Whether you are an Angel investor or just someone who helped a friend fund her company, you need to be aware that a business failure while holding unpaid debt will create a tax liability to its share holders if structured as a tax pass through.
I recently gave advise to a friend who faced such scenario. Excited for its potential, he had decided to invest in a company. In exchange, he received 25% of the shares. He originally found the opportunity as the company's landlord. When the business failed to make an on-time rent payment, the business founder explained the fact that he had to bootstrap operations to keep the company and its great potential alive. The business was part of an industry with a growing trend, so the upside was great. Furthermore, the founder was a highly enthusiastic and all around great guy who had the deep technological knowledge needed to succeed in its industry. The investment seemed both emotionally and fundamentally warranted.
When the company continued to have poor cash flows, evidenced by the repeated failures to pay rent, my friend turned down a requests to provide additional funding out of fear of ending up too deeply invested in a potential failure. While not ideal, he was somewhat fine losing his initial investment but did not want to risk any more. Nonetheless, he felt that the upside potential demanded that he help the business find individual lenders to help keep the momentum going. Without much to show in the form of success, the company had to pay a premium for borrowed money. Unfortunately, paying such premium made it more difficult to make the company break out of its base. The outcome potential became purely binary. Either things would eventually make everybody lots of money or the business would soon collapse due to the weight of its business debt.
The obvious problem for my friend was that he was stuck with an investment that made it difficult to sleep at night. On the one hand, a failure would result in an unexpected tax bill for any unpaid loans, due to the business' pass through status. If a $100K loan went unpaid, for example, he could suddenly owe around $8K in taxes. On the other hand, if the business flourished, he would not be able to participate beyond his 25% stake despite having given the business free rent on multiple occasions. He needed to find a way to manage his position. So I suggested what is called an Option Strangle. Yes, this is a real financial solution despite it sounding more like a bad horror movie.
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To buy a Put Option, my friend simply had to pay the premium price to the company's founder. Of course that there is the need for a Put Option contract to record the transaction and make everyone's responsibilities clear. There are many Put Option contract samples online. A Put Option grants my friend the right, but not the obligation, to sell his 25% of the company to the founder at a pre-agreed price before the Option's expiration date. To make sure the deal happened, I suggested that the pre-agreed price, also known as the strike price, be low; perhaps a dollar. The goal was not to sell the shares at a value higher than their market price right before collapse. Instead, the intention was to accumulate capital losses from his bad investment to reduce other tax liabilities while eliminating the ownership share that could end up creating a surprise tax bill because of any unpaid debt. Remember that a Put gave him the right to sell, which means that the company founder had the obligation to buy the shares.
The rights from owning an Option can be exercised at any time before the Option's expiration date; a date that could be as far into the future as necessary. In any case, it is also possible to close one Option and then buy another one to extend the protection period if the expiration date ends up happening too soon. Think of the fact that car insurance expires at the end of one year and must be bought again and again every year. In fact, Options are insurance devices where the price paid is in essence the premium of the insurance policy.
The second part of the Option Strangle requires the purchase of a Call Option from a company stock owner. In my friend's case, he needed to write an Call Option contract with the founder. A Call Option gives the right, but not the obligation, to buy additional shares at a pre-agreed price. Here, the founder would have to sell the shares to my friend upon my friend's request. If, on the other hand, my friend did not want any more shares, he could simply let the Option expire without exercising his right. The reason behind the Call Option was to convert unpaid rent into company equity in the future if things improved. I suggested that the pre-agreed price, the strike price, be defined by the present share price minus the amount of the free rent. Consider the fact that the Call Option contract must specify how many shares are available and at what strike price.
I further suggested that my friend use part of the free rent he already gave the company as payment for both Option premiums. This would allow him to protect his position against a downturn while gaining from any upside at no additional cost.
Remember that you must first check with your CPA on all tax related matters. I am not a tax specialist nor am I offering tax advice. I am also not legal counsel. My goal is to simply highlight the fact that there is the need to be better informed about these issues and that there are powerful solutions that could help you in case you find yourself in the same position.
I know well that the strategies I cover here are much more sophisticated than what is the norm for most business people. But you should learn them nonetheless. These are instruments that have wide use throughout the financial markets. I find that there are great possibilities for investors who are willing to break out of the proverbial box. To me, success in business is all about an open mind and an insatiable desire to solve challenges. Feel free to share your challenges with me. Together we may come up with solutions that will surely help many business owners and investors.