Structuring Your Business for Investment and Growth Presented by Teri G. Rasmussen Capital Crash Course 2008 December 2007

Lane, Alton & Horst, LLC2 Teri G. Rasmussen Partner and Vice Chair, Business Law Practice Group Lane, Alton & Horst, LLC [email protected] (614) 233-4753 [email protected] Lane, Alton & Horst, LLC Two Miranova Place, Suite 500 Columbus, Ohio 43215 www.lanealton.com

Lane, Alton & Horst, LLC3 Teri G. Rasmussen B.A., with honors, 1981, University of Iowa J.D., cum laude, 1984, University of Michigan Bar Admissions: Supreme Court of Ohio, 1984 U.S. District Court, Southern District of Ohio, 1984 U.S. District Court, Northern District of Ohio, 1993 U. S. Sixth Circuit Court of Appeals, 1997 Professional Associations: Columbus Bar association (Former Chair, Financial Institutions Committee), Ohio State Bar Association (Former Chair, Banking, Commercial and Bankruptcy Committee) American Bar Association American Bankruptcy Institute National Association of Women Business Owners (NAWBO)

Lane, Alton & Horst, LLC4 Teri G. Rasmussen Business Acquisitions and Sales General Corporate and Business Law Joint Ventures and Strategic Alliances Corporate Governance and Shareholder Disputes Contracts and Loan/Lease Documentation Business Formation and Financing Business Planning Creditors Rights and Debt Collection Business Bankruptcy and Insolvency UCC and Secured Transactions Commercial Finance Litigation Real Estate

Lane, Alton & Horst, LLC5 Visit my legal blog: O HIO P RACTICAL B USINESS L AW C OUNSEL http://ohiopracticalbuslaw.wordpress.com

Lane, Alton & Horst, LLC6 I. Structuring Your Business THE BASIC SETUP

Lane, Alton & Horst, LLC7 EVERY Business Has a Legal Form If you dont make a Decision, the Law will make one for you. A one-person business will automatically be a sole proprietorship. A business with two or more Owners will automatically be treated as a general partnership

Lane, Alton & Horst, LLC8 The TYPE of LEGAL ENTITY Matters Level of Formality Required for Recordkeeping Level of Formality Required in Decisionmaking Effect of Death or Disability of Anyone Actively Involved in the Management of the Business Taxes Who Pays and How Much Ability of Business Creditors, Disgruntled Employees, and Others to Reach Personal Assets of Owner(s) Who Has Say in, or Control of Business and its Operations

Lane, Alton & Horst, LLC9 Factors to Consider in Choosing a Legal Structure How much record-keeping are you able and willing to do on a continuing periodic basis? What is YOUR tolerance for risk? What sort of risks are you most comfortable having? What sort of risks do you MOST need/want to avoid? How will the business be financed? Outside Investors and Creditors Personal and Family Funds

Lane, Alton & Horst, LLC10 Factors to Consider in Choosing a Legal Structure What sort of business risks are there in your industry or type of business? How much government regulation is your business generally subject to? Where will your business sell or provide good and/or services? Locally or within one state? Regionally? Nationally? Worldwide?

Lane, Alton & Horst, LLC11 Factors to Consider When You Are Not the Only Owner How well do you know your fellow owner(s) and can you really trust them? Compatibility of Owners in Temperament, Work Habits, Spending, Risk Tolerance, Etc. Strengths and Weaknesses of Fellow Owner(s) Could a Weakness Cause a Problem for the Business? How Can That be Guarded Against?

Lane, Alton & Horst, LLC12 Factors to Consider When You Are Not the Only Owner How Many Owners Will There Be? Owners individuals or business entities? What Role, Responsibilities and/or Duties Will Each Owner Have? How will these be Shared or Allocated? Will any owner(s) or group of owners have veto power with respect to certain specific issues?

Lane, Alton & Horst, LLC13 Factors to Consider When You Are Not the Only Owner Are you the money person or the sweat equity person? What happens if an owner wants out of the business? Getting Investment Out of the Business Transfer, and Restrictions on Transfer, of Ownership What happens to ownership interest upon death or disability of owner? Will some owners get their investment back sooner than other owners?

Lane, Alton & Horst, LLC14 THE CHOICES

Lane, Alton & Horst, LLC15 Choices in Basic Legal Structure Sole Proprietorship Partnership Limited General Corporation C-Corp S-Corp Limited Liability Company (LLC)

Lane, Alton & Horst, LLC16 Basic Types of Ownership Interests PartnershipPartnership Interest Shares CorporationShares of Capital Stock LLC Membership Interest

Lane, Alton & Horst, LLC17 Sole Proprietorship Basic Characteristics No separate existence from owner. Business assets in owners personal name Owner signs contract in personal capacity If owner dies or becomes disabled, so does the business Profits and losses from, as well as expenses of, business included on individual income tax return Difficult to transfer

Lane, Alton & Horst, LLC18 Weighing the Sole Proprietorship Alternative Advantages Maximum authority and control Simplest and least expensive to start just find a location and open the doors Appropriate for very small service business not likely to borrow much money and not likely to be sued Business losses can offset income from other sources Disadvantages Death or Illness endangers business Growth limited by personal energies Obtaining financing and investment may be difficult Personal and business affairs easily mixed

Lane, Alton & Horst, LLC19 General Partnership Definition Ohio law defines a general partnership as an association of two or more persons to carry on as co-owners, a business for profit Ohio Rev. Code 1775.05(A)

Lane, Alton & Horst, LLC20 Purpose of Forming Partnership Nothing more than a common law contract between owners To operate broad-based business To share in the responsibilities of management To divide the profits realized from the enterprise

Lane, Alton & Horst, LLC21 Partnership Characteristics Almost any management and profit-sharing arrangement can be agreed upon among the partners. Must have at least two partners at all times. Joint Venture or Strategic Alliance differ from true partnership because they are generally limited to an isolated and particular transaction.

Lane, Alton & Horst, LLC22 Creation of General Partnership Can be accidentally created formation occurs whenever parties expressly or implicitly start sharing profits and losses and the management of the business Can be created orally no written agreement required, though recommended

Lane, Alton & Horst, LLC23 Limited Partnership Only valid if written and formed in compliance with statutory requirements One General Partner same responsibilities as in general partnership. Other Limited Partners Have limited rights in exchange for limited liability for partnership debts.

Lane, Alton & Horst, LLC24 General and Limited Partnerships Comparison General Partnership All Partners Participate in Management Dissolves upon death or withdrawal of any partner Limited Partnership Limited Partners Must Not Be Involved in Day- to-Day Operations Dissolves only upon death or withdrawal of General Partner More Complex than General Partnership

Lane, Alton & Horst, LLC25 Weighing the Partnership Alternative Advantages Two (or more) heads are better than one Income passes through to Partners Management Structure Flexibility No qualification requirements for doing business in other states Disadvantages Difficult to get rid of bad partners More Expensive to form than sole proprietorship, especially in case of limited partnerships Difficult to transfer ownership interest Hazy line of authority in general partnership Cannot have both management responsibilities and limited liability

Lane, Alton & Horst, LLC26 Usefulness of Partnership Alternative General Partnership is obsolete except in very special circumstances Owner is particularly concerned about deductibility and capital gains treatment of continuing payments to retiring partners (IRC 736(a)) Important that business not be treated as entity for tax purposes (e.g. oil and gas investments) Limited Partnership duplicated and supplemented by LLC alternative

Lane, Alton & Horst, LLC27 Distinguishing Characteristics of Corporations Ownership interests are known as shares or stock and are freely transferable to anyone else unless shareholders otherwise agree Shareholders are not liable for company obligations except under highly unusual circumstances, but the company itself will be held liable Existence continues even after departure of original owners or key individuals

Lane, Alton & Horst, LLC28 Corporate Governance Shareholders have no authority to control day-to- day management or business operations Shareholders elect Directors Board of Directors set general policy Board of Directors appoint Officers such as President, Vice President, Treasurer, and Secretary Officers manage day-to-day operations of company Officers are answerable to Board for their actions

Lane, Alton & Horst, LLC29 Formation of Corporation Corporation has NO owners until stock shares have actually been issued to owners by the Incorporator. Corporation IS NOT validly formed until Shareholders elect Directors AND Directors appoint Officers.

Lane, Alton & Horst, LLC30 Corporation Formation Procedure 1.Articles of Incorporation are signed by Incorporator, who may or may not become a Shareholder, and filed with the Secretary of State. 2.Incorporator receives subscriptions and payment for shares and issues them to owners. 3.Incorporator calls first meeting of Shareholders to elect Directors, adopt Code of Regulations, and transact any other business. 4. After Shareholders elect Directors, Directors pass resolution appointing Officers.

Lane, Alton & Horst, LLC31 Weighing the Incorporation Alternative: Effect Upon Personal Liability Incorporating Helps separate your personal identity from that of your business. Once incorporated, the shareholders of a corporation have only the money they put into the company to lose, and usually no more as a result of being a shareholder. Remaining Unincorporated Sole proprietors and general partners are subject to unlimited personal liability for business debt or law suits against their company. Creditors of the sole proprietorship or partnership, including ordinary suppliers, vendors, and other trade creditors can bring suit against the owners of the business and can move to seize the owners homes, cars, savings or other personal assets.

Lane, Alton & Horst, LLC32 Weighing the Incorporation Alternative: Credibility of Business Adds Credibility. A corporate structure communicates permanence, credibility and stature. Even if you are the only stockholder or employee, your incorporated business may be perceived as a much larger and more credible company.

Lane, Alton & Horst, LLC33 Weighing the Incorporation Alternative: Attracting Capital and Financing Incorporated Capital can be more easily raised with a corporation through the sale of stock. Investors are more likely to purchase shares in a corporation where there usually is a separation between personal and business assets. Some banks prefer to lend money to corporations. Unincorporated With sole proprietorships and partnerships, investors are much harder to attract because of the inability to have control without personal liability.

Lane, Alton & Horst, LLC34 Weighing the Incorporation Alternative: Transferring Ownership Incorporated Ownership of a corporation may be transferred, without substantially disrupting operations or the need for complex legal documentation, through the sale of stock. Unincorporated Cannot sell sole proprietorship as a going concern, i.e. can only sell individual assets Partnership may dissolve; generally not easily transferable

Lane, Alton & Horst, LLC35 Types of Corporations VERY C-Corp - for larger more mature businesses, especially those publicly held, and for those anticipating making initial public offerings (IPO) of capital stock in the VERY near future Cannot later be converted to S-Corp or LLC without tax consequences S-Corp - for smaller privately held businesses with less than 100 owners, all of whom are individuals; must specifically affirmatively select this status Can later be easily converted to C-corp

Lane, Alton & Horst, LLC36 S-Corporation Restrictions on Shareholders Maximum of 100 shareholders Must be individuals (or their estate planning trust) no corporations, LLCs, or partnerships Shareholders must be U.S. citizen or permanent resident no foreign nationals Only one class of shares/stock permitted no preferred permitted Taxes on corporation income are passed through to shareholders income

Lane, Alton & Horst, LLC37 Close Corporations A close corporation is a special sort of corporation (either S or C) designed for businesses with only a few owners. Allows owners by agreement to bypass many of the usual formalities required of corporations, thereby simplifying management of company affairs Requires a WRITTEN agreement complying with specific statutory requirements (Ohio Rev. Code 1701.591) Often has restrictions on ability of shareholders to transfer ownership

Lane, Alton & Horst, LLC38 Close Corporation Agreement Allows shareholders to vary and discard many of the legal formalities otherwise imposed on corporations. Allows shareholders to be more specific about how they will treat one another. This can be helpful if a question later arises as to whether a shareholders fiduciary duty to the company and other shareholders has been met.

Lane, Alton & Horst, LLC39 Contents of Close Corporation Agreement Respective voting rights of owners Circumstances giving rise to the right of one or more shareholders to dissolve company Conditions of employment of owners Management authority Payment and timing of dividends Permissibility of transactions with shareholders (e.g. leases) Can include Buy-sell provisions, including redemption provisions

Lane, Alton & Horst, LLC40 Close Corporation Agreement Formalities All shareholders must sign the Close Corporation Agreement. Adoption of Close Corporation Agreement must also be recorded in the Companys official minutes. Agreement must specifically reference the statute authorizing close corporation agreements. Ohio Rev. Code 1701.591 Very important that the Companys stock certificates carry a legend indicating the existence of the Close Corporation Agreement.

Lane, Alton & Horst, LLC41 Impetus for Emergence of Limited Liability Company (LLC) AROSE FROM DESIRE OF BUSINESS OWNERS AND INVESTORS To combine the limited liability protection provided by corporation law with Advantageous income treatment available to Partnerships BUT WITHOUT Management issues of Limited Partnerships S-Corp Restrictions on Type and Number of Shareholders Permitted

Lane, Alton & Horst, LLC42 Brief History of Limited Liability Company (LLC) Relatively recent legal form of business allowing owners to take advantage of the benefits of both the corporation and partnership forms of business First statute enacted in Wyoming in 1977 Gained popularity after IRS ruled LLC could be treated as a partnership for federal income tax purposes (IRS Rev. Rul. 88-76) Ohio has allowed since 1994 Single member LLC permitted since 1997 Written Agreement Not Required; Default Provisions of Ohio Rev. Code 1705.13 would govern Now available in all 50 States

Lane, Alton & Horst, LLC43 Limited Liability Company Characteristics Unlimited number of Members with any mix of individuals and business entities Management Participation without loss of Limited Liability Protection Flexible allocations and distributions of profits and losses Flexible Control and Governance Minimal Statutory Formalities Required Taxation Options Can choose to be taxed either as corporation or as a partnership

Lane, Alton & Horst, LLC44 Types of Limited Liability Company Manager Managed Similar to Corporation with only a single Member or small group of selected Members in control of management of business and affairs of company Member Managed More like a Partnership with all Members actively participating in management of company and it business affairs

Lane, Alton & Horst, LLC45 Manager Managed LLC Manager(s) selected and replaced in whatever manner agreed upon by Members In general, Manager(s) make all decisions concerning the companys business, operational, and financial affairs without input or prior approval of Members Some major substantive decisions still reserved to Members Manager does not have to be a Member Any number of Managers permitted

Lane, Alton & Horst, LLC46 Member Managed LLC Ohio statutory provisions govern unless displaced by provisions of a written Operating Agreement Can vote by headcount, pro rata Membership Interest, or any other system agreed upon by the Members A Members management voting rights do not have have any relationship to that Members ownership interest

Lane, Alton & Horst, LLC47 MAKING THE DECISION

Lane, Alton & Horst, LLC48 SelfSufficient Lifestyle Company Businesses with a local focus Non-technology product or service Not requiring or seeking large amounts of outside capital SHOULD PROBABLY CHOOSE BETWEEN LLC S-Corporation

Lane, Alton & Horst, LLC49 Special Advantages of LLC If you're planning to start a business that will hold real property that will appreciate C corporations and their shareholders are subject to tax on the appreciation when assets are sold or liquidated An LLC and its members are not subject to this double taxation

Lane, Alton & Horst, LLC50 Special Advantages of LLC If you're thinking about forming an "S" corporation: An "S" corporation is taxed in the same way as an LLC, but it has some restrictions on the number and types of shareholders, how profits and losses can be allocated among the owners, and The kinds of stock they can issue to investors. The LLC has none of these restrictions

Lane, Alton & Horst, LLC51 Weighing the LLC Alternative Similarities to S-Corp Both LLCs and S-Corps offer their owners limited liability protection and are both pass-through tax entities. Pass-through taxation allows the income or loss generated by the business to be reflected on the personal income tax return of the owners. This means that if you have business losses you want to use to offset other income you might have from another job or from your spouse's employment, for example, you can claim those losses on your personal income tax. This special tax status eliminates any possibility of double taxation for S corporations and LLCs

Lane, Alton & Horst, LLC52 Weighing the LLC Alternative Differences From S-Corp LLCs are more flexible in the way profits can be distributed An S-corporation can only have one class of stock and your percentage of ownership determines the percentage of pass-through income. LLC can have many different classes of interest, and the percentage of pass-through income is not tied to ownership percentage. The pass-through percentage can be set by agreement of the members in the LLC's operating agreement.

Lane, Alton & Horst, LLC53 GrowthOriented Businesses Businesses with Technology or biomedical product Large capital requirements Seeking a wide market SHOULD PROBABLY CHOOSE BETWEEN LLC S-Corporation C-Corporation

Lane, Alton & Horst, LLC54 What Do Investors Want? Conventional wisdom suggests that the market and at least institutional investors greatly prefer C-corporations Restrictions on who can be S-Corp shareholder preclude venture capitalists as shareholders Appreciate tax loss carry-forwards May be restricted from investment in flow- through entities due to concerns about unrelated business income tax(UBIT) General comfort level

Lane, Alton & Horst, LLC55 Alternative to Immediate C-Corp Form LLC (or S-Corp) now Convert from LLC or S-Corp if prospect of investment becomes realistic Conversion from S-Corp to C-Corp very easy just notify IRS Conversion from LLC to C-Corp may require merger and some tax planning, but is manageable

Lane, Alton & Horst, LLC56 Conversion of LLC Into C-Corp Process of converting from LLC to a corporation has recently become much easier Ohio Rev. Code 1705.371 and 1701.782 allow LLCs to convert into corporations by notifying certain governmental agencies and filing a Certificate of Conversion with the Ohio Secretary of State Conversions to and from other entities now also easier

Lane, Alton & Horst, LLC57 II. Structuring Your Business for Investment INVESTMENT AND FINANCING STRATEGIES AND CONSIDERATIONS

Lane, Alton & Horst, LLC58 General Concepts: RISK v. RETURN Free $$$ Smart money v. dumb money Equity v. Debt Dilution Timing Effect

Lane, Alton & Horst, LLC59 Dilution Early infusion of substantial outside investment can cause loss of control Same amount of $$$ investment at later stage in companys existence and growth less effect Smaller piece of the pie may be worth more than 100% ownership of more marginal company

Lane, Alton & Horst, LLC60 Business Plan Generally necessary whatever the investment or financing source being accessed Useful to have even if initially tapping into the friends and family network Helpful in establishing direction and goals Contains information needed to approach others later

Lane, Alton & Horst, LLC61 Business Plan Overview EXECUTIVE SUMMARY- ONE PAGE Description of Business Management Team Experience Product or Service Business Premises and Location Financials Marketing Promotion of products/services Addressing competition

Lane, Alton & Horst, LLC62 Funding Sources Personal savings and assets Friends and Family Bootstrap (profits from business) Banks, equipment lessors, factors, and other financial institutions Grant programs Outside Equity Investors Institutional Venture Capital Angel Investors I nitial P ublic O ffering aka IPO

Lane, Alton & Horst, LLC63 Pecking Order If Things Go Wrong. Secured Lenders Taxing Authorities Unsecured lenders and trade creditors Other investors in the company YOU

Lane, Alton & Horst, LLC64 PLAN A PLAN A : KEEP THE EQUITY

Lane, Alton & Horst, LLC65 Funding Sources Without Loss of Equity Grants Personal Funds Bootstrapping from operations Friends and Family Banks, Factoring, Equipment Lessors

Lane, Alton & Horst, LLC66 Assisted Bootstrapping Cooperative Ventures with Other Businesses Joint Development Agreement Joint Venture Strategic Alliance

Lane, Alton & Horst, LLC67 Economic Development Grants Available only under limited circumstances; eligibility requirements Can be local, state, regional, or federal Municipalities State of Ohio E.g. SBA Small Business Innovation Research/Small Business Technology Transfer (SBIR/SBTT) www.sbir.gov www.sbir.gov Can sometimes convert to debt upon happening of certain events

Lane, Alton & Horst, LLC68 Bootstrapping/Personal Funds Revenues from company operations or personal funds Other funding sources are more likely to be interested in becoming involved with your business if you are also putting some of your own money into the company Advantage no personal loans to be repaid or angry investors to have to confront Disadvantage may result in insufficient capital to bring a product or service to market successfully depletion of funds previously set aside for retirement or childrens college education

Lane, Alton & Horst, LLC69 Joint Development Agreement Larger established company provides money and resources to small company to refine a product useful to the larger company in some way, e.g. makes a production process less expensive. Spell out how ownership of IP generated under the JDA will be handled Confidentiality and Nondisclosure provisions Be aware of superior resources available to larger company in the event of a dispute

Lane, Alton & Horst, LLC70 Joint Venture Strategic Alliance Join together with another company to complete a particular project Can be done contractually Can also be done in form of a LLC with each of the companies involved being a Member

Lane, Alton & Horst, LLC71 Friends and Family Option ADVANTAGES May be easy to access May have less FINANCIAL consequences if business fails DISADVANTAGES Risk of losing a friend or straining family relationships if business is not successful Can cause problems even if business is successful

Lane, Alton & Horst, LLC72 Easy Money? Your company needs money, but really isn't bankable at the moment. Your brother-in-law agrees to put money into the business in exchange for shares of stock. At first you appreciate his generosity and the business tips he now hands out freely. However, when you discover hes cheating on your sister and divorce ensues, you start wondering how you can get rid of the arrogant pain in the neck.

Lane, Alton & Horst, LLC73 Guidelines for Family and Friends Option Best reserved for situation where friend or family member can afford to lose the money Decide and explain BEFORE you take the money what role, if any, the relative or friend will have in the business What the upside will be if the business is fabulously successful

Lane, Alton & Horst, LLC74 Guidelines for Family and Friends Option Take time to make a COMPLETE and FULL disclosure of the nature of the business and risks and rewards associated with it, just as you would with an outside investor. Provide regular periodic formal financial statements both before the business gets started and once it is operating. Put understandings about the money being given to you IN WRITING.

Lane, Alton & Horst, LLC75 Loans and Leases from Outsiders Factoring receivables Banks Asset-based lending SBA Loans Commercial Loans Equipment Lessors Ohio Department of Development

Lane, Alton & Horst, LLC76 Commercial Loan Categories Short Term (5 years or less) Typically made for equipment purchases and to meet cyclical inventory, accounts payable, and general working capital needs Long Term Commonly used to purchase, improve, or expand fixed assets such as borrowers plant, facilities, major equipment, and real estate

Lane, Alton & Horst, LLC77 Commercial Loan Categories Secured Promise to repay debt is supported by pledge, aka security interest of some or all of the borrowers assets If default occurs, lender is able to take possession of assets pledged, sell them in a commercially reasonable manner, and apply net sale proceeds to debt owed Unsecured No collateral supports promise to repay debt Lender relying upon the creditworthiness and reputation of the borrower

Lane, Alton & Horst, LLC78 Types of Commercial Loans Asset-Based - Revolving Credit facility Formula based upon Eligible Accounts Receivable and Eligible Inventory Often used for general working capital purposes All Business Assets Short Term Loan Line of Credit Can be Secured or Unsecured Loan Real Estate Long Term Loan

Lane, Alton & Horst, LLC79 Loan Applications and Proposals - Content In addition to purpose and amount of loan sought, loan applications and/or proposals will require the following General Information: Names of business, principals in business, and any other guarantors or co-debtors Legal Ownership and Governance Structure Business Description and History Thumbnail Management Profile, including background, education, experience, skills, and accomplishments of principals and key employees

Lane, Alton & Horst, LLC80 Loan Applications and Proposals Financial Informational Content Personal Financial Statements and Tax Returns (generally for preceding 3 years) of principals or majority ownership and any other guarantors or co-debtors Companys Financial Statements (including balance sheet and income statement) for YTD and preceding 3 years may require accountants audit or review Appraisal or other Valuation of Collateral

Lane, Alton & Horst, LLC81 Loan Applications and Proposals Market Informational Content Products or Services Produced Industry, Market, and Customers/Clients for Products and Services, i.e, Companys niche Production Capabilities and Procedures Outlook and Demand for Products and Services Procedures and Processes for Addressing Competition

Lane, Alton & Horst, LLC82 Loan Applications and Proposals Other Documentation to be Reviewed Leases for Business Premises Corporate Governance Documents (e.g. Code of Regulations, Close Corporation Agreement, Operating Agreement, Buy-Sell Agreement) Transaction Documentation if Loan Proceeds Constitute Financing for Deal Environmental Reports, Surveys, if applicable Key Contracts with Vendors or Customers?

Lane, Alton & Horst, LLC83 PLAN B PLAN B :SWAP OWNERSHIP FOR $$$

Lane, Alton & Horst, LLC84 Legal Considerations in Raising Capital Compliance with FEDERAL and STATE Securities laws Regulation of MANNER in which done, i.e. registration and issuance Regulation of INFORMATION DISCLOSED, i.e. accuracy and adequate disclosure of risks and rewards Proper documentation of business arrangements made Effect on Founder(s): Risk/Reward Calc

Lane, Alton & Horst, LLC85 Sources of EQUITY Funding I nitial P ublic O ffering Venture Capitalists Angel Investors

Lane, Alton & Horst, LLC86 I nitial P ublic O ffering Option? Extremely expensive Very time-consuming Most entreprenuers exit through sale of the business to someone else operating until eventually winding down

Lane, Alton & Horst, LLC87 Going Public The Facts Substantially less than 1% of all businesses in U.S. are publicly traded May take as long as a year or more to accomplish Need at history of accelerating growth Experienced management team crucial Establishment of formal corporate policies in areas such as human resources important Need to have strong business plan

Lane, Alton & Horst, LLC88 Weighing the IPO Option Advantages Stronger and larger capital base Owner diversification Increased credibility/prestige Access to financing Transferability of ownership Cash out for founders Disadvantages Ongoing reporting and disclosure requirements Trading Restrictions Less Control over company business and financial affairs Greater regulation Confidentiality loss Very expensive

Lane, Alton & Horst, LLC89 IPO Mechanics Registration Statement filed with SEC Prospectus provides information about companys financial history and forecasts, together with uses intended for offering proceeds Cooling Off Period/Road show with prospective investors, including distribution of preliminary prospectus aka red herring Valuation of company to determine offering price and size of offering SEC approval for distribution of Prospectus

Lane, Alton & Horst, LLC90 Venture Capital Investment Difficult to obtain, even for technology based business Expensive, both economically and otherwise Require extremely high rates of return on investment Finite time horizon to show economic results Typically not interested in investments of less than $1 million

Lane, Alton & Horst, LLC91 Venture Capital Investment = Involvement in Your Business WILL result in dilution of ownership WILL require seat(s) on board of directors WILL affect business operations and timelines

Lane, Alton & Horst, LLC92 Types of Venture Capital Funding Early Stage Seed - relatively small amount of capital provided to inventor or entrepreneur to prove a concept and ready it for a start-up operation Start-up provided to companies not long in existence who may not yet have widely sold their product or service commercially First-Stage provided to assist companies that have exhausted initial capital and require additional funds to initiate full scale manufacturing or servicing

Lane, Alton & Horst, LLC93 Other Types of Venture Capital Funding Mezzanine generally for companies showing promise to be used for further expansion or additional product development Bridge shorter term interim financing to assist company making transition to more permanent financing Acquisition funds to finance acquisition of all or a portion of another company

Lane, Alton & Horst, LLC94 VC Analysis of Target Companies Management Team talent, experience, maturity, betting on jockey, not the horse Business Model How realistic, scalable, and novel Technology Ownership rights; ability to protect from competitors infringement or design around; novelty of concept Market size, growth, type Competition whos already there and how well funded and/or established

Lane, Alton & Horst, LLC95 Factors Determining Value of Company Nature of Companys Business and Operating History, Especially as Compared to Similar Companies Industry and Economic Outlook Book Value and Financial Condition Earnings and Dividend Paying Capacity Value of Goodwill and Other Intangible Assets Purchase Prices of Other Companies Engaged in Similar Line of Business

Lane, Alton & Horst, LLC96 Special Factors Affecting Value Unique or Proprietary Products, Data, Processes or Services Desirable Contracts or Customers and/or advantageous Vendor/Supplier Relationships Synergistic with or Complementary to Other Portfolio Investments Barriers to entry for Would-be Competitors Favorable Leaseholds Existence/Use of Prior Capital Rounds

Lane, Alton & Horst, LLC97 Angel Investors Typically high net worth individuals or an entity owned by them Three Flavors Passive only interested in economic return on investment Hands-On add value to company through expertise or contacts Officious Intermeddlers those who think they add value, but really dont Beware of complying with Securities Laws!

Lane, Alton & Horst, LLC98 Angel Investors As high net worth individuals, the considerations driving selection of the C-corp form may not be as important as for institutional venture capitalists May appreciate pass-through losses

Lane, Alton & Horst, LLC99 INVESTMENT VEHICLES

Lane, Alton & Horst, LLC100 Outside Investor Bait Promissory Notes Membership Interests Shares of stock Preferred Common Options and Warrants Convertible Debentures

Lane, Alton & Horst, LLC101 Preferred Stock Many varieties May or may not have voting rights May be convertible to common stock Core characteristic is priority and preference in, i.e. paid first Payment of dividends Liquidation of Company Not permitted in S-Corporation

Lane, Alton & Horst, LLC102 Convertible Debt Financing Instruments - Trigger Business owner doesnt want to give up ownership unless absolutely necessary, but needs to attract investors Investors want Possibility of larger return than typically resulting from ordinary loan to business Greater protection of ability to be repaid

Lane, Alton & Horst, LLC103 Part Debt - Part Equity Hybrid Solution is to give investors promissory note which allows conversion to equity under certain circumstances Will be regarded as a securities transaction

Lane, Alton & Horst, LLC104 How Convertible Debt Financing Works Convertible debt holders expect A fixed rate of return based on interest payments AND Option to participate in any increase in the overall value of the business by exercising conversion privilege Greater ability than typical lender to take charge of companys affairs if not repaid

Lane, Alton & Horst, LLC105 Convertible Debenture aka Promissory Note Looks like a promissory note, including a fixed rate of interest, with some extra provisions included Generally has a conversion period or a triggering event which determines when OR whether lender can exercise its option to take stock in lieu of payment Conversion to equity may be at a discount or a premium to the face amount of the note Avoids valuation issues to some extent

Lane, Alton & Horst, LLC106 STAYING LEGAL WHILST CHASING $$$

Lane, Alton & Horst, LLC107 When offering a security Must be part of public offering OR Exempt form registration

Lane, Alton & Horst, LLC108 What is a security? Very broadly defined under both federal and state law (Ohio Rev. Code 1707.01(B)) Basically includes anything where the party providing funds is led to expect profits and return on the investment from the efforts of others. SEC v. W.J. Howery, 328 U.S. 293 (1946)

Lane, Alton & Horst, LLC109 Includes more than traditional shares of stock in a company Membership Interests Warrants and Options Can include Promissory Notes

Lane, Alton & Horst, LLC110 Promissory Notes CAN BE Securities Reves v. Ernst & Young, 494 U.S. 56 (1990) family resemblance test designed to ascertain ECONOMIC REALITIES of transaction Explicitly adopted as also governing Ohio securities law in Perrysburg Twp v. City of Rossford, 103 Ohio St.3d (2004) See also MacRitchie, Is a Note a Security? Current Tests under State Law, 46 S.D.L. Rev. 369 (2001)

Lane, Alton & Horst, LLC111 Reves Family Resemblance Motivations if for investment, then security; if commercial, then nonsecurity Plan of Distribution common trading for investment v. one-on-one negotiated transaction Reasonable Expectations would reasonable member of public consider it an investment Presence of Risk-Reducing Factors suggest that note is a security

Lane, Alton & Horst, LLC112 Securities Act of 1933 aka Securities Act Initial federal response to 1929 Stock Market Crash Federal version of blue sky laws which regulate what must be disclosed Intended to protect investing public against fraudulent schemes and unscrupulous promoters by requiring full disclosure of all material risks

Lane, Alton & Horst, LLC113 Securities Exchange Act of 1934 aka Exchange Act Enabling act to implement provisions of Securities Act Established and empowered Securities and Exchange Commission (SEC) to regulate virtually all facets of securities transactions Addresses registration and issuance procedures for securities Focused on the sale and trading of securities

Lane, Alton & Horst, LLC114 State Blue Sky Regulations Origin of name uncertain, but references perception that unscrupulous promoters would sell blue sky to investors if not properly restrained If selling in more than one state, must comply with requirements of EVERY state in which investors reside In Ohio, the Division of Securities in the Department of Commerce is responsible for enforcement of Ohio Rev. Code Chapter 1707

Lane, Alton & Horst, LLC115 Ohio Securities Laws Overview Ohio Revised Code Chapter 1707 Division of Securities enforces its licensing, registration and anti-fraud standards through administrative actions, civil injunctive proceedings and criminal prosecutions Ohio Rev. Code 1707.03(O) provides exemption for sale to ten or fewer investors in Ohio who are reasonably believed to be purchasing for their own investment Federal exemptions from registration also recognized

Lane, Alton & Horst, LLC116 Registration Requirements Must satisfy both federal SEC and state statutory and regulatory requirements Very expensive and complicated definitely need to consult attorney experienced in this area Several exemptions available which allow sale of securities without registration

Lane, Alton & Horst, LLC117 Warning, Warning. Neither this debenture nor the securities into which this debenture is convertible have been registered with the securities and exchange commission or the securities commission of any state in reliance upon an exemption from registration under the securities act of 1933, as amended (the "securities act"), and, accordingly, may not be offered or sold except pursuant to an effective registration statement under the securities act or pursuant to an available exemption from, or in a transaction not subject to, the registration requirements of the securities act and in accordance with applicable state securities laws.

Lane, Alton & Horst, LLC118 Bypassing Registration of Securities Sec (3)(a)(11) Intrastate Offering Refers to section of 33 Securities Act which contains exemption from registration Issuing company must be incorporated in the state in which securities will be offered (e.g. company incorporated in Ohio offers shares to Ohio residents) Issuing company must carry out a significant portion of its business in the selected state No limit on size of offering or number of purchasers

Lane, Alton & Horst, LLC119 Bypassing Registration of Securities - Sec.4(2) Private Offering Refers to section of 33 Securities Act which contains exemption from registration SEC 1982 promulgation of Regulation D Rule 501 accredited investor defined Rule 502 terms and conditions for Reg D to apply Rule 503 Reg D notice requirements Rule 504 Exemption for offering of securities of $1 million or less Rule 505 - Exemption for offering of securities of $5 million or less

Lane, Alton & Horst, LLC120 Rule 506 Safe Harbor Can raise unlimited amount of capital No general solicitation or advertising to market securities Can have unlimited number of accredited investors and up to 35 others ALL investors must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment

Lane, Alton & Horst, LLC121 Key Aspects of Federal Private Offering Registration Exemption Anti-fraud provisions still applicable Burden still on issuer to demonstrate offering qualifies for exemption from registration May not use public solicitation or general advertising keep careful records Allows for sale to unlimited number of accredited investors and up to 35 others If one investor doesnt meet requirements, entire offering can be in violation Securities are restricted - Purchasers cant resell without exemption or registration

Lane, Alton & Horst, LLC122 Advertising and Solicitation Can be difficult to apply what if media does story on product of new company? Prohibition may not be applicable to targets with whom there is a substantial preexisting relationship Important to keep careful records of who is provided information about the offering DONT put blanket information on company website with click here option to invest

Lane, Alton & Horst, LLC123 Accredited Investors Qualify as sophisticated investor able to bear investments economic risk Have access to type of information normally contained in a prospectus Agree to hold securities for investment and not to resell or distribute to the public Not required to receive PPM, but must receive adequate financial information

Lane, Alton & Horst, LLC124 Types of Accredited Investors Wealthy individuals Net worth (including spouse) of more than $1 million Income for each of last 2 years in excess of $200,000 (or $300,000 when considering jointly with spouse) Directors and executive officers of company issuing security Institutional investors

Lane, Alton & Horst, LLC125 Qualifying Accredited Investors Typically required to complete Subscription Agreements and Investor Questionnaires Remember to provide full and fair disclosure of all relevant information about the company to prevent misunderstandings

Lane, Alton & Horst, LLC126 Private Placement Memorandum aka PPM Required when offering securities to prospective purchasers who are not accredited investors Lengthy stand-alone document disclosing everything prospective purchaser needs to know about the company, as well as its plans and prospects, to make an informed decision to invest in the company Includes Subscription Agreement which acts as the sale contract for shares

Lane, Alton & Horst, LLC127 Why a PPM? Required by law with respect to investments by those who are not accredited investors Provides information to prospective investors Protection against securities fraud claims by establishing a record of what information was provided potential investors Enhances credibility

Lane, Alton & Horst, LLC128 Contents of PPM Cautionary Language regarding investment risks Summary of Offering terms often in a table format Description of issuing company, its organizational structure, management team, capitalization, and history Business Plan and selected financial data Specific risk factors Disclosure of potential conflicts of interest Subscription procedures

Lane, Alton & Horst, LLC129 PPM Timeline Prepare written business plan Corporate clean up and due diligence Select advisors Identify prospective investors Determine offering terms Make necessary filings Circulate PPM to qualified recipients

Lane, Alton & Horst, LLC130 If PPM has stated maximum or minimum, issuer cannot change unilaterally all investors must sign off

Lane, Alton & Horst, LLC131 III. Structuring Your Business for Growth STRATEGIES AND CONSIDERATIONS

Lane, Alton & Horst, LLC132 Follow Corporate Formalities Avoid Piercing the Corporate Veil Belvedere Condominium Unit Owners Association v. R.E. Roark Companies, Inc., 67 Ohio St.3d 274 (1993): Individual shareholder can be held liable for debts of corporation when business and financial affairs of the shareholder and corporation are so intertwined that corporation has no separate existence.

Lane, Alton & Horst, LLC133 Belvedere Test for Piercing Corporate Veil Control over the corporation is so complete that it has no separate mind, will or existence of its own Shareholders exercises control over corporation in such a way as to commit fraud or an illegal act Injury or unjust loss resulted from the control

Lane, Alton & Horst, LLC134 Practical Warning Signs Grossly inadequate capitalization Failure to observe corporate formalities or have regular meetings among owners Diversion of company funds or property for personal use Business used as mere faade for other operations of owner

Lane, Alton & Horst, LLC135 BizPointers for Avoiding Inadvertent Personal Liability for Company Debts KEEP GOOD CORPORATE RECORDS. If there is more than one shareholder or owner, have regular periodic meetings (monthly or quarterly) and keep MINUTES of what is discussed at those meetings KEEP ACCURATE RECORDS OF REVENUE COMING IN AND EXPENSES PAID. If you bill clients or customers, make sure they make the check payable to the company rather than you personally.

Lane, Alton & Horst, LLC136 BizPointers for Avoiding Inadvertent Personal Liability for Company Debts DONT PAY COMPANY BILLS FROM PERSONAL FUNDS, even if cash flow is bad!!! If the business is short of funds to cover payroll or some other expense, deposit a personal check in the company bank account instead of just paying it yourself. Keep track of these loans to the company. DONT PAY PERSONAL DEBTS FROM COMPANY FUNDS. Be sensible about what expenses the business pays for you.

Lane, Alton & Horst, LLC137 BizPointers for Avoiding Inadvertent Personal Liability for Company Debts Use signage, business order forms, invoices, and stationery with the companys proper name and address prominently featured. It may be worthwhile to consider investing in a PO Box if you dont yet have separate business premises. Remember to treat the Company as if it were a separate person. The Company IS NOT you and you ARE NOT the Company.

Lane, Alton & Horst, LLC138 Secure Rights to Intellectual Property IP may be the MOST valuable asset for an early stage technology based company Copyrights (includes software) Trademarks (includes company logo) Servicemarks Patents Trade Secrets

Lane, Alton & Horst, LLC139 Importance of Rights to Intellectual Property Freedom to Operate Need to be sure someone elses IP wont prevent your company from carrying out its business objectives Need to be sure the Company has the right to use IP key to achieving its business objectives Competitive Advantage Need to preclude other from using or working around key IP

Lane, Alton & Horst, LLC140 Protecting IP Register at state and federal levels U.S. Patent and Trademark Office or Library of Congress Copyright Office Ohio Secretary of State (trademarks and service marks only) Specify that it is Work for Hire so that the company becomes the owner License others who make use of your IP Confidentiality and Nondisclosure Agreements

Lane, Alton & Horst, LLC141 Special Founder IP Issues Assignment of ownership of IP developed by founder which is key to companys financial prospects, with the attendant filings at the appropriate governmental offices Waivers or disclaimers of any conflicting rights to key IP Assignment of subsequent IP developed Noncompete Agreement

Lane, Alton & Horst, LLC142 Employee IP Issues Employee agrees that he or she shall promptly and fully disclose in writing to the Employer, shall hold in trust for the sole right and benefit of the Employer, and shall make available to the Employer all Employee Developments, including but not limited to any work papers, drawings, designs, schematics, specifications, descriptions, models, diskettes, computer tapes, source codes or other tangible incidents of Employee Developments. Employee agrees that all Employee Developments shall be considered works made for hire, as that term is defined in the United States Copyright Act, by Employee for the Employer, and prepared within the scope of his or her employment, and that all right, title and ownership interest in and to the Employee Developments, including, without limitation, copyright, trade secret, patent or other intellectual property rights, shall exclusively vest in, be retained by, and are hereby assigned to the Employer or its designee, both during and following the term of Employees employment.

Lane, Alton & Horst, LLC143 Employee IP Issues Proprietary Rights Agreement -assigning IP developed by employee Confidentiality and Nondisclosure Agreement Noncompete Centralization of IP information Access limitations Restrictions on article publication

Lane, Alton & Horst, LLC144 Securing Key Employees Employment Agreement Noncompete Agreements (can be included in Employment Agreement) -must be reasonable in scope and time Prohibited activities and geographic areas must be related to Companys actual or reasonably anticipated business operations Longer the time period in effect, the less likely to be enforceable

Lane, Alton & Horst, LLC145 Equity Incentivizing to Attract and Retain Key Employees Purpose Attract top talent or skill sets Make up for below-market compensation Types Award of restricted stock Stock options Stock Appreciation Rights Stock Appreciation Rights, also known as phantom or shadow stock Lots of flexibility in structuring

Lane, Alton & Horst, LLC146 Employee Shareholders Have Rights Once an employee has even a tiny slice of equity ownership, the at will nature of the relationship can change

Lane, Alton & Horst, LLC147 Ohio Close Corporation Shareholder Heightened Fiduciary Duty Rule Under Ohio law, owners of small businesses with only a few shareholders, members, or partners have a heightened fiduciary duty toward one another. Applies no matter how small the ownership interest of the minority shareholder is Means that controlling shareholders DO NOT have ability to run the company in ANY way they see fit Must have legitimate business purpose when taking adverse action toward fellow shareholder

Lane, Alton & Horst, LLC148 Heightened Fiduciary Duty Crosby v. Beam, 47 Ohio St. 3d 105, 548 N.E.2d 217 (1989) Facts: Minority shareholder alleged that majority shareholders improperly expended Company funds to pay unreasonable salaries to themselves and personal expenses Holding: A "heightened fiduciary duty" exists between shareholders of close corporations. Majority or controlling shareholders breach such fiduciary duty to minority shareholders when control of the close corporation is utilized to prevent the minority from having an equal opportunity in the corporation.