May 2, 2012

Raleigh, N. C. The Social Science Research Network (SSRN.com), the world’s #1 Open Access Repository for scholarly articles (http://repositories.webometrics.info/toprep.asp) has cited, “HOW CROWD FUNDING SOLVES ONE OF THE BIGGEST CAPITAL MARKET GAPS IN AMERICA”, as one of the most widely downloaded economic articles in the world.

According to data compiled and released by Michael C. Jensen, Chairman of the Social Science Research Network, the paper by Thomas Vass was top 10 rated in the Entrepreneurs and Finance Topics Category on the SSRN global platform.

The paper available for free at: http://ssrn.com/abstract=2031051.

”I wrote the paper to alert executives of private technology companies about new funding opportunities under the new JOBS Act,” said Vass. “Most of the media attention about crowd funding has focused on the opportunities for startup firms, but I think the bigger story is about growth capital for existing firms that are over 3 years old,” he added.

Vass noted that he manages a crowd funding website called The Private Capital Market that allows private companies to raise either debt or equity or to obtain a commercial bank loan through a process called a direct corporate private offering (DCPO).

“The JOBS Act is a game-changer for the world of private equity in the United States,” said Vass. “I believe that the new provisions for raising capital will go a long way to solving one of the biggest capital gaps in America for small private technology companies.”

About Thomas Vass: Vass is a regional economist and fee-based investment portfolio manager located in Raleigh, N. C., and the author of Predicting Technology: Identifying Future Market Opportunities and Disruptive Technologies, (2007) which explains his theory of technology evolution. He is currently ranked in the top 2.5% of all economists on the SSRN platform and his papers are available for free at http://ssrn.com/author=831853

Thomas E. Vass, President, The Private Capital Market, Inc.

A Historical Entrepreneurial Opportunity If Only The Elected Representatives Will Seize It

A recent revision to the 1933 Securities Act allows small companies to raise small amounts of capital using the internet to attract potential investors. Section 4 of the Securities Act of 1933 (15 U.S.C. 77d) was amended to allow companies to solicit investors via internet social media.

The 1933 law contained two barriers to raising capital that were no longer valid in the era of the internet. The first prior barrier concerned public solicitation of investors, and the second barrier concerned a minimum net worth of $1 million for potential investors.

Under the new law, private companies can raise up to $1 million a year, with the provision of non-audited financial statements. Companies can raise up to $2 million if they provide audited financial statements to potential investors.

For investors with an annual income under $100,000, the limit of investment in a single company, per year, is the greater of $2,000 or 5 percent of the annual income.

For investors with annual income or net worth is greater than $100,000, the investment limit per year is 10% of income, up to an annual cap of $100,000 total investment for all company investments.

Most of the media attention on the new law has missed the historical significance of how the law’s provision of small amounts of capital will stimulate technological innovation. And, all of the press on the new law has missed the story that most of the social media for small companies will occur in distinct metro regional economies.

In other words, the big story of crowd funding is that local companies will be able to obtain local capital using internet social media. The local capital investment will stimulate technological progress, and create stable high-paying jobs.

The new law presents the citizens of North Carolina with a historical economic opportunity, if only the elected leaders of the state will seize it.

Seizing The Local Social Media Innovation Moment

Internet social media allows for the creation and exchange of communication. Nothing about the new crowd funding law, however, changes the local dynamic of raising private capital. Most capital is currently raised within 50 miles of where the company is located, and that fact is not going to change because of the new law.

What the new law does, however, is create a new way for local knowledge to be shared in a local geographical setting, which is called local social capital. Social capital combines with investment capital to create the conditions of local technological innovation.

In their research article, “A New Social Network Built on the Ashes of the Old Social Network,”  Shaul M. Gabbay and Roger Leenders, (1999) identify the most important resource that small manufacturers have in competing with the large corporations, which they called corporate social capital.

What they concluded was that small manufacturers had a potential advantage over large corporations if the small manufacturers replicated  the corporate technical knowledge in local social business networks.

In their research, they described social capital as “the set of resources, tangible or virtual, that accrue to a corporate player through the player’s social relationships, facilitating the attainment of goals. The assets from which entrepreneurs or entrepreneurial teams in deal-making and competition are embedded within and made available through social networks, or alternatively the assets entrepreneurs look for to strengthen their strategic position may be found in new social networks and through networking.”

In “The Locus of Innovation in Small and Medium-sized Firms: The Importance of Social Capital and Networking in Innovative Entrepreneurship,” Willem Hulsink, Tom Elfring and Wouter Stam (HES) describe how local economic communities are replacing large multi-national corporate innovation networks by organizing new social capital networks to promote economic innovation. (ERIM Report Series, ERS-2008-041, July 2008).

They find that the source of new information and ideas in knowledge-intensive industries is explored and exploited collectively by local inter-firm partnerships and mutual learning.

Using a stratified random sample of 227 manufacturers located in the Midwest of the United States, they investigated a hypothesis regarding the relationship between bridging ties, participation in regional institutions and the acquisition of competitive capabilities by firms operating within the same geographical cluster.

They found two important results:

• Entrepreneurs with heterogeneous networks are significantly more likely to engage in innovative behavior than those with homogenous networks. This suggests that diversity combines the feedback benefits of social ties with the lack of pressure to conform associated with directed ties.
• Entrepreneurs with ties that are directed at the concrete activities of other actors are found to be more innovative and those with ties directed to the abstract discussion of ideas in expert discourse (e.g. the business press) to be less innovative than entrepreneurs relying on weak ties.

HES explained in their research that innovation requires various kinds of input, skills and combinative capabilities. They cited the work of Thomas Edison and James Dyson who put inventions together from what they already knew and recombined existing ideas and practices from other industries and innovators.

They noted that “Many SMEs have insufficient organizational resources, knowledge or capabilities to develop innovations by themselves. These are all reasons why smaller firms may seek larger parties for the purposes of collaboration in social networks that provide a context for social action.”

Andrew B. Hargadon (2003) has also presented evidence about the sources of local knowledge networks in small manufacturers. He notes that there is an inherent paradox in the innovation process: on the one hand, innovators need wide-ranging ties from distant environments to generate their sketchy innovative ideas, mostly about how new products may work. On the other hand,  Hargadon noted that small companies needed the backing of solid and determined local partners to mobilize support for their emerging innovations.

Interestingly, Hargadon found that those determined partners are drawn from the same universe of small manufacturing firms who constitute the regional social capital networks.

North Carolina’s New Technology Small Manufacturing Innovation Strategy

In a prior time, around 1985, the RTP’s social capital networks for innovation included scientists and engineers from the large corporations who had been recruited to open branch operations in the regional economy during the late ‘60’s and 70’s.

The large companies bought goods and services from the small RTP manufacturers, who absorbed much of the internal corporate knowledge of the large corporations. This two-way trade between large companies and their small North Carolina supply firms proved very successful for a short period of time.

Most of those innovation research functions at the MNCs have been re-located to India and China, where the large corporations now buy goods and services from the small manufacturing communities in those countries.

The experience in the RTP is exactly the same as the experience in North Carolina’s other 7 metro regions. When the big companies left the state, they took both jobs and the ability for small manufacturers to innovate with them. The state’s over-reliance and dependence of small manufacturers on the large corporations did not work.

The state’s economy never recovered from this experience. But, a new strategy based on small manufacturing would re-start the state’s economy with exactly the same magnitude of income and employment multipliers for economic growth, as was the case in 1983 with the state government’s forecasts of economic decline.

In December of 1983, the North Carolina Department of Labor distributed a research paper to other state government agencies entitled “The Economic Development and Labor Market Implications of Computer Integrated Manufacturing in North Carolina.”

The two most important findings of the research were that:

• By the year 2000, only 7% of the North Carolina labor force would be employed in manufacturing. The estimate for employment in manufacturing was about 245,000 workers in manufacturing, down from 824,000 in 1980.
• By 1997, the Department of Labor predicted that 90% of the lower skilled jobs in N. C. manufacturing would be eliminated and 65% of the mid-level skilled jobs, including managers and supervisors will be displaced.

The direct loss of jobs in manufacturing would lead, said the report, to dramatic loss of income and jobs in other sectors of the state’s economy, as a result of the income multiplier effect of lost manufacturing jobs.

“In other words,” the report noted, “for every dollar of income withdrawn from the North Carolina economy as a result of labor displacement in the apparel industry, for example, an additional 79 cents of income is withdrawn from the state’s economy.”

The average range of lost income as a result of labor market displacement in the top 6 industrial sectors was about 65 cents. In other words, the report predicted that, as the large corporations moved their production facilities off-shore, the state’s economy would suffer a loss of 65 cents for every dollar lost in production.

When the state’s over-dependence of small manufacturing firms on large corporations is replaced with a new reliance on local technological innovation partnerships in metro regional industrial value chains, the income and employment multipliers of decline would turn into economic growth multipliers.

This is the fundamental economic fact of life that the state’s elected leaders must grasp. The old economic strategy of industrial recruitment did not work because it did not produce lasting economic prosperity for the state’s citizens.

Seizing The Historical Opportunity Presented By Crowd Funding

“More than ever before in financial history,” wrote the New York Times in 1919, “the small investor in the United States may be an important factor in financing business and building.”

The New York Times was reporting on a new idea in New York to pool the capital of small investors into a type of “fund” that would have trustees that would direct the capital to small businesses. (Small Investors Wanted, Published: April 27, 1919 Copyright © The New York Times).

The Times concluded their story by suggesting that a market mechanism needed to be created that allowed small companies to easily meet small investors. Citing the U. S. Department of Labor, the article stated, “It is essential, in the opinion of the Department of Labor, to devise ways and means of availing of the small investors’ capital.”

Soon thereafter, the U. S. economy was engulfed in a terrible economic decline that precipitated the passage of new government regulations on raising capital, among them the 1933 Securities Act. Some of the onerous regulations of that Act have now been amended by the passage of the JOBS Act in 2012.

The provisions of the Crowd Funding Act do not change the dynamics of local economic growth, they only change how investors and entrepreneurs can communicate, via social media, about investment opportunities.

The great majority of capital for both existing small manufacturing firms and for startup ventures is currently raised, and will be continued to be raised, within 50 miles of location of the firm.

This same 50-mile envelope also influences other important factors related to the commercial success of small high tech manufacturing firms.

Most knowledge about technological innovation is created and diffused in face-to-face communication networks (tacit knowledge) within 50 miles of the borders of a metro region. Most of that knowledge will be continued to be shared among a region’s firms in the regional industrial value chains.

And, in terms of the veil of trust for engaging in risky private investments, the extent and range of trust, and the ability to extend trust to strangers in capital market transactions, occurs within this 50 mile envelope.

The highly skilled workers for most scientific and engineering small firms live within 50 miles of where they work. The pool of scientific and technical skills in the local labor markets is a precursor agent in both coming up with new ideas for product innovation and providing the occupational infrastructure to implement and commercialize new product ideas.

Seizing the historical opportunity presented by crowd funding in North Carolina means that elected leaders must allow the creation of a private sector regional capital market infrastructure in eight metro regions so that investors and companies (buyers and sellers of capital) can transact business in a local setting.

In their research, “Entrepreneurial Theory and the History of Globalization,” Geoffrey Jones and R. Daniel Wadhwani, describe the historical interplay between an individual’s act of entrepreneurship and the surrounding environment. (Business History Conference, 2007).

“Studies using controlled experiments,” they wrote, “have revealed the importance of individual self-efficacy in determining if a subject interprets information from the market as an opportunity. A subjects’ perceptions of their self-efficacy shape whether or not they interpret a development in the market as an opportunity they can exploit. One relevant finding is that organizations can nurture or suppress the perceived self-efficacy of their employees and managers.”

The big story of crowd funding for North Carolina is that local companies will be able to obtain local capital using internet social media. The local capital investment will stimulate technological progress, and create stable high-paying jobs.

The new law presents the citizens of North Carolina with a historical economic opportunity, if only the elected leaders of the state will seize it. In other words, if only they will create the political environment that nurtures, and does not suppress, the entrepreneurial initiatives of the state’s small manufacturing firms.

Crowd funding, based upon internet technologies, provides the mechanism for local investment of capital from one generation of technological innovation to the next, unleashing a torrent of capital and an explosion of job creation in the state’s eight metropolitan regions.

About Thomas E. Vass: Vass is fee-based investment portfolio manager and regional economist located in Raleigh, N. C. He is the author of Predicting Technology: Identifying Future Market Opportunities and Disruptive Technologies, (2007) which explains his theory of technology evolution. His theory formed the basis of his 2007 patent that explains his method for selecting technology stocks for inclusion in an investment account. He manages online crowd funding websites, among them, The Private Capital Market.com.  Please visit his economic research papers on the Social Science Research Network (SSRN) at  http://ssrn.com/author=831853

Thomas E. Vass, President, The Private Capital Market, Inc.

The Jumpstart Our Business Startups (JOBS) Act As The Solution For AWOL Venture Capital

Both the U. S. House and the Senate have passed versions of the JOBS Act, and both versions contain new provisions that allow private companies to raise capital from “crowds” of investors. The crowds are the alternative to the monopsony that currently exists in the venture capital and angel marketplace.

Most of the public commentary and media attention has focused on how the JOBS Act will impact the capital market gaps for new ventures and entrepreneurial firms.

The New York Times cites Alon Hillel-Tuch, founder of the crowd funding platform, RocketHub, who states, “The initial stage, the seed stage, where people who are just looking to launch their product, they’re the best candidates for crowd funding. When investors discuss seed-stage companies, they’re usually referring to companies with prospects for tremendous growth — the sort of companies that ultimately rely on venture capital funds.” (Which Crowd Funding Bill Will It Be? Robb Mandelbaum, NYT, March 27, 2012).

The New York Times story correctly points out that the venture capital industry is not likely to be attracted to companies that raise capital through the crowd funding process.

But, do not shed crocodile tears for the VCs.

Industry statistics on VC funding indicate that only about 2 out of 10 companies that seek venture capital obtain funding, and that about 60% of all firms that actually obtain venture capital are terminated by the venture capitalists within 3 years of funding. This VC approach to investing would be called the Dr. Kervorkian model of capital funding.

In contrast to the capital market gaps for startups, most established firms, with real top line sales revenues, are generally not viable candidates for venture capital because the established firms do not have a clear path to an exit that results in a rapid capital gain for the venture capitalists or angels.

In addition, for many established technology companies, the amount of capital needed to fund growth, generally less than $1 million, is too small to interest venture capital, and the type of capital needed by the company does not fit the type of securities that the venture capitalists most prefer as an investment vehicle.

The venture capital community has a lot better public relations image than perhaps is warranted. The venture capital part of the capital markets was never going to solve the capital gaps that exist for small established technology companies.

The Jumpstart Our Business Startups (JOBS) Act Solves The Biggest Economic Problem In America

Jobs. Jobs. Jobs.

The biggest economic problem in America is the lack of jobs. The rate of job destruction for the past 15 years, mostly in large multi-national corporations, is much greater than the rate of job creation, mostly coming from established technology companies that are over three years old.

Brand new entrepreneurial startup companies do not create many new jobs, but established companies, with real life top line revenues from product sales, create most of the new jobs.

The statistics and evidence on job creation indicate that by the end of their third year, most 3-year old technology companies employ about 3 workers, including the owner/founder. At age 3, these young companies need a slug of growth capital, generally less than $1 million to get the next generation of new product out the front door and into the market.

If the companies obtain the second round of capital at age three, the evidence shows that the number of jobs increases from about 3 to about 7 workers. This spurt in jobs is one very important source of job creation in America.

But, it is not the most important source of new jobs.

If the company can stay alive to age 7, it will need another slug of capital, generally less than $1 million, to get the third generation product out the door. If the company can obtain this subsequent round of capital, the rate of job creation is exponential. The number of jobs increases from about 7 workers to about 20.

This third round of capital creates the Mother-Lode of new jobs in America. And, it is this third round of funding that will be solved by crowd funding allowed under the JOBS Act.

“Fend For Yourself” and Crowd Funding

In his careful legal review of early crowd funding efforts, C. Steven Bradford, the Earl Dunlap Distinguished Professor of Law, University of Nebraska-Lincoln College of Law, noted that “…none of the current exemptions from registration fit the crowd funding model. Second, the web sites that facilitate crowd funding may be treated as brokers or investment advisers under the ambiguous standards applied by the SEC.” (SSRN, 2011).

The new JOBS Act provides some legal guidance to the ambiguity about internet crowd funding offerings cited by Professor Bradford.

Even before the passage of the JOBS Act, Bradford provided some data on the importance of the new method of raising capital. He noted that as of late July 2011, over 600,000 different Kiva lenders had loaned over $225 million dollars to almost 600,000 entrepreneurs. Peer-to-peer lending, just one form of crowd funding, has alone been responsible for over a billion dollars in funding, and some industry analysts believe peer-to-peer lending could exceed $5 billion annually by 2013.

Prior to the JOBS Act, Bradford reviewed how the U. S. Supreme Court held in the Ralston Purina case that the exemption from registration of securities “…turns on whether the offerees (i.e. investors) [need] the protection of the 1933 Securities Act or if they are able to “fend for themselves.” Subsequent cases have focused on the sophistication of the offerees and their access to information about the issuer.”

The Court’s emphasis on investors being able to  “fend for themselves” will not be discarded under the provisions of the new JOBS Act.

Why Geographical Closeness Counts In Internet Crowd Funding of Established Technology Companies

As a result of crowd funding it is more likely that local investors will begin to make more investments in local companies that they discover on internet capital matching websites. Just because an investor finds a company on the internet does not mean that the investor takes leave of her common sense in investigating the merits of the opportunity.

Geographical closeness in crowd funding will continue to be an important component of investor due diligence and fending for oneself, just as it was prior to the JOBS Act.

In their research on the causes of success in biotech ventures, entitled “Towards an Evolutionary Model of the Entrepreneurial Financing Process: Insights from Biotechnology Startups,” Tom Vanacker, Sophie Manigart, and Miguel Meuleman (VMM), (Working Paper, University of Gent, July 2008), described two reasons why “closeness” counts for private capital market investments.

“Using multiple longitudinal case studies of young biotechnology firms,” they wrote, “we study differences in the financing process between high and low performing firms. Findings suggest that initial differences in the specialization of the investors with whom entrepreneurs affiliate early on, affect the ease with which firms attract (specialized) follow-on financing and firm performance. We demonstrate the role of the social context in shaping initial financing outcomes, as entrepreneurs limit their search for financing to one or a few investors with whom they have pre-existing ties.”

There are two components of closeness that combine to provide the ingredients to successful biotech companies. The first ingredient is the closeness of capital to fund the start-up. In both the VMM research, and confirmed by other research on sources of capital, it is widely understood that most investors in high tech start ups live in the same metro region as the new venture.

The evidence suggests that most technology firms raise all rounds of capital from investors who live within 50 miles of the company.

The second ingredient of success related to closeness is much more subtle, and carries an odd nuance of interpretation in the English language for a word that can have more than two meanings.

In most English translations, the word close carries the geographical connotation, as it is used above for the closeness of capital in proximity to the company. In this case, close counts because he investors want to be close to the company to observe the progress of the company and to “kick the tires” when the mood for kicking strikes.

The second interpretation of close involves a social and emotional connotation. Successful biotech firms are “close” to their sources of capital and close to the community business networks that support and sustain their success.

This second usage of the word close is more aligned with how Joel Mokyr, of the University of Chicago, uses the term when he writes that new ventures must be born into a “sympathetic” environment. The term close in this second context means close in terms of interindustry trading partners in the local supply chains.

In their research, VMM highlight both elements of closeness as it relates to biotech firms. As they note, “the search for financing is local. The notion of local search is a relative term and presumes a broader context (Stuart & Podolny, 1996). We define local search in the financing process as the search for financing from investors with whom the entrepreneur or firm has pre-existing ties as opposed to unrelated investors. Why do entrepreneurs limit their search for financing to one or a few investors with whom they have pre-existing ties despite the strategic nature of their decisions? The cases suggest that the social context is important as

(a)    it helps in locating potential investors,

(b)   it shapes norms, values and taken-for-granted assumptions about what constitutes appropriate economic behavior and

(c)    it helps in assessing the quality and intentions of investors.

As VMM note, “Historical financing decisions have a substantial impact on the subsequent financing process and firm performance as a whole.”

Small Amounts of Capital Via Crowd Funding

In his research on small high tech firms in Canada, Stephan Rousseau examined how the internet could substitute for larger capital markets by providing information services more suited for the “small ticket” problem of most existing biotech firms.

In his article, “Internet-Based Securities Offerings By Small and Medium-Sized Enterprises: Attractions and Challenges,” (Canadian Business Law Journal, 2001), he documented how the large centralized capital markets routinely and systematically underpriced the small offerings of small firms.

As he noted, “The results showed clearly that the degree of underpricing varies negatively with the size of the issue. Thus, issues of $1-9.9 millions were underpriced by 23% on average. Issues of $10-49.9 millions experienced underpricing of 10%, on average, while those of $50-99.9 millions of 15.6%. The largest issues of the sample ($100-199.9 millions) were underpriced by as mere 4.2% on average.”

Underpricing means that the capital market services for small firms allowed investors to capture an immediate 23% unearned capital gain on the day of the offering. In other words, the 23% underpricing went into the pockets of the investors and investment bankers, and not into the pockets of the firms that needed the capital.

In the language of Wall Street, this underpricing is called a “haircut.”

Part of the solution for underpricing advocated by Rousseau was the use of the internet to provide more transparent information on the small ticket problem in the initial rounds of investments. The internet works well, but must be connected to the geographical location of the firms, because investors like to invest in local firms.

Crowd Funding And The Secondary Market of Private Securities

After investors make the first round investment, they like to make a profit by selling their securities in a secondary market, primarily to other investors located in the same geographical area.

Rousseau’s emphasis on linking the initial rounds of local capital markets to subsequent rounds addresses the main issue related to the Dr. Kervorkian method of capital. The secondary rounds provide liquidity for exit events in secondary equity markets so that the early investors could take their gains without killing the growth prospects of the firms.

Crowd funding allows for both raising the early rounds, and for sales of securities in the second rounds of capital.

In “The Role of Proximity In Secondary Equity Markets,” Dariusz Wojcik documents that close also counts in the secondary markets. He writes, “geographical proximity, has significant implications for: investors (in terms of performance and trade-off with liquidity); investment industry as a whole (in terms of size, structure, and strategy); issuers (in terms of access to capital and liquidity); communities (in terms of herd behavior and financial literacy).” (Managing Financial Risks: From Global to Local, Forthcoming with Oxford University Press in 2009).

Crowd funding under the JOBS Act is the very first step in providing the market exchange infrastructure of local capital markets. The new marketplace infrastructure will eventually include transactions for the early rounds and subsequent rounds of capital for a individual company, as well as subsequent exchanges of  secondary capital.

In other words, the JOBS Act is the beginning of the creation for local capital markets that aim at serving very small local firms who need very small amounts of capital, who happen to create about 100% of the new jobs in America.

Internet based local crowd funding will tend to organize local social business networks into a coherent capital market that targets investments to the region’s most promising technological innovations. The local social business networks on the internet will eventually become the equivalent of institutional investors on Wall Street.

The most important function of crowd funding in regional capital markets, however, is not the initial investment in a single firm. The most important function is that crowd funding in the regional markets will provide a pathway for profits from the exit events to be re-invested in the regional innovation economy, in a type of Bayesian economic success model.

Crowd funding for secondary exchanges of capital means that cash flow from an earlier exchange is used to support subsequent local investments. Crowd funding, based upon internet technologies, provides the mechanism for this re-investment of capital from one generation of innovation to the next, unleashing a torrent of capital and an explosion of job creation.

About Thomas E. Vass:

Vass is fee-based investment portfolio manager and regional economist located in Raleigh, N. C. He is the author of Predicting Technology: Identifying Future Market Opportunities and Disruptive Technologies, (2007) which explains his theory of technology evolution. His theory formed the basis of his 2007 patent that explains his method for selecting technology stocks for inclusion in an investment account.  Please visit his economic research papers on the Social Science Research Network (SSRN) at  http://ssrn.com/author=831853

Thomas E. Vass, President, The Private Capital Market, Inc.©2012

Introduction: The Direct Corporate Private Offering As A Better Model For Obtaining Financing

Since 1933, private companies have had an avenue of raising funds called a self-underwriting, or a direct corporate private offering, but it has not been widely used as a method for raising capital. In a self-underwriting, the company issues securities directly to investors, without the benefit of a securities broker or financial intermediary between buyers and sellers of capital.

Most young companies and startup firms have primarily relied on a broker or venture firm to assist it in conducting another business model to raise capital that features presentations to venture capital firms or angel groups. Each capital firm or group listens to the company presentation, and then may, or may not, make the company an offer to invest, generally under terms and conditions that are more favorable to the sources of capital than to the company.

In this older model, the broker or intermediary represents the financial interests of the investors, and not the company. The broker or intermediary will often form partnerships or syndicates with other brokers to sell the securities.

Industry statistics show that about 2 in 10 firms are successful in obtaining funds using this older model, and that after about 3 years, of all the firms that raised capital this way, about 60% are terminated by the sources of capital because the company did not meet the performance metrics of the capital firms.

In contrast to the startups, most established firms, with real top line sales revenues, are generally not viable candidates for the older model because the established firms do not have a clear path to an exit that results in a rapid capital gain for the venture capitalists or angels.

In addition, for many established companies, the amount of capital needed to fund growth is too small to interest the sources of capital, and the type of capital needed by the company does not fit the type of securities that the venture capitalists most prefer as an investment vehicle.

Obtaining Favorable Terms and Conditions for the Company In Raising Capital

One of the advantages of a direct corporate private offering over the conventional methods of raising capital is the company’s ability to control the terms and conditions of the offering. By creating the documents related to the offering in advance of the offering period, the company avoids the costs and time lost in frustrating negotiations with multiple sources of capital, all of who may want to impose their own terms and conditions.

The benefits of the company controlling the terms and conditions must be tempered by two key considerations. First, the terms and conditions must be attractive to a wide range of investors based upon the merits of the investment itself. In other words, the terms must be fair to the investors so that they may enjoy the benefits associated with making the investment.

The investors are not going to have an opportunity to negotiate over the terms and conditions of their private securities, so the terms must be fair for them from the start.

Second, the terms and conditions for an early round of capital must be compatible with future rounds. This means that a logical sequence of terms and conditions must flow through all of the eventual rounds of capital raising.

The priority for the company CEO in the creation of the documents must be that they are created right and fairly from the beginning and then continue to be fair for future investors, throughout the life of the company.

The company will need to work with legal counsel to get the exact form and text of the terms and conditions to fit the type of securities for the specific offering today and in the future.

Preferred stock – The Workhorse Security of Private Placements

The first consideration for the CEO in contemplating a private placement is the type of security for the business to issue to investors. Most companies that have some capital gain potential, as opposed to an investor’s interest in the dividend income potential from stable revenues, issue preferred stock.

Preferred stock has various “preferences” over common stock. These preferences can include liquidation preferences, dividend rights, redemption rights, conversion rights and voting rights, as described in more detail below. The “preferences” in preferred stock are also called terms and conditions.

The text for the conditions attach to both the security itself, and to other elements associated with the investment. The same terms, such as “participating,” may be used for different parts of the investment. For example, “participating” can apply to both participating in the flow dividends and to participating in the profits at liquidation.

When used in different elements of the investment, the preferences tend to compound the original, single use of the term “preference.” The preferences associated with preferred stock allows the investor to benefit from a capital gain event because the stock represents equity in the company, and as the value of the equity goes up, the investors can obtain the larger gain when the stock is sold.

Venture capitalists and other investors in the older model typically receive preferred stock for their investment. Most of the negotiations in raising capital in the conventional method, where the company goes searching for capital at individual venture capital sources, concern the priorities and rights for the “preferences” between the investors and the company.

All of the good features and rights associated with the self-underwriting of preferred stock can be used to provide investors with greater security and reduced risk of loss of capital, while the more onerous features regarding venture capital control over decision making authority, can be eliminated.

An additional benefit for investors and the company in a direct corporate private offering (DCPO), is that standardization across many different companies, all of whom issued stock with common terms and conditions,  would eventually lead to easier transactions in the future via private securities exchanges.

Common terms and conditions would lead to greater liquidity in the private capital marketplace because less time and expense would be involved in determining how one security’s rights and features differed from another security.

One of the important features and rights associated with preferred stock is its ability to be issued with conversion rights into common stock at some point in the future. In the older method, the convertible preferred stock contained onerous anti-dilution protection for investors in the event that a second round of securities is issued to new investors at lower prices than the earlier rounds.

In the conventional model, the earlier investors had a built-in conflict of financial interest with the company associated with their capital costs of owning the stock. If the value of the company dropped, or the company did not meet the metrics of performance imposed by the capitalists, the conversion rights allowed the earlier investors to obtain a bigger profit when the stock was eventually sold, or the company itself was sold, for a gain.

As the name suggests, convertible preferred stock can also convert into common stock at either the holder’s option or at the option of the company. Usually, there is some form of coerced or mandatory conversion feature for all investors if the company becomes involved in an Initial Public Offering (IPO), or company buy-out, where all the private stock is converted to publicly-traded stock.

Some of the onerous features in the older method of this form of equity, from the company’s and founder’s perspective, is that the earlier rights provide for a guaranteed return of capital through redemption provisions if the company’s performance is mediocre. This explains one of the reasons why such a high percentage of companies in the earlier method were terminated by the capitalists if the company did not meet performance metrics.

In the earlier method, the investors were going to obtain a profit no matter what happened to the company.

These more onerous features of conversion upon redemption do not have to be inserted in company self-underwriting.

Convertible preferred stock often pays or agrees to pay some form of dividends, which can be paid in cash, or in the form of deferred additional shares. Usually the dividend rate is set by a vote of the Board of Directors. In the older model, one of the terms set by the investors was control over the Board of Directors, who could vote for dividends and also had the power to fire or terminate the original founders and entrepreneurs.

The payment of dividends is very beneficial to investors, as it gives them two ways to benefit from owning company stock. First, they may obtain a capital gain profit when they sell their stock, and second, they may also be paid income during the period of time they are waiting for the value of their stock to go up in price.

This type of outside investor control by the Board of Directors so prevalent in the earlier model can be avoided in the self-underwriting.

Conclusion: Making the Terms and Conditions of the Self Underwriting Fair Form the Start

The burden of making the self underwritten private offering attractive to investors from the beginning means that the company and its legal counsel will need to carefully balance provisions that shareholders would find attractive with provisions that are fair to the company.

Since the direct corporate private self underwriting process does not involve negotiations like the older model, the initial set of provisions needs to be attractive to both the investors and the company right from the start.

Among the important considerations of additional protective provisions are:

• A majority vote of the outstanding preferred stock holders to make any amendment or changes to the rights, preferences, privileges, or powers of, or the restrictions provided for the benefit of, the preferred stock;
• A majority vote of the outstanding preferred stock holders to authorize any increases or decreases in the authorized number of shares of Common or Preferred stock;
• A majority vote of the outstanding preferred stock holders any action that authorizes, creates, or issues shares of any class of stock having senior rights or preferences over existing shareholders;
• The broadest possible information rights and inspection rights possible with greater rights attached to owners of at least 15% of the total outstanding preferred stock.

In conformity with the provisions of Sarbanes-Oxley on public companies, private companies should aim at transparency and truthful dealings with their shareholders. Documents such as audited annual and unaudited quarterly financial statements, annual budgets and monthly financial statements, minutes of the meetings of the Board should be made available to preferred shareholders in pass word protected areas of the company’s investor relations web page.

The major desired outcome of raising growth capital, from the perspective of the company, is to obtain capital that helps the company grow. With direct corporate private offering, companies gain more control over their destiny when the seek growth capital.

Part of the solution for small companies gaining control over their destiny is to offer the securities directly to investors in a private placement self underwriting, always mindful of the fact that the prosperity that results from the company’s successful growth must be distributed fairly to all those who took the risk to invest.

Upcoming Article: The Solution to Dilution

About Thomas E. Vass: Vass is a registered investment advisor and regional economist with an interest in the relationship between technological innovation and capital markets. He offers investment management advice to private investors,  based on a 2007 investment management method patent issued to him. As a part of his capital market advisory services, he offers advanced web-based tools to help companies conduct a self-underwriting. He is based in Raleigh, N. C. 919 975 4856.

Date: February 24, 2012

To Subscribe To The PCM Newsletter Email Subscription,

Contact Us
Contact Us For all inquiries regarding  your free subscription to the  PCM Newsletter, please email us at: tvass@technologystockadvisor.com

Cancel Email Subscription
To unsubscribe from this email subscription> Please reply to this email with UNSUBSCRIBE in the subject line, along with the email address the newsletter came to you on.

If you need other assistance, please let us know or contact:
Thomas E. Vass, 6001 Waters Way Dr. Raleigh, N. C. 27606 919 975 4856

 The Politics of Religion As It Applies to Small Business

Ever since President Obama interjected his religious beliefs into the current political campaign with his diktat on contraception for Catholics, the main stream media (MSM) has been in a tizzy about Rick Santorum’s religious convictions.

Santorum has obliged by talking about the moral values that undergird a free democratic society.

This talk about moral values in America by Santorum has sent the MSM into an even bigger tizzy. The media suspects that as a Catholic, just like their earlier suspicion of  John F. Kennedy, there may be some Catholic cult or dark wicca practice, like SkyeClad, that Santorum may implement for all Americans.

As a way of diffusing this volatile political issue, there is a path for the MSM to take to on examining how religious beliefs apply to owning and managing a small business. Not that there is anything wrong with SkyeClad.

Seeking Redemption

In a quaint play on words, the language of business buy sell insurance adopted the term “redemption” to describe one possible method for implementing and funding the insurance for a small business buy sell agreement.

In its application of Santorum’s Catholicism, redemption has a slightly different meaning, with an ancient controversy over how exactly one who believes gains redemption.

In the business case, redemption comes when the insurance policy pays out the death benefit to the business.

In this special case of redemption, the business itself, was the lost soul who got redeemed. The business did three things, (good deeds alone) to gain redemption.

1. The business applied for a life insurance policy whose total death benefit value was large enough to buy out a deceased owner’s shares from the estate of the departed.
2. The business named itself as the legal owner of the life insurance policy.
3. The business named itself as the legal beneficiary of the death benefits.

And, Voila, at the moment of death of an owner, the redemption occurs.

The Calvinists hate this whole idea of good business deeds leading to redemption, preferring instead to believe that a business is pre-ordained for redemption from birth. But, in the case of business, nothing is pre-ordained, so it is best to seek redemption from an early age.

The Act of Redemption

The corporation will not recognize income for tax purposes when it receives the insurance death benefit  proceeds. (Hint to Republicans: Do not mention this business tax treatment to Obama).

The tax treatment for the business looks like a two-step tango. First, when the corporation first obtains the death benefit, it must reflect that part of the transaction on the earnings and profits of the corporation. The earnings and profits will increase with the life insurance proceeds received.

Second, and as a major act of faith, the earnings and profits decrease as a result of the stock redemption from the estate of the departed.

It takes a major act of faith, best codified by a legal agreement, for the business to buy the shares away from the estate. The legal agreement is between the company, and each owner, and it legally obligates the estate to sell, and for the company to buy the shares.

The surviving owners and remaining shareholders do not get the benefit of a step-up in basis on their own shares when the corporation purchases (redeems) the deceased shareholder’s interest from the estate. The ownership interests of the remaining shareholders retain their original tax bases in the company.

The Estate of the Dearly Departed

Under a redemption approach, the estate tax consequences can become more pronounced when the deceased shareholder has a controlling interest. Under IRC section 267A, shareholder who owns more than a 50% interest either directly or indirectly is deemed to control a corporation.

In this situation, the shareholder may be deemed to have an ownership interest in the life insurance policy due to the shareholder’s ability to designate a beneficiary other than the company itself.

This is one big important reason why both legal help in drafting the agreement, and tax help in accounting for the insurance proceeds are essential. A distribution from a corporation to a shareholder or a shareholder’s estate could possibly be taxed as a dividend, the preferred outcome in Obama’s philosophy.

The fact that the departed had a majority ownership could possibly result in the proceeds being includable in the deceased’s estate. Thus, the after-tax returns on life insurance policies can be substantially reduced if estate taxes are incurred as a result of the life insurance proceeds being included in the estate.

This outcome would not lead to Heaven for the estate, but to spending years in that other place, halfway between Heaven and Hell, commonly called the IRS.

The business attorney and the tax professional may qualify the transaction as a Section 303 redemption.

If the 303 requirements are met, a distribution from the business in exchange for stock will be treated as a capital transaction, and the shareholder’s basis may be subtracted from the sale price. And since the basis steps up to fair market value at a stockholder’s death, there is usually no difference between the basis and the sale price, so there is no gain.

Funding The Insurance Premiums for the Business Buy-Sell Agreement

The company applies for, owns, and is also the beneficiary of the insurance policy that funds the buy-sell redemption agreement.

Redemption is just one possible method of implementing the buy sell agreement, which is a legally binding agreement between owners. Sometimes, the legal agreement, which precedes the insurance policy, and the insurance policy itself, are confused and commingled.

The insurance policy requires a periodic payment of premiums. In many cases, a very beneficial outcome for the company can be obtained when the company uses business revenues to pay the insurance premium.

This payment of the insurance premium by the company requires careful deliberation from the attorneys and tax professionals who are providing guidance on implementing the redemption agreement. In many cases, it may be useful for the family to have its own legal and tax representation that is independent of the business professionals.

But, given the right set of precursor conditions, funding the insurance with business dollars sometimes leads to the seventh level of Nirvana, an incredibly blissful state, or so I am informed.

And, as is the case with Santorum’s religion, this blissful state inures to the happiness of the individual, and not the engorgement of the State.

Can I Help You Implement A Small Business Buy-Sell Agreement?

Thomas Vass is an independent licensed insurance agent, located in Raleigh, N. C., with a special focus on helping small companies implement buy-sell agreements. He works with the company’s other business professionals as a part of an advisory team that provides advice to business owners on getting the right buy-sell agreement in place. After the legal and tax issues have been solved, Vass provides advice on the right types of life insurance and disability income insurance to fund the agreements for a smooth financial ownership transition. Contact Vass 919 975 4856.

Please note: Vass is not an attorney and does not provide legal advice, and Vass is not a tax professional and does not provide tax advice. Vass is a business insurance professional and provides business insurance advice. Nothing in this article is intended to provide legal or tax advice, and any relationship to political advice is merely coincidental.

Contact Us
Contact Us For all inquiries regarding  your free subscription to the  PCM Newsletter, please email us at: tvass@technologystockadvisor.com

Cancel Email Subscription
To unsubscribe from this email subscription> Please reply to this email with UNSUBSCRIBE in the subject line, along with the email address the newsletter came to you on.

If you need other assistance, please let us know or contact:
Thomas E. Vass, 6001 Waters Way Dr. Raleigh, N. C. 27606 919 975 4856

The Cash Values In Your Company Buy-Sell Agreement Insurance Policies Are Going to Become A Lot More Valuable, For Many Different Reasons

 Getting Ready For The Next Fed-Induced Asset Bubble

No matter how much the Federal Reserve has lowered the interest rates or how much cash the Treasury has injected into the economy, the FDIC commercial banks and commercial lenders, have not extended the necessary business credit to worthy small businesses that are desperate for growth capital.

Now, the Fed has announced that it is going to hold interest rates at zero, for the foreseeable future. The ostensible reason is to provide more economic certainty for private sector decision-making.

The outcome of this policy, given the open global flows of money and capital, and the fixed and non-movable capital equipment and real estate in the domestic U. S. economy, is yet another Fed-induced asset bubble. The Fed’s interest rate policy lever does not work in a globally-integrated financial market because the other players can anticipate the Fed and take profitable contra positions in the international currency market.

Just like the asset bubble in tech stocks in 1998. Just like the asset bubble in real estate in 2005. Just like the asset bubble in commodities in 2007.

All of which led up to the financial melt down in October of 2008. All caused by a 20-year devil’s brew of government intervention and political manipulation of economic forces that should have been left to the free markets.

Witness now the elites in Europe trying to make decisions about the Greek debt, and decide for yourself if you have confidence in the ability of a tiny handful of U. S. political elites to manage the national economy.

The next Fed-induced asset bubble will make it even worse for small private U. S. technology companies to obtain growth capital from U. S. financial firms.

A Perverse Economic Benefit of Global Corporate Socialism
Oddly, one outcome of the Fed’s policy manipulations is that the main sources of capital for funding U. S. small business growth in America will likely be foreign lenders, who are seeking deals in the U. S. small high technology business sectors.

One effect of global financial integration is that the socialistic, collectivistic policies in European countries have effectively killed technology innovation in their home economies. Both corporations and banks in the U. S. and the rest of the world are dependent on new ideas that are commercialized and the best place to find ideas for technology commercialization is in the U.S.

To paraphrase one of President Obama’s favorite lines, there are millions and billions of dollars sitting in foreign bank accounts waiting for a good investment idea in America.

Which makes the Obama philosophy of turning the U.S. into a benevolent totalitarian European state all the more stupid, from an American exceptionalist point of view. Technology commercialization is the unique initial factor endowment that gives the U. S. economy a global comparative advantage, and having the President of the United States destroy that cultural advantage by turning the U.S. into a socialist state is not exactly the hope and change citizens were hoping for.

The main technique of foreign corporations gaining U. S. technology will be from buying the small companies outright, or loaning them money.
Loaning small companies capital is not such a bad thing if the baby of American technology innovation does not get thrown out with the nasty bathwater of European international socialism, or its more virulent cousin, Chinese Communism .

One good way to get on the global radar screen of foreign lenders is to show them an asset that they understand.

In other words, show them the cash.

In this case, the cash value assets of your corporate owned life insurance that funds your buy-sell agreements.

Generally Accepted Accounting For Corporate Owned Life Insurance Assets

In the United States, the Financial Accounting Standards Board (FASB) released a policy statement on the appropriate financial reporting treatment for life insurance owned by a company. (Technical Bulletin 85-4). The section states that an asset should be recorded on the financial statements at the amount that could be realized under the insurance contract at the financial statement date.

The balance sheet entry for the corporate owned insurance is described as an asset, at a specific date. In determining the expense or income to be recognized for the period, the premiums paid would be adjusted for the change in the cash surrender value.

If the life insurance contract were to be surrendered, the insurance company would issue the cash surrender value to the corporate policyholder on that date. The cash surrender value is the total balance of the accumulated value in the policy reduced by the charges that apply if the policy is cancelled in the early years of coverage.

In order to be recognized as an asset on a company’s financial balance sheet statement, the policy must be owned and controlled by the company and must have the potential for providing a future economic benefit to the company.

A company obtains control of a life insurance policy when it purchases the policy as the owner and deposits premiums into the contract. The death benefit proceeds on the life of the company official who is insured could be considered a future economic benefit, although receipt is contingent on the contract remaining in force and the death of the life insured.

It is the cash surrender value of the life insurance contract that is recorded as an asset on the balance sheet of the company, however, and not the future value of the death benefit. Each year the change in the cash surrender value either goes up or down, and this changes the value of the asset on the balance sheet.

The GAAP treatment of corporate owned insurance as a balance sheet asset originated in a November 1970, AICPA Accounting Interpretation entitled “Accounting for Key-Man LifeInsurance.” That Accounting Interpretation identified the cash surrender value method as generally accepted accounting for purchases of life insurance.

In October 1984, the AICPA’s Accounting Standards Executive Committee (AcSEC) approved an Issues Paper entitled ”Accounting for Key-Person Life Insurance.” In the Issues Paper, AcSEC reaffirmed support of the cash surrender value method as the only generally accepted method for the treatment of corporate owned life insurance.

Corporate Insurance Cash Value Assets In The Event of Your Untimely Demise

In their article “Business-Owned Life Insurance: Opportunities and Pitfalls, David M. Cordell and Ted Kurlowicz explain what happens to the cash value of corporate owned insurance if you or the insured employee dies. (FPA Journal, Sept 2006).

In order to insure an employee or key executive, a company must demonstrate that it has an “insurable interest.” Without this documentation and evidence of insurable interest, a new tax law provision would cause the death benefit policy proceeds for employer-owned coverage to be treated as taxable as ordinary income.

In other words, in order to show the assets of cash value, the company must first demonstrate the logic of buying the insurance policy on the life of the employee or key executive. As Cordell and Kurlowicz explain, a corporate insurable interest is often described as the need to fund certain key employee benefits since the business will have an obligation to provide the benefits under the company compensation plan.

Another beneficial use of the corporate owned insurance, in the first instance, is the funding of a buy-sell agreement covering the lives of the participating owners. As they note, a critical qualification in the buy-sell agreement is that for the business to be the policy owner and beneficiary of the death benefit.

This means that the company must have the obligation to be the purchaser of the ownership interest at the time of the untimely demise that triggers the buyout. For example, a stock redemption agreement with insurance on the lives of participating owners would be an appropriate use of life insurance for funding the buy out.

Finding A New Purpose For Your Cash Value Assets

The importance of using corporate owned cash value as a multi-functional asset is big and getting bigger. In his testimony before Congress, David M. D’Agostino, Director, Financial Markets and Community Investment for the GAO, describe why the asset was so important (Testimony Before the Committee on Finance, United States Senate, October 23, 2003, Business-Owned Life Insurance: Preliminary Observations on Uses, Prevalence, and Regulatory Oversight).

As D’Agostino noted in his testimony, “Generally, business-owned life insurance is permanent, lasting for the life of the employee and accumulating cash value as it provides coverage. Attractive features of business owned life insurance, which are common to all permanent life insurance, generally include both tax-free accumulation of earnings on the policies’ cash value and tax free receipt of the death benefit.”

He described how banks use the cash value of corporate owned insurance to meet Federal Reserve capital asset requirements. He testified that, “As of December 31, 2002, 467 banks and thrifts reported business-owned life insurance holdings in excess of 25 percent of their tier 1 capital. The GAO asked the bank regulators to explain their oversight of 58 institutions with the largest concentrations, all in excess of 40 percent of tier 1 capital. Bank regulatory officials said that their agencies were monitoring these institutions’ levels of holdings, had conducted preliminary reviews or detailed examinations, and concluded that major supervisory concerns do not exist.”

Non-financial corporations also use corporate cash values for a variety of purposes. D’ Agostino described research from 2002, and stated that. “In the 2002 results from its survey of Fortune 1000 corporations, Clarke/Bardes reported that 65 percent of those companies that fund nonqualified deferred compensation plans and 68 percent of those that fund nonqualified supplemental executive retirement plans do so using business-owned life insurance.”

The audit and accounting guidelines for the larger, SEC reporting companies in showing the value of the assets in their financial statements was also described by D’ Agostino. “The SEC,” he noted, “requires public companies to prepare their financial statements in accordance with generally accepted accounting principles (GAAP), which would require them to disclose information about business-owned life insurance policies when such information is material. According to SEC officials, however, following GAAP would rarely require purchases of and earnings from business ownedlife insurance to be shown as separate line items because they typically are not financially material to the company.”

The main idea is that cash value assets of life insurance are currently used by very large, public, global companies in a wide variety of business purposes and strategies, and their model can easily be adopted by very small private companies, and turned to their advantage in the global market.

Making Your Cash Value Life Insurance Perform A Dual Business Purpose

The cash value of corporate owned life insurance is an asset that foreign lenders can easily see and easily value. It is, after all, cash value held on the balance sheet of the company, according to GAAP.

Unlike the fluctuating or imprecise values of some other corporate assets that an asset bubble will obscure, that type of cash is going to become even more valuable. With the coming of the next Fed-induced asset bubble, the value of that cash sitting on your company balance sheet will be one asset that very few lenders will question when they go about their task of figuring up how much money you can borrow.

What the foreign corporations really want is your American technology, but show them your assets, and you may get the benefit of their capital without giving away the intellectual property of your company.
Can I Help You Implement A Buy-Sell Agreement?

Thomas Vass is an independent licensed insurance agent, located in Raleigh, N. C., with a special focus on helping small companies implement buy-sell agreements. He works with the company’s other business professionals as a part of an advisory team that provides advice to business owners on getting the right buy-sell agreement in place. After the legal and tax issues have been solved, Vass provides advice on the right types of life insurance and disability income insurance to fund the agreements for a smooth financial ownership transition. Contact Vass 919 975 4856.

Contact Us
Contact Us For all inquiries regarding  your free subscription to the  PCM Newsletter, please email us at: tvass@technologystockadvisor.com

Cancel Email Subscription
To unsubscribe from this email subscription> Please reply to this email with UNSUBSCRIBE in the subject line, along with the email address the newsletter came to you on.

If you need other assistance, please let us know or contact:
Thomas E. Vass, 6001 Waters Way Dr. Raleigh, N. C. 27606 919 975 4856

What To Do If They Just Won’t Take A Hint

Having the earlier generation of owners stick around in the business sometimes is like the punch line in the joke about the couple in their 90’s who divorced after 60 years of marriage.

“But, why now, after 60 years of marriage?’ asked a concerned friend.

“Because, we had to wait until the children died,” the husband replied.

In many cases, it may be a better idea to provide the older owners and partners a viable financial alternative to leaving the business, but that idea requires early planning to implement. In order to help the older owners ease out the door, the younger owners need to show them the cash.

The cash to fund the older owner’s retirement is held in the company-owned life insurance contract whose death benefit would have been used to buy the older owner’s shares, if the owner had died before reaching retirement age.

Unlike the joke about the divorce, the owners did not die first, so the cash values in the company-owned insurance policy can be used for another purpose. In this case, the cash is used as a monthly stream of income that buys away the owner’s shares during the first years of the owner’s retirement.

The Top 3 Issues That A Buy-Sell Agreement Can Solve For Retirement Income For Older Owners

The buy-sell agreement is drafted by a business attorney, and contains the legally binding obligations of the owners to sell their ownership shares for an agreed-upon price.

The legal terms and conditions of the agreement cover 3 important issues related to the ongoing viability of the company:

·    The agreement restricts the older owners from selling their shares to outside parties at the time of retirement.
·    The agreement sets the fair value of the shares to be transferred at retirement.
·    The values contained in the agreement act as evidence for tax issues related to the treatment of capital gains for the older owners.

The agreement would provide guidance on the retirement age and the length of installment payments to the older owner.  Generally, the duration of installment payments would be 5 to 10 years.

Even though the words used in the agreement may be described as retirement income payments, the stream of income paid to the older owner are classified as installment payments on buying away the shares of the owner.

Selecting The Type of Insurance Policy That Can Be Used As A Vehicle to Fund The Retirement Payments

The type of insurance to be purchased is a different question than who owns the insurance policy. Sometimes, it is more advantageous for the company itself to buy and own the insurance policy, and in other cases, when the company has less than 3 owners, the policies can be owned by each individual owner.

The insurance policy that is bought must create internal cash value buildup. The cash values inside the policy are usually borrowed by the owners to pay out the retirement income to the older owner.

In other words, the type of life insurance policy used to fund the buy-sell agreements would not be term insurance. Rather, the policies would be whole life, universal life, variable universal life or indexed universal life that build cash values.

In these types of policies, premium payments are directed into two types of internal accounts inside the insurance policy. Part of the premium pays the cost for the death benefit and part of the premium is placed in the cash value account. The cash inside the cash value account generally earns some form of interest, and over time, the cash value accounts grow in value.

At some point in the future, the cash values of the insurance policy can be used to fund the retirement income payments to the older owners.

The logical sequence of events in implementing the buy-sell agreement means that the attorney who drafts the agreement works on the project first, then the CPA who provides accounting and tax services blesses the contents of the agreement, and later argues with the tax authorities over the meaning of the agreements, followed by the insurance advisor, who helps the owners select the right types of policies to buy.

The insurance advisor tries to match the titles and ownership interests in the buy-sell agreement with the title and ownership interests of the insurance policy. Otherwise, events will get messy at the time of retirement.

This coordination between the legal agreements and the insurance policies means that the attorney, the CPA, and the insurance advisor will need to communicate with each other. Generally, the advice provided by the most senior female in the group will hold the greatest influence on what happens next.

Using The Same Insurance Policy Over Again To Fund The Future Retirements of the Younger Owners

Sometimes, the insurance policies used to fund the buy-sell agreement are surrendered, or sold back to the insurance company. In this case, the insurance company would pay out the internal cash values to the owner of the policy. The legal buy-sell agreement would require that the cash values of the surrendered policy be used as a down payment on buying the retiring partner’s share.

A better alternative than surrendering the policy may be for the owners of the insurance policy to borrow the cash value but keep the policy in effect by continuing to pay the premiums. The loans against the cash value are used to fund the retirement income to the older owner.

Then, if it had been a really smart attorney who drafted the agreement, and a really smart CPA who blessed the agreement, the existing life insurance policy can be used to insure the life of a new owner. The terms and conditions in the legal agreement must describe this treatment of the life insurance policy.

The new owner who is insured by the policy may often be substituted on the same policy when the older owner leaves the company. The premium and policy values may have to be adjusted in light of differences in ages and health between the previous and new insured, which means that the insurance advisor will need to do more work to make the transition on the insured happen at the insurance company.

The great financial advantage to keeping the insurance policy in effect for the remaining owners is that the internal cash value build up continues in the existing policy. At some time in the future, after the installment payments to the older owner are completed, that cash value build up may be used again to fund another retirement payout.

This time the retirement payments are to the former young whipper-snapper who helped the previous older owner out the door.

Can I Help You Implement A Buy-Sell Agreement?
Thomas Vass is an independent licensed insurance agent, located in Raleigh, N. C., with a special focus on helping small companies implement buy-sell agreements. He works with the company’s other business professionals as a part of an advisory team that provides advice to business owners on getting the right buy-sell agreement in place. After the legal and tax issues have been solved, Vass provides advice on the right types of life insurance and disability income insurance to fund the agreements for a smooth financial ownership transition. Contact Vass 919 975 4856.

Contact Us
Contact Us For all inquiries regarding  your free subscription to the  PCM Newsletter, please email us at: tvass@technologystockadvisor.com
Cancel Email Subscription
To unsubscribe from this email subscription> Please reply to this email with UNSUBSCRIBE in the subject line, along with the email address the newsletter came to you on.
If you need other assistance, please let us know or contact:
Thomas E. Vass, 6001 Waters Way Dr. Raleigh, N. C. 27606 919 975 4856

News About Business InsuranceThe Inadvertent Death of Your Company: What To Do Before The Funeral At the birth of your company, you make a hidden decision about your company that you may not realize. That decision affects many other financial, tax, and emotional issues about your company, in the event of your death. Without proper forethought, your company may die when you die. Inadvertently.	News About Buy-Sell AgreementsAdding Disability Insurance To Your Buy-Sell Agreement Many of the baby boomers in their 50’s and 60’s have probably seen the tell-tale signs in the behavior of their business partners. Things are starting to get wacky. Your partner cannot remember to do important daily tasks and misses meetings. Fails to call back important clients, and cannot find important documents. Your dilemma goes beyond trying to figure out how to delicately remind your partner about coming to the weekly staff meeting. If your partner becomes totally disabled, but is still drawing an income, but not contributing to the bottom line, your business will suffer.
News About Business Financing Using Webinars To Raise Capital: PCM January 26, 2012 The PCM comprehensive full-service communications tools help private technology companies gain national visibility with multiple sources of capital.	News About Investment BankingWe Seeking Private Branded Food Companies for Acquisition or Merger Top Line Revenues of $5 – $75 million Growing or underdeveloped brand Will benefit from access to a network of grocers and food brokers Contact Thomas Vass for more detailed information. We provide referral fees for a successful transaction. 919 975 4856 Please contact Thomas E. Vass. 919 975 4856 if you know of a possible candidate
News About A Successful Capital RaisePlease contact us for information about asset-based lending.	News About Metro Regional Closed End Mutual FundsThe Economic Development and Job Creation Effects of Investments Made by The North Carolina Franchise Opportunity Fund The North Carolina Franchise Opportunity Fund intends to seek registration with the U. S. Securities and Exchange Commission as a closed end mutual fund, pursuant to the provisions contained in the 1940 Investment Company Act. The operation of the proposed fund could have a big impact on job creation in North Carolina. The Direct and Indirect Job Creation Effects Are Described In This Article.
News About Online Stock Selection AdviceOnline Newsletter Subscription For Detailed Daily Stock AdviceFor $15 per quarter, you can subscribe to the daily TSA stock update, that contains the detailed buy price targets, sell price targets, news alerts on stocks and advice on what you should do today with your TSA stocks.	News About Investment PerformanceTechnology Stock Advisor Selects Top Five Competitors for 2012 Investment Performance ComparisonInterested Investors Can Follow Stock Picking Competition Throughout the Year With: · Barclays · James Glassman-Kiplinger · Goldman Sachs · J.P Morgan · UBS Investment Research
News About Life InsuranceNorth American Index Universal Life Builder IUL®An excellent product for those looking to help provide financial protection in the form of a death benefit, while building cash value accumulation for supplemental retirement income.Product Highlights: The ability to earn interest based on the movement of a stock market index without the risk of investing directly in the market. The interest rate credited is never less than zero percent—guaranteed! Bonuses to help build long-term cash values for future financial needs. Access to your cash value through withdrawals and policy loans2, including Net Zero-Cost Loans in policy years 6 and later.1 Access to a portion of the Death Benefit to help cover the cost of a chronic or terminal illness If death benefit protection and long-term cash value growth matter most, Builder IUL may be the right product for you. Contact Thomas Vass, 919 975 4856	News About Retirement AnnuitiesANICO Strategy 7 Indexed Annuity offers a 7 year indexing term; with A Lifetime Income and Enhanced Death Benefit Riders. There is a premium charge for the Enhanced Death Benefit Rider and the Lifetime Income Rider.With a fixed index annuity, premium payments are not reduced by market downturns.A contract owner of a fixed index annuity can receive credit based on index growth without loss based on index decline.With a fixed index annuity, you determine how your premium is allocated across fixed and index based crediting strategies. Fixed strategies are credited a guaranteed fixed interest rate over a set time horizon. Index based crediting strategies are generally based on a market index and you receive interest crediting on your contract value up to the caps and limits of the contract. Your contract value will never decrease based on market performance. There are additional benefits and features included such as contract guarantees, medical confinement access, and annuitization options. There are also optional benefits available for an additional cost that give you the ability to receive guaranteed lifetime withdrawals without annuitizing. For questions about the ANICO Annuity, please contact Thomas Vass.
News About 401K Investments in 2012IRA and 401k Investing In Corporate Bonds In An Era of Rapid Inflation: What To Do When “Safe” Investments Become More Risky?	News About Professional Management For Your IRA AccountsNorth Carolina Technology Stock Advisor Releases 2011 Year End Investment Performance Comparison To Nation’s Top Four Stock Pickers 2011 TSA Portfolio of Top 10 Technology Stocks Ends Year Up 10.97%

Contact Us
Contact Us For all inquiries regarding  your free subscription to the  PCM Newsletter, please email us at: tvass@technologystockadvisor.com

Cancel Email Subscription
To unsubscribe from this email subscription> Please reply to this email with UNSUBSCRIBE in the subject line, along with the email address the newsletter came to you on.

If you need other assistance, please let us know or contact:
Thomas E. Vass, 6001 Waters Way Dr. Raleigh, N. C. 27606 919 975 4856

 The Private Capital Market® Business Insurance Buy/Sell Agreements Series

Thomas E. Vass, Insurance Advisor

How To Solve The Buy-Out Funding Dilemma When You Can’t Buy Insurance?

Most business advice columns on buy-sell agreements contain an underlying assumption that all of the owners and partners are healthy enough to obtain life insurance or disability income insurance.

The primary reason a business would fund the buy-sell agreement with a life insurance policy on each owner is that the insurance contract shifts the risk to the insur­ance company. If one or more shareholders dies be­fore the other owners have saved enough money to buy the shares away from the deceased owner’s estate, then the insurance benefits will provide the needed cash.

The same type of risk shifting occurs with the purchase of a disability insurance policy on all the owners, in the event that an owner becomes disabled and the other owners have to buy out her shares. The disability buy-out insurance is a different policy than the disability income insurance that funds the monthly salary for the disabled owner.

But, what do the owners do in the case where insurance cannot be purchased because one of the owners is not insurable?

The dilemma arises because the legal terms and conditions of the buy-sell agreement obligate the other owners to buy the shares, and mandate that the deceased owner’s shares be sold, for an agreed upon price, no matter when the death or disability event occurs.

Coordinating the Legal Buy-Sell Agreement With The Cash Flow Needs of The Company

In the event that there is not insurance in place, then the legal agreement should contain provisions that allow for an installment sale process, where the other owners, in a cross-purchase arrangement, or the company, in the entity arrangement, buy the shares away from the estate over time.

Generally, the agreement would contain the business value, that is updated every year, according to an agreed upon formula.

The agreement would specify the agreed upon initial down payment on the purchase of the shares, and the correct rate of interest to be paid on the remaining balance, for the principal and interest payments, until all the shares have been purchased.

Both of the provisions about down payment and periodic monthly installments must be adjusted to fit the reality and needs of cash flow in the business, or salary needs of the other owners.

Combining An Installment Buy-Sell With Partial Insurance Coverage

Sometimes, the uninsurable owner may have an existing personal policy that can be legally re-titled or modified to suit the purposes of the buy-sell funding requirements. This is not a good solution, because the outside policy probably had some logic or rationale to serve another death benefit need when it was first purchased.

Re-designating the goals and purpose of the outside policy is suboptimal, but is sometimes necessary. Even when an outside existing policy can be found, the death benefit may not be high enough to serve the purposes of the buy-sell business valuation.

If the outside existing life insurance policy is going to be used, then the legal terms and conditions of the buy-sell agreement must contain provisions that allow for a combined installment sale in conjunction with partial insurance death benefit proceeds.

The attorney who prepares the business buy-sell agreement must coordinate the legal agreement with the legal contractual terms of the life insurance policy, including a possible re-titling of the ownership, premium payer and beneficiaries.

This is very complicated and fraught with tax consequences for both the surviving business owners, and the estate of the deceased owner. Both professional legal help, estate help and tax help will be required to assist handling this case. Plus, the types of insurance death benefits options available in the insurance contract will need to be coordinated with the legal agreements.

A slight variation on this idea of using an existing outside insurance policy to fund part of the buy-sell agreement involves the use of an existing term insurance policy, or even the purchase of a new term policy, for a death benefit and premium that covers the risk of a very early death, within the first several years of the buy-sell enactment.

The very early years of the buy-sell are the most risky for all the owners because the company and the owners do not have the financial resources then that they may accumulate in the later years. In other words the gap in funding for the buy-sell agreement from non life insurance coverage is greatest in the early periods.

The insurance underwriting of the term life insurance companies, especially for smaller amounts of death benefit are not quite as restrictive or onerous as for a universal life or whole life insurance policy.

If the term life insurance idea is going to be implemented on the non-insurable owner, then the legal terms of the buy-sell agreement must contain provisions describing how the term insurance death benefits are coordinated with the provisions of the buy-sell agreement.

Combining An Installment Buy-Sell With Internal Cash Values From the Other Owners Insurance Contracts

The buy-sell agreement contains an agreed upon future business value that will be used to assess the dollar value of each owner’s share of the company.

Imagine that the company business value is $300,000 and each of the 3 owners owns 33% of the company.

Assume that one of the three owners can not obtain life insurance.

The total amount of death benefit needed to fund the entire buy-out of the non-insurable owner is $100,000.

The two insurable owners can do two things to help cover the gap in funding on the other owner. First, they can buy and own a type of insurance policy that contains an automatic yearly increase in death benefit on themselves. The automatic increase rider costs a little bit more, but tends to avoid a problem down the road on the funding gap if the company becomes more profitable.

In the example, the current year value of the company is $100,000 for each owner. If one of the insured owners happens to die first, before the non-insured owner, then part of the future funding dilemma can be moderated as a result of the automatic death benefit increase.

Second, the insurable owners can buy a type of life insurance policy that has high rates of internal cash value build up, especially in the early years of the agreement. The internal cash value can be designated to be used to cover part of the funding gap caused by one partner not having an insurance policy.

Sometimes, this idea is called “split-dollar” where parts of the insurance policy are split between different parties.

The attorney who drafts the buy-sell agreement will need to coordinate with the lawyers for the insurance company how the life insurance policies will be titled and owned.

Establishing The Company Escrow Investment Account To Fund The Buy-Sell

One idea to help solve the funding gap on the non-insurable owner is to begin funding a company investment account where the funds are escrowed and held for the specific purpose of funding the buy-out.

Each month, or periodically, the company would fund the escrow investment account, just like funding insurance premiums. The goal for the company would be to fully fund, or self-insure, the amount required to buy out the non-insurable owner.

The attorney who prepares the buy-sell agreement would insert provisions into the legal agreement on the uses of the escrow funds, tied to the buy-sell agreement.

In an entity arrangement, where the company buys the shares from the estate, this idea is less complicated than when it is combined with a cross-purchase agreement, where the other owners are buying the shares from the estate.

The company would generally open an investment or savings account, titled and owned by the company, and managed by the company. Generally, the company would probably want to obtain outside independent investment advice on the management of the account, to avoid conflict-of-interest or other fiduciary issues.

Buying The Uninsurable Owner A Deferred Annuity To Fund The Buy-Out

Most deferred annuities contain payout provisions on the death of the annuity owner. The insurance underwriting requirements of an annuity are not as restrictive as the underwriting for a life insurance policy.

So, in the event that an owner is not insurable for life insurance, that owner may still be able to buy and own a deferred annuity.

The company, or the other owners, would make periodic premium payments to the annuity, just like the case of insurance premiums in a life insurance contract.

The future income benefits and future death benefits of the annuity would match the values of the company in the buy-sell agreement. The future income benefits would match the terms and conditions of the installment sale provisions, and the death benefit would designate the pay out to fund the buy out from the owner’s estate.

The attorney who drafts the buy-sell agreement would need to coordinate the provisions of the agreement with the title and beneficiary of the annuity.

In the case of retirement, instead of death of the uninsured owner, the annuity income payments can be used to fund a living buy-out of the owner’s interest.

Obtaining A Contingent Business Loan or Commercial Financing To Fund The Buy-Out

Sometimes, the revenues and cash flows of the company are so good that a bank or commercial finance company would consider offering credit or loans to fund the future buy out of the owner’s shares.

Often, the loan could be secured or collateralized with equipment or real estate owned by the company.

It may be a good idea to begin negotiations with asset-based lenders on financing invoices or receivables that could be implemented at the time of death or disability of the non-insured owner. The commercial finance companies require a lead-time to assess the risk associated with a contingent loan to be made in the future.

For commercial banks, the future contingent loan to fund the buy-out may look to the bank like a future line of untapped working capital.  As in the case with a commercial finance asset-based lender, the commercial bank will need time to underwrite their risk in offering that future line of credit to fund the buy out.

The bank may be more interested in offering the buy out loan if it is attached to an active line of credit or working capital, so early negotiations would be a good idea.

The attorney preparing the legal buy sell agreement would incorporate provisions regarding the authority of the company to obtain a future loan to fund the buy out and also prepare the board’s resolution to authorize a future contingent loan linked to the buy-sell agreement.

Can I Help You Implement A Buy-Sell Agreement?

Thomas Vass is an independent licensed insurance agent, located in Raleigh, N. C., with a special focus on helping small companies implement buy-sell agreements. He works with the company’s other business professionals as a part of an advisory team that provides advice to business owners on getting the right buy-sell agreement in place. After the legal and tax issues have been solved, Vass provides advice on the right types of life insurance and disability income insurance to fund the agreements for a smooth financial ownership transition. Contact Vass 919 975 4856

Cancel Email Subscription
To unsubscribe from this email subscription> Please reply to this email with UNSUBSCRIBE in the subject line, along with the email address the newsletter came to you on.

If you need other assistance, please let us know or contact:
Thomas E. Vass, 6001 Waters Way Dr. Raleigh, N. C. 27606 919 975 4856