The COVID-19 pandemic is presenting businesses and individuals with a new set of financial and legal challenges. To help our clientele during this time, Salcedo Attorneys at Law P.A. has compiled a series of articles on resources and considerations we deem useful to help you navigate the current scenario.
The pandemic forced many businesses into discontinuing or significantly changing their operations. Others have seen a decrease in customer demand for their products and services as consumers switch to more defensive spending practices.
This translates into the possibility of a liquidity crisis, a sudden reduction of cash flow that can prevent a business from meeting its key obligations to employees, landlords, suppliers and lenders. The options available to businesses to overcome the cash crunch fall essentially into three categories, which are discussed below.
1. Seeking debt financing
In a previous article, we discussed the financing options that have become available to small businesses under the Payroll Protection Program (the “PPP’) and the Economic Injury Disaster Loan program. Should this options no longer be available, businesses may consider resorting to traditional financing options, from banks or non-institutional lenders. A healthy balance sheet and available collateral will greatly help in finding available opportunities. If you have an established relationship with your bank, this is the time to contact them to inquire about establishing new lines of credit or refinancing existing debt.
2. Self-funding your business
If lending options are not available, you and your business partners (used interchangeably to refer to shareholders, LLC members and partners) may have to provide the additional capital required to keep the business running. Not all partners may be willing or able to make contributions in proportion to their equity interest in the entity. This will require a reallocation of the partners respective equity interests which will have to be properly documented and reflected in the entity’s records.
Alternatively, the partners may seek to become themselves lenders of the entity. This option, which can at times generate long term positive tax effects, will have to be evaluated carefully to avoid incurring in “thin capitalization” issues and, similarly to equity financing, will require proper documentation of the loan terms.
3. Accepting new investors
If none of the partners can provide the entity with the additional financial resources it requires to continue operating, this may be the time to add a new investor who will acquire an equity interest in the entity in exchange for a contribution to the Company. This will inevitably result in the existing partners’ interest being diluted, including their voting rights and their rights to future distributions. The issuance of an equity interest to a new interest will require a review of the entity’s organizational documents to ensure compliance with, among the others, preemptive rights provisions. The tax aspects of the contribution will have to be also considered carefully, particularly in the case of non-cash contributions. Finally, it may be necessary for the new investor to sign off the existing organizational documents or enter into new organizational documents reflecting changed governance provisions.
Broken corporate records may generate future disputes among partners, delay future lending opportunities and cause uncertainty as to each party’s rights and obligations. Similarly, signing on loan documents without the review of an attorney may result in unintended or unforeseen circumstances. The assistance of a competent attorney will prove crucial to avoid pitfalls in any of the three scenarios described above.
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