Bite-Sized Bits of Knowledge

The Effects of Capital Calls on a Business and Its Shareholders

What Is A Capital Call and How Does It Affect Your Shareholder Status?

A capital call arises when management determines the need for additional funds and issues a notice to shareholders. The notice requests shareholders to contribute more money or assets. 

Typically, these contributions are made in proportion to the number of shares owned by each individual. Such calls for additional funds may surprise individuals who enter into agreements without fully comprehending their contents.

Capital calls serve as a means to obtain short-term financing in private equity funds, bridging the gap between the financing agreement and the actual receipt of funds. Typically lasting for 30-90 days, these calls are issued to investors through registered mail or email.

Acting as short-term loans, capital calls ensure the liquidity of equity funds and support ongoing investment projects. They are backed by the fund’s capital contributions, unfunded commitments, or granted through power of attorney. Clear and comprehensive, capital calls provide essential details such as deadlines, amounts, and investor/fund names. 

Complying with a Capital Call… Or Not

When you comply with a capital call, you contribute the requested funds or assets. The value of your tax capital account increases, reflecting the additional contribution made. This aligns with the fundamental principle that capital calls seek to maintain equity among shareholders and ensure sufficient resources for business operations.

[Read Transcript]

Hi, thanks for tuning in for another dose of Bite-Sized Bits of Knowledge, where we give you meaningful information in a short amount of time. Today, we’re talking about a concept called capital calls. You’ll find these mentioned in operating agreements, shareholders agreements, and then partnership agreements, or in other words, documents that are signed and govern the rights of owners. 

So a capital call means that management needs more money for whatever reason they deem necessary, and they have issued this notice to the shareholders that says you have to put in more money, usually pro rata based on a number of shares that you have. And that’s what’s going to happen. However, sometimes people go into these opportunities or deals where they are putting in some money or some other contribution, and that’s the extent that they think that they’re contributing. 

They’re surprised to hear that they have to put in more money because they probably didn’t read the agreement or have it reviewed by counsel. And so all of a sudden they get this capital call, and they don’t want to do it. So let’s talk about what happens if you do it and what happens if you don’t do it.

If you do it, you contribute more money, and your capital account, your tax capital account gets adjusted accordingly. It goes up. If you don’t do it, then well, a lot of things can happen. I’ve seen agreements where if you don’t contribute your pro rata portion of the capital call, then you lose your shares. I think that’s a bit punitive and unfair. 

Suppose someone just can’t financially cover it. That’s a bit unreasonable in our view. Another option we’ve seen is that your equity could be adjusted proportionately to how much you did not come up with because presumably, somebody else has to come up with it. Now, if the other partners come up with it or they get a loan, that’s to be determined. But the idea there is that your equity would be diluted a bit. 

Another alternative is that the money can be covered by someone else or whether it’s a loan and that money, plus the cost of that money can be paid out to the other partners using your distributions that you get. And if it’s a partnership, that is, until that money is paid back plus the costs of that money, and then everything would result to normal.

The point of all this, though, is that number one, you got to be aware of it. And number two, you got to understand what happens if you can’t contribute or you can’t participate in a capital call. Okay? So there’s a lot of agreements where that’s not in there. And it’s not in there usually because someone didn’t want it in there. You need to just be aware of what’s in your agreement. This is an example of a provision that could hurt you. So I hope you found this helpful. And thank you for stopping by and stay tuned for more.

Consequences of Not Complying with a Capital Call

As mentioned in the above video, the ramifications of failing to meet a capital call can be significant. Different agreements may outline various consequences for non-compliance, highlighting the importance of thoroughly reviewing and understanding the terms. 

Some agreements may stipulate that failing to contribute to a capital call may lead to the loss of shares. This approach, viewed by some as punitive and unfair, may disproportionately affect individuals unable to meet their financial obligations.

The crux of the matter is twofold: awareness and comprehension. Being aware of the existence and implications of capital calls within your agreements is crucial. Unfortunately, many agreements may lack this provision due to deliberate omissions. 

Therefore, it becomes your responsibility to be diligent and fully comprehend the contents of your agreement to protect your interests. Capital calls exemplify how overlooking crucial provisions can harm your position within a business or partnership.

Being proactive in reviewing and comprehending the terms of your agreement is vital to safeguard your rights and interests as an owner. Feel like you need some help understanding what your agreement actually means? We can help. Get in touch with our office and we’ll walk you through the ins and outs of whatever business agreements you’re dealing with.

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