Legal Matters | Archive

Creating a capital structure to support your business strategy

by Nelson Blitz
for Virginia Business
July 2006

When you created your business' legal entity and equity (share) holding structure, did you consider the short- and long-term strategy of the business? Are you thinking about adding new equity owners - whether through passive investments, active participants or employee plans - and in doing so are you considering the strategic path for the business? Of course, you probably reviewed, along with your legal and accounting specialists, the differences in federal and state tax treatment of the choice of entity and, perhaps, your exit strategy, but did you review the various structures and processes that should be implemented in light of the strategic path and the differing interests of the owners?

Alignment of ownership- that is, structuring the company so that that different owners, with different ambitions and different resources, are aligned in their both their incentives and ultimate goals - is essential in creating a capital structure. Owners when aligned find decision making facilitated; when not aligned can reduce or destroy the value of their investment. Owners should thoroughly consider and reconsider alignment issues and implement structures and processes through a capital structure created with organizational documents and shareholding and operating agreements that support their goals. Here are some different ownership situations to consider.

Funding growth
One of the owners wants the business to grow; but the others are concerned about the risk. Does your capital structure align the reality of risk among the owners? In smaller businesses, certain owners may be required to co-sign credit and loans for the company and thus are at risk, whereas others are either not required to do so or have an intuitive sense that the lenders will seek recourse primarily against those with the bigger pockets.

In these situations, those who do not "feel" the risk may advocate quick and expensive growth because the chances of a higher return are increased without the corresponding risk. In other situations, the owners may want to fund growth through capital contributions, but others do not have the ability to fund to the extent of the others. Their ownership positions are typically diluted. Will those owners balk at the additional funding because their ownership percentage is reduced? How about going outside the current ownership group for investment and thereby risking loss of control? The capital structure you create can support a secure result; whether the decision is to assure sources of capital or assure ownership percentage or control.

Employee equity incentives and retention
Typically we hear that a company wants to increase entrepreneurial spirit by providing stock options or other equity ownership plans to employees. Of course the plan will reduce in some fashion the current owners' returns because equity is being shared. The reduction in current ownership may be worth it if the employees will sell more, be more productive, be retained as employees, etc. However, owners should continually monitor whether the equity plan actually creates incentives for employees, otherwise the current owners will have diluted themselves without value in return.

Equity appreciation v. cash flow
One owner wants to grow the enterprise's value and the other wants to take as much cash out of the business as possible. These goals are usually contradictory. These desires may be based on resources, age and family situation or many other factors. And even if there is general agreement that the owners want to maximize enterprise value and appreciation, the timing of an exit and liquidity can also significantly impact the decisions relating to the amount the owners take out of the business in the nearer term. While it is difficult to predict the future needs of the owners, it is critical to have outlined in appropriate documents a process and path toward decision making on these issues.

Succession/transfer planning
Some owners might not want to share the rewards of the business' growth with those owners who are no longer involved. Many owners are concerned about having an owner being replaced after death or disability by the children or spouse; and the impact on important decisions from those events. The possibility that a retired or terminated owner may sell their ownership interest to someone outside the group alarms some.

Where death, disability, retirement or even employment termination of an owner occurs, there is often substantial risk to the remaining ownership group. Funding and planning for these circumstances and perhaps a buyout requires long-term planning and a clear process. Implementing clear transfer restrictions that maintain the fairness of the underlying value of the ownership interests, rights of first refusal, pre-emptive rights and buy-sell funding is central to assuring the future of the business.

Alignment and the exercise of leadership
Finally, we all know the importance of leadership. Leadership is exercised through vision, relationships, excellence and other personal characteristics. Leadership can be embedded in the capital structure, as well, through protective provisions and differing voting rights which may deviate from the democratic notion of one share-one vote. Through whom and how leadership is exercised may be embedded in the organizational documents; and many companies have found implementation of these provisions were the basis for their success.