What Is a Capital Contribution Agreement?
One of the most fundamental elements of a business partnership agreement is a capital contribution agreement. Broadly speaking, capital contribution agreements are contracts between a business entity and/or its owners (members or shareholders) describing the terms and conditions under which those owners agree to contribute capital to the business entity. Sometimes the capital contribution is money, but alternatively could be property, services, or any similar consideration that adds value to the entity. Capital contributions typically describe the amount of capital to be contributed, the deadlines for such contributions, the type of contributions required, and sublcause 3 . 1. The purpose of such agreements is to clearly describe the obligations of and benefits afforded to each partner who is contributing to the entity, and to generally afford protection for each parties’ investment. Capital contribution agreements become especially important in the event that a partner withdraws from the partnership. When such a partner withdraws, the capital contribution agreement will determine whether the withdrawn partner receives compensation and how much compensation such partner is entitled to receive.
Fundamental Aspects of a Capital Contribution Agreement
A capital contribution agreement should clearly delineate what the individual partner is contributing and what is expected in return. Beyond the possible contributions of cash or assets, it is beneficial for the capital contribution agreement to outline the terms of payment. If payment will be made in installment or escalating amounts, those details should be explicitly expressed in the agreement. The terms can also address when payment will be due, whether payments can be made via cash, check, goods, services, etc.
The capital contribution agreement should address how capital contributions will affect ownership and corporate structure. Ownership is generally expressed in percentage terms, reflecting how much of the business is owned by the respective partner. The agreement can allow partners to contribute assets to fulfill a predetermined amount or percentage of ownership.
There may be instances when a capital contribution agreement requires a partner to verify or prove that a desired asset actually exists or is easily accessible. In such cases, the agreement can include language that outlines certain conditions or milestones that must be met. These requirements can be tied to additional payments, equity, or even a fixed percentage. If there is a delay in meeting a condition that conforms to the agreement, a partner could forfeit his or her share of the asset contributions or be required to make a cash payment in an equal or greater amount.
Legal Considerations in Formulating the Agreement
When crafting a capital contribution agreement, the language used must be precise and clear. Any ambiguity in the terms can lead to confusion and conflict, which are far from the intention of such an agreement. Capital contributions can be both in tangible forms, such as cash or property, or intangible forms, such as services or intellectual property. As a result, the agreement must contain a clear and comprehensive definition of the contributions being made. Parties must understand whether services will be provided at no cost in place of a cash contribution or if an ownership interest is to be obtained in lieu of a monetary contribution. Furthermore, the schedule for future contributions should be laid out, as well as what potential consequences will arise in case of a default in payments or a failure to provide a contribution. A capital contribution agreement may contain non-competition agreements, sale restrictions, transferability agreements and other terms depending on the intent of the parties. Each agreement is unique and requires careful attention. Careful drafting and planning are required not only in regards to upfront contributions, but also regarding the contributions that will be required in the future.
Forms of Capital Contributions
Capital contributions can take various forms under such agreements. Identifying the different types of contributions that can be made is an important part of the process of understanding this type of agreement.
Monetary
Monetary capital contributions are those in which one party contributes cash as capital to the new venture. This is often thought of as the "default" contribution because it is the only thing that other forms of capital contributions may be converted to. In other words, when you sell your business, the funds (or the value of your business) that you receive are considered to be a cash contribution. The same can be said for the business where your money has been invested.
Assets
In addition to the cash contributions, sometimes parties contribute other kinds of assets to their venture as the only form of capital contribution that they have to give. A capital contribution agreement that defines what those assets are can be very helpful for the business moving forward. These assets often include:
Professional Services
The last kind of capital contribution is that of professional services. Sometimes one party will enter into an agreement and provide their services as their initial form of being a partner or member of the business. You should consider including such provisions in your capital contribution agreement to avoid confusion later on.
Advantages of Having a Well-Structured Agreement
The advantages of a well-structured capital contribution agreement extend beyond mere prevention of conflicts down the line. It establishes a common understanding of each member’s or partner’s financial input into a business, and its ultimate economic future. For this reason, it is wise to include such a document in the formation of any business.
There are several common scenarios in which disputes arise over capital contributions to a business. In some cases, one member may have contributed more initially, but in the long run, other members were found to be contributing more in terms of valued skills, knowledge or experience. In other cases, members have put up varying amounts of money to keep a company afloat when it was losing money, and fought later about the numerable amount of a share of profits. Having a clear and well-structured capital contribution agreement can help eliminate these types of disputes , ensuring smooth day-to-day operations.
A comprehensive capital contribution agreement is also beneficial in helping to keep the business from failing. When partners truly understand their own stake in the company due to the agreement, it is more likely they will remain committed to the business through thick and thin, as a way of protecting their own investment. And when partners see their business bringing in strong profits, they will have a clearer grasp of how much of that is theirs to claim, as well as how much money should be used for such purposes as growth and reinvestment in the company.
A capital contribution agreement should be part of nearly any business plan, ensuring that all members are aware of the extent of their investment in the company, both financially and in their overall involvement in the process. In doing so, they will place their own interests in the forefront and work toward the success of the business with a clear understanding of what they should expect.
Common Pitfalls and Solutions
Common challenges that may arise with capital contribution or Capital Call Agreements include valuation disputes, compliance issues or defaults in funding by partners. To reduce these risks it is important to address and provide for numerous contingencies in the documents. As to valuation disputes, it is often important to have an independent valuation process. Far too often partner decisions in refusing to contribute capital are made based upon personal rather than economic concerns. It is also common for the relative values of contributions by a new or continuing partner to be a source of disputes. An independent valuation process can help reduce these risks. As to certain compliance and default issues by partners, these are often better dealt with through a general partners due diligence process prior to closing and funding of the entire fund, rather than retention of the ability to refund capital contributions which are used towards the projects. The value of the capital contribution agreement to a developer or fund manager cannot be understated, but it can often be overlooked.
Drafting an Effective Capital Contribution Agreement
Drafting an effective capital contribution agreement involves several practical steps to ensure that all material terms are clearly set out and that each party’s rights and obligations are fully described. As discussed above, there is no standard form capital contribution agreement, so each one is drafted on a case-by-case basis, with the goal of reflecting the specific intentions of the parties.
Negotiation. After the parties have agreed to the basic terms of their business arrangement, the next step is to prepare a draft capital contribution agreement that accurately expresses those terms. Typically, the first draft will be prepared by one party’s legal counsel, with each party subsequently reviewing and negotiating proposed changes to the language of the agreement.
When negotiating the material terms of a capital contribution agreement, both parties should make sure that no material term is left out and that any material term is clearly stated. A vague or poorly-worded capital contribution agreement can create unnecessary confusion and disputes in the future. Similarly, an agreement that does not record all material terms may break down due to a failure to reach an agreement on a material term that the parties thought had already been agreed upon. Negligence in documenting the material terms of a capital contribution agreement can lead to misunderstandings and costly litigation.
Material Terms . There are three main types of material terms to a capital contribution agreement: the parties, the actual contribution (or contributions) and the deadlines for making the contributions. These terms are generally self-evident from the language used to describe them but require careful drafting to ensure that they accurately reflect the parties’ intentions. For example, if a party is contributing partial ownership of a piece of real estate, it’s important to cover the type of interest being contributed and its proportionate share. Likewise, the deadline for making the contribution should be clearly stated so that it is clear what is being "delayed" if either party does not make its contribution on time.
Templates and Resources. For drafts containing material terms that are more complicated than the typical contribution of funds, the investor or the person making the contribution may wish to use a template or general form of capital contribution agreement as a starting point. There are many legal and industry-specific websites offering free or inexpensive downloadable templates or forms. For example, Legal Templates provides a series of reasonably priced templates, while Rocket Lawyer offers a simple, no-cost capital contribution agreement form. It’s important to note that these websites are just general guides and do not contain provisions that may be unique to the parties’ capital contribution agreement.