Startup Financing -- Fixed BuyOut Certificates
FBO financing has been favorably reviewed by the SEC. For free
advice about FBOs, call us at (800) 872-5244 or email us at:
Short Description of FBOs:
If you buy stock in a company you get ownership and the possibility of gain. An FBO separates power from profit. There is no ownership and it is a long term investment (there is no market -- they can not be sold). If the company does well but not great, then the FBO is backed by a promissory note (which hopefully the company can pay). If the company does very well however, then (based on the total number of sales of a unit), all the FBOs trigger and must be paid out over a three year period.
The rate of buyout of an FBO generally is higher for those FBO which were issued early (when the risks were higher -- when there was say no patent, no prototype, etc.). Rates up to 20 or 30 to one for these might be reasonable.
One great advantage to the use of FBOs is that the company does not have to go public for substantial gains to be realized. Further, the usual case for startups frequently is that the initial sums needed tend to be less, so even though the buyout rates may be high initially, the totals are relatively low .The FBOs can be issued to employees, consultants and to others such as special suppliers. They are vested when issued, but they become binding only when triggered. The real skill is in setting the trigger point so that the buyout does not hurt the company. Further, it appears that the buyout money should not be treated as funds derived from profits but rather as a part of the cost of obtaining the financing. There are no IRS rulings on this. This approach keeps the equity in the company from being diluted. It means that control is never an issue.
Also FBOs have a partial or complete buyout provision which allows the company to buyout a troublesome investor at any time and thus avoid ugly litigation. One key aspect of the FBO is to attempt to match the risk involved with an appropriate buyout rate. Generally, this rate should decline with time and, for a mature company, should approach normal commercial bank lending rates. One item which is completely avoided is the normal SEC practice of valuation of the company when an IPO is involved -- since the buyouts are very specific, no such valuation is ever needed.
Income which the company may realize should not be deemed to be a "profit" -- which in a regular company, the investors might argue should be disbursed. Also, it means that the investors are betting on the management for the long haul -- and not on a shifting of top personnel as new tiers of financing are obtained. The use of FBO financing also eliminates much of the speculative aspect of investing. Most of the factors that are important in an SEC filing are usually still important. Nicely, the abnormal situation of trying to meet artificial benchmarks and/or quarterly deadlines as is frequently found with IPO related companies, is avoided. For many companies these are serious adverse and distracting requirements.
Should Your Company Use FBOs? [To raise needed capital]
FBO financing is suitable for many startup companies which have little or no current income and which have a real potential for generating substantial profits in the future. The following guidelines indicate the type of situation for which such financing may be suitable:
1. The required financing may ultimately reach $5 to $10 million and your company can qualify to use an SEC Regulation A filing. This will give your company the ability to raise money by advertising or by circulating announcements without the creation of a publicly traded financing instrument.
2. The initial startup costs for the company are fairly routine (e.g., patent costs, prototype development costs, testing, preproduction costs, etc.). The company is not a service company -- it produces a tangible product.
3. The overhead costs for the company are anticipated to increase before any substantial income is realized.
4. The owners and/or management wish to retain ownership without dilution of their equity. They also desire to provide substantial compensation to early participants (as a function of the actual level of risk).
5. It is not desired to issue an IPO which would thereby create a publicly traded security.
6. The effective separation of profit from power which the FBO approach allows (i.e., the absence of voting rights which would be associated with stock) is not objectionable. Note that the lender/investors are in for the long haul. The financing provided is completely illiquid -- no market is created through the use of these certificates and/or notes.
7. Meaningful sales volume for the company's product(s) can be projected to commence within 3 years.
8. There are no complications with regard to the company, its management or with the principal markets involved (e.g., patent litigation, etc.).
How does an FBO work? An FBO can be drafted in two basic ways. For purposes of obtaining financing, an FBO certificate should be drafted in association with a debt instrument.
If the FBO certificate is not triggered because the company's product(s) did not reach a given sales level as set out in the FBO certificate, then the only compensation for the investor/lender is payment of the debt instrument (the promissory note). This approach (as compared with equity held in a stock issue) seeks to preserve the capital through the use of a debt instrument. Normally the FBO certificate which is associated with a debt instrument pays some multiple of the amount of the debt instrument. When the FBO is used as a form of compensation or reward to employees, consultants, suppliers or others, no associated debt instrument is used. The triggers used for both types of FBO certificates can and normally should be the same. Both types of FBO certificates can be used together by a company. If the triggers are properly selected, the result is that the company should be in a good position to pay off the triggered FBO certificates. Further it appears that the payout (also called a buyout) probably can be termed an expense rather than a distribution of profits. There are no IRS rulings on this issue however.
FBOs also are easy to use on a non-registered basis (i.e., on a private placement basis). Free sample FBO forms are made available for use by the public (see above). Before using FBOs, you should consult a lawyer to determine it they are appropriate for your situation, however you can also call us at (800) 872-5244 for free advice.
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