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Preparing your business for a capital raise, including tax considerations

Authored by Chase Murphy and John Melbourne

Preparing for a capital raise and high-level process insights provides a high-level summary of the capital raise process and highlights key factors to consider when preparing for a capital raise.

There comes a time in a business’s operating lifecycle where there may be a need to source outside capital. The timing of this need is very different for each underlying business and is typically influenced by key operational challenges that most early-stage businesses are forced to overcome at the onset of their venture (including product/technology development, inventory constraints, hiring of additional human capital, enhancing marketing/advertising, etc.). Unfortunately, there is no definitive reason to how or why these challenges occur and more often than not, the timing is often unpredictable.

When early-stage businesses find themselves at this unique juncture, some elect to bootstrap their way through the adversity while others seek outside investment for cash and/or strategic purposes. Section 2 is designed to offer general insights into the capital raise process while also highlighting various things to consider when preparing to take on outside capital investments.

Please note: there is no “one-size-fits-all” strategy for raising capital with each process being independently unique (typically differentiating from one another on a basis of operational maturity, human capital expertise, sector/vertical focus, technology and cash-flow generation, varying levels of investor interest) and no two outcomes are exactly the same. As a result, the following section is intended to offer high-level insights that are directional in nature and not definitive.

Process and considerations when preparing to source capital            

Prior to a company exploring its capital raise prospects, it is important to understand the structure of a typical process, key events that occur at each phase of the process and the level of detail/work involved. Figure 1 provides a hypothetical summary of what could be expected when venturing into a more traditional capital raise process and the underlying tasks that correspond with each stage.        

Figure 1

Process overview

Setting the stage: Upon realizing the desire and/or need to raise outside capital is appropriate and will support the company’s current and future growth initiatives, it is imperative that the company’s objectives are clearly defined. Thoughtful preparation is critical at the onset of this phase as the details compiled will eventually evolve into the basis of your overall strategy and support your efforts throughout all subsequent stages of the capital raise process.

Key points to consider:

  • The initial step after defining company objectives is to assess whether your business is investable and to measure the probability of executing a successful capital raise. Although there may be a perceived need for an investment, this belief does not necessarily mean the business is ready for an investment. Simply put, all businesses have different levels of potential and capital providers will have differing suggestions based on their assumptions. Operational growth and day-to-day focus cannot be ignored during this time, so one must be confident that allocating time to seeking outside investment is worth the effort and will not sacrifice the health of the business.
  • Understanding available capital sources and underlying investor types is important. There are different types of investors at each stage of a company’s growth so knowing which ones to approach is essential. See Figure 2 below for a hypothetical summary of company growth and the typical timing of investor interest at each stage of development.

Figure 2
  • Once you understand where your company resides from an operational lifecycle perspective, you will have a better understanding of who the appropriate type of capital provider might be and can begin compiling a list of preferred investors. Some criteria that you’ll want to be sure to consider when building this list may include:
    − Your investor will become your partner. Not only will you be exchanging equity ownership for cash, they’ll likely sit on your board, have voting rights and expect frequent financial, operational and performance-related updates. As a result, it is important that you seek out a partnership that will continue to be a fit throughout the short- and long-term period.
    − There are numerous reasons why capital providers invest at different periods of a company’s operating lifecycle so it is important that you consider the following when assessing fit:
    °  Industry/vertical focus
    °  Fund size and timing of investment – this will offer insight into potential investment size and anticipated investment horizon
    °  Prior investments history (i.e., type, size, time to exit, etc.)
    °  Value proposition each investor brings to the table (industry expertise, product/technology development, sales and marketing, strategic relationships, etc.).

Preparing the materials: It is important to note that the later the capital raise (i.e., Seed and Series A – D), the more detailed your summary materials will need to be. Venture capital firms take more of an institutional approach to their diligence and expect entrepreneurs and business owners to present investment summaries in a more detailed format. This information is generally presented in what is called an Investment Opportunity Summary, which consists of 10-15 slides that cover key aspects of the business and industry. Each summary should be customized to the underlying business, but the following list captures common topics that are typically part of due diligence during preliminary assessments and will allow investors to gain a clear understanding of your business.

(Note: the following sample outline is more applicable to early/late-stage VC audiences):

Figure 3

Key things to consider:

  • VC investors get inundated with thousands of investment summaries from entrepreneurs so the trick is to create a summary that is differentiated from the rest, concise and to the point (yet still detailed).
  • Short opportunity summary: there is no guarantee that an investor will review the entire opportunity summary, so this slide is intended to offer a quick summary of the business and capture the reader’s attention (i.e., your “elevator pitch”)
  • Market opportunity: this slide should include a top-down summary of the business’s total addressable market/market size (bigger is generally better).
  • Current and future road map: this slide is essentially your company’s business plan and maps out short-to-medium term insights. It is critical that this slide mirrors your projections as it will essentially substantiate the equity ask and provide insights into how the investors’ capital will help you through each phase highlighted on this slide. Most investors will not only focus on the high-level initiatives outlined here, they will utilize this summary as an indirect assessment of an individual’s strategic vision and preliminary assessment of one’s ability to execute the underlying growth strategy.
  • Team overview: the earlier the capital raise, the riskier the investment will be to a VC investor, so it is important to note that most will be paying particular attention to the individuals they are investing in.
  • Financials and projections: as noted above, it is important that company projections are realistic and mirror the company’s current and future road map summary (the projections should also correspond with the “uses of funds” summarized on the final slide).
  • Equity ask and uses of funds: having a clear equity ask will allow VCs to better understand perceived and/or real pre-money valuations. All investors will assess the opportunity differently, so not all will be in agreeance, but is important to their preliminary assessments. Be prepared to understand the implications of this equity ask (in terms of equity ownership dilution and how post-investment capital tables will be impacted).

Tax planning considerations

With the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), proactive tax planning and diligence continues to be a critical component for any transaction process. Careful consideration should be made regarding the tax impact raising capital may have on the business or the existing shareholder(s).

While the tax impact of an equity raise is dependent upon the individual facts and circumstances at play, there are some general topics to consider. You should consult a tax advisor when contemplating a transaction of this nature to review the relevant fact pattern.

Entity structuring:
  • Partnerships, LLCs and S corporations
    − Pass-through businesses report items of income or loss to owners on an annual basis by issuing K-1s.
    − Considered a single layer of tax, as company is generally not obligated to pay taxes. Partners and shareholders report and pay taxes on their share of income based on K-1s received.
    − Raising capital in a pass-through context will cause an investor’s tax reporting to be intimately tied to the company’s return filing. The company will be required to provide each investor with a K-1 reporting their share of income or loss before the investor can file their return(s).
    − S corporations are limited in the types of investors (natural persons and certain trusts), number of investors (fewer than 100) and single classification of stock. Consider any restructuring opportunities prior to raising outside capital to avoid defaulting on existing S elections.
    − Consider administrative burden and any investor relation issues surrounding annual K-1 reporting. State-level K-1s may also be required for any companies with significant multistate operations.
  •  Corporations
    − Subject to double layer of tax. The corporation pays tax on annual taxable income of the business. Items of income or loss generally are not allocated to shareholders on an annual basis. Shareholders recognize income on any dividends received, creating the second layer of tax on distributable profits.
    − Some administrative simplification with reduced shareholder tax reporting annually (no K-1s)
    − No limitations on classes of stock or participation
    − Most efficient structure if contemplating an eventual IPO
    − Often preferred structure for any foreign or institutional investors
 Common tax planning considerations:
  • Sale or exchange of existing units versus issuing new units in a partnership – when a new party enters a partnership, careful consideration should be given to determine whether a sale or exchange has occurred with existing partners, or whether the entity issued additional units to the new member. If an existing partner receives a distribution of proceeds otherwise contributed by another partner, care should be given as to whether a taxable event has been created for the recipient via a sale or exchange of existing equity. A contribution of capital by newly admitted partner and receipt of additional units generally does not create a taxable event for existing shareholders, rather a dilution of previous ownership.
  • Basis for investor dependent upon entity structure. Investment in C corporation gives shareholder basis in stock. Investment in partnerships can provide an investor an opportunity to “step-up” their basis in the partnership’s assets in certain circumstances, giving opportunity to recover investment through depreciation or amortization deductions against future income.
  • Section 1202 qualified small business stock provides opportunity for the capital gains from select small business stock to be excluded from federal tax, assuming certain conditions are met. Primarily, stock must be issued by a domestic C corporation (certain industries excluded) with less than $50 million in assets and the stock must be held for five years.
    − Provides incentives for noncorporate taxpayer to invest in small businesses.
  • Tax diligence – ensure timely and accurate reporting around all open tax periods. Lacking consistency around the compliance process can cause concern or loss of confidence with investors. Ensure all state and federal taxes are compliant prior to raising outside capital.
  • Tax attribute limitations may exist in circumstances with a change in control of a C corporation. NOLs and other credits may be limited for future utilization.
  • If your business is structured as an S corporation, consider restructuring into a C corporation or a disregarded LLC to allow for non-natural persons (entities, VCs, PEs, etc.) to invest without consequence.
  • Short period returns may exist if any restructuring taking place.

Conclusion

  • Not all businesses are created equal and outside investments don’t always make sense for every company.
  • Be sure to understand the implications of raising outside capital and only approach prospective partners that are a good fit now and into the future.
  • Upfront preparation is key and will benefit your efforts throughout each phase of the capital raise process.
  • Raising capital is not an easy task, timing is critical and the process tends to take longer than anticipated.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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