Module 3

Study Guide: Module 3 - Business and Capital Formation

I. I Need a Lawyer 101!

Top Legal Considerations When Starting a Business

1. Different Legal Entities and Choice of Entity

   • C-Corporation

     • Ownership: One or more stockholders; no restrictions on owners.

     • Formation: Certificate/Articles of Incorporation.

     • Governance: Bylaws.

     • Tax: Double taxation—entity level and stockholder level.

     • Liability: No personal liability for stockholders.

     • Equity: Common and preferred stock; multiple classes allowed.

   • S-Corporation

     • Ownership: 1–100 stockholders; only US citizens/residents.

     • Formation: Certificate/Articles of Incorporation.

     • Governance: Bylaws.

     • Tax: Pass-through taxation.

     • Liability: No personal liability for stockholders.

     • Equity: Common stock only; one class allowed with varying voting rights.

   • Limited Liability Company (LLC)

     • Ownership: One or more members; no ownership restrictions.

     • Formation: Certificate/Articles of Formation/Organization.

     • Governance: Operating Agreement.

     • Tax: Taxed at the member level.

     • Liability: No personal liability for members.

     • Equity: Membership interest; customizable through the Operating Agreement.

   • Limited Partnership (LP)

     • Ownership: General partners (GPs) and limited partners (LPs).

     • Formation: Certificate/Articles of Limited Partnership.

     • Governance: LP Agreement.

     • Tax: Taxed at the partner level.

     • Liability: GPs have full liability; LPs have limited liability.

2. Corporate Compliance and Formalities

   • Limit personal liability by adhering to corporate formalities.

   • Examples: appointing officers, holding annual meetings, keeping accurate minutes.

3. Intellectual Property (IP) Concerns

   • Protect intellectual capital (formulas, logos, patents).

   • Use proper license agreements to grant or gain access to IP.

4. Proper Contracts

   • Examples: NDAs, supply/vendor agreements, IT and SaaS contracts.

   • Document everything to sustain claims in breach of contract cases.

5. Industry Licensing

   • Essential for regulated industries (e.g., healthcare, food).

   • Comply with federal, state, and local regulations.

6. Employee Issues

   • Governance of equity, voting rights, and ownership in agreements.

   • Treat equity as valuable and allocate carefully.

7. Franchising Basics

   • Franchisor vs. franchisee roles.

   • Understand pros/cons and adherence to franchising agreements.

8. Miscellaneous Considerations

   • Insurance, taxes, cultural/international factors, and non-compete agreements.

II. Capital Formation

Critical Decisions

• Balance risk, cost, and growth for optimal sourcing.

• Consider the desired endgame (e.g., public offering, acquisition).

Types of Capital

1. Debt

   • Funds provided with a repayment promise, including interest.

   • Types: Secured (backed by assets) and unsecured (personal guarantees possible).

   • Examples: Bank loans, SBA loans, personal funds.

2. Equity

   • Investors gain ownership interest in exchange for investment.

   • Higher risk for investors; they often seek involvement and expertise.

3. Alternatives

   • Factoring, crowdfunding, grants.

Key Debt Types

• Loans: Fixed amount provided upfront; most traditional.

• Lines of Credit: Revolving debt; used for short-term needs.

• Factoring: Selling invoices for immediate cash at a discount.

Equity Considerations

• Investor involvement increases with equity.

• Retaining control vs. raising capital.

Crowdfunding

• Forms: Donation, investment, loan.

• Useful for gauging product demand; requires visibility for success.

III. Pre- and Post-Money Valuation

1. Enterprise Value (EV)

   • Formula: EV = Equity + Debt - Cash.

   • Includes both equity and liabilities.

2. Pre- and Post-Money Valuation

   • Pre-Money: Company’s equity worth before funding.

   • Post-Money: Equity worth after funding.

3. Example Calculation

   • Pre-Money Valuation: $25M.

   • Investment: $5M.

   • Post-Money Valuation: $30M.

IV. Cost of Capital

Overview

• The expected return required by providers of capital.

• Used to evaluate project returns.

Weighted Average Cost of Capital (WACC)

• Formula: WACC=(Debt Proportion×Cost of Debt)+(Equity Proportion×Cost of Equity)WACC=(Debt Proportion×Cost of Debt)+(Equity Proportion×Cost of Equity).

Cost of Debt

• Formula (after-tax): Interest Expense÷Total Debt×(1−Tax Rate)Interest Expense÷Total Debt×(1−Tax Rate).

• Includes risk-free rate (e.g., Treasury Bill yield) + credit spread.

Cost of Equity

• Calculated using the Capital Asset Pricing Model (CAPM):

  • Formula: Cost of Equity=Risk-Free Rate+β×(Market Return Rate−Risk-Free Rate)Cost of Equity=Risk-Free Rate+β×(Market Return Rate−Risk-Free Rate).

  • ββ: Measures stock volatility compared to the market.

Key Takeaways

• Understand legal and financial structures for your business.

• Balance growth and risk when choosing capital sources.

• Protect your business with compliance, contracts, and intellectual property safeguards.

• Master valuation methods and cost of capital calculations for effective financial planning.