Changes to Employment Based Green Cards

A number of changes have been proposed to reduce long wait times for some employment based green card categories, and to make a sufficient number of visas available for highly skilled workers that are in high demand in the U.S.. The current immigration system sets a cap on the total number of visas issued by category (EB-1 through EB-5) and then further limits this by country.  For example, country-specific limits on employment-based immigrant visas have caused significant wait times (in excess of 10 years) for some applicants from countries like China and India.  These wait times would be eliminated if the bill becomes law and this will present an opportunity for employment based green cards from applicants from these two and other countries which in the past has been extremely difficult.

The reform proposals also eliminate cap amounts in some other visa categories.  For example, highly skilled and exceptionally talented immigrants are not subject to a cap.  In addition, candidates with advanced degrees in Science, Technology, Engineering & Math (STEM) fields from U.S. universities will also not be subject to the cap.  STEM graduates would also be exempt from the labor certification requirement which would make it much easier for them to get a green card after graduation.

The Creation of New Entrepreneur Visas

Current immigration law has two visas that have been developed to encourage foreign nationals to start a business in the U.S. and hire U.S. workers.  These are the E-2 Investor Visa and the EB-5 Visa.  To find out more about the E-2 visa click here. To find out more about the EB-5 visa click here.  As another attempt to attract foreign investment and create jobs, the bill creates a nonimmigrant investor visa (this is not a green card), or X visa.  The X visa is geared towards entrepreneurs whose businesses have attracted at least $100,000 in investment, or have created three jobs, and generated $250,000 in annual revenue.

The bill also creates an EB-6 immigrant investor visa that leads to a green card. This visa is for entrepreneurs who have a significant ownership in a U.S. business and have had a significant role in the start-up of the business.  In order to qualify for this visa, the business must create five jobs and must have received at least $500,000 funding, or created five jobs and generated $750,000 in annual revenues in the prior two years.  The E-2 and EB-5 Visas will still be available to investors.

Undocumented Workers Will Obtain Work Authorization

Although a violation of tax and immigration law, many employers hire workers “under the table.”  If this bill becomes law, the 11 million undocumented immigrants will be able to apply for Registered Provisional Immigrant (RPI) status, and work authorization, if they have been in the U.S. since December 31, 2011, have not been convicted of a felony or three or more misdemeanors, pay their assessed taxes, pass background checks, and pay a penalty, among other requirements.  As these workers are currently off the books, some employers do not comply with minimum wage and/or other department of labor requirements and the proposals would change this.  Moreover, in order to get RPI status, an undocumented worker would have to pay their back taxes and this would result in them telling both immigration officials and the Internal Revenue Service (IRS) who they had worked for.  This may result in a flood of fines and/or other penalties against employers.  You should note that while some immigration violations are only subject to fines, failure to pay payroll taxes is tax evasion which is a felony.

Introduction of a Merit-Based Program for Green Cards

One widely anticipated feature of the new immigration proposal is that it creates a new merit system that is based on points accrued through education, employment, family ties and other qualifications.  The premise here is that the higher you score, the more chances that you would have to get a green card. This proposal is similar to current legislation in other countries that link permanent residence applications to features such as length of time the person has been in the country, language ability, education and employment.  This could open up job availabilities for highly qualified workers with strong educational backgrounds.

New Visa for Lower Skilled Workers (Agricultural and Non Agricultural)

The current immigration proposals also create a program that allows foreign agricultural workers to enter the U.S. to work for employers designated by the Department of Agriculture. Employers must pay the W workers a wage determined by the department of labor and meet other conditions.  Temporary agricultural workers have been one of the areas where employers and lobby groups have expressed a keen interest in repair as many farm workers rely on seasonal workers.

The bill also creates a new W visa for less-skilled, non-seasonal, nonagricultural workers, such as workers in construction and restaurant industries. The program will be closely monitored and supervised by a new entity, the Bureau of Immigration and Labor Market Research, which will mandate what constitutes a shortage occupation.  Like the agricultural W visa, employers must pay the W workers the actual wage or the prevailing wage for the occupation, and follow other department of labor requirements. As this is a highly controversial area where many feel foreign nationals are taking U.S. jobs, a complaint process will be established to report violations, and penalties will be assessed for abuse.

Employers Will Be Required to Use E-Verify

E-Verify is an internet-based system that allows businesses to check whether or not an employee is lawfully permitted to work in the U.S..  The system is not currently mandatory and as such less than 1% of employers in the U.S. are enrolled in E-Verify.

The new bill expands E-Verify and makes it mandatory for all employers over a period of five years. The bill requires identity verification through the use of enhanced fraud-proof documents to allow employers to verify an individual’s identity.  In addition, a mandatory entry and exit system will be implemented at all air and sea ports to help ensure that foreign nationals are leaving the U.S. when they are supposed to.

If you are considering moving to the U.S. or acquiring an Investor or Entrepreneurial Visa, contact Scott Legal Services, P.C..  For more information on these and other immigration Visas click here.  You can also call us at 212-223-2964 or email us at iscott@legalservicesincorporated.com.

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Also, click here for your free White Paper that summarizes the top 10 Immigration Questions and Answers.

What Are The Consequences of Hiring an Undocumented Nanny?

Finding a good Nanny is a very difficult task and once you find the perfect person you should hold on for dear life.  That being said, many do not fully understand the possible impact of hiring an undocumented Nanny and paying him/her “off the books.”   There are three distinct consequences associated with hiring an undocumented worker and these consequences range from relatively minor to severe.  Here are the consequences.

First, each employer (you are considered an employer when you hire a Nanny) is required to check immigration status of new employees and you can be subject to a penalty/fine if you fail to do this.  If you just forget to check status the penalties are less severe than if you knowingly hire an undocumented worker.  In addition, penalties and fines increase substantially for repeat violations.  All in all though, most people that hire an undocumented nanny are not dissuaded by this consequence and this consequence is categorized as the least severe.

Second, hiring an undocumented nanny could expose you to reputational risk. This is particularly the case if you are a professional regulated by a professional body or if you are running for office.  There are numerous examples of public officials who have run into difficulty because of immigration violations related to their undocumented nannies.

Finally, the most severe consequence is criminal prosecution and/or jail.  To understand this you should separate the immigration consequences from the tax aspect.  To explain, just as employees are required to pay income tax, employers are required to pay payroll taxes for their employees.  As a nanny is considered an employee an employer is required to submit these taxes to the government and this is the case whether the nanny is documented or not.  Failure to pay these taxes is a felony (tax evasion) and ignorance of the law is no excuse.  The key thing to note here is that even if you are not sure about the immigration status of your nanny, you should remit payroll taxes to the government.  If you do this, you will only have to worry about the first two consequences outlined above which are arguably less severe.  The best advice though is to hire a documented worker.

How Will Changes in Immigration Law Impact Those Who Currently Employ Undocumented Nannies?

There are several potential impacts on Households who currently hire Nannies.  These range from increased enforcement (fines and penalties), having to look for a new nanny & higher wages.  These are all described below.

Many see the current fines and penalties associated with hiring an undocumented worker as low and as such are willing to take the risk.   The new immigration proposals though, set out to significantly ramp up enforcement and penalties (both civil and criminal) and this could spell trouble for households who have not really been subject to much enforcement in the past.  It is very likely that the government will start to actively seek out employers who are not following the law and this will likely include households.

So how will the Government find out?  In addition to a ramp up of enforcement, one of the key provisions of the new proposals is that all undocumented workers applying for the new immigration status will be required to file tax returns and pay back taxes and this means they will have to identify who they work for.  As such, both branches of government (U.S. Citizenship & Immigration Service and the Internal Revenue Service) will know that the employer was doing something that they should not have been doing. (violating immigration law and not paying taxes).  While it is unclear exactly what enforcement measures the government will take against households, you should be aware of the risks you are running and perhaps attempt to remedy your situation.

Another impact of immigration reform will be that many nannies will pursue other lines of works and many who have a nanny may quickly realize that their nanny has a different plan now that he/she can apply for any job they want.  While some nannies take up the profession because they love children, others select the profession out of necessity.  As some nannies will decide to peruse other interests and employers will have to ensure that they are complying with minimum wage requirements, Immigration reform could actually open up tremendous opportunity for good nannies and will likely have the overall impact of increasing wages in the profession.

What is the Best Approach For Hiring A Nanny?

Comply with the law.  With current tax law and the proposed immigration reform changes you run a substantial risk if you decide to hire undocumented workers and pay them under the table.  As such, you are strongly advised to check the immigration status of your Nanny before hiring him/her and set them up on payroll so that payroll taxes are regularly remitted to the government.  Even if you do not have them set up on payroll, you can avoid possible felony tax evasion charges by submitting the required payroll taxes when you file your tax return.

Contact Scott Legal Services, P.C., www.legalservicesincorporated.com today and let us help you with your Immigration needs.  You can also call us at 212-223-2964 or email us at iscott@legalservicesincorporated.com.

Click here for your free White Paper that summarizes the top 10 Immigration Questions and Answers.

What are “Corporate formalities” and how Difficult are they to Implement? 

Adherence to corporate formalities is often cited as a significant disadvantage for those who consider a Corporation as a business form and this is often why many instead opt for a Limited Liability Company (LLC).  While forming an LLC is certainly an option, corporate formalities are not as bad as most think.  Here is a list of corporate formalities you must follow along with some general comments.

1. Create Bylaws. Every corporation must have bylaws and bylaws are really a set of internal rules governing how the corporation is run.  While this at first may seem like a daunting task, there are many templates that can be used as a starting point. Also, if you hire a lawyer to set up your corporation, he/she will typically draft these for you and this will usually be included in the set up fee.
2. Hold Shareholders Meetings. Shareholders of the corporation should meet at least annually to elect directors.  When you initially form a corporation, you should immediately hold a meeting and elect the board.  Minutes should also be recorded at this meeting.   You should note that shareholders, board members and officers can all be the same people and each can have multiple roles.  What that means is that a corporation formed by one person will hold a meeting by himself and document the appointment of himself to the various roles.
3. Hold Board of Director Meetings. The board of directors of the corporation  has to meet regularly.  Also, a designated person from the corporation (eg. person designated secretary) should record minutes of the meetings, reflecting resolutions and discussions that the directors had at that meeting.  When forming a corporation, the initial bylaws should also be adopted at the first board meeting.  All major decisions of the corporation should be adopted in a board resolution pursuant to the procedure set forth in the bylaws (such as mergers, stock issuances, major financial decisions such as loans, dividends, guarantees, hiring of consultants and legal experts, transactions with insiders, senior officer compensation, etc.).
4. Maintain A Stock Ledger & Issue Stock Certificates. A stock ledger should be maintained which reflects the stock ownership of the corporation and the names and addresses of the shareholders.  You should also issue stock certificates to those who own shares that represent their ownership in the corporation.  If you do not have a ledger or certificates, you can pick one up at a stationary store.
5. Set up a Corporate Bank Account. The Corporation has to have a separate bank account that is in the name of the Corporation.

Here are some additional things that you should consider when setting up a corporation to establish strong corporate governance and to ensure that you do not run into any piercing the corporate veil problems.

1. All business of the corporation with third parties should be conducted in the name of the corporation so that it is clear that the directors and officers are acting on behalf of the corporation and not in their individual capacity.
2. The corporation should file all appropriate federal, state and local tax returns and pay taxes when due, as well as obtain all necessary permits and licenses.  In addition, the corporation should apply for a federal tax ID number and this can easily be obtained by applying online by visiting the IRS Web site.
3. Retain a qualified accountant.  A qualified accountant can assist you with your tax return and can set up your books and records for you.
4. You should make sure the corporation is adequately capitalized by maintaining adequate capital in the corporation to meet all current and foreseeable debts. If you do not, your corporation could be viewed as a “sham” corporation which would permit the corporate veil to be pierced.
5. You should ensure that you maintain adequate liability insurance necessary for your type of business.
6. You should consult with a lawyer before you personally guarantee any debts of the corporation and do not offer to personally pay corporate debts.
7. Do not commingle corporate and personal funds by placing any corporate funds in personal accounts.
8. Make sure you do not use corporate assets for personal use unless the board of directors of the corporation explicitly authorizes such use.

The above is not an exhaustive list of all corporate formalities but the majority are covered.  While maintaining corporate formalities for a small company is not difficult, issues do arise and it is very important to establish a strong corporate governance structure as your company expands.  As such, you should seek the counsel of an experienced attorney familiar with corporations and corporate formalities.

If you are considering setting up a corporation, contact Scott Legal Services, P.C. for a consultation. You can call us at 212-223-2964 or email us at iscott@legalservicesincorporated.com.

Click here for PDF Version

Also, click here to obtain a free chart that summarizes a number of things to consider when selecting a business entity in an easy to read and understandable format.

1.     What Are the Different Forms of Business Entities That I Can Select from?

There are many different types of business entities that one can select and the decision is governed by tax considerations, risk tolerance, budget and personal goals.  For the most part, your decision will be between a Sole Proprietorship (“SP”), Corporation (“C”) a Limited Liability Company (“LLC”) or a form of Partnership (“P”) and each entity has various advantages and disadvantages.  A Sole Proprietorship is the easiest entity to set up but does not protect the owner’s personal property if someone decides to sue the business.  Instead, the company and the individual are considered the same person and if the business is sued or incurs debts, you, the business owner, will be personally liable.  A Corporation and LLC, while more complicated to set up, solves the problem of personally being sued by separating the individual and the business.  These entities are both “limited liability” entities where your risk is typically limited to the amount of money you invest in the business.  A Partnership can also be set up as a limited liability entity and often accounting, consulting and law firms are set up using this business form.

2.     Should I Select An Entity With Limited Liability Protection?

Generally Yes.  Even though a Sole Proprietorship is easy to set up, in order to better separate personal & business finances, a business entity that offers limited liability protection is highly recommended.  This can be a Corporation, a Limited Liability Company or a Limited Partnership and these entities will stop a creditor or litigant from coming after your home or personal assets.  For those who think there is very little risk  of being sued, your risk jumps significantly if you deal with vendors, hire employees or have clients visit your premises.  Even a picture on your website can result in a law suit.  As a practical tip, to ensure that your personal assets are truly protected, you should remember to always try to ONLY include the name of the business on any legal documents such as a loan document, lease, utilities set up, etc..  If you also include your name you may inadvertently extend the liability of your entity to yourself.

In addition to the limited liability protection there are several good reasons why you should select a business entity other than a Sole Proprietorship.

• A separate business entity adds legitimacy and credibility to your business.
• You will have more flexibility when it comes to tax planning.  (this is a complicated area and you should consult with your lawyer or tax advisor).
• You will start to develop business credit.  You will find that when you start your business, most creditors/others will require that you sign personally along with the business.  (For example, if you sign a lease the owner of the property will have your name and the company’s name on the lease). Just like an individual establishes credit a business can establish credit and this can best be done if the business is a separate entity.

3.     Should I Select a LLC or Corporation?

The determination of which business entity to select requires a comprehensive assessment of the particular facts and circumstances of your company and should be done in conjunction with a lawyer and/or accountant.  We have included a summary of the advantages and disadvantages of these two entities below.

4.     What is an S Corp?

When you search the Internet, you will see many references to an “entity” referred to as a S-Corporations but it is best to think of “S” as a TAX STATUS rather than as a type of entity.  If you do, most of your confusion will vanish. So here is the lowdown.

S status is a tax categorization that allows an entity to avoid the problem of double taxation by allowing income to flow through to the business owner’s personal tax return.  This is particularly important for a Corporation as without S status, a business owner would be forced to pay taxes on corporate earnings as well as personal distributions (this is why it is called double taxation).  S status also has the potential advantage of saving the business owner some amount of payroll taxes.  You should keep in mind that BOTH a Corporation and a LLC may elect S status and if they do, they could avoid self-employment taxes on at least a portion of their earnings.  Here is a brief and simple example.  An entity (LLC or Corporation) makes $100,000 and the owner assigns themselves a salary of $60,000 (salary must be reasonable in order to qualify).  When this occurs, and S status is elected, the owner will only have to pay self-employment tax on the $60,000 rather than the full $100,000.  Do not confuse self-employment tax with income tax as income tax is paid on the full $100,000 and this cannot be avoided.  In order to be eligible, you must file the S tax status election with the IRS right after you set up the LLC or Corporation (they give you around 60 days).  If you forget to make your S election, the IRS will usually accept late applications provided you have a good reason. (eg. bad advice from your accountant)

S status though, does have drawbacks as the ownership structure is not that flexible and you must be a U.S. resident for tax purposes to be eligible.  In addition, if you elect S Status there is a limitation on the amount of owners that may hold shares or membership units in the company.  If you are considering electing S Status, you should consult a Lawyer or Accountant as it is a complicated area.

5.     What is an LLC?

An LLC (Limited Liability Company) is a hybrid of a sole proprietorship/partnership and corporation. This structure is very popular among small businesses, and for good reason. The LLC limits the personal liability of the owners, but doesn’t require much of the heavy formality and paperwork of the corporation. This makes it a great choice for business owners that want liability protection but don’t want to deal with meetings, documenting minutes, addendum filings or other paperwork you would need to file as a corporation.  If you want to avoid corporate formalities, a LLC might be perfect for you. As described in the disadvantages above, the publication requirement is an initial outlay that discourages many from this entity.

Click here for some additional tax considerations that further explain the advantages of an LLC.

6.     Where Should I Incorporate?

I am often asked the question of whether an entity should incorporate in Delaware, Wyoming or Nevada and this is because Delaware offers flexible, pro-business laws, and Wyoming and Nevada have low filing fees and no state income taxes.

As a general rule of thumb, if your business has a small number of shareholders, you should incorporate in the state where you actually live or where your business has a an office.   This is primarily because incorporating in a different state from where you are doing business will require you to have to deal with added fees, filings and paperwork and you still may have to file forms in your home State.  In our opinion, for most small businesses the added hassle and fees are not worth it.  This decision should be made with a qualified lawyer so that the companies goals can be explored.

7.     Can I Hire Someone and Pay Them As An Independent Contractor?

The question of whether or not someone is an employee or independent contractor often comes up and many small businesses make the mistake of incorrectly classifying workers as independent contractors (and issuing a 1099) rather than properly classifying these individuals as employees. One obvious advantage of the independent contractor classification is avoiding payroll taxes but the correct classification is one that is based on substance rather than form.  To make this determination, the Internal Revenue Service lists a number of factors that must be considered and generally speaking when a small business hires a worker to perform day to day tasks, the worker will be an employee.   You should keep in mind that an incorrect classification could lead to significant penalties and it is not difficult for the government to “catch” those who classify incorrectly. As a result, when hiring staff, you are advised to seek out counsel from a qualified employment attorney.  We refer all of our employment matters to White & Harris, a law firm that specializes exclusively in employer based employment law.  Click here to find out more about White & Harris.

8.     If I Am A Foreign National Do I Need A Visa To Run A Business In The U.S.?

Yes.   In order to be present in the U.S. and operate a business, you must have a Visa.  Generally speaking there are 4 Visa types that a small business can consider.  These are the E-2 Investor Visa, H-1B Visa, L Visa & EB-5 Visa.  To find out more about each of these visas click here.

9.     If I Issue Stock To My Friends & Family Do I Have To Comply With SEC Regulations?

Yes.  Many small business want to raise funds to finance ongoing operations and  you are required to comply with the Securities Exchange Commission’s (SEC) requirements if you sell stock or any security.  The term “security” is defined by Statute but most financial products that a company can sell to an investor would qualify as a security.  (For example, preferred stock, convertible debt, member units, common stock, etc.)  In addition to federal SEC requirements, a company that issues securities would also have to comply with State Securities regulations.

All of the government requirements have been set up to protect investors and generally require any company who wants to attract investors to provide the investors with information such as financial statements, offering documents, prospectuses and other information so that an investor can make an informed decision.  Failure to follow these requirements can result in dire consequences.

10.  Should I Hire A Lawyer If I Start A Business?

Yes.   Starting a business can be complicated and finding a qualified lawyer to assist you with your business entity selection, issuance of stock, obtaining the proper Visa and strategy advice is essential.  In addition, a lawyer can get you to start thinking about the right questions to ask and can put a legal framework around your business that could save you money.

If you are considering issuing securities to friends and family, contact Scott Legal Services, P.C. for a consultation. You can call us at 212-223-2964 or email us at iscott@legalservicesincorporated.com.

Click here for a PDF Version

Confused?  No problem, click here to obtain a free chart that summarizes a number of things to consider when selecting a business entity in an easy to read and understandable format.

E-2 Investor Visa

An E-2 Visa is a Visa option for business owners that wish to start a company in the United States that they want to develop and direct the operations of.  Although a person could live indefinitely in the U.S. with an E-2 Visa, it is a non-immigrant Visa which means that it does not lead to a green card.  In order to qualify for this Visa, you must either start a business or buy a business that you plan to run and the investment amount really depends on the type of business you start. For example, if you start a consulting firm, the amount of investment can be as low as $50,000.  If you start a manufacturing plant, the required investment amount would be much higher. In addition to the unlimited duration of the E-2 Visa (as long as you continue to run the business) and the potentially small investment amount, this Visa has the additional advantage of allowing an Investor’s spouse and children to join them in the U.S. and the spouse can get authorization to work in any field.  Find out more about E-2 Visas by clicking here.  Also view frequently asked questions by clicking here.

EB-5 Immigrant Investor Visa

An EB-5 Visa is a great visa option if you have a large amount of capital and is often referred to as the million dollar Green Card. The key advantage of this Visa is that you and your immediate family get green cards, but the down side is that the Visa requires a substantial investment (could be $1,000,000), EB-5 law is a very complex legal area (so expensive), and the Visa petition requires extensive documentation.

There are 5 main criteria to get an EB-5 Visa and they are as follows:

1. You must invest or be actively in the process of investing either $1,000,000 in a city settings, or US $500,000 in rural settings;
2. You must show that the funds come from a legitimate source
3. The entire amount of the investment must be active or at risk (this means that you cannot just be thinking about buying a business and you have to put capital up that could be lost)
4. You must make the investment in a “new” or “existing business enterprise” (this allows you to create your own business or buy one); and
5. You must demonstrate that the investment directly or indirectly results in the creation or preservation of ten full time jobs

Find out more about EB-5 Visas by clicking here. Also, view frequently asked questions by clicking here.

H-1B Visa

The H-1B visa is a non-immigrant visa that permits a company to hire workers in specialty occupations.  This visa category requires that the beneficiary (the foreign worker) have a Bachelor’s degree, and the Petitioner (the U.S. company) can employ the worker for up to six years.  In the case of a Business Owner, Investor or Entrepreneur, the petitioner and the beneficiary are often the same person but a business owner can use this Visa to sponsor his employees also.  An H-1B Visa can be a tricky visa for a Business Owner if the owner is also the beneficiary as there are strict laws that govern whether or not a person who has an ownership interest in a company can sponsor themselves for an H-1B Visa.  While difficult, it is not impossible and can be done with the help of a qualified immigration specialist.  For more on H-1B Visas click here.

L-Visa

The L-Visa allows a company to transfer an executive or manager from one of its affiliated foreign offices to one of its offices in the United States.  This classification also enables a foreign company which does not yet have an affiliated U.S. office to send an executive or manager to the United States with the purpose of establishing one.  As such, this visa can be used by foreign entrepreneurs, investors, & business owners who want to move either themselves or their employees to the U.S..

To qualify for L-1 classification, the employer must:

1. Have a qualifying relationship with a foreign company; and

2. Currently be, or will be, doing business as an employer in the U.S. and in at least one other country directly for the duration of the beneficiary’s stay in the United States as an L-1.

If you are considering an Investor or Entrepreneurial Visa, contact Scott Legal Services, P.C..  For more information on these and other immigration Visas click here.  You can also call us at 212-223-2964 or email us at iscott@legalservicesincorporated.com.

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Also, click here for your free White Paper that summarizes the top 10 Immigration Questions and Answers.

1.     What Is Convertible Debt?

Convertible debt is a financial product that is debt (like a loan) that converts to equity (usually preferred stock) based on some trigger event (usually a Venture Capital or other funding/financing round).  The debt usually accrues interest but the interest is not paid until the trigger event occurs.  Once the trigger event occurs, the debt holders can convert the money they loaned, and the accrued interest, to preferred stock and they can usually get the same stock that the Venture Capital fund gets.  In addition, Convertible Debt holders are usually able to purchase the preferred stock at a discount. There are other provisions covering various what-if scenarios, but those are the basics.  Convertible debt is often referred to as a fancy bridge loan since it ‘bridges’ the company to its next financing.

2.     Is Convertible Debt a “Security” and Do I Have To Follow Securities Exchange Commission (SEC) Regulations If I Use It To Raise Capital?

Yes & Yes.  Unlike a regular loan, Convertible Debt is a security and if you sell it to Investors, you must comply with complex SEC and State regulations.  You can find out more about this by clicking here.

3.     What are Some Advantages of Convertible Debt Over Equity from The Perspective of the Founder?

There are three key advantages associated with Convertible Debt. They are as follows:

a.     Simpler, Cheaper & Faster

A Convertible Debt term sheet and the associated documentation is often much shorter and easier to compile than preferred stock documentation.  In addition, there often are not many terms to negotiate and this can cut down on back and forth time between founders and Investors.  As the documentation is easier, the legal fees associated with them are cheaper. How much cheaper is debatable but a “light” preferred share offering would often cost twice as much as a comparable Convertible Debt offering.

Given the relative complexity, Convertible Debt is also faster.  Once your investors are ready to talk terms, you can negotiate a term sheet in one week and close the deal one week after that as the documents are short and simple and as such there isn’t much to discuss. This is compared to an equity financing which can take two weeks to negotiate and 4-6 weeks to close.

b.     You Can Push Off Valuation of the New Company Until Later

Convertible debt allows a new business to get necessary investment funds without setting a valuation on the company before institutional investors enter the picture.  If preferred shares are issued to Investors, the founders and Investors musts agree on a valuation of the company so that a price can be set for the shares.  Another potential problem is that  business owners can overvalue how much the business is worth and convertible debt can eliminate the risk of a the situation where a Venture Capital fund later buys shares at a share price that is lower than what is expected or paid by the original investors.  Moreover, at the early stages of a company, most company’s technology, business models & cash flows are largely untested and unproven (in some cases they do not exist) making any valuation difficult to do.

c.     Ability for Founder to Maintain Control

If Convertible Debt is issued to Investors, Founders usually continue to control a company after the Debt has been issued.  This can be the case with Preferred Shares also but only if the Preferred Shares do not have any voting rights.  It is important for a Founder to maintain control so that he/she can promptly act if a Venture Capital Fund or other significant investor decides to invest, and Investors often dictate that the Preferred Shares that they buy have beneficial provisions (eg. voting and board election) which could force the Founder to give up some control.

4.     What Are Some Disadvantages of Convertible Debt?

Here are three key disadvantages of convertible debt.

a.     Investor May Not Understand The Product So You May Have Trouble Selling It

While the product is not that complex and people know what debt is, some unsophisticated Investors may not fully understand the conversion feature of the product.  In contrast, everyone knows what a stock is and this may be an easier sell to Investors (in particular friends and family).

b.     Interest Payments Have to Be Made & You Have Debt Outstanding

Convertible notes accrue interest from the date they are issued and even though the amount is not paid until a trigger event occurs, this costs the company money.  Moreover, make no mistake that until converted this product is debt and if a financing event does not occur the amount (plus interest) has to be paid back.  Depending on the wording of the contract, a delay in Venture Capital or other financing could allow the debt holders to force bankruptcy.

c.     Investor Does Not Get Any Control So May Not Find the Product Attractive

While several pro-Investor features can be added to Preferred Stock, convertible debt is debt until a trigger event occurs. As such, an Investor cannot elect board members or have any say in the direction of the company.  This may not be that attractive for some Investors who may look somewhere else to invest their money.

5.     What Are Some Other Financial Products That Can Be Issued to Investors?

When a founder wants to raise capital for his/her company, there are a number of financial products that can be offered other than Convertible Debt.  First, the company can get a simple loan.  This is often impractical as most lenders (usually a bank) will not extend funds to new companies and new companies often cannot afford to pay the money back.  Second, Preferred Stock can be issued.  Preferred Stocks are usually non-voting shares where a dividend is paid and Investors receive preferential treatment if the company is liquidated.  In addition, Preferred Stock can be tailored so that they have any feature associated with them that the founder would like.  (eg. voting, right to appoint board members, etc.).  Another product is Convertible Preferred Shares.  This product is similar to convertible debt except the loan features (eg. interest) are stripped away.

6.     Should A Founder Issue Convertible Debt or Equity?

It depends.  It is not possible to give an answer of which instrument (preferred stock v. convertible debt) is “best” and you should sit down with your lawyer to fully understand the different options to assess which one works best for you given your goals.  In fact, many in industry have very different view on which product is the best product for start-up companies.  Speak to a lawyer at Scott Legal Services, P.C. so that your options can be explained to you.

If you are considering issuing securities, contact Scott Legal Services, P.C. for a consultation. You can call us at 212-223-2964 or email us at iscott@legalservicesincorporated.com.

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Scott Legal Services, P.C. regularly represents start up founders and investors and the same questions often come up.  Here are some of the common questions asked with short answers.  This article focuses on the top Start-up Founder/Investor questions asked by our clients.  The answers are short answers to complicated questions and should only be used as a basis for a discussion with a qualified start-up business attorney.  Here are the top questions.

1.     What are some of the ways that a Start-Up Founder can structure an Investment for Family & Friends?

There are various ways that an investment can be structured.  One simple way that family and friends can invest is through a loan.  While this is a simple form of investment, it is not very practical as most start-up companies cannot afford to pay interest (or pay back anything) and will not be in a position to do so for years.  As such, most founders keep common voting stock for themselves and issue either convertible notes or preferred shares to investors.  Convertible debt is a somewhat complicated financial product that is debt (like a loan) that converts to equity (usually preferred stock) based on some trigger (usually a venture capital funding round).  The debt usually accrues interest but the interest is not paid until the trigger event occurs.  Once the trigger event occurs, the debt holders can convert the money they loaned and accrued interest to preferred stock and they can usually purchase the preferred stock at a discount.  Preferred shares are equity stock and the stock is usually non-voting.  A number of features can be added to the preferred stock (eg. right to appoint board members) to give investors comfort.  Both Preferred Stock and Convertible Notes are financial securities and require extensive legal documentation to set up.

2.     Should a Founder Sell Preferred Shares or Convertible Debt to Friends & Family?

Many start-up founders ask the question of whether or not they should issue convertible notes or preferred stock to investors.  Convertible debt has the advantage of being a bit cheaper as the legal set up is not as complex.   In addition, convertible notes push off the valuation of the company to a later date (usually when a Venture Capital fund comes along).  On the down side though, some find the product complicated and difficult to explain to investors.  Preferred stock is a simpler product to explain to investors but does cost more in legal fees to set up and at the start-up phase money is usually not abundant.  In addition, a valuation must be done and when a company is just formed and does not have any sales, founders and Investors may not agree on the initial valuation.  This could cause complications as the valuation is going to be the basis for the price that an Investor pays for their shares.

It is not possible to give an answer of which instrument (preferred stock v. convertible debt) is “best” and you should sit down with your lawyer to fully understand the different options to assess which one works best for you.  In fact, many in industry have very different view on which product is the best product for start-up companies.  Regardless of which one is selected, there are a number of legal documents that must be prepared in addition to ongoing SEC compliance.

3.     If Family & Friends invest in a Founder’s company and the Founder sells them stock, does the Founder have to follow any laws or regulations?

Yes. You are required to comply with the Securities Exchange Commission’s (SEC) requirements if you sell stock or any security.  The term “security” is defined by Statute but most financial products that a company can sell to an investor would qualify as a security.  (For example, preferred stock, convertible debt, member units, common stock, etc.)  In addition to federal SEC requirements, a company that issues securities would also have to comply with State Securities regulations.

All of the government requirements have been set up to protect investors and generally require any company who wants to attract investors to provide the investors with information such as financial statements, offering documents, prospectuses and other information so that an investor can make an informed decision.  Failure to follow these requirements can result in dire consequences.

4.     How much Information must be provided to friends and family investors? Is it as much information as if the offering were to be made to the general public?

If you are offering securities to your friends and family, you can usually file Federal and State exemptions so that you can limit the amount of information that you provide to investors.  If you qualify for the exemptions, you can provide investors with your business plan and other information you have available.  If you do not qualify for the exemptions, the full SEC disclosure requirements kick in and you are required to provide investors with a complete set of information including offering documents,  audited financial statements, prospectuses and more.  The exemptions are complicated and rules often limit who you can sell securities to and place restrictions on the securities that are sold.  For example, some exemptions require that your friend and family investors be “Accredited Investors” such that they have significant financial assets and superior knowledge of financial markets.

 5. What happens if SEC Regulations are not followed?

A company or individual that issues securities and does not follow U.S. law can be subject to sanctions including prohibition of future securities issuances, fines or imprisonment.  A founder must take special care not to mislead Investors by providing false or misleading information as Securities prosecutions can result in both hefty fines and imprisonment for egregious violations.

6.     Can a company pay employees with Stock?

Yes but this is very complicated area.  In the United States if you issue a security (stock is a security), you are required to comply with the Securities Exchange Commission’s (SEC) requirements.  This is the case even if investors are awarded shares in lieu of salary or other compensation.  In addition, if you set up a stock option plan, this is another area where you must comply with complex regulation.  Compensation is a complicated area and a founder would always be well served by seeking legal advice in this area.

7.     Does a Founder Need A Lawyer to Raise Funds From Friends & Family?

Yes.   Unless your friends and family are giving you a loan, you are probably issuing securities to them.  When you issue securities the law and regulations are complicated and you need an expert to make sure you are complying with both federal and State requirements.  In addition, a lawyer can get you to start thinking about the right questions to ask and can put a legal framework around your business that could save you money.  Moreover, as investors are friends and family it is important to ensure that a founder is providing the investors with all of the information that they need to make an informed decision.  Also, a founder has to ensure they are following the law to protect themselves in the event an investor becomes disgruntled.

If you are considering issuing securities to friends and family, contact Scott Legal Services, P.C. for a consultation. You can call us at 212-223-2964 or email us at iscott@legalservicesincorporated.com.

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