FBO -- Low Buyout Rate (example)

11 Jul 2008 -- Good afternoon,

We are starting a brewery and are thinking of using FBOs to finance the operation rather than give up equity. We have several questions:

1. Can we file for an exemption under Regulation D and still use FBOs or do we have to file under regulation A as discussed on your website?

2. Offering a return of 20 - 30 times the principal investment is not a reasonable offer for us as the projected revenue streams do not support such high returns. For us something like 2-3 times, maybe up to 5, is far more reasonable and logical. Is this still a worthwhile return for an FBO?

3. What would a reasonable interest rate be for the promissory note of the FBO?

Thank you for your help with this, and if you have any other information or advice on FBOs, we would be grateful for any information.

Thank you, Matt D

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Dear Matt D:

Thank you for your email. We will try to address the issues you have raised.

First, I should say that the feedback from the SEC and from the California securities staff has generally and specifically been very favorable with regard to the use of FBOs. The primary reason for this seems to be that they don't have to place a valuation on the certificates -- normally this is always a major headache for them for other participation methods. The other reasons seem to be that the certificates are initially not vested, that they are backed by (unsecured) promissory notes (generally corporate paper is completely unregulated) and that they are not marketable. The commitments for the notes can be personal, corporate or both. The FBOs are general contingent obligations of the corporation.

The buyout and the trigger should be the same for all types of issues (at a given moment in time) -- that is, if you wish to compensate a consultant (in addition to paying a normal consulting fee), you can also give him/her an FBO related to the value of the services (but without a note). The buyout rate however should be the same as would be given to regular investor/lenders. The reasoning is that everyone shares a given level of risk at a given moment and so the rate for any FBO issued at that time should be the same. Note that FBOs which are issued without a note encourage bystanders (consultants, vendors, etc.) to be rooting for you to really make it -- they win on these only if the FBOs are triggered.

As to your questions:

1. [use of Regulation D versus Regulation A] I am not a securities lawyer. Further, even if I was a securities lawyer, it would not help much on this issue. Part of the problem here is that there are no statutes or regulations whatever which address the use of FBOs (actually none are needed). Both Reg A and Reg D filings require substantial and detailed disclosures. I would not like to try to guess what response you would get, however if you otherwise fully qualify, I can perceive of no reason why there should be a problem in seeking a Reg D exemption. If you try it and do have a problem, please let me know what happens.

2. [buyout rates] For investors, the buyout rate is the rate less the note (20:1, is 19:1 if the note has already been paid). The idea is that the rate given should shrink as the risk is reduced. If the risk is low, then the rate should be low (2:1 or 3:1 is fine; actually you can fine tune this -- e.g. 2.456 to one). FBOs really serve to provide non-equity financing to a point in time when commercial lines of credit are routinely available. Note also, that if you (need and) raise X dollars at a Y buyout rate, the company is then stronger. Then, if you (immediately) raise another X dollars, a lower buyout rate Z would be justified (which implies that the second X dollars are largely cash reserve).

If you file with the SEC/state authorities, it is best to determine what all of the financing you could possible use might be and to proceed to raise only a portion of this initially. Then, if you need more, it (largely) becomes a discretionary matter with the company. You might also think of just using a private placement approach -- which means no Reg D/Reg A filing at all (if you can find a few investors for the venture). Note that most securities laws relate to equity/bond issues and are concerned with fairness in the marketing of the securities. However, FBOs are completely illiquid. If you buy in (or get one) -- you are in for the ride. There is virtually no speculation here. The primary concerns (aside from fraud) of the SEC are absent.

A buyout rate of 2:1, 3:1 and on up still justifies the use of FBOs. The reasoning here is that you want to separate profit from ownership/control. One of the major reasons for using FBOs is to allow this separation to be reasonable for all parties. The really tricky part here is to set a reasonable level for the trigger. The buyout normally should be over a three year period (to avoid a hardship on the company) -- however it is wise to make the manner and timing of the buyout of these discretionary with the company. There are no IRS rulings on this but if there is a good business reason for retiring certificates on a flexible (or arbitrary) schedule (other than pure tax avoidance), they probably would not complain.

One item here; it is not good to tie the trigger to a dollar amount (of sales) -- it raises many unwanted issues regarding pricing and discounts. For your product, it would be best to tie the trigger to the actual total (or annual) physical volume (gallons) sold (say, as projected 18 months out). Note that there is NO time limit on the trigger (this provides a lot of flexibility). Generally once set, the trigger should not be changed.

[promissory notes; rate] These notes are designed for the bad day -- when things do not go well. It is hard in life to foresee all of the hazards and difficulties which can arise. These are unsecured notes (basically just corporate paper). These are normally 3 year notes and are in place in case the trigger is never reached. They are there to provide for the return of the capital which was invested if the venture languishes. If for example there is bankruptcy in the future (say from adverse litigation), the notes would then have no value (but then neither would the related stock). They would have priority however in bankruptcy over stock.

It is best to think of the rate for the notes as part of the overall bargain being made -- the major factors being (1) the need of the company for capital and the related risk, (2) the buyout rate, (3) the time for the notes to mature and (4) the likelyhood of having the certificates triggered. This is a judgment call. Personally, I would go with a higher interest rate and a lower buyout rate. If you issue a series of FBOs over a couple of years, the buyout rate used should be progressively lower for the later ones (since presumably you have created a steadily increasing cash flow and related profitability), then the rate on the notes can be held constant. Think of the notes as a form of insurance for the investor -- a healthy rate is fine (we currently use 8%).

Also -- if you read the notes carefully you can see that these notes are taken directly from notes as issued by major financial institutions (e.g., banks) -- they can survive a lot of grief.