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FINANCING
PREFERRED STOCK
Alice and Andy
INVESTOR
$1,000,000
ALICE
$250,000 Cash
$375,000 Services
$625,000
INVESTOR
$1,000,000
ANDY
$250,000 Cash
$375,000 Services
$625,000
INVESTOR
$1,000,000
Right to manage the general affairs of the corporation
Right to get paid first and right to vote for funda-mental decisions
Is the use of common stock and preferred stock appropriate for Alice and Andy's corporation when the promoters have greater management rights, but investors have priority rights to payment?
Common Stock: ordinary shares representing basic ownership and control rights.
Proportional issuance determines shareholder rights
Passive stockholders are protected from any liability resulting from company action
Potential for large annual return on investment
Last in priority of distribution of profits and liquidation
Stockholders are not necessarily legally entitled to review company documents
Arbitrary and constant fluxation of stock value
Preferred Stock: shares representing specific voting rights in a company and/or securing priority access to the company's financial allocations.
Receives priority in asset/financial distribution
Higher and more regular dividends
Best for long-term investments, generally low-risk
Limited voting rights as described in operating agreement
Profits are typically smaller
Interest rates for preferred stockholders can fluctuate with the market
As common stockholders, Alice and Andy are undertaking a bigger risk than the outside investors. While they retain voting rights, they will be paid at the very end. Additionally, since they are contributing cash and services/property, they will be paying a capital gains tax on the latter, regardless of how well the business does.
As preferred stockholders, the investors receive dividends in a predetermined amount per pay period. Because they want voting rights regarding major decision to the business, this must be spelled out in the operating agreement. More importantly, they will not be on the hook for company losses past their initial investment.
Is this arrangement appropriate for the business entity at this stage of formation?
PROBLEM
Because TouchScreen, Inc. issued more than 2 classes of stock (preferred and common), the corporation is therefore ineligible for S-Corp classification.
Because Alice and Andy are contributing services in addition to cash, they will be taxed that year, despite the business's success or failure. Additionally, since common shareholders are last in line to be paid, they will also stand to receive little or nothing upon liquidation, merger, etc.
Investors, on the other hand, can use their losses as a tax write-off against personal income or taxable dividends. As holders of preferred stock, investors will only be liable for their initial contribution ($1 M each).
$15 M
Any dividends received by preferred shareholders (as an appreciation of their stock's value) will be taxed as a capital gain. Assuming a coupon rate of 8%, the preferred shareholders will receive about $80,000 each. This would incur a sum of about $620,000 after all preferred shareholders are paid. That leaves $3.23 M to be distributed.
$3.85 M
$8 M
Assume for simplicity's sake that the investors agreed to receive interest on their $1 M investments as dividends, as long as their initial principal of $1 M was met before anything else. This would leave about $3.85 M to distribute as dividends.
Applying 21% tax rate for corporations = $11.85 M
The business needs $10 M to run for a year. After the $8 M from outside investors and $1.25 M from Alice and Andy, the business is still short $750 K. How will Touch Screen, Inc. raise the rest of its seed money? How do the common and preferred shares affect future investments?
This will be difficult, given that, at the present time, the business has no collateral for such a substantial loan.
Any modification in the number of shares issuable by the company requires consent by voting parties & amendments to the operating
agreement.
If a third party investor decides to invest in the business with no physical property to serve as collateral,
they may insist on an
equity-to-debt ratio
that must be
highly monitored.
At this point in time, it would be ill-advised to suggest to Alice and Andy to issue preferred stock to their outside investors and retain common stock for themselves.
There is little to gain, and as we just saw, a lot to lose, especially when they already have to pay tax on their services/intellectual property contributions.
However, even if this arrangement is not proper at this time, it demonstrates the importance of a separate employment contract by which Alice and Andy receive a fixed salary. Relying on dividend payments which are subject to double taxation and are last in priority is not a good idea when the company is still growing.
Finally, the preferred shareholders benefit from utilizing another financial structure for tax purposes and more clarity on their voting rights.