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The situation where founders contributing different amounts of capital in a China company law issue

Ihave come across a difficult legal problem (at least one I have not yet had the fortune [or misfortune] of encountering in my still-young career). You always face difficult situations even  you are experienced China lawyer, trust me!

There are 5 founders of a company, a just incorporated China type Limited Liability-corp; four are going to be working on the company, while the fifth is essentially the "money" guy. He has agreed to invest significantly more cash than the other founders, and as far as I understand, aside from advice/expertise/contacts, isn't going to be as active in day-to-day operations as the other founders.

This presents the issue of how to structure the stock purchase, since they've already agreed to the equity split (the cash founder's share is not relative to his investment, and I think it would be very difficult to make them go back to the drawing board on that issue). This may have a simple solution, but I've never come across it or this issue, as in all the companies I've formed the founders have been able to contribute on the same stock price. I would like to find the simplest solution that results in the smallest tax liability for the founders and the company, and doesn't negatively affect their opportunity for further investment down the road.

The first idea that came to mind was to have the investor pay the same stock price that everyone else pays, and structure the balance of his investment as convertible debt or a straight note. While it's simple, I believe it may also lead to a tax liability for the founders (since the injection of capital will immediately render the company more valuable relative to what everyone will pay for their stock, which as far as I can make out would result in liability even after an election -- unless the loan is made a couple months down the road), and it also immediately gives the company a six-figure liability, to one of its founders no less, which could turn off investors.

The final two ideas I'm leaning toward are to: 1) simply structure the cash founder's purchase as a separate transaction with a share price relative to his investment (potentially as a separate class of stock, but with the same rights as the other founders' stock); or 2) do one transaction at a share price relative to the cash founder's investment, and have the other investors' consideration be a mix of both cash and deferred compensation (they are all ready and willing to forego a salary for the time being, regardless of how this transaction is structured). However, I'm still trying to wrap my head around both the tax implications of both options, as well as how it may affect the basis or value of the company and their efforts to raise further capital in the coming months.

Generally speaking, though there are a few ways to structure this, the most straight forward way would be to sell stock to the sweat equity founders upon formation of the company at par value and in a separate transaction (possibly a couple of weeks later) have the investor invest at a higher price based on the amount / equity he will be getting. No need to a separate class.

 

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I am a licensed China lawyer. Most clients are foreign nationals and companies. China Lawyer Blog have associates in Beijing, Shanghai, Tianjin, Guangzhou, Suzhou, Nanjing, Qingdao, Fuzhou, Hainan, Hefei, Wuhan, Xian, Changsha, Xiamen and Hangzhou. Learn More

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China Lawyer BLog AuthorPeter Zhu, an experienced China attorney licensed to practice law for more than ten years, the author of this China Lawyer blog, welcomes any enquiry or consultation related to Chinese law.