Changing Your Choice of Entity: Cross-Species Mergers and Conversions

With increasing frequency, companies are considering a change in their form of entity.  The reasons for the change vary considerably: sometimes companies are underwhelmed by the tax benefits of being a limited liability company and are overwhelmed by its complexities (international tax withholding issues, multi-state K-1’s, profits interests management, phantom income, and employee education regarding equity-based incentives), while other times companies are frustrated by the restrictions on S corporations and desire the flexibility that limited liability companies afford.  In other cases still, institutional investors may require a certain form of entity (e.g., a C corporation), while other investors (e.g., active angel investors) are looking to take advantage of pass through losses. 

Today, most states make it fairly easy to change the type of entity or even to change the state of organization of the entity.  It is important to keep in mind though that while the mechanics of converting to a new entity from a legal perspective are not typically too complex, the related tax issues can be incredibly intricate, especially for an organization with a long operating history and a complex capitalization structure.  While in many situations converting to a different type of entity will be tax-free, that will not always be the case.  Your tax advisor and accountants should be consulted early in the process when considering a change in entity form.  Assuming a change in structure is justified and the tax issues are manageable, this article focuses on the mechanics of converting from one type of entity to another.  

While there are variations among the states, there are generally two ways to change your type of entity from a legal perspective: merging with and into another entity of a different type and effectuating a conversion.  The method selected, as well as some of the finer details associated with the particular method selected, is often driven by tax considerations.

Change of Entity Form Through Merger

The more traditional way to change the form of an organization is through a merger.  Sometimes people refer to this as a cross-species merger.  A merger enables two or more entities to combine into a single entity.  The surviving entity can be recently created just to effectuate the change in entity form or it can have an operating history. The surviving entity typically files with the applicable state a plan of merger and a statement that the plan was approved in accordance with applicable law.  In most states, the plan of merger identifies the parties to the merger, the surviving entity, and the manner and basis of converting equity interests in each entity into interests in the surviving entity.  The plan of merger also includes any applicable amendments to governing documents (e.g., articles) for the surviving entity.  

After the merger, only the surviving entity continues to exist and it is responsible for all liabilities of each business entity that is a party to the merger.  Subject to certain exceptions and filing requirements, title to assets automatically vests with the surviving business entity.

Change of Entity Form Through Conversion

Within the last decade, most states have adopted statutes that allow organizations to convert their form of entity by just filing the applicable conversion documentation.  For example, in Wisconsin, a business that desires to convert to another type of legal entity must submit to the Department of Financial Institutions a certificate of conversion with a plan of conversion and a statement that the plan was approved in accordance with the laws applicable to the pre-converted entity. 

Similar to a plan of merger, most states require that a plan of conversion include the name, form of business entity and jurisdiction governing the entity both before and after the conversion.  In addition, the post-conversion articles of incorporation or other charter document is an attachment to the plan of conversion.  Some states however require a separate filing for the charter document.  Like with a plan of merger, the plan of conversion must also include the terms and conditions of the conversion and the manner and basis of converting the ownership interests in the old entity to the ownership interests in the new entity. 

Upon conversion, the new entity continues to be subject to the liabilities incurred prior to the conversion.  If a business owner had any personal liability by reason of the owner’s position in the entity (such as the general partner of a limited partnership), such liability will continue, but only to the extent accrued prior to the conversion.  The new entity continues to be vested with title to all its properties, subject to modest exceptions and certain filing requirements.  Any legal proceeding pending against the old entity will be continued against the new entity.  

Conducting Due Diligence When Changing Your Form of Entity

Despite the fact that the legal filing requirements for cross-species mergers and conversions are rather straight forward and mechanical, there are a number of due diligence issues that should be considered prior to making the change in entity form.  For example, in contracts, a merger is sometimes treated as an assignment of a contract from one entity to another and many contracts prohibit such assignments without prior consent.  Businesses should review all their material contracts and consider seeking consent for assignment where necessary.  Trademark and patent filings in the U.S. Patent and Trademark Office (USPTO) will need to be updated to reflect new company names in a conversion.  Mergers are treated as an assignment that also needs to be recorded with the USPTO.  Likewise, regulatory approvals, permits and licenses may need to be updated.  Because a conversion, rather than a merger, involves only a single entity, many consider that general contract anti-assignment provisions do not apply to conversions unless conversions are specifically addressed and prohibited.  In either case, however, there is frequently a company name change that may need to be reflected on a variety of documents. 

In addition to third party contracts and government filings and licenses, there are a number of organizational documents that may need to be created as a result of the merger or conversion.  For example, if an entity changes from a limited liability company to a corporation, many of the provisions from the organization’s operating agreement prior to the cross-species merger or conversion will be incorporated into a combination of the new corporation’s bylaws and perhaps a separate shareholders agreement, investor rights agreement or voting agreement.  Some of these organizational-related documents can be adopted wholesale with no or modest changes.  Others, however, will need considerable changes or even termination because of statutory requirements, efficiency, or custom.  

Conclusion

While it would be convenient to have all the facts up front prior to choosing an entity’s form when creating it, even the most diligent and seasoned entrepreneurs experience change in facts or laws that necessitate changing the organization’s form of entity.  With proper planning and involvement of your attorney and accountant, the process of converting your form of entity is usually manageable.  In the end, like with most things, the decision often becomes a cost-benefit analysis.

Differentiating Introductions

Whether looking for an investor, a joint venture or joint development partner, or your next CEO, a warm introduction is almost always better than a cold one.  But the quality and effectiveness of warm introductions vary considerably.  In fact, setting up the right type of introduction from the right type of person can be a test of your entrepreneurial skills. 

Elements of a Good Introduction

In essence, there are at least two elements to a good introduction: (1) the introducer is someone who the prospective investor, joint venture or joint development partner, or CEO listens to; and (2) the introducer has something persuasively positive to say about you or your company.

Types of Introducers

Using an unscientific approach, here are my tiered groupings of people from whom to make your warm introductions:

    Top Tier Introducers

  1. The introducer successfully concluded a recent close business relationship in which the prospective investor, joint venture or joint development partner, CEO, etc., did very well. 
  2. The introducer has an on-going regular business relationship with the prospective investor, joint venture or joint development partner, CEO, etc., that is going well.
  3. The introducer is someone well known to the prospective investor, joint venture or joint development partner, CEO, etc., and he, she or it wants to do business with the introducer.
  4. The introducer and the prospective investor, joint venture or joint development partner top execs, CEO, etc., are close socially (e.g., families going on vacations together)
  5.  

    Middle Tier Introducers

  6. The introducer currently works with or has worked with the prospective investor, joint venture or joint development partner, CEO, etc., but not closely.
  7. The introducer has a good close working relationship with an affiliate or existing partner of the prospective investor, joint venture or joint development partner, CEO, etc.
  8. The introducer is an acknowledged scientific expert or significant player in the industry and is known to the prospective investor, joint venture or joint development partner, CEO, etc., by reputation
  9.  

    Bottom Tier Introducers

  10. The introducer and the prospective investor, joint venture or joint development partner, CEO, etc., has an on-going regular or previous business relationship that is not going well (or did not go well) through no fault of the introducer.
  11. The introducer knows the prospective investor, joint venture or joint development partner top execs, CEO, etc., only through casual social situations (e.g., reception, conference, party, mutual friends)

Of course, there are situations where a “warm” introduction from a hostile source can lead to a problem, one in which a cold call may yield a better result.  But in most cases, even a positive introduction from a “bottom tier” introducer is better than no third party introduction.  For example, I’ve heard a number of venture capitalists say that they have never (ever) invested in a company that sent directly its summary or powerpoint over the transom. 

Ensuring a Positive Message in the Introduction

Just because you have someone lined up who is a top tier or middle tier introducer, does not mean you are set.  As an illustration, I have a client who was looking for an introduction to a particular potential joint development partner.  The client discovered that an MD working at one of the company’s clinical trial sites had previously done a lot of work with the targeted joint development partner.  Upon discovering this, the CEO quickly moved to ask the MD for the introduction, which the MD agreed to do.  As it turns out, the MD by his nature was very measured in his words when making introductions.  In making this introduction, the CEO later found out that the MD spent as much time disclaiming knowledge about the company and its prospects as he did explaining in a measured way the positive results of the recent trials.  While the CEO did get the meeting, he spent considerable time explaining why the MD was not more enthusiastic about the CEO’s company.

So, how do you ensure a positive message in the introduction?  Ask the introducer what he or she is going to say.  Provide the introducer with an elevator pitch length email about your company.  Provide him or her an executive summary or the bullet points to touch on during the introduction.  You should do as much work as possible for the introducer to make sure that his or her job is easy and that he or she gets the facts right.  That said, the introducer should know the basics about your company as the prospective investor, joint venture or joint development partner, CEO, etc., will likely have at least one question for the introducer.  If the introducer does not know rough headcount or revenue numbers, or whether the company has filed an IND, for example, not only can that be embarrassing to the introducer but it will also degrade the effectiveness of an otherwise good introduction.

While serendipitous introductions or connections do happen, many times a good introduction is the product of deliberate, diligent entrepreneurial efforts of finding the right person with the right connection to deliver the right message.

Best Practices for the Friends and Family Financing Round

When companies start up, often the first place they look for seed financing is from friends and family. As frequently as they occur, there is very little available on the details of what consists of a “good” friends and family financing. In this post, we will go through some of the considerations for your next friends and family round of financing.

Friends and family financings are frequently the first financing from outsiders of the company. Increasingly though with tough financial times, companies are relying more heavily and for longer periods of time on friends and family support to get them through the early times. So, let us get into some of the details.

Type of Securities to Issue

Almost invariably, when the company is a corporation, the company issues common stock in the friends and family round. For limited liability companies (LLCs), the security issued in the friends and family round is whatever the common stock comparable security is for the LLC—sometimes it is referred to as Class A Units or sometimes it is just a percentage interest or just “units” (if the LLC has only one class of securities). As LLC capital structures are most often a matter of contract per the company’s operating or LLC agreement and the laws vary from state-to-state, there is no single standard name for the type of security.

As later posts will echo, one important point to keep in my mind in terms of deciding on the type of security to issue is the importance of keeping the capital structure simple. In this case, with a friends and family round, it is typically best to issue common stock (or the LLC comparable). While one sees convertible notes, a “stripped down preferred,” or a certain level of warrant coverage, I recommend keeping the capitalization structure as simple as possible, for as long as possible.

Pricing

High Risk and High Price?

Pricing is often a difficult topic for a friends and family round. In my experience, it is often the round least likely where one is to see negotiation on price. It is not uncommon, however, for the friends and family round to be overpriced. How do I know that? Few would argue that of all the rounds of outside investment that companies go through, the friends and family round is likely where there is the most risk (technical and commercial) and there is likely the fewest tangible and intangible assets. I’ve seen some statistics indicate that over 90% of tech startups end unsuccessfully. Yet, it is (1) very common to see seven (or in some cases, eight) figure pre-money valuations for not much more than a skeleton of a management team, a business plan, and a patent application, license right, prototype, or vaporware, and (2) not uncommon to see either a flat round or better terms offered in the first VC or angel deal following the friends and family financing. It is not that entrepreneurs are trying to take advantage of their friends and family. But rather, it is likely because they are overly optimistic concerning their prospects; they are entrepreneurs after all, and a good sense of optimism is essential to success.

Impact of Price on Subsequent Rounds

When pricing a friends and family round, it is also important to consider the impact of the price in the context of the long term capitalization strategy. I talk about the long term strategy in my earlier post, Capitalization Strategy: Begin with the End in Mind. As mentioned in the previous paragraph, a common problem that some entrepreneurs face is having too high of a price in the friends and family round (or subsequent angel round for that matter). How can too high of a price be a problem for a company? After all, a higher price means less stock is issued and therefore less dilution. The reason it can be a problem goes back to your long term plan. Often, a high price in an early round yields problems in later rounds in terms of existing investor expectations. If you understand the likely pricing expectations of later round investors, those expectations should be incorporated in earlier round pricing. Promising companies can sometimes get too aggressive on pricing in early rounds and often stall, not because of their technology or lack of success in their commercialization efforts, but rather because they cannot find financing sources that meet their existing investor expectations. So, after a considerable delay in not getting a timely financing, companies are forced to consider either (a) “down round” pricing to get the amount of financing they need from subsequent round investors or (b) accepting less investment (most likely from existing investors) and prolonging the current share pricing as they hobble along and exist on less than ideal amounts of financing. Also, by accepting down round pricing, it can not only affect morale of existing investors but also employees as well in terms of the perception of the direction and speed of the company’s momentum.

Effect of Price on Stock Options

On a related note to employees, one other thing to keep in mind is the impact of your friends and family round pricing on your stock option pricing (or other equity-based incentive), especially if you issue common stock in the friends and family round. The price at which you sell your securities will likely affect significantly your stock option exercise price or the amount that has to be taken into income by employees and contractors if stock or other equity-based securities are issued to them. This is especially true as the ability to issue discounted stock options is no longer the option (pardon the pun) it once was in light of tax code section 409A. This is one area where offering convertible notes (or preferred stock) to friends and family yields a benefit over common stock.

Accredited Investor Status

As a general rule, it is best to limit your friends and family offering to accredited investors only. Many companies want to enable their friends and family who are not well off to “get into the action” early. Ignoring the issue of whether friends and family who are not accredited can bear the risk associated with an investment in a start-up, by including friends and family who are not accredited in an offering can drive up your legal costs to do the transaction and increase the risks of legal problems associated with the entire offering. If you are considering including investors who are not accredited in your offering, have a discussion with your attorney first before announcing the offering. Doing so will help to ensure that you make an informed decision without the pressures of the implications of backing down from an earlier announcement to your friends and family.

Amount of Funding

The amount of financing should be driven by, you guessed it, your long term capitalization plan. Conventional wisdom is that you should raise sufficient money to comfortably get you to the next significant milestone that increases your valuation. However, there are some companies that believe that they should get as much money as they can, as soon as they can. The problem with this latter approach is that, assuming your subsequent round financing is an up-round, you will suffer more dilution by getting the money earlier than what you would otherwise experience by waiting and then selling the securities later at a higher price. Also, some people believe that companies can become less efficient, less “hungry,” and lose their sense of urgency with significant amounts in the bank. On the flip side, a benefit of raising more in an early round is that less time is spent on subsequent fundraising. In addition, as those who adopted this approach a year ago will say, they are not now seeking financing in what is a very difficult time to raise money.

Importance of the Friends and Family Round

While typically not the biggest round of financing to say the least, the friends and family financing is essential for most high growth companies. It is important to do the financing right and not fall into one of the easy traps that create problems later in the company’s life cycle. If there’s interest, I can elaborate on some other traps and pitfalls in a later post.

Capitalization Strategy: Begin with the End in Mind

“Begin with the End in Mind”: what a simple, yet profound concept. It is one of the habits of Stephen Covey’s 7 Habits of Highly Effective People. It is so simple, but too often overlooked.

When entrepreneurs start companies they often have vivid visions of success. Through the business planning process, entrepreneurs often develop and work through the various issues that need to be addressed in order to obtain the commercial success for which they are looking. But, what is the desired end state or exit? Or, is death the only exit? Seriously though, is the exit, sale of the company within 5 or 10 years? Is it working with and growing the company until retirement, with younger management or the next family generation buying out the company? Is it an intellectual property holding company collecting royalties from various licensees? Is it the sale of stock after a public offering? Too often, entrepreneurs dedicate only two or three sentences in the business plan to the intended exit, using almost boilerplate language. Of course, only time will tell how things will end up, but having a vision for a desired outcome will help drive decisions and planning, making your desired outcome more likely to come to fruition.

Backwards Planning Process

With the desired end in mind, the business planning process and capitalization strategy development can truly begin. It is what is referred to as the backwards planning process. Many people do this instinctively as part of their normal planning. Identify what assuredly has to happen in order to get you in position to meet your desired end state. Think of these “have to happen” items as interim objectives. It may be a certain level of sales or EBITDA, successful completion of a lead drug phase II clinical trial, a successful public offering, etc. Then, identify what conditions, tasks, and shorter-term objectives it will take to meet those interim objectives. Continue to repeat that process until you are back in time to the present day.

Capitalization Strategy

When looking at your capitalization strategy, it is a very similar process. In fact, it should go hand in hand with business planning. You also need to consider though the needs, expectations, and desires of your sources of capital—meaning your prospective investors, bankers, government agencies, customers, etc. Figure out what it will likely take in order for you to get the sources and amount of capital you need to reach your desired end state. When looking at equity capital, think through valuation issues, dilution, capitalization structure, liquidation preferences, etc. Again though, start with the end in mind and work back through time, through each anticipated round of investment, each grant and grant phase, etc. It will help you develop a coherent strategy and identify what needs to be done to get you where you want to be.

Understanding Investor Needs

I’ll go through more on investor needs, expectations, and desires in later posts, but for present purposes I will touch on two very basic ones to illustrate some of the considerations to include in developing your capitalization strategy: the amounts of money that different types of investors invest as well as when in a company’s life cycle those investors invest.

Here are a couple of charts to consider. The first one shows the ranges of investment amount by investor type. The chart contains generalizations. Of course, sometimes investments are outside of these ranges for unique deals or situations or current market conditions. For instance, this year we are in relatively tight markets so both the number of deals and the amount of investments by group are generally down.

Investor Amount by Investor Type

Investor Amount by Investor Type

This next chart shows the stage of company development that investors generally invest at. As with the amount of investment, one see deals outside of these ranges based on unique opportunities or situations or the general market conditions. Also, there are variations by industry. For example, in therapeutics, the categories on the y-axis would be different: they would likely include positive preclinical animal data, filing a new drug application, commencing the clinical trial, completing phase I of the trial, etc.

 

Investor Interest by Company Stage of Development

Investor Interest by Company Stage of Development

The point to take from all this is that developing a coherent capitalization strategy is a deliberate process. It should take into account the entire time between today and the day you meet you desired end state, not just where your next grant or equity financing is going to come from. Have a long term strategy will actually help guide you through many decisions and assessments of opportunities that you will likely encounter.