Tag Archives: partnership

Do Founder Investments Dilute Earlier Investors?

ScalesAs president of Offtoa, a company committed to assisting entrepreneurs succeed, I am often asked by first-time entrepreneurs if their “investments” after founding dilute the ownership stakes of their earlier investors. The answer is always “it depends.”

Specifically, it depends on the type of legal entity that the company is; it depends on the terms laid out in the articles for the company; and it depends on what the founder means by an “investment.”

I’d like to explain the various implications of a founder “investing” money in a company subsequent to its creation and acceptance of earlier investments.

First of all, let me explain how the question is usually posed:

The Starting Conditions

“When I started the company a few years ago, I invested $20,000 and owned 100% of the company. Later, two outside investors made cash investments and purchased 10% and 20% of the company, respectively. Now I want to make another investment of $20,000. Will that dilute the ownership positions of the two outside investors?”

The Answer if your Startup is a Corporation:

If your startup is a corporation, then the outside investors did not purchase a percentage ownership stake; instead they purchased a number of shares.

Investment. If you are purchasing additional shares with your new $20,000 investment, these shares always come from the company’s treasury. Thus, the total number of outstanding shares will increase, and the percentage ownership represented by the outside investors’ fixed number of shares will indeed decrease. So, yes, they will be diluted.

Loan. If you are just lending the company $20,000, then this has no effect on the number of outstanding shares, and outside investors will not be diluted. You become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before shareholders.

Convertible Loan. It is common practice for insiders who lend the company money to convert those notes into equity if a major investment round occurs in the future. That is, the note is retired, and the outstanding principal including accumulated interest becomes part of the next investment round.

The Answer if your Startup is a Partnership:

Capital Account. Typically, if you invest cash in a partnership, it has no effect on ownership distribution; instead, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the partnership to the partners, you would be eligible to receive that amount from your capital account.

However, because partnerships allow for “special allocations,” both allocation of profit and loss to a capital account and subsequent distributions is negotiable. So, no, the “outside investors” (i.e., partners) will not be diluted.

Increasing Your Stake. Notice that if you did want your investment to dilute the partners, you would pay the other partners to acquire their positions. This would not provide cash to the company to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the company. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before partners.

The Answer if your Startup is an LLC:

Because most LLCs are treated as partnerships for tax purposes, the manner of priority, allocations, and distributions are negotiable. However, here is how they typically work.

When you as a founding member invest additional capital in the LLC, it could be treated in either of two ways, based on the LLC’s articles of organization:

  1. Capital Account. Like in the case of a partnership, it is recorded in your capital account and in the case of a liquidity event or other cash distribution from the LLC to the members, you would be eligible to receive that amount from your capital account. So, no, the “outside investors” (i.e., members) will not be diluted.
  2. Like in the case of a corporation, the cash could be used to add to your ownership interest, diluting other members (in this case, the “outside investors”), with their approval.

Increasing Your Stake. As in the case of a partnership, most LLCs also allow you to pay other members to acquire their positions. This would not provide cash to the LLC to help its operations.

Loan. If you are just lending the company $20,000, then this has no effect on your capital account or ownership distribution. You simply become a creditor of the LLC. The company will need to repay you according to the terms of the promissory note, and in the case of company closure, creditors will be paid before members.

Summary:

It is extremely common for founders to want to make additional infusions of capital into companies after starting. But notice that the implications of making such an investment are non-trivial. This is one of the many reasons why almost all startup mentors recommend that first-time entrepreneurs consult with an attorney experienced with entrepreneurial matters prior to creating their companies.

The type of legal entity that you decide upon and the terms you include in your incorporation/organization/partnership agreement will have significant effects on many aspects of your business. The above example of re-investing in the company is just one small example.

Please note that I am neither a CPA not an attorney. If you want to understand how investing in your company will affect your earlier investors, please consult with your CPA or attorney.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.
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