I hope you are all well and enjoyed the Easter holiday! This message is part of the educational program series that was started by the authors last month in order to provide you with insights relating to many of the issues that businesses and business owners may begin to face due to the downturn in the economy as a result of the COVID-19 pandemic and collapse of energy prices and the related market. We have spent the last couple weeks addressing many of the provisions and rules found in the recently enacted Federal bills and IRS pronouncements that are intended to support the near-term liquidity needs of businesses. Today, we want to begin to shift our discussions toward some of the general business (economic and governance) and tax issues that businesses need to be aware of as they attempt to navigate and work through these challenging times.
With the foregoing in mind, it is becoming increasingly apparent that many businesses may soon be faced with the realization that they must raise additional equity capital (such capital infusion event herein referred to as a “recapitalization”) in order to keep their business afloat. To the extent that an existing business owner or owners are able to provide their applicable business with this capital, the business issues stemming from such recapitalization event (while still important and critical to consider) are likely to be far more limited and less daunting. Hopefully, in any such case, existing business owners already have a well drafted agreement that will address many of the issues likely to arise/result therefrom. However, for those businesses that will need to raise equity capital from one or more outside investors that are not current owners thereof, the list of business and tax issues and concerns may be quite significant and expansive. Not wanting to let the “tail wag the dog” today’s discussion will focus principally on the non-tax issues to be considered in connection with a recapitalization. We will address related tax issues in a future email.
First, making sure that you strike an economic deal/arrangement that makes sense for all parties involved, and that is understood by all parties is absolutely critical. Among the issues to consider are:
- what is the current business really worth;
- will the additional equity capital be given any sort of preference or priority in terms of economic splits or rights;
- is a preference or priority even possible in light of the type of business entity currently used, or will a subsidiary entity need to be formed to operate the business going forward so that the necessary economic rights can be incorporated;
- how do you draft the applicable agreement to make sure that current owners are not giving away too much (from the perspective of both timing and amount);
- should existing business owners retain a promote or profits interest relative to the interest of the presumably passive investor;
- how do current business owners avoid accelerated income (tax) allocations attributable to difference in value and tax basis in existing business assets; and
- who will determine timing and amount of future distributions made by the business.
Second, of equal importance is giving adequate consideration to the revised governance terms, including:
- whether the capital provided will have a board/manager designee option;
- what issues/events/actions/compensation arrangements will require a majority/supermajority owner consent or approval (which obviously may limit what the business can do without the consent or approval of the outside investor);
- what confidentiality, restrictive covenant, and fiduciary duty language needs to be included in the applicable agreement;
- what and when various types of information may be required to be provided to the applicable investor (and other owners); and
- when and how should buy/sell provisions be included and drafted in connection with governance/management deadlock scenarios.
Third, significant consideration will also need to be given to additional capital contribution provisions, transfer provisions (including related tax and non-tax restrictions), buy/sell triggers (including community property events/drags/tags/etc. but unrelated to deadlock) and all related terms.
The foregoing is merely intended to highlight some of the significant issues that likely will need to be considered by existing businesses and business owners as they consider a potential recapitalization with additional equity capital. Of course, a business may be able to avoid many of these issues and concerns if it has adequate access to debt capital. Nevertheless, debt financings may result in many lender-mandated restrictions and also should not be entered into lightly without giving adequate consideration to potential business limitations and issues.
We hope that you and/or your clients find this email informative should a recapitalization event become necessary in connection with a business venture. If you have follow up questions please feel free to reach out to either of the authors of this email. Until next time, stay safe and have a great week!