April 2011 Archives

Convertible Notes

April 25, 2011,

Bridge financing for Silicon Valley start-up companies is a fairly standard, relatively inexpensive method to raising money pending a larger investment round. This type of financing is typically provided in the form of debt that converts into shares issued in the next funding round, often at a discount from the per share purchase price.

Recently, the simple convertible bridge loan has changed to provide substantial tax incentives to investors. For any qualified small business stock, or QSBS, purchased before December 31, 2011, the recently enacted 2010 Tax Relief Act allows 100% of the gain recognized from the stock to be excluded from taxable income.

Although a convertible loan will not qualify as QSBS, the stock that a start-up company issues normally will. Bridge loan investors have a great incentive to purchase stock in exchange for their bridge funds instead of a convertible note. Designing stock that has many of the same attributes as convertible debt has provided some additional complexities to what was formerly a plain vanilla transaction.

Because debt is not being issued, the investor will have no right to return of its funds, barring securities violations. Most bridge loan investors, however, provide funds on the expectation of ultimately holding stock. As a result, the lack of a repayment feature is not a concern. If it is, a redemption feature could be designed, but it is unlikely the Company would be able to legally redeem the stock if it couldn't otherwise raise money.

The key advantage to a convertible note, that value need not be negotiated, is eliminated because stock is issued. This creates the need to negotiate a valuation, which adds time to the transaction. This can be solved, in a sense, by requiring the stock to convert into stock issued in the next round if the next round is expected to close soon. If this approach is used, a separate and forced conversion rate must be established to make sure the bridge stock converts into the next round.

As a result of the above items, and the need to issue stock, a new series of stock will need to be created. This requires charter documents to be amended and corresponding board and stockholder approval to be secured.

Price-based antidilution adjustments may be triggered. If so, capitalization estimates have to take account of corresponding changes in the conversion rate of the applicable series of preferred stock.

Tax benefits will come at some cost in the deal due to more complex documentation and expense. The structure, however, may provide just the right push to close that extra funding.

Are You A Real Estate Professional?

April 18, 2011,

Over many years of working with real estate investors, one question has come up over and over again: "Can I qualify as a real estate professional so I can deduct my passive losses against my ordinary income?" The last time was from a San Jose full-time professional who has rental property in Sunnyvale. I almost always have to disappoint my clients with the answer that they do not qualify. Several times I have had my Silicon Valley clients and their advisors disagree with me, despite explaining the rules to them. Many of them go on to report it the way they want to, and take the risk.

The United States Tax Court just answered the same old question again. In Yusufu Yerodin Anyika et ux. (TC Memo. 2011-69, March 24, 2011), the taxpayers were a married couple that had been buying, renovating, managing and selling rental real estate for years. He worked 37.5 hours per week, 48 weeks per year as an engineer and she worked 24 hours per week as a nurse. During 2005 and 2006 they had two rental properties, which Mr. Anyika considered to be his second job as well as their investment property. They filed their tax returns themselves with TurboTax, claimed he worked 800 hours per year managing the real estate, and deducted their rental real estate losses. The Tax Court held that for them to be able to deduct their rental real estate losses he must have worked more than 750 hours and over half of his working hours on their real estate investments. Mr. Anyika then re-estimated his real estate hours to be 1920, just over the 1800 he spent in his day job. Unfortunately for Mr. Anyika, the Tax Court did not believe his new, unsubstantiated re-estimate and held that he did not qualify as a real estate professional. The Tax Court did hold that Mr. Anyika qualified for a $25,000 deduction for materially participating in real estate, but this deduction was not available to him because his adjusted gross income was too high.

Something to note, which was not an issue in the Anyika case, is that the rules are even worse for short term rentals. Time spent on properties with average rental periods of seven days or less does not count towards the 750 hour test, and losses on those properties are also ineligible for the $25,000 deduction for actively managed real estate. (Source: Kiplinger Tax Letter, March 18, 2011, Vol. 86, No. 6)

So - if you think you should qualify as a real estate professional, create a log of every hour you work on the real estate and, at the end of the year, compare those hours to the hours you work in your regular job. If the real estate hours exceed 750 hours and also exceed the hours you worked in your regular job and you can prove it, you qualify as a real estate professional. If they do not, try for the material participation test to get the $25,000 deduction (unless your income is too high). And no matter what you choose to do... don't blame TurboTax. The Tax Court has heard that one before.

Save Me! Purchasing the Financially Troubled Company - Part 2

April 11, 2011,

Acquiring a financially troubled company, whether in San Jose, Palo Alto, or New York often requires consideration of the bankruptcy process. If the seller is already in bankruptcy, the buyer must convince the bankruptcy court that it represents the best source of funds to repay existing creditors. If the bankrupt company has attractive technology, there may be other buyers, and the court will typically award that company to the buyer who will pay the most money.

If the seller is not yet in bankruptcy, the parties may decide to purchase the company through a bankruptcy proceeding. If planned properly, the bankruptcy process can provide the buyer with a number of advantages. First, the seller's assets are purchased free of any liens or other claims (although courts continue to wrestle with allowing subsequent successor liability claims). Second, because the assets are purchased "as-is," sale documentation is typically shorter than for sales outside of bankruptcy, and stockholder approval is not required.

Planning for purchasing a company through a bankruptcy involves entering into arrangements with the selling company's creditors and other stakeholders before the bankruptcy filing. As part of these arrangements, a reorganization plan and acquisition agreement may be prepared and agreed to prior to the filing. Once the appropriate pieces are in place, the seller will file for bankruptcy and include the pre-agreed reorganization plan in its bankruptcy documentation. The sale can be completed in a few months barring no other suitors or other unforeseen impediments. Bankruptcy counsel is necessary for both parties to properly shepherd the transaction through the proceedings, and corporate counsel is critical to insure that documentation is accurate and necessary corporate formalities are followed.

Financially troubled companies often provide the opportunity for others to purchase businesses at a relatively lower cost. Reaping the advantages successfully requires balancing the needs of all the business's stakeholders.

Continue reading "Save Me! Purchasing the Financially Troubled Company - Part 2" »

Save Me! Purchasing the Financially Troubled Company - Part 1

April 4, 2011,

Technology start-up companies in Silicon Valley exist in a highly dynamic environment, where survival can be crushed by competition from a kid in a garage or a fund partner refusing further investment. As a last gasp, some companies may try to be acquired. Companies which have had to take refuge from their creditors may be able to sell their business through bankruptcy proceedings.

When compared to a standard sale of a business, sales of financially troubled companies require the professional advisors to manage a number of different stakeholders to successfully close a transaction. More so than in standard transactions, professional advisors play an important role in helping a transaction proceed smoothly. Under certain circumstances, their fees may be paid by the buyer or the bankrupt estate.

Most acquisitions of financially troubled companies are structured as an asset purchase. This prevents the acquirer from having to automatically assume liabilities that it doesn't want. The existing creditors are then left with satisfying their claims out of the proceeds from the sale. Most companies, however, need the products or services of its creditor vendors to survive. In the case of technology companies, these vendors often include technology and hardware suppliers who are core to the company's business. Irritated suppliers may not want to deal with the company even after its acquisition. Creditors and stockholders of the company may have claims against the company's board of directors if a company is sold for less than the reasonably equivalent value of its assets. At the same time, key employees of the company, aware of the company's financial stress, may be looking for alternate opportunities. The importance of these stakeholders, and how they are managed as part of the acquisition, is at the heart of any purchase of a financially troubled company.

The first task of any potential buyer is to perform extensive due diligence to determine what employees and suppliers are necessary to the company post-closing, and whether the company's operations can be streamlined sufficiently to enable it to become viable. For the seller, the key task is to maintain those relationships of most value to the company. This may require creating cash retention bonuses for key employees.

The second task is to document a letter of intent and definitive agreement rapidly so that the company remains viable. Preliminary negotiations can be challenging, because, among other things, the buyer will need access to the seller's vendors to determine if payment accommodations can be made. In exchange for the time the buyer requires for vendor discussions, the seller may insist that the buyer funds the company's operations, particularly its payroll, until closing.

The third task is to close the transaction quickly so that valuable employees and vendor relationships are not lost. This can be difficult given that contracts for many of the seller's key relationships will need to be assigned, and the consent of the other contracting party may be required.

In my next blog, I'll discuss how the bankruptcy process is used in acquiring a financially troubled company.