Structuring Deals with Angel Investors

By Jason Watson, CPA
Posted Saturday, October 21, 2023

We are only going to scratch the surface on the types of deals and arrangements that 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 is, “I have a guy who is giving me $100,000 to help me start my business.” Our next response is, “Will the guy be an investor, lender or both?” Then your response is stunned silence… which is certainly re-assuring. 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 him or her a bank, and pay or accrue interest accordingly. Done. This is also finite, right? After the loan is paid back, the cord is cut, and everyone lives on like perfect strangers.

Investor is a Lender with Profit Interest

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

This is commonly called a profits interest where you receive a share of the future profits (revenue less expenses) and the appreciation of the assets of the business. There are some rules, with the most common one being “the service partner must receive only a profits interest in the partnership in exchange for the contribution of services.” In turn, the profits interest partner cannot be given a share of current capital in exchange for the contribution of services. This makes sense since you usually have tax basis in your capital, and to have tax basis you needed to have paid taxes on that capital at some point in the past.

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 necessary, 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 and they are 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, etc. For example, you have an agreement that upon sale you get 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 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 particular 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 his or her 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).

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 scenario a messy one such as ruined friendships, awkward Thanksgivings and all that 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 business the way you see fit.

Your Capital as a Loan

While there might be some good reasons, typically you do not personally lend money to your single-owner business. We hear it all the time, “my business owes me money.” Unlikely. Rather, what is meant is that you’ve invested money into the business and / or perhaps you’ve paid for business things with personal funds (since the business was broke). This is invested capital and not a loan. When there is distributable cash, you can take that capital out of your business generally tax-free.

Keep in mind that a loan requires a loan document, amortization, interest expense (and income to you) among other things. Therefore, while the business might have your money, it doesn’t technically owe it to you. However, you are allowed to take it back when it’s sitting on a pile of cash.

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 to get a rip of the action ahead of others. In partnerships, not taxed as an S Corp, these “payments ahead of others” are usually in the form of guaranteed payments. You do not have this option in an S Corp unless it is in the form of increased shareholder salaries which largely defeats the purpose of an S corporation election.

What about varying capital accounts in an S Corp situation? Let’s say you and another person are consultants and you ban together to form a 50-50 partnership, and you also want to use the S Corp election to save on self-employment taxes. Furthermore, you have $100,000 to invest and your partner has $1,000 and some average looks. A consideration (not a rule or a must-have) would be to have each of you inject $1,000 in cash as capital, and then you provide the remaining $99,000 to the shiny new S corporation as a loan. This allows for an elegant way for you to get your cash out.

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 allocation 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, and
• Options and warrants, including convertible debt.

This list isn’t exhaustive, but what this is telling 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 a S Corp. That’s easy. However, the outside agreements such as employment, buy-sell, redemption, options, warrants, debt instruments, etc. (all the fun stuff in this section), can create a second class of stock. As you might recall, an S corporation can only have one class of stock (voting and non-voting is allowed, however) according to IRC Section 1.1361-1. Recall? Of course you do!

We talk more about this in a later chapter.

Front-End Backend

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, or the backend, or both? In other words, do you want to make money along the way as an investor owner getting a return on investment from operations? Or… do you want to forego some money from operations, and put more emphasis on an eventual sale?

Sidebar: You might hear the term liquidity event. According to Investopedia, a liquidity event is an acquisition, merger, initial public offering (IPO), or other action that allows founders and early investors in a business to cash out some or all of their ownership shares or interest.

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 over saying 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?

Who knows? Perhaps that is what they have always done, and why change now? Or… perhaps that is how the investor was able to raise capital and the prospectus outlined this detail such as “all equity investments will be made into C corporations domiciled in Delaware only.”

By now you should have a good handle on the fact that a C corporation is a lousy tax vehicle and that Delaware only adds to your tax filing headache if you operate in a state other than Delaware. 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 personally are 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 to this new member, this is not a taxable event. This also does not mean the business is worth $250,000 (1/5 = $50,000 so 4/5 = $200,000). 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 then lack of marketability (difficulty in 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 a part of the capital account of the new owner. This is a tax-less transaction for the existing or original owner(s).

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

• The entity can 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 (versus a corporation), the second scenario is preferred. There is an election under Section 754 which allows a new member (partner) to receive a step-up in basis of the entity’s assets which might lead to additional depreciation and amortization benefits. The “754 election” as it is commonly tossed around at parties and accounting back alleys aligns the new member’s portion of inside basis (the assets inside the entity) with the outside basis (the investment by the new member). This can also occur when you buy out another member (partner).

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 backend. The product cost about $7.5 million dollars to develop and ABC fronted all the costs.

They wanted to create another entity where our client was going to be a 25% owner and ABC was going to be the remaining 75%. Initial capitalization was low since our client did not want to realize any income until later. In other words, if the injected product was valued at $10 million, our client might have to realize the $836,000 deferred income as part of the $2.5 million capital account. There were a bunch of other basis issues that are 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 out 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 $826,000 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. Then 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 be sold for more than $8.4 million or so that was split 75-25 (or along party lines of the member interests).

This was a shared risk approach. Certainly, ABC was the 800lb 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 and 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 several options and you can certainly rip off best practices or other ideas, smash them up, and create your own plan.