Still Time to Take Advantage of Tax-Free Investment in Small Business Stock

With all of the uncertainty in the markets recently, now is a great time to take another look at one way to create jobs with tax free investment. But you only have a few more months to take advantage of it. Remember the Small Business Jobs Act of 2010?  How about the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011?  Well, if you are a small businesses, a provision of these laws give investors, founders, and other stockholders the right to purchase certain types of small business stock and then sell that stock with tax-free gains of up to $10 million, provided you act quickly and then exercise a little patience.

United States Code Section 1202 was revised to exclude 100% of gains from the sale of "qualified small business stock" and that exclusion counts for both income tax and alternative minimum tax purposes.  But here is some fine print:

• the company must be a C corporation (if you are taking advantage of the flow-through tax treatment of an S corp, you are out of luck);
• the stock must be acquired between September 27, 2010 and January 1, 2012, and must be held for five years before being sold;
• and at least 80% of the assets of the company must be used for one or more qualified businesses.

There are other provisions that may apply to your company as well, so you should review this carefully with your legal and accounting advisors.  But for those companies that meet the conditions, now could be the time to take advantage this temporary opportunity.

Can You Finance and Grow a Small Business Through Crowdfunding?

I have received more inquiries recently about the possibility of using crowdfunding to fund a business.  Crowdfunding is a method of using small donations from the public as a way to raise money without losing control over a project.  It has been used successfully to fund many different types of projects over the past few years including movies, music, fashion, and art.  Now that same model is starting to be applied to business ownership - but that is a much different and risky proposition. Here's why. If you have never seen crowdfunding in action, you should check out sites like Kickstarter, RocketHub, and Quirky which allow artists, designers, inventors, writers, and others to raise money to fund some creative project they are working on.  Donations are pledged online and, once a certain set amount is reached, the project gets funded by those small donations.  The key here is that backers of the project are making a donation to support the project but they receive no ownership in the project other than perhaps getting a free copy of the finished project as a gift.  But this simplicity is what makes the project-based model successful.  First, potential backers can easily wrap their heads around, say, a new short film or a book, and donating a small amount of money is a low risk proposition.  So a project gets completed, and backers may get a free copy of the project to keep.  A win-win.

But now companies are trying to expand the model beyond project financing to funding business concepts, which can be another avenue to funding without turning to angels or VCs.  The problem with taking money from a large number of people in exchange for ownership in a company is that this is exactly what the U.S. securities laws - both on a federal and state level - are guarding against.  In general, any securities sold in a company must either be publicly registered or must qualify for one of the enumerated registration exemptions.  Generally speaking, selling ownership in a company to people without a large net worth (so-called "unaccredited investors") may trigger a number of disclosure and registration obligations on the company, and specific laws of each state where investors are located will have an effect as well.  As the number of investors and states involved goes up, so do the costs.  So tackling a financing project like this should be done with the careful counsel of a securities attorney because these rules can be treacherous to navigate and could result in penalties and rescission.

Some may opt for services from companies like Profounder, which was recently launched to provide assistance with this kind of financing for a flat or small percentage fee (in addition to all of the filing fees).  Sounds like a great option for companies to raise money, but be very careful here.  The securities laws were written pre-Internet, and are certainly not optimized for the rapid changes in technology.  Just because you can do it does not mean you can get away with it.  And compliance requirements under state securities ('blue sky") laws vary and are notoriously different.  Again, seek out an experienced securities lawyer to help guide you through.

Have you tried crowdfunding?  What was your experience like?

Because It Can't Be Said Enough: Choose Your Founders Wisely

I ran into another situation this week where a business completely fell apart and is heading for dissolution solely because of a growing war between the two founders.  I will have more on the details of this in a future post because it is enlightening for startups, but in the mean time, you can find more info on the right way to choose your founders and how to structure your initial equity here in my Founders Series Parts I, II, and III. Remember that you should always set up an agreement between the founders at the beginning of the business, but structure it for the end of the business.

The Ghost of Par Value and its Real Effect on Startup Businesses

Par value is one of those legal mysteries involved in forming a business that entrepreneurs have never heard of and ten minutes after incorporation, may never consider again.  However, I ran into a situation recently where it mattered to one startup company (at least for a moment). For a quick bit of history, par value is an anachronistic concept where the company sets a stated value on each share of stock it authorizes.  States allow that par value to be any any amount, but typically it is set at zero or some very small value.  In the past, this amount had legal effect and represented that amount that was originally paid for the stock and made up the initial capital of the company.  However, now, it has little import aside from some minor accounting issues and calculating state taxes in some states (like Delaware).

I am working with a startup that was incorporated in Massachusetts and is now considering a reincorporation in Delaware.  The  founders originally choose to have "no par value" as is permitted in Massachusetts and did not give another thought to it because of what I stated above and because annual fees for corporations in Massachusetts are not based on par value.

When reincorporating in Delaware, the founders increased the number of shares (to provide some flexibility with investors and with employee equity plans) and assumed that the company would use the same no par value stock.  But in Delaware, there are two methods for calculating the franchise taxes that the company must pay every year.  Without going into the particulars of each of the calculations (because you would fall asleep on your keyboard), the franchise tax with stock at a par value of $0.01 per share resulted in an annual franchise tax of $350.00 whereas the same amount of stock with no par value could result in a franchise tax of $75,075!

The bottom line. In thinking of par value, do not think any more than this: just go with par value of $0.01 or less and don't think about it again.

Of Shoestrings and Bootstraps: How to Start a Business Without Investors

As a follow up to my recent post on starting a business without breaking the bank, here is another example of a successful business that is being successfully built without angels, venture capital, or other outside investors.  For this entrepreneur, maintaining control over decision-making and keeping the employees engaged through their own ownership stakes seem to be the key to their success. While the founder has to give up some ownership in either case, for this company, giving up value to the employees made for a stronger organization. As she notes in the interview, there may be a time to take on experienced investors at some point in the company's development - so called "smart capital" because with the money comes the expertise of seasoned investors and often former entrepreneurs who can provide value to building your business.  But many entrepreneurs are more reluctant to take that plunge until they have established the business and need the capital to advance to a new level.

I am curious to hear more stories of this (both successful and otherwise).  Has bootstrapping worked - or not worked - for you?