Capital Contributions, Capital Calls, Financing, …

1 The University of Texas School of LawContinuing Legal Education 512-475-6700 :LLCs, LPs, and PartnershipsJuly 14-15, 2011 Austin, TXCapital contributions , Capital Calls, financing , Funding and New Equity:Key Planning and Drafting Issues forLLCs, LPs and PartnershipsCliff ErnstAuthor contact information:Cliff ErnstGraves Dougherty Hearon & Moody, A Professional Corporation401 Congress Avenue, Suite 2200 Austin, Texas contributions , Capital Calls, financing , Funding and New Equity:Key Planning and Drafting Issues forLLCs, LPs and PartnershipsTable of .. Versus Equity .. of of of Assets Estate or Non-Cash Personal Property .. Timing of Capital Commitment VersusAdditional Capital call for Failure to Make a Capital Investors Added After the A Contract Language for Initial Capital contributions of Cash at FormationAppendixB Contract Language for Initial Capital contributions Conforming to Subscription AgreementAppendix C Contract language for Initial Capital Contribution of Personal Property (Other Than Cash)Appendix D Contract Language for Initial Contribution of Real PropertyAppendix E Assignment and Bill of SaleAppendix F Warranty DeedAppendix G Contract Language Prohibiting Additional Capital ContributionsAppendixH Contract Language Permitting Additional Capital contributions with Owner ApprovalAppendix I Contract Language for Capital CallsAppendix J Contract Language for Failure to Make a Capital Contribution.

2 Providing for Loans by the Non-Defaulting OwnersAppendix K Contract Language for Failure to Make a Capital Contribution; Providing for Dilution Based upon Initial ContributionsAppendix L Contract Language for Failure to Make a Capital Contribution;Providing for Dilution through Adjustments in Percentage InterestsBased upon Cumulative ContributionsAppendix M Contract Language for Failure to Make a Capital Contribution; Providing for RedemptionAppendix N Contract Language for Failure to Make a Capital Contribution; Providing for ForfeitureAppendix O Contract Language for Failure to Make Capital contributions ; Providing for SubordinationAppendix P Contract Language for Failure to Make a Capital Contribution; Providing for Forfeiture and SubordinationAppendix Q Contract Languageto Protect Rights of Minority OwnerAppendix R Contract Language for Issuance of Units1 Capital contributions , Capital Calls, financing , Funding and New Equity:Key Planning and Drafting Issues forLLCs, LPs and PartnershipsCliff ErnstGravesDougherty Hearon &Moody, A Professional CorporationAustin, faced with the task of drafting formation documents for a new entity, there are several issues a lawyer and her or his client must consider, including what type of entity best suits the needs of the client and the situation, who will control the entity, what steps should be taken to comply with federal and state securities laws, and many others.

3 But perhaps the issues that are near the top of the list for most clients and in most situations are the financial considerations: how will the entity be funded and how will profits from the entity be divided?1 This outlinewill focus on the first issue, the funding of the entity, in the context of unincorporated entities (limited liability companies, general partnerships or limited partnerships) are often selected by practitioners and clients to own and operate ventures because of the flexibility offered by these structures in establishing the relationship among the entity owners. And while this flexibility makes the unincorporated entity a valuable choice, this same flexibility can impose an additional responsibility or burden on the lawyer to understand the needs and concerns of her or his client and draft documents that address those needs and concerns. This outlinewill attempt to address those needs and concerns as they relate to the funding of the entity.

4 To attempt to provide some clarity to these issues, they will be considered in a decision tree format, identifying forks in the road that the lawyer and the client will face as they navigate the decision process and examining the issues surrounding those decision forks and consequencesof the choices. From time to time sample contract language will be provided and referenced in the appendices to this last introductory matter relates to the decision to form a limited liability company versus a partnership. The issues surrounding that decision are outside the scope of this paper, and that choice will have little consequence for the issues related to the funding of the venture. 1A related issue that lawyers should always consider is how will losses be divided, although most clients rarely start new ventures or form new entities anticipating losses. A detailed discussion of the allocation of profits and losses is beyond the scope of this outline.

5 See Whitmire, Nelson, McKee, Kuller, Hallmark & Garcia, Structuring and Drafting Partnership Agreements through for a detailed discussion of this course, the nomenclature will vary slightly depending upon the entity chosen. The governing document for a limited liability company is called a company agreement,2while the governing document for a general partnership or limited partnership is called a partnership agreement or limited partnership The owners of a limited liability company are called members 4and the owners of a partnership are called partners .5 The governing person orentity of a limited liability company is the manager or the managing member 6and the governing person or entity of a limited partnership is the general partner 7. Generally speaking, limited liability companies are treated as partnerships for federal income tax Business and drafting decisions related to the initial funding of the entity (as well as other financial decisions related to the operations and termination of the entity) are not significantly impacted by the choice to form a limited liability company or a partnership.

6 For purposes of this the paper, no distinction will be made and the appended drafting examples provide alternative nomenclature for both types of author wishes to acknowledge and thank his partners and fellow practitioners (including opposing counsel in some instances) who provided him withsome of the examples of contractprovisions that provided a basis for the sample provisions included as appendices to this outline. The sample provisions included should not be considered forms to be completed by filling in the blanks. Drafters should be certain that any agreement used by them is appropriate for the particular transaction. The presence or absence of a particular term in these sample provisions should not be taken as an indication that the provision is or is not market standard . Versus first fork in the decisions road related to the funding of an unincorporated entity is whetherto treat the investor's investment as debt or equity.

7 Many people assume that an investor in an unincorporated entity will naturally want to be an owner of the entity, that is that the investment will be structured as equity. However, it is always valuable to at least consider that 2 TEX. BUS. ORGS. CODE ANN. (Vernon 2010).3 (A)(5) and (a).5 to the so-called check-the-box rules under the Internal Revenue Code of 1986, as amended (the IRC ), limited liability companies with more than one member are automatically classified as partnerships unless the company elects to be classified as a corporation (which is relatively rare). Treas. Reg. See McKee, Nelson & Whitmire, Federal Taxationof Partnerships and Partners, for an in-depth discussion of classification of partnerships and limited liability companies under the IRC, a topic that is beyond the scope of this certain circumstances structuring the relationship between the venture and the investor as a borrower/lender relationship may better suit the needs of the of Debt.

8 The advantages to a debt structure may include any of the of drafting: It is relatively easy to draft a promissory note and, if appropriate, a security agreement for a debt relationship. Drafting provisions for an equity investment in an unincorporated entity can also be simple or, as we will see later in this outline, can become quite of management and accounting: The establishment and maintenance of Capital accounts can be a complicated and somewhat burdensome processboth for accounting purposes and for income tax accounting and No special bookkeeping or accounting is required for a loan and most businesses and their financial advisers are very familiar and comfortable accounting for loans. One should always consider in a simple business relationship if the additional burden of partnership Capital accounting is Generally speaking creditors are paid before owners. The fundamental quality of debt is that of an unqualified obligation to repay the amounts advanced.

9 In general, equity is only repaid from the profits of a business. If a lawyer is representing the funding source ina transaction, this is animportant distinction for the clientto of Debt. There are potential disadvantages to the entity and investor ifthe funding is treated as debt, including the Sheet Considerations: If the funding is structured as a loan to the entity, thiswill of course be reflected on the balance sheet of the entity. This may be detrimental to the business in finding other sources of fundingor attracting other Loans. If it is contemplated that the entity will be seeking outside debt financing , then besides weakening the balance sheet of the entity, the presence of investor loans may also run afoul of requirements by institutional investors for a clean balance sheet, and prohibitions against other indebtedness,createconflicts over priorities against collateral (if the initial fundingloans are collateralized) and adversely impact the entity s ability to meet financial covenants.

10 An institutional investor will almost certainly require that any owner investors subordinate their loans to the loan by the institutional investor, which may complicate a relationship meant to be Issues: Even though investors often look to the manager of an entity to handle ongoing management decisions for the entity, they often wish to maintain some element of control regarding the entity by retaining the right to approve major decisions 9 See McKee, Nelson & Whitmore, Federal Taxation of Partnerships and Partners, through for a discussion of tax accounting and reporting obligations and strategies for the ability of a lender to control the management of the entity is limited and exercising too much control might create a risk thatthe lender would subject itself to lender liability : Usury laws limit the amount of interest that a lender may charge on A priority return on invested Capital is not subject to, or limited by, the usury laws.