What is a common area of dispute between collaborators in the formation and capitalization of a business? It is the characterization of their respective capital contributions as either the purchase of equity in the enterprise or a loan to it. Often, the pressing circumstances driving the business’s need for the capital can distract those involved from thinking through, agreeing to or properly documenting the nature of the transaction. The passage of time rarely clarifies the confusion.
As time passes, and circumstances change, so too can memories. The company’s financial performance often dictates the differing recollections of the transaction by the company and the investor. If the business is doing well, the investor is more likely to claim an ownership interest and the corresponding right to share in profits. Yet, the company is more likely to treat the investor as a creditor, entitled to a return of principal and interest, but no more. If the company is just treading water, it is more likely to claim the investor as an owner, pointing to the lack of profits as justification for refusing to pay distributions. But the investor is more likely to claim creditor status, demanding the return of investment, with interest. Because the respective rights of the company and the investor will vary greatly depending on how the transaction is characterized, the stakes are high.
When faced with these questions, Georgia courts look to a variety of factors to determine whether a contribution should be considered an equity purchase or a loan. Relevant caselaw defines a loan as the delivery by one party to, and the receipt by another party of, a sum of money upon an agreement, express or implied, to repay the principal with or without interest. An investment is the contribution of money or something else of value in pursuit of a common enterprise with profits to come often from the efforts of others.
In absence of clear documentation – such as a promissory note evidencing a loan, or a stock purchase agreement evidencing an ownership interest – Georgia’s courts look to the conduct of the parties to determine whether there was an implied agreement to repay a loan or to purchase an ownership interest. This can be a notation on the memo line of a check, or a telling email. The manner in which the parties characterize the transaction in accounting records or tax returns can be telling. Was a K-1 issued? Is the contribution treated as a liability on the company’s balance sheet? Did the company make payments to the investor contemporaneously with distributions to other owners, or did it make consistent (interest only?) payments, regardless of profitability? Any of these factors may be determinative.
As with most things in business and in life, prevention is the best medicine. Properly documenting a capital contribution at the outset can avoid these disputes altogether. But hindsight does little to solve the problems of the here and now. Faced with a dispute about the characterization of a capital contribution, a careful examination of evidence that may point to the intent of the parties is warranted. This effort, and the assistance experienced legal counsel, can frame the issue in the light most likely to lead to a favorable outcome.