Capital Calls – What Happens When a Business Needs Money?
Businesses finance operations from one or a combination of capital contributions from the partners, debt, cash flow from operations, and sales of interests in the business.
But what happens when the money runs dry? Can a partner be forced to contribute more funds to the business or to personally guaranty a bank loan?
A business’ partnership, shareholder or operating agreement (depending on the type of entity) should address this topic. Many do not.
Absent a provision requiring partners to contribute their share of future capital calls, state statutes governing these entities do not typically provide that a partner has a legal obligation to contribute additional capital to a business or to guaranty the debt of the business. Similarly, absent an agreement setting forth the consequences for failing to contribute additional capital, a failure of a partner to contribute his or her share of a capital call does not automatically result in the dilution of their interest. Assuming they have the requisite votes, the partners willing to contribute may be left with the option of contributing the money as a loan to the business, which often fails to adequately compensate the contributing partners for the additional risk they are shouldering.
Many shareholder agreements simply recite the initial capital contributions of each partner and their corresponding ownership share of the company, which exposes the partners to unnecessary risk that the business does not have a path forward to deal with its inevitable capital needs.
Compounding the issue is the reality that often, partners have varying financial resources, commitments to the business, credit histories, personal situations and cash flow needs. Partners who fail to address these issues do so at their peril. As like a marriage, there is no easy, quick or inexpensive way to resolve a dispute between partners unless the shareholder agreement clearly and unambiguously addresses these issues.
The Role of a Shareholder Agreement
A shareholder agreement should address what happens where the partners approve a capital call and a partner fails to contribute. Shareholders should also contemplate whether a simple majority can force a capital call. Absent a provision addressing the vote required for a specific business decision, state law generally provides that a simple majority vote is all that is needed for every decision, which is not necessarily a problem if you hold the majority of all interests in the business; but what if you are a majority shareholder or a 50% shareholder?
Often, partners provide that there is no requirement that a partner contribute additional capital to the business. In those instances, the partners still need to deal with what happens if a business needs additional capital. Options range from the additional capital being treated as a loan to dilution of the non-contributing partners. When providing for the latter, consider to what extent a non-contributing partner gets diluted? Proportionately? Your answer may vary depending on the circumstances. If the business is in trouble (hence a capital call), partners contributing additional funds may be entitled to a disproportionate increase in their share the company. If the capital need is for expansion or the acquisition of another business, your feelings regarding the consequences for the non-contributing partners may be different. Instead of contributing additional capital to the existing business to fund an acquisition, can the contributing partners simply take the opportunity and form a new company or a division that is disproportionately owned? A properly drafted shareholder agreement should address these issues.
Prevent Capital Call Issues- We Can Help
In our experience as corporate lawyers, it is alwayseasier to deal with possible issues before they arise rather than when faced with the crisis. How do you do that? You draft a proper shareholder/partnership agreement. Contact Lex Nova today to work with our experienced team and formulate a partnership agreement for your business.