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COMMON VOTING STOCK

CORPORATE

FINANCING

PREFERRED STOCK

THE CLIENTS

Alice and Andy

THE CLIENTS

THE BUSINESS

INVESTMENT BREAKDOWN

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

INTEREST

BREAKDOWN

Right to manage the general affairs of the corporation

Right to get paid first and right to vote for funda-mental decisions

QUESTION

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?

STOCK OPTIONS

STOCK

OPTIONS

COMMON

STOCK

COMMON STOCK

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

PREFERRED STOCK

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

CAN WE USE IT?

APPLICATION TO

OUR FACTS

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?

TAX CONSIDERATIONS

TAX

CONSIDERATIONS

S-CORP

STATUS

REQUIREMENTS FOR S-CORP STATUS

  • No more than 100 shareholders
  • Shareholders must be individuals (exceptions apply)
  • USC/LPR shareholders only
  • Only one class of stock
  • + Timeliness/Writing Requirements

PROBLEM

Because TouchScreen, Inc. issued more than 2 classes of stock (preferred and common), the corporation is therefore ineligible for S-Corp classification.

TOUCHSCREEN, INC. GOES BANKRUPT. WHAT HAPPENS?

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).

TOUCHSCREEN, INC. DOES REALLY WELL AND MAKES $15 M THEIR FIRST YEAR.

$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

NON-TAX CONSIDERATIONS

NON-TAX

CONSIDERATIONS

NEED MORE

$

$750,000

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?

More Stock Options

Miscellaneous Factors

Third Party Secured Creditor

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.

ALICE & ANDY

CLIENT INTEREST

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.

WHEN DOES IT WORK?

TURN $500 K INTO $2.5 B

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