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.

Could the Recent Financial Reform Make it Harder for Your Company to Raise Funds

The recently enacted financial reform law (the "Dodd-Frank Wall Street Reform and Consumer Protection Act" for the sticklers out there) impacts a range of financial services and companies in the way they do business.  For startups and small businesses, it may just make it harder for you to raise funds.  That's because the Act changes the definition of "accredited investor" under the federal securities laws. For a bit of background, the securities laws were originally established in the 1930s amidst the Great Depression as a consumer protection initiative against excesses and fraud in the sale of securities.  Under the Securities Act of 1933, any stock or other securities sold by a company have to either be publicly registered or qualify under one of the limited exemptions.  Which means that companies can conduct limited offerings of stock to certain purchasers, and "accredited investors" fall into a special category with fewer requirements.  The logic being that they are more "sophisticated" than an average investor and can make more educated investment decisions (ed. note: this is regardless of what the last couple of years have shown).

For the past three decades, an accredited investor was any individual with a net worth of at least $1,000,000 - including the value of a primary residence - or who earned a personal income of $200,000 in the past two years (or $300,000 with a spouse) and with a reasonable expectation to repeat this year.  While the income test levels remain the same for now under the new law, the net worth test now excludes the value of the investor's primary residence. In addition, the SEC will have the authority - actually, the obligation - to revisit these amounts periodically in the future.

What does this mean for your company? From a practical standpoint, the new law means companies will need to revisit their subscription agreements and investor representations in offering documents to make any necessary changes before making any further offerings.  This should be done with the help of your company's attorney.

But the net effect is to make it harder to qualify as an accredited investor, which means that there will be fewer of them.  Since the income and net worth tests have remained at the same amounts since 1982, the effect of inflation means that many more people would qualify as accredited investors now than when these rules were adopted.  So this new law ameliorates that change to a certain extent.

But at the same time, it cuts down the available pool of potential investors in startups and small businesses.  That is a good thing in order to protect those people that technically meet the requirements but are otherwise unsophisticated investors.  But it could also result in an impediment to companies who need outside investors to grow, but won't or can't tap the more expensive institutional money available.

Best of Both Worlds: Converting Your Startup From a LLC to a Corporation

Entrepreneurs often ask my opinion on which type of entity is best for a startup or small business and, while I have written about this before, I generally say that one size never fits all.  That choice is made by each company depending on founder structures, short- and long-term planning, and, of course, tax.  I have seen companies start as corporations and as LLCs and both can be successful depending on your circumstance.  But are you stuck with that form once you make that choice?  That requires a bit of explanation. C-Corporations as Default? Many lawyers and entrepreneurs will tell you that all new startups must be Delaware corporations, and more explicitly, C-corporations.  This is the result of a common view that Delaware law is more friendly to your business than your state's, the courts are specialized and prepared to deal with business law issues that your company may face, and that a C-corporation is the structure that you will need in the event you take on investors (which you will certainly need if you are going to be taken seriously).

Without rehashing my previous post, I don't automatically subscribe to that line of thinking.  There are some startups that have very valid reasons for starting as, say, a limited liability company.  Those are mostly attributable to the flow-through tax structure and the flexibility of management and with allocations and distributions to the members. In other words, a company can take advantage of the tax savings of not having to pay corporate tax like a C-corporation during the early years of operation, the flexibility of adjusting the amount of distributions it gives to its members, and the freedom to customize management and ownership structures.

Can you Change your Entity? And if your LLC needs to be corporation later in life - for, say, investment or tax reasons - state laws provide mechanisms that vary by state for conversion from a LLC to a corporation (note: converting from a corporation to a LLC results in a much different, and less favorable tax treatment).  In Delaware, it is as simple as filing a conversion form.  In other states, such as Massachusetts, the same thing is accomplished through a somewhat more complicated conversion process or by enacting a full merger of your company into a newly-created Delaware entity.

What's it Going to Cost? Yes, there are both legal fees and filing fees associated with this type of conversion that will dissuade some companies from going down this route.  Your company needs to weigh the savings of flow-through tax treatment it will enjoy as a LLC with the cost of going through the conversion later.  And in addition to the legal fees, there are certainly some additional tax issues to consider (there we go again with the tax issues) particularly if you have passive members or hold certain types of debt.  But for many small and growing companies, you could accomplish a conversion without breaking the bank.  The key will be to make sure that your lawyer and accountant are involved early in the process.

Have you converted?  What was your experience?

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?

"$100 and 100,000 hours": Launching a Startup Doesn't Have to Break the Bank

I had a meeting today where we talked about the economy and the environment for entrepreneurs, and while the uncertainty in the economy is certainly not helping, the outlook is not all bad.  During the last two recessions in the early 90s and the early part of this century, new businesses sprang up in a variety of industries.  Sometimes necessity drives these ventures, such as when people start a new company after being laid off.  The times now are no different in the sense that many new entrepreneurs are looking to replace a job they used to have. But what is different this time is that many entrepreneurs do not have access to capital in the way they did in previous downturns.  The current uncertainty in the market is forcing many banks, investors, and other sources of capital to hold back.  That certainly hampers growth in industries that require large investments in inventory, real estate, or equipment, but innovation and entrepreneurship continue to find ways to thrive.

The timely article in the Wall Street Journal today about "Startups on a Shoestring" was a good reminder of the power of using creativity to overcome these kinds of obstacles to starting a business.  As I was reading it, I noted two important take-aways for entrepreneurs looking to launch a new venture.  First, that successful businesses can be started with such small amounts of capital.  I have worked with clients who started the same way: they took an idea and nurtured it through bootstrapping and hard work.  Second, the article

First, this is a good reminder that starting a company does not always require a large, upfront investment of money.  There are many businesses that have started and thrived on much less.  I have noted before that there is nothing like bootstrapping to focus a founder on what is really critical for the development of the business, and to maintain your flexibility and control for the future.

Second, it is important to note that new businesses can come from anywhere.  Traditionally, there has been a lot of attention paid to technology-driven startups in the high tech, clean energy, and biotech spheres.  And certainly, almost all businesses today will have a Web presence of some kind; that is just a fact of life in today's economy.  But it is good to remember that a company does not need to be revolutionary to get noticed, and that "low tech" ideas like bracelets, tours, and flooring services can still turn into successful businesses.

The bottom line is that entrepreneurship and innovation can find a way to thrive is just about any economy.  While the barriers to entry may be more difficult for some industries, these stories prove that there are still ways to start a business with just an idea and some hard work.