along the way as an investor-owner getting a return from operations? Or… do you want to forgo some money from operations and put more emphasis on an eventual sale?

Sidebar: You might hear the term liquidity event. It means an acquisition, merger, initial public offering (IPO) or other transaction that lets founders and early investors cash out some or all of their ownership. In plain English, the day the paper turns into money.

Of course, your risk aversion and the risk versus reward thing are going to drive this decision, including your current lifestyle and income needs. Are you the person who works hard trusting you’ll get paid in the end? Or are you the person who wants money today and is willing to sacrifice the big payday at the end? Everyone is different. Every deal is different. You just need to find one that fits everyone involved.

Venture Capital

As we’ve mentioned here and there, and at the risk of overstating it, the one with the gold makes the rules. This is the Golden Rule. Some venture capitalists and other “professional” investors have specifications before they will entertain an investment. For example, an investor might require a C corporation domiciled in Delaware. Period. Take it or leave it. Why?

Partly habit, and partly how their fund was raised, with a prospectus that says something like “all equity investments will be made into C corporations domiciled in Delaware.” But there are real reasons too. Venture funds are partnerships, and a partnership cannot own S Corp stock. Investors want preferred stock, which an S Corp cannot issue. And the qualified small business stock exclusion we mentioned in another section requires a C Corp. Delaware is about corporate law and courts that investors know, not taxes.

By now you should have a good handle on the fact that a C corporation is usually a lousy tax vehicle for a small business, and that Delaware only adds to your filing headache if you operate somewhere else. But! If that is what it takes to receive seed money for your big idea, then that is what you do.

Nuts and Bolts of Adding Another Owner

Let’s assume you have a single-member LLC, and you want to add a 20% member for $50,000. What are the accounting mechanics behind this transaction? It depends. If you are personally receiving the $50,000, then you are selling a part of your interest directly to the new owner, which might create a capital gain to you as a seller.

Conversely, if the LLC is receiving the $50,000 as a capital injection and carving out a 20% interest for this new member, this is generally not a taxable event. This also does not mean the business is worth $250,000 ($50,000 for one-fifth implies $200,000 for the other four-fifths). When a business valuation is performed, the enterprise is valued as a whole, and then discounts are taken for lack of control (minority interest) and lack of marketability (difficulty converting ownership into cash).

Therefore, this $50,000 is just a number the two of you came up with based on some data. When that $50,000 is received by the LLC, it becomes the capital account of the new owner. This is a tax-free transaction for the existing or original owner(s). Either way, your single-member LLC just became a partnership, with a Form 1065 to show for it.

Let’s recap this a bit. When adding an owner, you can-

• Sell or gift a portion of your interest or shares to them, or
• Have the entity sell shares or “create” an interest in exchange for consideration (usually money, but it could easily be another asset like property).

In the case of an LLC, the second scenario is often preferred. No gain to you, and the business keeps the cash to work with. The first scenario has a different tax consequence. When someone buys part of your single-member LLC, the IRS generally treats the transaction as a partial sale of the underlying assets, which gives the buyer a new tax basis in their share of those assets.

Once the LLC is already taxed as a partnership, a different rule comes into play. When a new member purchases an existing partner’s interest, or you buy out another partner, an election under IRC Section 754 can give the buyer an adjustment to their share of the partnership’s inside asset basis, which can mean additional depreciation or amortization. The “754 election,” as it is commonly tossed around at parties and in accounting back alleys, aligns the buyer’s share of inside basis (the assets inside the entity) with their outside basis (what they paid). S corporations have no equivalent, which is one more reason LLCs are the better deal-making vehicle.

Sorry for throwing you into the weeds on this little tax code issue.

Injecting Different Property

This is one of those Pet Shop Boys “I’ve got the brains, you’ve got the looks, let’s make lots of money” sort of things. The best way of describing this deal arrangement is with a real-life example.

WCG has a client who helped a business (let’s call them ABC Co) develop a product. However, he wasn’t fully paid for his services (about $836,000) and was willing to get paid on the back end. The product cost about $7.5 million to develop, and ABC fronted all the costs.

They wanted to create another entity where our client would be a 25% owner and ABC the remaining 75%. Initial capitalization was kept low, and the ownership economics were structured carefully, since our client did not want to receive a taxable capital interest in exchange for unpaid services. In other words, if the injected product was valued at $10 million, our client might have had to realize the $836,000 of deferred income as part of a $2.5 million capital account. There were a bunch of other basis issues not worth going into with this approach.

So, it was abandoned for a different arrangement.

The plan was to keep developing the product and eventually sell to another business who would take it to market (a liquidity event). If this new entity sold for $12 million, then it would be easy to pay out $7.5 million to ABC and $836,000 to our client, and then split the remainder 75-25. But what if it sold for $5 million? Who gets what and when?

We agreed on various tranches. Tranche 1, ABC received $2,500,000. Tranche 2, our client received $278,000. Tranche 3 was 90% ABC and 10% our client for the remainder of what was available. Finally, there was a Tranche 4, should the business sell for more than $8.4 million or so, split 75-25 (along party lines of the member interests). If that sounds like the profits interest and waterfall ideas from another section, it is. Same tools, bigger numbers.

This was a shared risk approach. Certainly, ABC was the 800-pound gorilla and wanted to recoup a big chunk first, but it was also willing to reduce our client’s risk as each tranche was satisfied.

These things are unique, since they involve humans, emotions and various risk horizons. But as they say, there are a thousand ways to skin a cat, and as such, only limited imaginations get in the way of a good deal.

Recap of Angel Investors

Are we suggesting avoiding these situations entirely? No. At times they are the only options available. We just want to let you know of the concerns and considerations. Marriage is all about love, and divorce is all about money. Business is no different, and in some respects can be worse.

The cool thing is that you have several options, and you can certainly rip off best practices or other ideas, smash them up, and create your own plan.