Ad­di­tion­al capital con­tri­bu­tions: Defin­i­tion and ex­plan­a­tion

A limited liability company’s assets and an unlimited company’s assets involve capital provided by its share­hold­ers. However, under certain cir­cum­stances, ad­di­tion­al capital deposits may be required. The ob­lig­a­tion to make a sup­ple­ment­ary payment is set out, where ap­pro­pri­ate, in a company’s operating agreement.

A limited company (LC) has share capital provided by all of its share­hold­ers pro-rata. In the US, an investor can make a capital con­tri­bu­tion as set out in an operating agreement. Members agree to make payments to the company at the rate and time specified in the agreement. But sometimes an LC may require urgent cash to stay afloat or finance an ac­quis­i­tion. To cover these costs, LC operating agree­ments will often include a clause on ad­di­tion­al capital con­tri­bu­tions. Im­port­antly, under UK law, capital con­tri­bu­tions aren’t legally re­cog­nised, yet they can still be made. In that case, they must be reported as reserves or gifts. When a company requires ad­di­tion­al funding, it may issue a capital call.

There are initial and ad­di­tion­al capital con­tri­bu­tions. LC owners can usually secure initial capital con­tri­bu­tions in the following ways:

• Equity in­vest­ment: When a person or business invests money into your LC in the form of equity, they will usually receive a stake in your business in return. It is often a preferred type of initial capital in­vest­ment because LC owners will not be required to pay back the money whether their business succeeds or not. At the same time, the addition of a qualified investor may also add a know­ledge­able partner to the business.
• Debt in­vest­ment: Debt in­vest­ments are es­sen­tially loans. Investors and business owners will usually agree on an interest rate and time frame during which they will be required to pay back any in­vest­ments made.
• Con­vert­ible debt in­vest­ment: Con­vert­ible debt in­vest­ments are a com­bin­a­tion of equity and debt in­vest­ments. LC owners can accept a loan in­vest­ment that can later be converted to an equity stake in the company.

Failure to make an initial capital con­tri­bu­tion could result in a penalty or for­feit­ure of a share­hold­er’s stake in the LC. However, whether the share­hold­er loses their share in a business or not will depend on the stip­u­la­tions set out in the original agreement. There’s usually also a grace period during which share­hold­ers can make con­tri­bu­tions.

If the de­fault­ing share­hold­er has pre­vi­ously taken over their share of the business from someone else, then the legal pre­de­cessor is liable for the out­stand­ing amount. However, they may purchase the share in the business against the amount owed.

An operating agreement may contain a clause which stip­u­lates that share­hold­ers con­trib­ute ad­di­tion­al capital to meet un­ex­pec­ted demand for cash. Cases where funding may be required un­ex­pec­tedly include tax payments, paying off debt or paying for repairs. The agreement may contain a set per­cent­age of capital or variable amounts. There may also be a cap on the amount of capital a company can request from share­hold­ers. It’s important that pro­spect­ive share­hold­ers check their re­spons­ib­il­it­ies in regard to ad­di­tion­al con­tri­bu­tions before entering into an agreement.

The need for ad­di­tion­al funding is usually decided by the decision-makers or members board. If the majority vote for ad­di­tion­al capital con­tri­bu­tions, a capital call can be initiated.

In many cases, the operating agreement will grant share­hold­ers a set amount of time to respond to a capital call. If a share­hold­er fails to make the ad­di­tion­al in­vest­ment, there could be drastic con­sequences. Investors could be expelled from the LC and their share in the company may be diluted. The latter is referred to as “squeeze-down”. The freed-up shares can then be dis­trib­uted among other members.

To prevent loss of funding (or in the worst case the collapse of the company), agree­ments often allow other members to loan the money another share­hold­er is unable to provide. The loan is then repaid at an agreed interest rate. The share­hold­er who failed to respond to the capital call will be penalised.

Please note the legal dis­claim­er relating to this article.