“Friends and family are still the largest source of capital for companies in the early stages of development, but the current funding market presents several additional options for young companies. Be open-minded and investigate numerous sources of capital,” says Thomas C. Armstrong, corporate attorney at Berliner Cohen and a FINRA registered investment banker.
Smart Business spoke with Armstrong about the financing options available to startups and emerging enterprises.
What are the choices when it comes to raising equity capital?
- Friends and family. When starting a company, many times they are the primary source for capital. That’s true even in Silicon Valley, where you read about all of the angel investors and venture capitalists.
- Angel investors. These are wealthy individuals who provide financing, advice and connections. The investment is usually in the form of equity or possibly a convertible note that converts to equity when the company obtains a larger round of financing. There also are angel groups that will analyze the company and make a determination whether to invest. The process tends to be somewhat more formal and can take longer than what the entrepreneur may anticipate.
- Venture capitalists. Conventional wisdom is that they are looking for 10 times return on investment, so it’s for high-growth companies. Quite honestly, there are many companies that don’t fit that model. It doesn’t mean that they’re bad companies; it is just that they don’t fit the criteria for venture capital funds.
No matter what type of investor you’re making a pitch to, it’s important to present them with a credible exit plan or strategy. A lot of companies talk about how they’re going to grow and be the next big thing, but never clearly explain how the investor is going to get liquid on their investment and exit the company. If you’re taking outside financing, investors want a clear and credible exit strategy.
Why should debt financing be considered?
Often overlooked as a financing option, debt may be an option or part of an overall financing package. Banks are trying to be more creative and there’s been renewed interest in so-called revenue loans. Of course, for revenue loans the company has to have revenue — so it’s not for pure startups — but it can be a relatively modest amount of revenue. Revenue lenders will lend a certain percentage of your gross revenue, and a percentage of your monthly gross revenue goes to pay the loan. That payment amount goes up or down as your gross revenues go up or down. The good news is that they’re not asking for personal guarantees with these loans.
The downside is the interest rate is higher than for traditional bank loans. Your cost of capital, however, may ultimately be less than if you raised equity from angel or investor groups because you’re not giving up any ownership in the company. Of course, don’t forget about grant money if that is something the company may be able to apply for.
What problems can companies encounter if they don’t choose the financing route that’s best for them?
If they go to the wrong places for capital, they risk giving up too much of the company with a bad valuation or losing valuable time in their search for capital.
Another consideration is the expectations of investors. What is their time horizon? Are they patient or impatient money? Do they want to see distributions or just capital appreciation?
Entrepreneurs also need to think about whether these investors are going to be involved in the business. Some business owners may want that, while others don’t want to deal with people that are too meddlesome.
There also are legal ramifications to consider. Any time you are issuing securities in the company you have to comply with federal and state securities laws.
That’s a broad topic, but essentially you have to ensure that investors understand their investment and have been given sufficient disclosure about the company and the risks associated with investing in it. In particular, there are rules and regulations regarding who can invest and how much.
Under the recently passed Jobs Act, the government has tried to make it easier for companies to raise capital and the emergence of crowdfunding and the internet are opening up new avenues for raising capital. But again, you still need to comply with securities laws. The important thing for entrepreneurs is to look into all sorts of capital sources. ●
Insights Legal Affairs is brought to you by Berliner Cohen
Smart Business spoke with Tyler A. Shewey, an associate at Berliner Cohen, about three tax issues that are receiving more attention in 2014.
What is happening with sales and use taxes?
The California State Board of Equalization (SBE) has focused on several areas lately.
One area relates to delivery charges. When a business invoices customers, it must provide a separate line item for shipping charges paid to a common carrier in order for that portion of the charge to be exempt from sales tax. If a business ships merchandise using its own vehicles, invoices must specifically state that title transfers to buyer before delivery.
Otherwise, the SBE will require sales tax to be charged on the entire amount.
Custom manufacturers should be aware that the SBE is auditing businesses to determine whether labor charges should have been included in the measure of sales tax. In general, labor charges are not taxable in California.
When it comes to product fabrication, however, this often is not the case.
Why should someone considering an IRS Offer in Compromise act quickly?
An Offer in Compromise allows a taxpayer to settle tax debts for less than the amount owed. A proposed Offer Amount is based on a formula that accounts for income and equity in assets. If assets and income are significant, the Offer Amount must be higher; but if both of those are low, it may make sense to file an Offer.
In recent years the Offer terms have been more lenient; however, the pendulum now is swinging back the other way, so it may become more difficult in the future to make it through the Offer process.
What has changed regarding foreign bank account reporting?
For many years, the U.S. Treasury Department has required U.S. persons with a financial interest in, or signature authority over, any foreign financial account (i.e., bank, securities, or other types of financial accounts) to disclose such accounts if their aggregate value exceeded $10,000 at any time during the calendar year.
These persons were required to report such accounts on Schedule B of their U.S. individual income tax return, and on the Report of Foreign Bank and Financial Accounts (FBAR), which is required to be filed annually and must be received by the IRS on or before June 30th of the succeeding calendar year.
Historically, FBAR compliance was low because civil penalties for the non-willful failure to file the FBAR were nominal and IRS enforcement was weak. Two developments changed this. First, the Jobs Act of 2004 enacted a $10,000 maximum non-willful FBAR penalty which applied to FBAR forms due starting June 30, 2005 (for the 2004 tax year).
For willful violations, the penalty could be up to the greater of $100,000 or 50 percent of the account balance per account per year. Second, the IRS began to prosecute FBAR violators more aggressively. Although a voluntary disclosure practice has been in existence for many years, it became clear that the IRS was applying the voluntary disclosure mechanism to taxpayers inconsistently.
Accordingly, the IRS instituted a new offshore voluntary disclosure program (OVDP) to resolve these cases in a consistent and predictable manner. To date, approximately 39,000 people have applied for the OVDP, which has generated $6 billion in revenue. Still, the U.S. Treasury estimates that offshore compliance is still only around 10 percent.
It is important to note that starting in November 2013, all FBARs must be filed electronically. It is expected that electronic filing will enable the IRS to apply greater scrutiny to offshore reporting. ●
Insights Legal Affairs is brought to you by Berliner Cohen
While tax laws continue to affect estate plans, protection of assets has become an increasing priority as baby boomers age.
“There’s been a lot more conversation in the last five years about asset protection, not just about the client’s assets, but also about protecting the assets the children will eventually inherit,” says James P. Cashman, a partner at Berliner Cohen.
Smart Business spoke with Cashman about trends in estate planning and what has occurred in response to the American Taxpayer Relief Act of 2012, which changed estate, income and gift tax laws.
What has changed with estate and gift taxes?
Large estates — the applicable credit for each individual is now $5.34 million per person — i.e., the amount that can be passed to family members (or anyone else for that matter) without any estate or gift tax. In the last several years the credit has grown from $1million to what it is today. Married couples can now shelter up to $10.68 million from estate taxes.
Because of that change, we expected married couples with estates of under $10 million to want to simplify their existing plans by leaving everything to the surviving spouse and then to the children; however, such has not been the case. Married couples with estates under $10 million are still opting for dividing the estate into two parts upon the death of a spouse. In so doing, each spouse wants to make sure that if they die first, their share of the estate ends up with the children rather than the surviving spouse’s new spouse or someone else.
How has the end of the Bush-era tax cuts affected estate plans?
Especially in California, which now has a state income tax rate of 13.3 percent on top earners, more estate planning decisions are being made based on income tax and capital gains tax issues than ever before.
Not only do people want to know about estate transfer taxes when they die, they also want to limit or avoid income or capital gains taxes while they’re alive. Therefore, the conversation of shifting income to family members in a lower bracket and charitable gifting techniques has increased tremendously.
That includes increased interest in charitable remainder trusts or gift annuities, where a person can donate a highly appreciated asset in return for a guaranteed income stream for a term of years or their lifetime and avoid having to pay capital gains tax.
More people also are inquiring about moving to jurisdictions without state income taxes, like Florida, Texas and Nevada. They have businesses in California and want to know how to detach from the state, as rules regarding how California recognizes residents are becoming stricter.
For example, one client with substantial real estate holdings all over the country wanted to move to Florida; he’s a better candidate than someone with real estate only in California. But my advice was that if he wanted to be a Florida resident, he must give up all (or most all) of his contacts in California, including, but not limited to, his California business office, his California license and his California voting registration.
But not all estate planning trends are about taxes. Protection of assets for children and grandchildren has been a growing concern.
Why has protection of assets become more important?
Baby boomers like to be very clear about what they want. They worry about where assets would go if a child got divorced or owed creditors. Perhaps people have become more aware of our litigious society, and they now are talking to professionals to review all options.
Baby boomers are also concerned about who inherits their personal effects. Traditionally, personal property distribution was covered in wills. Now, in many instances, this is covered by a letter of instruction form that the client can update easily.
This trend also extends into other areas, such as health care directives. Clients are getting more clear about what they want — feeding, hydration, CPR — and want to be able to make these choices clearly in their health care directive or the POLST. ●
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Trade secret cases are considerably different from other legal disputes, and not being properly prepared could prove costly.
“A trade secrets complaint is not like other complaints that can be fixed later if there’s something missing,” says Christian E. Picone, a partner at Berliner Cohen. “Later” comes fast in trade secrets litigation. “A seasoned trade secrets defense attorney will take action right away, essentially freezing discovery until they get an articulated definition of the trade secret.”
That can be done because of a special statutory requirement under California law that mandates the plaintiff identify the trade secret prior to the discovery process. “That statutory provision can be useful as a shield or a sword, depending on which side you are on,” says Picone.
Smart Business spoke with Picone and Kathleen F. Sherman, an associate at Berliner Cohen, about how to address that provision and other issues to consider in trade secret litigation.
What’s the best way to handle the trade secret definition?
A plaintiff should spend some time with its attorney preparing the case before the complaint is drafted and filed. In particular, the plaintiff should be ready to articulate its trade secret as soon as the case is filed because the defense could immediately serve a special interrogatory demanding identification of the trade secret, and the plaintiff would have only 30 days to respond. If the plaintiff is not prepared, the defense could seize control of the case at that point.
The trade secrets identification requirement is perceived differently by plaintiffs and defendants. Typically, a plaintiff will want to keep the trade secret definition as broad as possible to keep options open as the case progresses, while the defense will challenge the plaintiff to narrow the definition. On the other hand, a plaintiff can show the strength of its case early on — and perhaps force a settlement — by clearly and confidently articulating its trade secret.
What makes something a trade secret?
A trade secret is information that:
- Derives independent economic value by virtue of not being known by the general public or persons who could obtain economic value from its disclosure or use, and
- Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.
A plaintiff must establish both prongs in order to establish a trade secrets claim.
Taking the example of a trade secret within software, the entire piece of software would not be a trade secret because common functions, such as a print function, are well known in the industry. The trade secret is the particular aspect of the software that is unique and not known to others in the industry.
Even if a plaintiff establishes the first prong, it also must establish that, prior to litigation, it took steps to prevent competitors from knowing the trade secret, such as limiting access to source code to those with a need to know, using passwords, and marking code with the appropriate designations.
Cases involving customer lists can be particularly tricky. Not only must the trade secret have been properly protected, the customer information can’t be something that can be discovered by independent means, from public information such as directories, for example. In addition, a trade secrets claim based only on the identities of customers can be extremely difficult to prove. The fact that a former employee is doing business with the plaintiff’s customers does not, by itself, establish a violation of law. Noncompete clauses are invalid in California. An employer can require an employee to sign a nonsolicitation agreement, but the law is clear that an employee may make an announcement that he or she is leaving and supply new contact information to customers; such an announcement does not constitute solicitation.
Is proper protection of trade secrets a standard practice?
Most companies try to take steps to protect their trade secrets, but not all are properly advised or do not take the time to think about the potential consequences down the road of inadequate trade secrets protection, especially in the heat of trying to get a start-up company off the ground or a new product to market.
Best practices include having every new employee sign a confidentiality agreement including a provision that they understand their obligation not to disseminate the company’s confidential, proprietary information, which includes trade secrets.
We have had clients that didn’t properly protect trade secrets. Then their challenge was to determine whether confidential information used by others to compete with their clients could be the basis of an intentional interference with contract claim or another tort claim.
Trade secret claims are often preferred by plaintiffs because trade secrets law allows a plaintiff to request attorneys’ fees if it prevails, an option that isn’t available for tort claims. However, the attorneys’ fees provision cuts both ways. If a plaintiff files a trade secrets claim without a reasonable basis for doing so, the judge could order the plaintiff to pay defense attorney fees. That’s why it’s so important to vet trade secrets cases carefully prior to filing. ●
Insights Legal Affairs is brought to you by Berliner Cohen