CHAPTER 4

Preparing Your Company for a Crowdfunded Offering

Having decided that your company is a good candidate for a Title III crowdfunded offering, you will need to do several things before you begin drafting your offering statement, contacting funding portals, and taking the other steps necessary to launch the offering that we will discuss in Chapter 5.

Choose the Right Legal Entity

Regulation Crowdfunding requires that an issuer of crowdfunded securities be “incorporated or organized.” Unincorporated businesses such as sole proprietorships and partnerships do not qualify for crowdfunding.

That leaves only three types of legal entities that legally qualify for Title III crowdfunding:

1.Regular or C corporations

2.Subchapter S corporations

3.Limited liability companies

Regular or C Corporations

A corporation is a taxable entity; when you form a corporation it is as if you have had a baby and the baby pays taxes from the day it’s born. It’s called a C corporation because it is taxed under Subchapter C of the Internal Revenue Code of 1986.

What’s Good About a C Corporation? In two words: limited liability. Generally, the owners of a C corporation (called shareholders or stockholders) are liable only for the amounts they contribute (or agree to contribute) as capital to the corporation but will still be liable for their own negligence or stupidity.

EXAMPLE 1: A and B are shareholders of ABC Corporation. A runs over someone with his car while on the corporation’s business. The injured party may sue the corporation and win a judgment up to the amount of the corporation’s assets (because that’s all it has). The injured party may sue A in his individual capacity and take A’s house away. But the injured party cannot sue B in any way unless it can be shown that B contributed actively in some way to the injury (for example, B served A too much liquor, which caused A to be intoxicated at the wheel).

EXAMPLE 2: A and B are shareholders of ABC Corporation. ABC Corporation enters into a contract with a supplier to buy ten thousand widgets and then discovers that it doesn’t have enough money to pay for the widgets. ABC Corporation breaches the contract, and the supplier sues. The supplier may sue the corporation and win a judgment up to the amount of the corporation’s assets, but the supplier cannot sue A or B, even if A or B actually signed the contract as an officer or employee of ABC Corporation.

What’s Bad About a C Corporation? C corporations are expensive to form. Legal expenses and filing fees are usually between $1,000 and $1,500 to form a corporation in most states. They are also expensive to keep alive: if a corporation fails to pay taxes for X consecutive years or fails to file a report (and pay a fee) every Y years with the secretary ofsState’s office, the attorney general comes along and dissolves the corporation (and your limited liability along with it). To add insult to injury, you are not informed that this has been done, so you continue blissfully doing business, thinking you have a corporation when you really don’t.

If you don’t use the corporation and treat it with respect, you lose the corporation. People suing you for something your corporation did will always try to argue they didn’t know they were dealing with a corporation—if you conducted business in your own name, wrote checks from your own checking account, and accepted money in your own name that should have gone to the corporation, you can’t argue it was really the corporation that should be sued and not you personally. Lawyers call this piercing the corporate veil.

C corporations involve lots of paperwork. When you have a corporation, you don’t do anything; the corporation does everything. This means that for a corporation to do anything, the shareholders (that’s you) have to prepare written documents (called resolutions or minutes) authorizing the directors of the corporation (again, that’s you) to do the thing, and the directors have to prepare written documents authorizing the officers of the corporation (again, that’s you) to do the thing. Resolutions are a pain in the neck, but if you don’t do them you will be tempting the courts to say you didn’t treat your corporation with the proper respect so creditors are allowed to get at your personal assets.

Dealing with taxes is somewhat complicated when you have a C corporation. Because corporations are taxable entities, they file their own returns (IRS Form 1120, due March 15 of each year for a calendar year corporation) and pay taxes separately from the owners (albeit at a lower rate than you do, in most cases). This means that any income a corporation earns is taxed twice.

EXAMPLE: XYZ Corporation has two stockholders, A and B, and makes $100 in net income for a particular year. The corporation pays 15 percent to Uncle Sam as federal income tax and books the remaining $85 as net after-tax earnings. XYZ Corporation then resolves (remember those minutes?) to pay A and B the $85 in the form of a dividend, and distributes $42.50 to each of A and B. A and B each has to report that $42.50 as income on Form 1040 for the year and pay taxes on that $42.50 at his or her individual rate. The result? If A and B are in the top tax bracket, that $100 in corporate income has dwindled to about $26 in each of A’s and B’s hands after federal income taxes. Add state and local taxes to this calculation, and the tax bite becomes much larger.

The C Corporation as a Crowdfunding Vehicle. If you are planning to raise capital in an accredited-investors-only offering under SEC Rule 506(c) and Title II of the JOBS Act, you are almost certainly going to have to organize your company as a C corporation. Why? There are two basic reasons:

1.Professional investors and angel investors normally like to receive preferred stock in the companies they invest in, and S corporations, as we can see below, cannot issue preferred stock. While LLCs can legally issue preferred membership interests, the mechanics are quite cumbersome and awkward to draft in legal language.

2.When sophisticated or professional investors see the LLC designation after a company name, they tend to think “small-time, mom-and-pop, will never grow big.” This is a false view, as there is nothing in the law to prevent an LLC from growing big or even eventually going public. The bias against LLCs, however irrational, is strongly felt within the investment community. Accordingly, a new business that plans to seek venture capital or private equity funding (angel money) within the first one to two years of its existence should be set up as a corporation, preferably in a state like Delaware that offers a number of advantages to venture-capital-backed companies.

C corporations are also an ideal vehicle for a Title III crowdfunded offering because of the limited liability they offer and the opportunity to create a special class of securities for your crowdfunded investors. Also, as a matter of optics, many people in the investing community take corporations more seriously than they do LLCs.

Subchapter S Corporations

An S corporation is the same as a regular or C corporation with one important difference: it is not taxed by the federal government. This means that the S corporation is taxed just like a general partnership: profits, losses, and other tax benefits flow through to the corporation’s shareholders and are taxed on their individual Form 1040 tax returns, but with the powerful advantage that stockholders in an S corporation have limited liability, unlike partners in a general partnership, who are personally liable for everything that happens in the partnership business.

However, some state and local governments (including New York City) do not recognize S corporations. This means that S corporations with offices in such states or municipalities are taxed twice at the state or local level.

What’s Good About an S Corporation? Like a C corporation, there is limited liability: shareholders are not personally liable for debts and obligations of the corporation. Moreover, the corporation is not taxed by the federal government, although it does file its own tax return (Form 1120-S, due on March 15 each year; virtually all S corporations are required to use the calendar year for accounting purposes).

Taxation is also favorable. Because the S corporation does not pay taxes, profits, losses, and other tax benefits flow through to the corporation’s shareholders, who report these on their personal Form 1040 federal income tax returns.

What’s Bad About an S Corporation? Because S corporations are taxed like partnerships, S corporations have what is called a phantom income problem. This means that, unlike C corporation shareholders, who are taxed only on amounts the corporation distributes or pays out to them, S corporation shareholders must also pay taxes on their pro rata (proportionate) share of the corporation’s profits and losses that were not distributed to them.

EXAMPLE: XYZ Corporation, a subchapter S corporation, had $100,000 in taxable income this year. The corporation has two shareholders, A and B. A owns 60 percent of the corporation’s shares, and B owns 40 percent. The corporation did not distribute any cash or dividends to either shareholder. At the end of the year, A must report $60,000 as income on his federal income tax return (60 percent of $100,000), and B must report $40,000 (40 percent of $100,000) as income on his federal income tax return.

Subchapter S corporations were originally designed only for small businesses; they were never intended to go big or launch an IPO. Accordingly, S corporations have lots of icky little rules to comply with if they don’t want to be taxed as a regular or C corporation. (Note: if the IRS takes away your S corporation status you don’t—repeat, don’t—lose your limited liability; the worst thing that happens is that you’re taxed as a regular or C corporation). For example:

Only natural human beings can be stockholders in an S corporation (no corporations, LLCs, or trusts, with only one or two limited exceptions).

S corporations can’t have more than one hundred stockholders (that alone puts Title III crowdfunding out of reach for S corporations).

S corporations can have only one class of common stock (no preferred stock, which alone puts Title II accredited-investor-only financing out of reach for S corporations).

The shareholders of an S corporation must be U.S. citizens or green card holders (permanent resident aliens of the United States).

The S Corporation as a Crowdfunding Vehicle. Generally, it’s a bad idea. Most accredited investors involved in a Title II private placement under Rule 506(c) want to receive preferred stock or some other form of senior security, which S corporations cannot issue as they are limited to a single class of security.

The one-hundred-investor limit and the prohibition on foreign and corporate shareholders will also put Title III crowdfunding out of reach for S corporations.

If your business is currently organized as an S corporation, you should discuss with your accountant or tax adviser the possibility of opting out of an S corporation and becoming a C corporation before launching any sort of crowdfunded offering. Keep in mind, however, that if you do convert to C corporation status and the crowdfunded offering goes nowhere, you will not be able to elect to be taxed again as an S corporation for three consecutive tax years.

Limited Liability Companies (LLCs)

Since the early 1990s, the LLC has become the legal entity of choice for many small businesses and early-stage technology start-ups.

What is an LLC? Well, it’s basically an S corporation without all the icky little rules that make S corporations unattractive for a lot of folks.

What’s Good About an LLC? Owners of an LLC (called members) have limited liability. If A and B are members of an LLC and B runs someone over with her car while on LLC business, B may lose her house, but A will not lose his house unless A actively contributed to the injury.

Like partnerships, LLCs are simple to operate. There is no need to prepare resolutions or minutes to authorize people to do things (although banks and some other folks may still require you to do resolutions because they haven’t gotten the idea yet)—they just do them. If the idea of doing legal paperwork makes you want to gag, the LLC is the legal entity for you.

The costs of starting up an LLC are likely to be much less than forming a C corporation or an S corporation—$400 to $600 in most states.

LLCs are taxed like partnerships, so there is no double taxation of an LLC’s income. Everything flows through to the owners of the LLC, who report their shares of the LLC’s income on their personal federal income tax returns, the same as shareholders in an S corporation. However, as was the case with S corporations, owners of an LLC must pay taxes on phantom income the LLC earns that is not distributed to them in the form of cash.

If you are doing a lot of overseas business, the LLC format may give you an edge on your competition. Most foreign business organizations (such as the German GmbH and the Italian S.r.l.) are a lot closer in structure to an LLC than they are to a partnership or corporation; with an LLC, you can give your managers the same titles as their European or Asian counterparts (Europeans especially cannot understand that in America one can be a “director” of a corporation and have absolutely no power to bind the corporation; in Europe, business organizations are managed by their “directors,” not by officers or mere employees).

What’s Bad About an LLC? Really not a lot. While not actually flawless, LLCs are the closest thing to a perfect business organization the law has come up with to date. Limited liability, favorable tax treatment, and easy to operate: who could ask for more?

There are a few negatives, however.

It may be difficult for existing businesses to convert to LLC status: corporations and their shareholders incur double taxation upon liquidation, while general and limited partnerships formed to acquire or hold title to real estate (as many are) may incur transfer taxes and other fees on converting to an LLC.

If your business is high tech or will seek outside capital within the first twelve to eighteen months of operations, be aware that many investors (wrongly) associate LLCs with small business, mom-and-pop, no growth potential. While this perception is unfair, it is widespread, and you may want to consider becoming a C corporation instead (preferably in a high-visibility state like Delaware).

LLCs are not recommended for businesses that will have physical locations in New York State. When New York adopted its LLC statute in 1994, it included a burdensome publication requirement that drives up the costs of forming a New York LLC. LLCs in New York are required to publish a legal notice in two newspapers—one daily and one weekly—in each county in New York where the LLC maintains an office of business. In most upstate counties, the cost of doing this publication is in the $200 to $300 range. In New York City, however, the cost can be upward of $2,000 to $3,000. Also, LLCs located in New York City are subject to that city’s unincorporated business tax. Overall, it may be less expensive to form a corporation or S corporation in New York State than an LLC.

A growing number of states are imposing special taxes or minimum taxes on LLCs and other unincorporated business organizations. For example:

California and Rhode Island have a minimum $800 income tax on LLC profits, payable even if the LLC had no profits.

Connecticut requires domestic and foreign LLCs to pay a business entity tax of $250 every two years whether or not they make money.

The LLC as a Crowdfunding Vehicle. One of the main goals of the JOBS Act was to expand the private equity market to companies that could not obtain financial support under the previous rules. The vast majority of issuers seeking traditional venture capital were high-tech ventures organized as corporations.

But in theory there is no reason why an LLC couldn’t raise capital under either Title II or Title III of the JOBS Act. In recent years, some attorneys have pioneered the creation of corporate mimic LLCs for their clients. These LLCs continue to be taxed as if they were partnerships and are otherwise subject to the LLC statutes, which generally are more flexible and less restrictive than the corporation laws, but they are structured to look exactly like corporations. For example:

The corporate mimic LLC would be structured with “units of membership interest” (think shares of stock), which could be voting or nonvoting.

The LLC could be authorized to issue “preferred” units of membership interest with terms and provisions identical to those of preferred stock in a corporation.

The LLC would be managed by a board of managers (think board of directors).

The board of managers could delegate some of its responsibilities to officers with specific job titles and duties, just as in a corporation.

The LLC’s organizational document, called an operating agreement, could provide that the LLC could incorporate any time the board of managers felt it was appropriate by merely swapping each unit of membership interest for one share of stock of the same class in the new corporation.

If you are organized as an LLC, or desire the flexibility and informality of the LLC way of life, speak to your attorney about setting up a corporate mimic LLC that walks, talks, and swims like a corporation but isn’t really (or legally) one.

The Bottom Line on Legal Entities

If you and your advisers cannot decide on the best form of legal entity to engage in a Title II accredited-investor-only offering or a Title III crowdfunded offering, form your company as a C corporation. That structure gives you the most flexibility in putting together the offering and limiting the rights of your investor crowd once the offering is completed. It is also what most sophisticated investors expect, and you will spend less time explaining the finer points of “Series B preferred equity units of membership interest” in an LLC.

If your company is currently organized as an S corporation, convert to a C corporation prior to launching the offering, as it will be virtually impossible for your company to maintain its S corporation status unless you restrict your crowd to fewer than one hundred individual investors who are U.S. citizens or green card holders. Even then, you may have to give these folks voting shares of common stock in your corporation, which will not only dilute your ownership of the corporation but also your ability to manage the corporation’s business without outside interference from the crowd.

Still Have Questions?

For a more thorough discussion of each of these entities and the advantages and disadvantages of each, consult the detailed outline titled “Demystifying the Business Organization” available as a free download from the author’s website at www.cliffennico.com. This document will answer almost all of the legal and tax questions you should be asking when forming a legal entity for your business.

Decide Where to Incorporate, or Consider Reincorporating Somewhere Else

Generally, corporations and LLCs are best advised to incorporate in the state where their physical offices are located or where the business activities will actually be conducted. There is usually no point in incorporating in another state. If your business is located in state X and you incorporate in state Y, your income will still be subject to state X taxes, so the state Y corporation or LLC will have to register as a foreign corporation or foreign LLC in state X and so end up being taxed by two states instead of one.

A corporation or LLC that wishes to take advantage of Title III crowdfunding may wish to reconsider that decision, however. Bringing on board dozens if not hundreds of crowdfunded investors changes the way corporations are governed, for better or worse, and it helps to be incorporated or organized in a state that has the most conducive rules for crowdfunded offerings of securities.

Here are some of the legal issues you will need to think of when selecting the right state of incorporation prior to launching a crowdfunded offering.

Franchise Taxes on Authorized Shares

When forming a corporation in virtually any state, you will be required to pay a tax (commonly called a franchise tax—on the permission, or franchise, of doing business with limited liability) when filing your articles of incorporation with the state.

This tax is based on the number of authorized shares of stock you designate in your articles of incorporation. So, for example, in a particular state the tax could be one cent per share for the first ten thousand shares, one-half of one cent for the next ninety thousand shares, one-quarter of one cent for the next four hundred thousand shares, and one-tenth of one cent thereafter. There is almost always a minimum franchise tax that must be paid, and sometimes (in nicer states) a maximum franchise tax as well.

This is traditionally one of the main reasons entrepreneurs like to incorporate their businesses in Delaware. Like virtually all states, Delaware has a franchise tax, but it allows corporations to calculate the tax in two different ways and pay only the lower amount of tax. The two methods are known as the authorized shares method and the assumed par value capital method. Almost always, the assumed par value capital method results in a much lower tax than the authorized shares method.

Using the authorized shares method, a corporation would pay $35 up to the first three thousand shares, then $62.50 for the next two thousand shares, then $112.50 for the next five thousand shares, then $62.50 for each additional ten thousand shares, up to a maximum of $165,000.

To use the assumed par value capital method, you begin by determining your corporation’s total gross assets (basically the corporation’s total assets as reported on its Form 1120 federal income tax return) for the fiscal year. The calculation is fairly involved and is easier to illustrate than it is to explain in words.

So here’s an example: Let’s say a Delaware corporation with one million shares of stock with a par value of $1, and two hundred fifty thousand shares of stock with a par value of $5, has gross assets of $1 million and issued shares totaling four hundred eighty-five thousand. Here’s how you would calculate the corporation’s Delaware franchise tax:

1.Divide the corporation’s total gross assets by its total issued shares carried to six decimal places. The result is the corporation’s assumed par. So: $1,000,000 assets ÷ 485,000 issued shares = $2.061856 assumed par.

2.Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par. So: $2.061856 assumed par x 1,000,000 shares = $2,061,856.

3.Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value. So: 250,000 shares x $5 par value = $1,250,000.

4.Add the results of 2 and 3 above. The result is the corporation’s assumed par value capital. Example: $2,061,856 + $1,250,000 = $3,311,956 assumed par value capital.

5.Figure the franchise tax due by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $250. So: 4 x $250 = $1,000.

Corporations that plan to engage in Title III crowdfunded offerings will need to have lots of authorized shares: at least one million and possibly as many as ten million. Choosing the state with the lowest franchise tax for a large number of authorized shares will be critical to many start-up companies, especially those on extremely limited budgets.

One way to avoid the whole franchise tax issue, believe it or not, is to form a corporate mimic LLC and authorize it to issue voting and nonvoting units of membership interest. An interesting loophole in the law is that in virtually all states, franchise taxes are limited only to shares of stock in corporations.

The idea that LLCs could be set up to mimic the capital structure of corporations using units of membership interest did not occur to state legislatures when they drafted their LLC statutes in the 1990s. They probably assumed that LLCs would be used only by small businesses managed by their owners and accordingly would operate as partnerships in which owners have percentage interests in the LLC’s profits and losses rather than shares. If that was the case, they certainly underestimated the creativity and shrewdness of your average corporate attorney.

As a result of this discrepancy between the two statutes, in virtually every state I’m aware of:

A corporation with one million authorized shares of common stock would have to pay a hefty franchise tax upon incorporation.

An LLC with one million authorized units of membership interest would not.

That loophole may well be closed in future years (especially after state tax authorities get hold of this book). Until that happens, however, many companies seeking to avail themselves of Title III crowdfunding that do not want to (or cannot afford to) reincorporate in another state with a lower franchise tax may want to consider forming an LLC, at least temporarily, to eliminate their franchise tax exposure.

If the crowdfunded offering is successful, the LLC will then have plenty of money to convert into a C corporation and pay the franchise tax at that time.

Shareholder Rights

Next, look at the rights granted to shareholders in your state corporation statute. Generally, you want to be able to limit your crowdfunded investors’ rights as much as possible without jeopardizing the success of the offering. You want (and need) their money, but you do not want their unsolicited advice, and you certainly do not want them to have the right to tell you how to run your company. Yet if these rights are granted by your state corporation law, you must honor them in your dealings with investors.

LLC statutes in virtually all states are much more flexible—the rights of LLC owners (called members) are generally not set out in the statute but rather in an operating agreement (similar to a partnership agreement) that you would prepare as one of your crowdfunded offering documents. You or your legal counsel would set out the rights your investors would have when becoming members of your LLC and any limits on those rights. As part of the offering terms, investors would be required to agree to be bound by the terms and conditions of the LLC operating agreement.

Here are some basic rights state corporation laws grant to shareholders of corporations (both C and S). A summary of how these rights are granted in each state appears as Appendix 3.

Voting Rights. Virtually all state corporation laws grant shareholders the right to vote at meetings of shareholders and participate in the management of the corporation’s business unless these rights are denied in the articles of incorporation. Most corporations have two classes of common stock, one of which (sometimes called Class A) carries with it the right to vote, while the other one (sometimes called Class B) does not. The rights of each class of shares would be spelled out in the corporation’s articles of incorporation. The company founders and key executives would own the voting shares, while investors would own the nonvoting shares. For an example of what the articles of incorporation for a corporation with voting and nonvoting shares looks like, see Appendix 1.

Inspection Rights. Virtually all state corporation laws grant shareholders the right to inspect and review the books and records of the corporation at reasonable times and on advance notice to the corporation.

Antidilution Rights. There are two types of antidilution rights shareholders can have:

1.Price based antidilution protection: the right to acquire additional shares (without paying for them) in the event the company makes a subsequent offering of securities at a lower valuation than the offering the shareholder subscribed to; the number of shares would be enough so the shareholder would maintain its original percentage ownership of the corporation’s shares.

2.Structural antidilution protection: the right to acquire additional shares (again without paying for them) in the event of a stock split, stock dividend, or other event that increases the number of the corporation’s issued and outstanding shares other than a public or private offering of those shares.

Virtually all state corporation laws deny these rights to holders of a corporation’s common stock. These rights are almost certain to be included, however, in offerings of preferred stock, by agreement between the corporation and the investors. As will be seen later in this chapter, it wouldn’t make much sense to launch a crowdfunded offering of preferred stock, although an accredited-investor-only offering under Title II of the JOBS Act could easily be structured that way.

Preemptive Rights. A shareholder with a preemptive right has the right to acquire additional shares (and pay for them, at the same price per share offered to subsequent investors) in the event the company makes a subsequent offering of securities at a higher valuation than the offering the shareholder subscribed to; the number of shares would be enough so the shareholder would maintain its original percentage ownership of the corporation’s shares.

Right of Nonvoting Shareholders to Receive Notice of Shareholder Meetings. Even if shareholders in a corporation are denied the right to vote, they still may have rights under the state corporation statute. For example, do they have the right to receive notice of meetings of the voting shareholders, even though they have no legal ability to influence the decisions made at those meetings? In many states, the answer is yes, especially if the matter being voted on is a major change, such as a merger or acquisition, the sale of all or substantially all of the corporation’s assets, the amendment of the corporation’s articles of incorporation, or the corporation’s dissolution or liquidation (including a filing in bankruptcy). The failure to give notice to your nonvoting shareholders within the time frame required by the statute (usually ten days before the meeting is held) could void any decision made at that meeting.

Shareholder Rights to Compel Dissolution of the Company. A handful of states allow owners of a significant minority percentage of a corporation’s shares (usually 10 or 20 percent) to petition a court to dissolve the corporation, or force the majority shareholders to buy out their interest at fair market value, if they can demonstrate they were “oppressed” by the majority shareholders. The definition of “oppressed” in these states is left up to the courts to decide.

What Type of Security Will You Be Offering?

There are three types of securities you would consider for a crowdfunded offering: notes (or promissory notes), common stock, or preferred stock.

Notes or Promissory Notes

These are debt instruments. The investor in a note agrees to make a loan to the corporation or LLC at a set rate of interest. The loan is repaid with interest over a period of months or years, in monthly or quarterly installments. The investor’s return on the investment is limited to the amount of interest set forth in the note.

Convertible notes may be exchanged for shares of common or preferred stock in the corporation at the option of the investor and may also be convertible on demand of the corporation immediately prior to an IPO or a merger or acquisition transaction.

Notes may also be issued with warrants attached—these are like options to acquire shares of the corporation’s common or preferred stock in the future and are in addition to the note. An investor exercising a warrant to acquire shares in the issuing company still has the right to receive interest on the note until it is paid in full.

Common Stock and Preferred Stock

These are equity instruments, representing ownership of a percentage of the corporation’s total issued and outstanding shares. Investors in common stock are entitled to all the rights granted to common stockholders in the state corporation statute and the corporation’s articles of incorporation, while investors in preferred stock receive the rights granted to them in a purchase agreement with the corporation that is usually the subject of some negotiation.

Unlike common stockholders, preferred stockholders are entitled to a liquidation preference. If the corporation is dissolved or otherwise goes out of business, preferred stockholders get their money out before the common stockholders get a penny. Preferred stock may be voting or nonvoting, convertible into common stock or not, as the corporation’s board of directors determines, and may afford the investor the right to receive preferred distributions of cash, known as cumulative dividends, before dividends are paid to the common stockholders.

LLC Membership Interests

If you are planning to launch a crowdfunded offering of equity securities in an LLC, you will be issuing membership interests or units of membership interest in the LLC to investors. Like shares of a corporation’s stock, units of membership interest in an LLC can be voting or nonvoting and can grant investors whatever rights are spelled out in the LLC’s operating agreement. You can even grant investors preferred membership interests containing many of the same terms and conditions as would apply to preferred stock in a corporation.

Which Security Is Best for a Crowdfunded Offering?

Most early-stage companies want to avoid debt like the plague, especially if the debt is being held by dozens or possibly hundreds of individual lenders. It is unlikely that a company will want to offer notes in a Title III crowdfunded offering, but one of the most common private placement structures under SEC Rule 506 is the offering of convertible promissory notes, and an offering of debt securities in an accredited-investor-only offering under Title II may make sense for a more seasoned company.

Similarly, it would make little sense for a company to issue preferred stock in a Title III crowdfunded offering because the sheer number of investors having the right to a liquidation preference upon the dissolution or liquidation of the company may discourage anyone from investing in the corporation’s common stock in subsequent offerings because they would fear being wiped out in that event. Because most accredited investors will want preferred stock in your company, you may want to consider convertible preferred stock as the vehicle for a Title II accredited-investors-only offering, or indeed any other offering under the SEC’s Rule 506.

Accordingly, it is anticipated that the vast majority of Title III crowdfunded offerings will involve common equity securities: voting or nonvoting common stock in a corporation, or membership interests in an LLC.

Amend Your Articles of Incorporation to Create a Separate Class of Shares for Your Crowdfunded Offering

Most early-stage companies launch multiple offerings of securities over time—a friends-and-family or crowdfunded offering to begin with, followed by subsequent offerings of notes, preferred stock, or common stock to angel investors and other accredited investors, followed by one or more so-called mezzanine offerings to venture capital firms, followed (it is hoped) by an initial public offering.

As will be seen in Chapter 9, Title III and Regulation Crowdfunding make it particularly easy for companies to launch multiple offerings. Many companies, for example, may want to launch an “upstairs-downstairs” offering—a Title II offering of preferred stock to accredited investors, together with a Title III crowdfunded offering of common stock to nonaccredited investors.

Create Multiple Classes of Stock

It is therefore important to prepare and file articles of incorporation with several different classes of stock, allowing for maximum flexibility in structuring future offerings. Because this is seldom done when a corporation is first incorporated, it is customary for the corporation to “amend and restate” its articles of incorporation to spell out the rights, privileges, and limitations for each class of its common and preferred stock.

Create a Class of Convertible Preferred Stock. If your company is considering a private placement to accredited investors under Title II of the JOBS Act, you will need to create at least one class of preferred stock. Investors like preferred stock because if hedges their bets on a start-up company: if the company crashes and burns, preferred stockholders get their money before common stockholders get a penny. Also, preferred stock can be structured so the investors get cumulative dividends—a guaranteed return on their investments that accrues over time (albeit without interest) if the company fails to pay dividends on time.

Accredited investors will want your preferred stock to be convertible into common stock at the investor’s option. That way, if the company takes off and becomes wildly successful, the investor can convert preferred into common stock and participate in the rapid growth of the company.

Keep in mind that you must be a C corporation in order to have one or more classes of preferred stock; S corporations are prohibited by law from having more than one class of stock.

Create Voting and Nonvoting Classes of Common Stock. Now let’s look at your company’s common stock—the security you are most likely to offer to your crowdfunded investors in a Title III offering.

Generally, it’s a bad idea to give crowdfunded investors voting common stock. Holders of voting common stock are granted extensive rights under state corporation laws, including the right to vote on matters affecting the company’s business and operations, the right to participate in the company’s management, (sometimes) the right to appoint members of the company’s board of directors, and in general the right to make themselves into time vampires if they so choose. You want to keep those rights in as few (and trusted) hands as possible: yourself, the other company founders, the key members of your management team, and perhaps one or two angel investors who provide the seed capital that gets the company off the ground.

Simply put, everyone else should get nonvoting common stock: not just your crowdfunded investors but employees, consultants, advisers, and other people who are not essential to the success of your company or its business plan. Now, I realize that may sound a bit nondemocratic to some readers and not consistent with the spirit of crowdfunding, which is to open start-up investment opportunities to the masses. But as someone who has advised hundreds of start-up companies in my career, I can tell you that having too many powerful investors too early in a company’s life cycle is more likely than not to crush a company’s prospects. Investors can be (and frequently are) demanding. They ask lots of questions (facilitated by the ease of using email, instant messaging, and texting), they expect prompt response from management, and if they don’t like what’s happening, they can turn into hostile and unruly whistle-blowers who post unfavorable, unfair, possibly incorrect, and overly critical information about your company on social media.

Those problems won’t go away even with nonvoting common stock and are discussed in Chapter 8 on shareholder communications. But giving investors voting stock creates the possibility of a hostile voting bloc that will attempt to take over your company, or at least act collectively as a roadblock to important business decisions that must be made as quickly and efficiently as possible.

Even if your voting shareholders are as quiet as mice and complacent as lambs, you must give them notice and explain to them in detail what’s going on before making important decisions.

While it may seem unfair, undemocratic, or downright Neanderthal to offer crowdfunded investors nonvoting common stock, I think you will find most of them understand that for an investment of $2,000 or less they cannot, and should not, have the right to tell management what to do. If they really feel your company is headed in the wrong direction, they should take that $2,000 and start companies of their own rather than invest in yours. Those who don’t understand that should be investing in your competition.

Consider Making Your Nonvoting Common Stock Redeemable. Virtually all state corporation laws give corporations the right to make one or more classes of their stock redeemable, thereby allowing the corporation to repurchase those shares for cash under certain circumstances. Frequently, corporations will make one or more of their classes of preferred stock redeemable so they can remove that class at the demand of subsequent investors (or investment bankers as part of an initial public offering) or otherwise due to market conditions.

Historically, corporations have not chosen to make classes of their common stock redeemable, although state corporation laws do not prohibit them from doing so. The reason has more to do with marketing than the securities laws: many investors will in theory be reluctant to buy shares in a company if those shares can be repurchased out from under their noses days, weeks, or months after the investment is made—especially if the shares are nonvoting common stock that don’t give them the right to complain about that decision.

Title III crowdfunding may, however, lead more corporations to conclude that having redeemable common stock—which would enable them to buy out overly difficult or needy shareholders and otherwise help them cull the herd whenever necessary—outweighs the possible negative impact on the company’s ability to market the offering.

You should discuss with your attorney the relative advantages and disadvantages of redeemable nonvoting common stock. If you do decide to offer redeemable shares as part of your Title III crowdfunded offering, make sure:

The repurchase price is at least 120 percent of the price per share you are asking for in the offering (this gives the investor a guaranteed return if the shares are repurchased)

You stipulate that you are not allowed to redeem any shares in the offering for a period of at least one year after the closing date of the offering

These provisions will make the idea of redemption more palatable to your crowdfunded investors and make it easier for you to make a successful offering.

Appendix 3 to this book is a sample amended and restated articles of incorporation for a Delaware corporation having classes of convertible preferred stock, voting common stock, and nonvoting common stock (which is not redeemable).

Can LLCs Have Multiple Classes of “Stock”? LLCs can be structured the same way as corporations, with common and preferred, voting and nonvoting units of membership interest. The rights, privileges, and limitations of each class of units are normally spelled out in the operating agreement of the LLC rather than by amending the LLC’s articles of organization.

Appendix 4 to this book is a sample provision for an LLC operating agreement creating two classes of membership interest—voting and nonvoting—with the option to issue nonvoting units as either common units having the same rights as the voting units (except for voting) or preferred units having the same rights, privileges, and limitations as preferred stock in a corporation.

Set Your Offering Amount and Determine the Dilution for Existing Investors

Now is the time to make two key determinations:

1.How much money do you plan to raise in the offering?

2.How much of your company do you want to give up?

Offering Amount

Before you determine this, it is a good idea to put together a use-of-proceeds chart or Excel spreadsheet with the help of your accountant listing exactly what you will do with the proceeds of the offering if it is successful. Under the Title III regulations for crowdfunded offerings, you will be required to spell this out in some detail, and one of the most common entrepreneurial mistakes is to underestimate how much capital will be needed to fulfill specific purposes.

The more capital you wish to raise, the more investors will have to participate. The Title III crowdfunding regulations require that you set the amount of capital you wish to raise at the beginning of the offering; fail to hit that target and you have to give all the investors their money back. The more money you ask for, the less likely you will be able to hit your funding target.

Accordingly, it will be difficult for start-up companies to raise more than a couple of hundred thousand dollars in a Title III crowdfunded offering. Concept companies probably should not ask for more than $50,000. More established private companies will be able to raise more significant sums under Title III, but after a certain point it will be much more cost-effective to raise money via a traditional Rule 506 private placement, or an accredited-investors-only offering under Title II.

Dilution: How Much Equity Do You Want to Give Up?

When issuing debt securities such as notes, you do not give up any equity in your company.

Because equity securities involve owning a percentage of your company’s shares, by issuing new common or preferred stock (or membership interests in an LLC) to anyone, you end up owning a lower percentage of your company than you did previously. To use the simplest possible example, if you and your founders own 100 percent of your company today and you sell common stock for 20 percent of your company to crowdfunded investors, you and your founders will end up owning 80 percent of the company when the offering closes. You and your cofounders continue to have the same number of shares as previously, but because your company has issued additional shares, your shares constitute a lower percentage of your company’s total issued and outstanding shares after the offering is completed.

(I apologize if I appear to be condescending or talking down to the reader, who presumably has at least some college-level mathematics experience, but you would be amazed at how many otherwise sophisticated first-time entrepreneurs fail to grasp this very basic and simple concept.)

You cannot issue more than 100 percent of a company’s shares, so each new issue of equity securities dilutes the percentage owned by the founders and the previous investors. How much dilution are you and the other founders willing to tolerate each time you launch an offering of securities, crowdfunded or otherwise?

As an attorney who has represented start-ups for more than thirty years, I can tell you that these can be extremely difficult conversations for entrepreneurs.

Larger corporations make this decision by hiring experts to perform a valuation of what the company is worth. Once the valuation has been determined, the company determines how much money it needs and how much of the current valuation that amount constitutes. For example, if a corporation is worth $500,000 and needs to raise $100,000, it would issue stock constituting 20 percent of the total issued and outstanding equity in the company after the investment is completed.

For a start-up company that is still trying to develop or perfect its products or services (or concept companies that are little more than an idea), valuation is pretty much impossible. Any valuation you put on your company is mostly guesswork because the company has no revenue and no tangible assets.

Here are some basic rules of thumb:

Don’t even attempt to project revenues or profits—focus instead on the things you need to do to make your product or service a reality and get it into the marketplace, and on how much each of those things will cost.

Always ask for more (120 percent to 150 percent) of what you think you will need—there are always hidden costs you fail to foresee, and it’s helpful to have the money readily available when you realize that’s the case (just keep in mind that you will have to explain to your funding portal and the SEC what you will do with any excess proceeds of your offering).

Do not give up more than 10 percent of your company in your initial offering, especially a crowdfunded one.

The last point is by far the most important one. If your company has an exciting product with huge market potential, you are likely to get some investors in your crowdfunded offering no matter how many risks you disclose in your offering statement. Under no circumstances do you want a crowd (or mob) of people owning a significant percentage of your company, especially if they have the right to vote on matters affecting the company’s business. There are three reasons for this:

1.The more equity investors own of your company, the more power they have to influence your decision making (and may have legal rights under your state corporation laws).

2.Future investors will not like your having a significant percentage of minority owners to deal with.

3.The more equity you give away early on, the less you will have for yourself and the other founders later.

Unlike the title characters in the famous Mel Brooks movie (and Broadway show) The Producers, you can’t sell more than 100 percent of your stock. I have personally seen companies give away so much of their equity during the first two years of operations that the founders ended up owning less than 10 percent of their companies when the big venture capitalist firms started knocking on their doors wanting a 40 or 50 percent equity stake.

Prepare a Term Sheet for the Offering

Once you have determined the rights you want your investors to have, the amount of money you need, and the percentage of your company you wish to give up, it is time to put together a term sheet and begin looking for funding portals to manage and handle your Title III crowdfunded offering.

As opposed to a traditional private offering, in a Title III crowdfunded offering you must make two sales pitches: first, you must sell the funding portal; second, once accepted by a portal, you must sell prospective investors. The term sheet is the document that will help you sell the funding portal.

A term sheet is not a legal document and is therefore not binding on your company as a contract or legal obligation. It does not commit your company to follow through on the offering; it merely indicates your interest in launching an offering of securities on those terms. Your term sheet should be as detailed as possible, but be sure to leave room for some negotiation, as funding portals, accredited investors, and others will surely comment on your terms and try to change them more to their advantage.

In structuring your offering, you should look closely at the terms and conditions of other offerings involving similar companies in your industry offering comparable products and services. Unfortunately, as will be seen in Chapter 11, funding portals are extremely limited by the Title III regulations in their ability to advise and coach issuers on market conditions and ways to improve their offerings’ likelihood of success.

Appendices 6, 7, and 8 are, respectively, sample term sheets for:

An offering of convertible promissory notes

An offering of convertible preferred stock in a corporation

An offering of nonvoting membership interests in an LLC

Get Your Management Team and Initial Investors On Board

State corporation laws require any offering of securities to be authorized by resolution of the corporation’s board of directors and (often) its shareholders. Similarly, state LLC laws require any offering of membership interests or units to be authorized by the LLC’s members.

This must be done at a special meeting called for the express purpose of approving the offering and must be documented (minutes must be taken). Advance notice of the meeting must be given to all shareholders or LLC members as required by the statute. Failure to conduct this meeting may void the offering as being not properly authorized under state law.

Once your Title III crowdfunded offering has received all required internal approvals, you are ready to launch.