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.