My elite legal team on Isle of Man is working 24 hours a day to finish up my investor legal documents, which I've given an overview of previously. You'll probably want to read that post before or immediately after this one as it gives a very brief description of those documents. So what does investing in
Panic Alarmist Brewing, LLC or any LLC mean exactly? Investing in a publicly traded company is something many of us are familiar with. Investing in a privately held LLC is something quite different. I can only speak somewhat intelligently about my investment structure, but there are many, many ways to do this.
First let's get to the big question: what does an investor get for their investment? In other words, how does an investor make money? I'm glad you asked! An LLC doesn't have shareholders with shares per se, they have "Members", and Members have "Interests" instead of shares. I'm a Class A Member, my investors will be Class B Members. Any annual net profits less reserves/operational cash is what my legal documents call "net cash flow". Basically, I have a net profit, I subtract out whatever I think
Panic Alarmist needs to maintain for operational cash flow, future expansion, etc. What's left is net cash flow. Net cash flow is divided between the Class A Member "pool" and the Class B Member "pool". In my case, I am the sole Class A Member. The Class B Members will share the Class B pool proportionally based on each member's investment amount. So naturally someone who invests $20,000 will get twice as much money as someone who invests $10,000. The big decision to make is how do you split that pool between Class A and Class B. In my case, Class A represents 67% of the company, Class B represents 33%. This is based on what percentage Class B Members total investment dollars represent to the entire start up amount required. So it would seem that you simply split the moolah up like that and you're done!
Well, not quite. Small businesses are a pretty risky investment, even craft breweries, so it behooves you to make the deal as enticing as you can in order to not have to spend 27 years seeking investors. There are many ways to do this. One way is to offer a larger share of the entire business. Another is to accelerate the payback to the Class B Members until they recoup their original investment, and that's exactly what
Panic Alarmist is doing. Until each investor recoups their original investment, net cash flow will be split 20/80 Class A/Class B. That means 80% of net cash flow will go into the Class B Member "pool". This allows investors to recoup their initial investment much more quickly and is a nice reward for taking the risk when they could have put their money in historically safer investments.
But wait, there's more! First, understand that an LLC has something called "pass-thru taxation". This means that any net profits are added to each Member's taxable income proportionally based on their investment. Each Member will receive a K-1 form indicating the taxable amount (I have an accountant who will take care of this during tax time each year). Pass-thru taxation is good because company profits aren't taxed and then followed by a capital gains tax for each Member. In other words, LLC's don't suffer from double taxation. So here's the cool part. If there's a loss, and there definitely will be during Panic's (now named Alarmist) first year of operation, each Member will be able to lower their taxable income for the year. Based on the advice from my crack legal team in the Cayman Islands, until
Panic Alarmist Brewing Class B Members recoup their original investment, they will divvy up 90% of the losses, Class A will only get 10%. That means bigger tax deductions for Class B Members. Now, I'm not an accountant and I'm sure things are not quite as simple as I've written, so please, please consult with an account or an attorney on these matters. I'm only relaying what I think I've learned.
Once Class B Members recoup their original investment, the percentage of net cash flow will flip to the aforementioned 67% for Class A and 33% for Class B and that will remain in place until forever. By forever I mean until a Class B Member decides to sell their interests, in which case the Operating Agreement and Private Placement Memo clearly lay out how that happens. In my case, Class A Members (me) will get right of first refusal to purchase those interests at a negotiated price. Should I choose not to purchase those interests, the Class B Members will then have the right to buy them. Again, this is all described in detail in my Operating Agreement and PPM.
One consideration that any investor interested in something like this should understand, and it's very important that the managers/owners of the LLC explain this, is that profits do not automatically equal a cash distribution to the funding pools. As I mentioned earlier, "net cash flow" as defined in my documents (and this is typical from what I understand), as net profits less operating cash flow and any other amounts management deems necessary to maintain the health and growth of the business. In other words, if in year two,
Panic Alarmist has a net profit of $300,000, much of if not all of that amount will very likely stay in the company's bank account in order to have a nice safety buffer for monthly cash flow (the #1 killer of small businesses!) and to use through out the following year for expansion. Brewing is a capital intensive business. Growth = more fermenters, more construction, new equipment. And of course more employees to help with that growth. I see this as a good thing however. Allow the company to grow now and reap the rewards of more profits down the road. Not everyone might understand this, so it's important to explain that very clearly. Investors looking for quick returns on investment might do well to look elsewhere.
One other item related to the previous paragraph. In the same example, if
Panic Alarmist were to make a net profit of $300,00 in year two and distributed none of it, the profits would still be reported as income for each member proportionally based on their investment amount. That means all members could have a tax liability or at least an increase in income tax. The solution to this problem is for the LLC to disburse at least enough funds to the Class A and Class B pools to cover the additional tax liability. However, this may or may not be possible based on the cash flow requirements and growth plans of the business. Do you buy another couple of fermenters to increase your production which would return significantly more profit down the road, or do you instead disburse the money to negate any tax liabilities for the Members? Well, that's something you'll have to figure out and you need to address that in your operating agreement and PPM. I've handled it by basically stipulating that Panic Alarmist will try to disburse funds to cover increased tax liabilities, but not necessarily. That will be a judgement call I'll have to make. I don't want to dramatically hurt the growth and health of the business, but I also don't want to saddle my investors with a tax burden. This is something I'll figure out as we go along and work with my investors to reach an amicable solution. Remember, any money not invested back into the business has a cost in the long (and maybe not so long) term.
There is much more to LLC investment than just cash distributions. There are voting rights, limitations on transferability of Class B interests to other parties, management rights, and lots of other considerations. I'll try to go into those topics at some point in a later post. Let me stress that this is but one way to do this. I know of another Chicago based brewery who relied mainly on promissory notes to raise their start up cash. As I understand it, that's basically a loan with interest paid at an agreed upon rate to the lending party. This has the advantage to the owners of not having to give up any equity in the company. One disadvantage of this approach is having the ability to make those payments on time without harming operational cash flow and such.
My philosophy is that I am sharing this journey and I think anyone who is willing to risk their hard earned money with someone like me who has never run a small business, let alone a brewery, should have the potential to reap some nice rewards for the long term. Hope this helps anyone thinking about taking on investors for whatever venture they might be planning and hopefully clarify some things for potential investors.