Whenever we form a new LLC for a client, we include an operating agreement with a capitalization table of the ownership interests that has a column for capital contributed by each owner. That’s the “Cap Table.” Invariably, clients ask us how much money they should contribute to their new company?
Here’s the long answer:
First let me say that there are only a few ways money comes into your company: By capital contributions, revenue from sales, borrowing money, or donations (who would do that?).
Now back to the question: Well only YOU can say how much money your company will need in order to last until sales generate enough income to carry it forward. But here are the mechanisms you should follow:
- Keep track of your expenses during startup. You probably spent money before you even started the company maybe on legal fees, buying equipment, obtaining the domain name, or starting a website. You and your partners used your own money to do that, but the company needs to take over responsibility in order for those expenses to be deductible from future income. So, submit an expense report to the company with receipts wherever possible. At that time, you should contribute capital to the company in an amount a little more than those startup expenses, and have the company write you a check to pay you back against the expense report. You may think this shifting of money is a meaningless endeavor, but that way those startup expenses are entered on the company’s financial records and become the company’s (deductible) expenses. Mind you, your CPA will tell you that the startup expenses are not deductible until the year that the company earns its first dollar of revenue.
- If the company runs out of your startup capital cash before it makes enough to sustain itself, then you need to decide which of the other three ways you are going to use to get additional cash into the company: No one is going to donate to your company, so forget that and focus on the difference between more capital contributions vs getting a loan. For various reasons, debt is probably your best bet. Lenders do not get equity, but they do get paid back first and they first call against company assets of the company becomes insolvent. If you cannot get someone else (a bank, and angel investor, family, etc.) to lend money to your company, then you, the current owners need to lend the money. Do not treat those loans as capital contributions! Capital contributions are made in return for ownership interests, loans are made in return for interest payment–that is two different kinds of “interest.” Keep them separate on the company’s financial records. Always write up a detailed promissory note whenever the company borrows money. That note may be a “convertible” note, a topic for a different post.
- Repeat step 2 as needed until the company become self-sufficient. If one of the people who wants to put money into your company does demand ownership interest in return (or more ownership interest if that person is already an owner), then think seriously whether you want to take that money, because taking it will change your cap table and the relative ownership interests of all existing owners.
If you do decide to accept that money, make sure of these two things:
(i) have the company sell some of its reserve interest to the new owners, don’t sell your own interest (that money would go to you, not to the company)
(ii) the new owners must sign your operating agreement.
Alright you say, but that does not answer the question: How much money should you contribute as capital at the start? Some would say, contribute as much as you can afford, because that sets a higher valuation for the ownership interest. Wrong! You should put is as little as possible by way of capital contributions then lend the company more when it needs extra money. If a future investor does not like your company’s debt-equity ratio, you can convert part of those loans to equity then. But you might not need to make those adjustments.
So here is the answer, and you have waited a bit to hear it: “Contribute capital that just covers and pays your startup expenses.”
But what if one of the founders wants to contribute property, not cash? Well, stay tuned for the answer to that question as it will come in the next blog post!