Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

Before you let your team of due diligence advisers loose in the data room, it’s crucial to reach an agreement about each adviser’s role and responsibilities. Accountants, banks, and other M&A advisers recognize their success depends on their ability to deliver reliable, incisive analysis of a target’s business operations and future prospects. On the other hand, advisers also have an interest in limiting their liability for the advice they give to their clients. When negotiating engagement letters for M&A due diligence services, private equity firms and other buyers should pay careful attention to provisions that restrict their right to seek compensation for losses brought on by bad advice. In today’s post, we review several customary ways in which advisers try to decrease their risk exposure in engagements for M&A due diligence.       

Scope of the Engagement

An M&A adviser will often try to limit its liability by narrowly defining its area of expertise. To some extent this makes sense. Understandably, accountants don’t want to be held liable for having given legal advice, even if their financial review may have legal consequences, such as a modification to the deal’s structure. But private equity firms should ensure that the scope of the adviser’s engagement is not so narrowly construed that it effectively eliminates the firm’s recourse against the adviser. In M&A transactions, this issue is usually resolved by limiting the scope of the adviser’s liability to the contents of a final due diligence report. Anchoring the adviser’s liability to a specific, written deliverable eliminates ambiguity about which statements the private equity firm may rely upon. 

In practice, an adviser issues preliminary drafts of its reports to the firm and other advisers at periodic intervals throughout the due diligence process. The private equity firm, after all, wants to know immediately about any previously unknown risks or “deal killers.” An effective due diligence program helps the firm understand a potential target’s strengths and weaknesses and identify issues that need to be addressed in negotiations with the seller. Periodic due diligence updates enable private equity firms to keep abreast of what its advisers have learned about the target in real time. Without receiving some comfort in the engagement letter that they will only be liable for their final deliverables, M&A advisers may not be as willing to provide potential buyers with provisional reports.

Limitations on Liability

Engagement letters contain a number of provisions that specify the circumstances under which advisers may be taken to court and restrict the amount for which they may be sued. In New York, a court will not infer that an adviser’s liability has been limited unless clearly and unambiguously expressed in the engagement letter. Except for certain exclusions held to be against public policy, however, New York courts will uphold liability limitations in contracts between sophisticated commercial parties.       

There are several mechanisms an M&A adviser may use to limit its liability:

Causation Requirement. Advisers often seek to restrict their liability to losses that are “finally judicially determined to have resulted primarily from” a misstatement or omission. The purpose of this clause is to fix the adviser’s liability to losses directly attributable to errors in its final report. Unfortunately, the phrase “resulted primarily” has no settled sense and raises the specter of Jarndyce and Jarndyce in future litigation. A better drafting choice for a potential buyer is to make the adviser liable for all losses “directly arising from or related to” the firm’s reliance on the adviser’s final due diligence report.  

Restriction on Damages. Engagement letters generally exclude liability for any “indirect or consequential damages.” Consequential damages are losses that do not arise directly or immediately from a contractual breach, but indirectly result from the breach. They can include such claims as loss of revenue and may be recovered if a court concludes that the indirect losses were foreseeable. This provision is often heavily negotiated. Private equity firms argue it’s foreseeable that they may suffer indirect damages as a result of misstatements or omissions in an adviser’s report. Advisers in turn contend that the ultimate investment decision lies with the firm and their risk in the engagement should be commensurate with their fees. In the end, these discussions become relatively less important compared with negotiations over the adviser’s liability cap.   

Cap on Liability. One of the most important provisions in an engagement letter deals with the amount for which an adviser may be held liable. Advisers will typically seek to put a ceiling on their exposure by capping their liability at a fixed amount, at the amount of fees they receive under the engagement, or at some multiple of their fees. The amount of an adviser’s liability cap ultimately turns on a number of deal-specific factors, including the deal’s size and complexity, the importance of an adviser’s findings in the negotiation of essential deal terms, such as price, and the adviser’s transaction fee.        

Definition of Misconduct. The adviser will generally include a provision stating that it will only be liable for losses resulting from its “gross negligence or willful misconduct.” In New York, courts have described gross negligence as acts or omissions that exhibit a reckless indifference to the rights of others or “smack of intentional wrongdoing.” Though not precisely defined by the courts, gross negligence can be thought of as unintentional acts so careless that they ignore the rights of others or appear as though they were intentionally designed to do so. Willful misconduct occurs when a person commits an intentional act with knowledge that the act is likely to result in injury or damage or otherwise exhibits a reckless disregard for its consequences. Advisers’ acceptance of liability for gross negligence and willful misconduct comports with New York common law. New York courts have refused to enforce contractual provisions precluding liability for willful misconduct or grossly negligent acts, finding them to be against public policy.   

Related Posts:   Reviewing a Confidentiality Agreement: What a Potential Buyer Wants

                          Growing the Company through Strategic Acquisitions

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Are earnouts in today’s M&A market still primarily serving to bridge the valuation gap between buyers and sellers? Or do we need a different explanation for the prevalence of earnouts in recent, large M&A deals? Buyers and sellers are negotiating in what is arguably the most uncertain economic climate of the past decade. Whereas in the past, the caricature of a cautious, risk averse buyer bargaining with an optimistic seller may have served as a useful – if crude – illustration of the buyer-seller valuation gap, it’s unlikely there are many Panglossian sellers out in today’s market. What is more, the idea that the valuation gap arises from a buyer’s superior knowledge about market and industry conditions doesn’t seem as plausible when applied to large deals between sophisticated players. 

Earnouts have been a common term in acquisition agreements for high-growth businesses and small companies. By making part of the purchase price contingent on a target’s ability to meet future earnings targets or reach designated milestones, a buyer can reduce its exposure to the risk that the target doesn’t fulfill the seller’s rosy predictions. At the same time, a buyer can promise to reward the seller if the target’s post-sale performance equals the seller's projections of its pre-sale prospects. An earnout, the theory goes, enables wary buyers and eager sellers to bridge the gap between their respective valuations of the target’s future profitability. 

What accounts for this disparity in valuations? Professor Brian Quinn quotes the abstract of a recent paper by Roberto Ragozzino and Jeffrey Reuer concluding that the use of earnouts “increases with information asymmetries surrounding mergers and acquisitions.” In their article, the authors argue that earnouts appear more often in acquisitions where the target is a new company or for other reasons doesn’t have access to the buyer’s superior market and industry knowledge. For acquisitions of small, private companies by buyout firms and strategic buyers like public corporations, Ragozzino’s and Reuer’s empirical findings make sense. But for this M&A season’s rash of earnouts, especially those appearing in large transactions, we may need to abandon our reliance on the explanatory power of a presumed valuation gap. 

The cost of capital for buyout firms and other acquirers has risen considerably. On top of that, buyers are operating with an informational deficit. Even if they feel they may have a strong grasp of a target’s industry and confidence in its business model, the outlook for the general economy over the next 12 to 18 months is foggy at best. More important, unlike the M&A boom period of a few years ago, buyers do not have to push past as many elbows to bring a potential seller to the bargaining table.   Buyers, that is, appear to have a negotiating advantage in today’s market. Earnouts help buyers negotiating with poor information under current economic conditions in two ways. First, it allows them to limit their financial exposure to new investments in the event the economy doesn’t revive in the short- to mid-term. Second, it allows them to defer a significant portion of the purchase price to a time when the cost of capital should be cheaper. 

It’s true that earnouts in private equity deals have always served as a risk management tool. Yet, in the past earnouts generally served to protect buyers from a target’s failure to compete successfully in its industry, not from a continued or worsening recession. Now, however, private equity firms and other buyers are not merely hedging against business and industry-specific variables. They’re signing up for a broader insurance policy against future market conditions. The prevalence of earnouts in today’s market cannot be entirely attributable to a valuation gap; it would be wise to take a close look at the negotiation gap as well.  

Related Posts:  

Valuation of a Private Company

Growing the Company through Strategic Acquisitions

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Yet another draft confidentiality agreement sitting in your Inbox? Private equity firms, investors, and businesses looking for growth opportunities always seem to be signing a new non-disclosure agreement with another potential business seller. Many times, a seller’s first draft of the agreement will be aggressively one-sided. What sorts of issues does a potential buyer care about in a confidentiality agreement? In today’s post, we’ll highlight some of the terms buyers typically negotiate when marking up a confidentiality agreement received from a potential seller. While some of the discussion focuses on the special situation of private equity firms, much of it applies to any confidentiality agreement related to the purchase or sale of a company. (If you’d prefer to follow the discussion below with a first draft of a non-disclosure agreement in front of you, click here.)

Definition of “Confidential Information.”  The definition of “confidential information” generally comprises all oral and written information furnished to the buyer as well as any derivative products, such as the buyer’s analyses of the seller’s underlying financial statements.   There are, however, several customary exceptions to the definition of confidential information that may be absent from a seller’s first draft. A buyer will generally seek to have the following types of information deemed non-confidential: information that (1) comes into the public domain (other than due to a breach by the buyer), (2) the buyer can demonstrate was already in its possession prior to the seller’s disclosure, (3) is given to the buyer by a third-party that is not itself bound by a duty to keep the seller’s information secret, or (4) is developed by the buyer independently, without any use of the information supplied by the seller.      

Return of Confidential Information.  Most sellers require a potential buyer to return all confidential information if negotiations end without a deal. Buyers in turn often ask that they at least be given the option to destroy the information and usually agree to a seller’s request that the destruction be certified in writing by the buyer. In a time when data rooms are often online and vendor due diligence reports are distributed by email, the physical return of confidential information may be impracticable. 

Permitted Disclosures. If the buyer is going to share confidential information with its financial, accounting, legal, or other advisers, the buyer will identify them in the agreement’s definition of permitted recipients. Of course, distributing confidential information to people not directly under the buyer’s control creates additional risks, but the buyer’s exposure can be diminished by taking some additional precautions.   

Limit Liability for Third-Party Breaches. If the buyer’s advisers have been included among the permitted recipients, then the buyer usually takes measures to limit its liability for any non-permissible disclosures by its advisers. For example, a buyer may insert language stating that the buyer will not be held liable for the disclosure of confidential information by any adviser that signs a non-disclosure agreement directly with the seller. The buyer may try to persuade the seller that the advisers are best positioned to police their respective employees’ use of the confidential information. Moreover, if advisers are contractually bound to the seller to keep the information private, they may have a greater incentive to abide by the agreement’s terms. Alternatively, a buyer may sign “back-to-back” confidentiality agreements with each of its advisers. These back-to-back agreements substantially reflect the terms and conditions of the buyer’s underlying confidentiality agreement with the seller. In the event that the buyer is sued by the seller because of a disclosure by one of the buyer’s advisers, the buyer will have a contractual cause of action against the breaching adviser.

Establishing Breach and Liability for Damages. A confidentiality agreement typically makes the buyer liable for any claims or losses resulting from the buyer’s disclosure of confidential information. It is therefore in the interest of the buyer to limit the types of losses for which it can be held liable. A buyer usually negotiates to eliminate all consequential damages (that is, damages suffered by the seller but only indirectly caused by the buyer’s breach), such as lost profits, from its liability. Another concern of the buyer is how the parties will determine whether a breach causing damage to the seller has occurred.   To protect its right to appeal a lower court’s ruling, a buyer may want to include a stipulation that a breach by the buyer must be “established by a final, non-appealable order issued by a court of competent jurisdiction.” This provision can save the buyer from the unlikely – but infuriating – situation in which it has already been forced to pay damages to the seller, even though an appellate court later rules in its favor.       

Sunset Clause. It may come as a surprise, but many first drafts of confidentiality agreements don’t include a sunset clause specifying when the buyer’s obligations under the agreement end. Given that if the deal doesn’t go through all written and electronic information will be destroyed, a reasonable term ranges from 1 to 3 years.

Non-Solicitation of Employees. When certain key employees are essential to a seller’s business, the confidentiality agreement may include clauses prohibiting the buyer from soliciting or employing the seller’s employees.   Buyers generally tailor their comments on this section to fit their specific needs. If the buyer is a company trying to grow its business by acquiring a competitor, for example, considerable care is taken to ensure the non-solicitation and non-employment provisions don’t unduly interfere with the buyer’s efforts to recruit top talent. If, on the other hand, the buyer is a private equity firm investigating a new business, then the firm generally seeks more limited exceptions. Customarily, the non-employment provision does not apply to any job offer that results from a general advertisement (such as in a newspaper or on the Internet) or occurs after a person has left the seller’s employ (without encouragement from the buyer) and a specified period of time has elapsed.

No Additional Obligations. In order to emphasize the limited nature of the buyer’s and seller’s respective obligations under the confidentiality agreement, a potential buyer often inserts a clause emphasizing that until the buyer and seller have executed a definitive agreement regarding the acquisition, the buyer doesn’t have any obligation to the seller regarding the transaction.

Novation to Acquisition Vehicle. When the potential buyer is a private equity fund, more often than not an advisory entity associated with the fund, rather than the fund itself, signs the confidentiality agreement with the seller. If the deal closes successfully, it’s in the interest of the advisory entity to be released from its obligations under the confidentiality agreement.   For this reason, private equity firms try to include a novation clause under which the advisory arm will be released, and the fund’s acquisition vehicle will assume, all of the buyer’s obligations under the confidentiality agreement upon the transaction’s closing.

Related Post: Negotiating Liability with Your Due Diligence Advisers: M&A Engagement Letters

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In my last post, I said that indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

I'd like to explore this here.

The "promise" of indemnification is contained in an agreement that is primarily concerned with something else. For example, in a contract to develop a website, the party that performs the development service will be asked to provide certain assurances and indemnifications to the customer.  The promise of indemnification is in addition to the assurances about the services that are contained in the contract.  For example, the website developer will promise to make good any losses suffered by the customer in case a third party claims that the website infringes a copyright, or in case the website does not meet specifications.

In some respects, a promise of indemnification is redundant.  If the website developer represents in the contract that her work will not infringe a copyright, and it does, then the customer has a right to sue for breach of contract.  A separate promise to indemnify the customer against a claim of infringement is not really necessary, at least as to a claim brought by one contract party against another.  For this reason, some indemnification claims cover only claims by “third parties,” that is, people who are not parties to the contract. In general, it is accepted practice to ask and receive broad indemnification language, even though redundant.   

The "person" who makes the promise to indemnify is someone who has, in consideration of some payment or benefit, undertaken some kind of action, such as building a website.  The action, however, is one that has some risk or uncertainty associated with it.  For example, the finished website may infringe the copyright of someone else or may not meet specifications. The possibility of infringement may not be immediately apparent from an inspection of the website at the time it is delivered.  The possibility may only becomes apparent over time, hence the risk.

The promise to make good backs up some kind of assurance that the person made. The assurance is usually about something specific, such as “this website does not infringe any copyright” or “this website will meet specifications.” The “make good” includes the promise to “indemnify, defend and hold harmless”.  It is a promise to put the injured person back in her original condition, before the covered injury took place. In our example, that might include fixing the website to eliminate the infringing material, meeting the required specifications, refunding the payment if infringement cannot be cured or “defending” any legal costs, for example if the copyright holder sues for infringement.

The promise to make good covers only certain losses, namely, those losses arising out of a breach of the assurance. If an assurance is given that the website will not infringe a copyright, then the losses covered are only those that arise out of the infringement. Thus, before there can be a claim for indemnification, there has to be a loss; and for there to be a loss, there has to be a breach of some specific assurance. Often, where the loss is based on a third party claim, the loss has been established before the claim for indemnification is made. Where the loss is based on the character of the service itself, such as the specifications, then the loss will have to be established at the same time as the claim for indemnification.

The losses covered by indemnification include the costs and expenses of defending or pursuing a claim in court.  the biggest cost here is attorney fees.  In the American legal system, each party has to pay its own legal expenses.  Including attorneys fees in "losses" shifts this burden to the party who is providing the indemnification. 

Indemnification only covers losses "suffered by" the person to whom the assurances were made.  The suffering person is often expanded to include, in the case of a corporation, its officers, directors, shareholders and affiliates.  The losses cannot be speculative and must actually be incurred or suffered.

Related Posts:  What is Indemnification? -- Part 1

                         Indemnification Provisions of a Purchase Agreement

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When the topic of "indemnification" is reached during contract negotiations, the principals often grow silent and wait for their lawyers to speak.  The topic seems taboo, mysterious, off grounds to any but the intrepid legal specialist. 

But this is wrong, for indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  It is akin to a policy of insurance.  It is given where one person wants to back up or support an assurance made to another person. The word itself -- indemnification -- has the ring of insurance.  In fact, real insurance companies, like The National Indemnity Company, use a form of the word in their names.  I will discuss here the section of a business contract (usually near the end) in which one party, or both, agree to provide indemnification.

To illustrate this discussion, assume that a website developer has been hired to create a new website. The customer wants and receives written assurances that the website will not infringe any copyright, and that the website will function according to specifications.  The contract contains these assurances, along with the following simple, mutual indemnification clause:

“Each party shall indemnify, defend and hold harmless the other party (including such other party’s affiliates, partners, officers, directors, employees, agents, and representatives) against any claims and/or liabilities of any nature, including reasonable attorneys’ fees, arising out of or relating to any breach of the warranties made by such party in this Agreement.”

As I mentioned above, indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  To those like me who love bullet points, indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

In my next post, I will discuss each of these elements in detail.

Related Posts:  What is Indemnification? -- Part 2

                          Indemnification Provisions of Purchase Agreements

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Shareholders of closely held, privately owned companies often worry that their voting and economic rights may be diluted if the company were to issue new securities. An issuance of new securities could diminish a shareholder’s proportionate share of profits, dividends, and other distributions. These concerns may be especially acute when a company is just starting up and its owners anticipate future rounds of equity or debt financing. To prevent these undesirable consequences, shareholders may seek preemptive rights in offerings of new securities.  

Some states provide shareholders preemptive rights as a matter of law, while others require that preemptive rights be expressly granted in a company’s state filings or its organizational documents. Delaware’s general corporation law, for example, requires that preemptive rights be granted to shareholders in a company’s certificate of incorporation. Although there is some variance among state corporation laws, a company usually spells out the terms and conditions of any preemptive rights in its shareholders’ agreement.

Preemptive Rights: Determining a Shareholder’s Ownership Percentage

Preemptive rights entitle shareholders of a company to maintain their proportionate beneficial ownership interests by allowing them to participate in offerings of new securities on a pro rata basis. When a company issues new securities, each shareholder has a right to purchase a percentage of the new securities equal to the shareholder’s ownership percentage of the company’s outstanding stock prior to the offering. Each shareholder’s ownership percentage is calculated by dividing the number of the shareholder’s shares by the total outstanding shares of the company. One of the key differences among preemptive rights provisions is the way that the amount of total outstanding stock is determined. 

Preemptive rights may be offered either on an “as converted” or “as converted, fully diluted” basis. If the preemptive rights are offered on an “as converted” basis, then a company’s total outstanding stock prior to a new securities issuance includes both the total outstanding stock of the company and the outstanding stock there would be if its convertible preferred stock and convertible debt were to convert. If the preemptive rights are offered on an “as converted, fully diluted” basis, then a company’s total outstanding stock prior to a new securities issuance includes the company’s total outstanding stock on an “as converted basis,” plus the outstanding stock there would be if all options and warrants were exercised.

When a company plans to issue new securities that are subject to shareholders’ preemptive rights, the company commonly sends each shareholder a subscription warrant notifying him of the number of shares he is entitled to purchase.

Limitations on Preemptive Rights

Whether preemptive rights are offered on an “as converted” or “as converted, fully diluted” basis, they are customarily subject to certain limitations. Shareholder agreements restrict preemptive rights by excluding, or carving out, specific securities offerings from the definition of “new securities.” Securities offerings that may be carved out from the definition of new securities include those related to:

Equity Incentive Plans. Shareholders generally do not have preemptive rights in any new securities issued as part of a board approved employee equity incentive plan or other benefit program where the primary purpose is not to raise additional capital for the company. This exception allows the company’s board to incentivize management by offering them stock options and other interests in securities, while at the same time shielding the company from the prospect of a management buyout.  

Strategic Acquisitions. Where new securities are issued as consideration for the acquisition of another business entity, shareholders’ preemptive rights typically don’t apply. This exception enables the company to enter into transactions like stock-for-stock exchange mergers, or B reorganizations, in which an acquiring company issues new securities to the target company’s shareholders in return for a controlling interest in the target, and asset-for-stock exchange mergers, or C reorganizations, in which a company issues new securities to a target company’s shareholders in exchange for substantially all of the assets of the target. By affording the company an opportunity to grow through strategic acquisitions, this exception allows the company’s business operations to benefit from synergies and economies of scale and scope. 

Equity Kickers. So-called “equity kickers,” or equity interests attached to corporate debt, issued in connection with arm’s-length debt financing transactions are often excluded from a shareholder agreement’s definition of new securities. Banks may want to couple their rights as senior lenders with an equity position in the borrowing company and purchasers of corporate debt securities may prefer bonds issued with convertible features like options and warrants. In return, the issuing company receives lower interest rates on its senior and subordinated financing.

Stock Splits and Dividends. Another exception to the definition of new securities is the issuance of common stock resulting from a share dividend, share split, or similar event that is made on a pro rata basis. In shareholder agreements involving venture capitalists, this exception is generally not included. As primary capital contributors to a business, venture capitalists have considerable bargaining power and negotiate for additional anti-dilution protections by having their respective ownership percentages preserved after stock splits.

Public Offerings. Often, there is an exception for an initial public offering or listing of the company’s shares on a nationally or internationally recognized stock exchange. Usually, the exception only pertains to certain public offerings in which the new securities represent a specified percentage of the company’s total outstanding stock or raise proceeds above a defined threshold. The qualified public offering exception is commonly included in shareholder agreements among private equity firms when the sponsors anticipate a partial or total exit from their investment by means of an initial public offering.  

In practice, shareholder preemptive rights only benefit those shareholders with enough capital to participate in new securities offerings on a pro rata basis with their fellow investors. Shareholders with limited cash reserves may find themselves unable to exercise their preemptive rights in qualified offerings of new securities and consequently discover that their voting and economic rights have been diluted. 

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A recent opinion issued by the Delaware Court of Chancery serves as a cautionary tale to entrepreneurs, venture capitalists, and others entering into LLC operating agreements in connection with start-up companies. A minority investor with a substantial stake in a company sought to dissolve the company on the grounds it had abandoned its original business plan. However, because the purposes of the LLC were worded quite broadly in the operating agreement, the court ruled against the dissolution, much to the frustration of the minority investor. Thanks go to Francis Pileggi for bringing the case of In re: Arrow Investment Advisors, LLC to my attention and providing, as usual, an excellent summary and analysis of the court’s opinion on his blog. 

 Along with two others, Noah Hamman co-founded Arrow Investment with the intention of offering advisory services to investment funds. Hamman, who held a 30% membership interest in the company, had been its CEO until he was removed by his two fellow founders as a result of disagreements over management decisions. Like many other financial services firms, Arrow’s prospects began to sink with the market’s. In response, Arrow’s management committee decided to explore other investment opportunities and sent out a notice to the company’s members requesting capital contributions to fund their new programs. Hamman disagreed with this approach and brought a petition before the Court of Chancery seeking dissolution of the LLC under §18-208 of the Delaware LLC Act, alleging that Arrow had departed from the business strategy set out in its original business plan.  

 The court noted that Arrow’s LLC operating agreement, and not its business plan, was the controlling document for determining the company’s purpose. Arrow’s operating agreement clearly stated it was formed “for the purpose of acting as an investment adviser to certain investment funds and for such other lawful business as the Management Committee chooses to pursue.” Given the broad formation clause of the operating agreement, the court ruled that Arrow’s management had not violated the purpose for which the company had been formed simply by choosing to pursue new business strategies. In the words of Vice Chancellor Strine:

Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue. 

A company suffering disappointing financial returns resulting from a downturn in general economic conditions did not meet this standard.    

For most companies, including a broad purpose of formation clause in the operating agreement makes sense because it provides management with flexibility to adapt to changing business conditions. But founders of start-up companies should accept that the company’s eventual trajectory may not follow the one they initially conceived. 

To address this unknown and unknowable future, LLC operating agreements can institute appropriate governance procedures and potential exit provisions that would allow management and the company’s members to resolve significant disputes, or, if necessary, to part ways. Members of LLCs with substantial minority stakes, for example, may be given veto rights over certain material managerial decisions (such as when capital calls may be made to fund new business ventures) or exit rights that would allow a withdrawal from the LLC under narrowly specified conditions.        

Nobody won in the case of Arrow Investment Advisors. Hamman remains bound to a company he no longer wants to be a part of, management must continue to deal with a contrary minority investor, and the LLC itself has lost valuable time and money in defending this lawsuit. 

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The decision to sell a company is usually made only after a host of threshold questions are addressed: Why are the owners selling? What price would they accept? Should the form of consideration be cash, stock, Notes, or something else? Who will manage the business after it is sold? Will the buyer demand that the purchase price be adjusted after the closing? Should there be an earn-out? Answers to these questions can have significant tax and economic consequences, and they are typically examined and renegotiated many times during the course of the sale.

Enhancing Value Before the Sale

There are a number of things companies can do ahead of time to make themselves more valuable in a financing or acquisition transaction. Most importantly, they can assemble a management team that works cohesively to execute a well-considered business plan. Also, before seeking a transaction, a company should resolve any problems, such as contingent liabilities or unprofitable lines of business, which detract from value.

Several other steps that can be taken to enhance the value of a company before a sale are:

• Identify the most profitable product or service lines or distribution channels and focus the company’s resources on them.
• Implement a strategy for growth that capitalizes on the company’s core strengths and takes a wide view of its market and opportunities.
• Identify a profitable market the company is not currently in and develop a plan to enter that market using existing resources.
• Study and learn from the mistakes of competitors.
• Find the measurement tools most closely tied to the company’s profitability, record them and track progress.
• Develop robust information technology systems that manage and record assets and core business operations.
• Resolve any contingent liabilities, difficult customer/supplier issues and other hidden items that detract from the company’s value.
• Prepare financial projections that assume the company’s growth plans are achieved and base the company’s valuation on them.

Pricing the Company

Price is certainly the most important element in the sale transaction. In fact, nearly every issue that arises in a sale transaction relates in one way or another to the price. For example, the structure of the transaction generally dictates how it will be taxed, and taxes of course directly affect the price. In addition, the presence of an undisclosed liability or the possibility of the cancellation of a material contract would make the business less valuable.

Even if there are purchase price adjustments or earn-out provisions, an initial value must be negotiated for the business. For privately owned companies, valuation is generally based on a multiple of annual earnings prior to the payment of interest and taxes. In addition, for smaller companies it is customary to adjust earnings for compensation paid to the owners or members of their families. This adjusted earnings number is thought to reflect the true earnings power of the business more accurately. 

The multiple which is applied to the annual earnings figure can range widely from industry to industry and within companies in the same industry based on size, profitability, and management strength. An established company with good market position, some competitive pressures, and the need for steady management generally receives a multiple of five to eight times restated earnings. An established business with no competitive advantages, stiff competition, few hard assets, and heavily dependent on management generally receives a multiple of three to four times annual earnings. As a rule of thumb, a business should be able to pay for itself in four to five years, assuming that earnings remain steady during the period.

Of course, higher and lower multiples can be paid for companies depending on other economic factors such as interest rates, the general outlook of the economy, and the state of the industry in which the company competes. Also, book value is often used as a secondary measure of value, or as a method of testing the valuation of manufacturing companies. When book value is used, it generally benefits the seller to use fair market value for machinery and inventory, as these items are generally carried on the books at a lower value.

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Buying another company is a tried and true growth strategy. Making an acquisition can achieve economies of scale, increase a customer base or product line, expand into a new territory or eliminate a competitor. The cost of acquiring a company with a new product or technology may be less than the cost of creating it internally. In addition, an acquired business may be more profitable as part of a larger organization with greater resources than as a stand-alone business.

Due Diligence

In the initial stages of an acquisition, it is important, of course, to understand exactly what is being acquired. Every company has its own culture, accounting practices and hidden liabilities. An effective due diligence program can identify the target’s strengths, weaknesses and issues that need to be addressed in the acquisition context. The following checklist of items represent the principal areas of legal due diligence.   The acquisition candidate should be asked whether it has any of these items, and if so they should be studied carefully to assess their impact on its business, value and prospects.

• Agreements among stockholders, such as voting trust, buy/sell, stockholder, or right of first refusal agreements.

• Convertible debt and preferred stock instruments; notes and credit agreements.

• Restrictions on doing business in any territory or with any group of customers and any other material business contracts such as supply or distribution, franchise, license or alliance agreements.

• Pleadings in pending and recently settled lawsuits and summaries of disputes with suppliers, competitors or customers.

• Employment, consulting and non-compete agreements and management incentive agreements or bonus plans.

• Audited and unaudited financial statements, financial and operating budgets or projections and business plans, marketing studies and consultant reports.

• Lists of real and material personal property and eases for real or personal property.

• Lists of proprietary technology including issued patents and patent applications.

• Acquisition, partnership or joint venture agreements and any governmental agency inquiries.

Once an acquisition candidate has passed due diligence and a decision has been made to proceed with an acquisition, a new set of issues must be addressed. These issues concern how the transaction will be structured for tax purposes and how other liabilities of the target will be allocated between the buyer and the seller. These questions require input from an experienced tax advisor.

Tax Issues

The principal tax issues that must be addressed in an acquisition include the following:

• Will the transaction be structured so that the purchaser obtains a new cost basis in the target’s assets or will the purchaser take a carryover basis in the target’s assets (generally, the lower historical asset basis)?

• Will the transaction cause the target to pay a corporate-level tax on all the gain inherent in its assets, including good will and other intangibles? If so, will the economic burden of this fall on the buyer or the seller?

• Will the seller pay tax on the gain inherent in its stock? If so, can that gain be deferred?

Critical Non-Tax Issues

The principal non-tax acquisition issues include the following:

• Will the purchaser inherit all of the target’s liabilities (disclosed and undisclosed) or will the purchaser assume only specified liabilities of the target?

• If the seller’s representations and warranties turn out to be false, and the purchaser suffers losses from undisclosed liabilities (such as environmental cleanup, unpaid taxes, employment discrimination, anti-trust violations, product liability or patent infringement) or some other shortfall in assets or business operations (such as lack of title to assets, receivables not collectible, inventory not saleable or financial statement inaccurate), will the buyer be able to recover a portion of the purchase price from the seller?

• Will the executive management of the target be retained to operate the business?

Structure of the Transaction

After these issues have been resolved, the parties must settle on the structure of the transaction and negotiate other contract issues. The following is a partial list of the most common matters that need to be resolved:

• If part of the purchase price is payable in notes, what will be the terms of the notes? What will be their maturity, interest rate, default and other provisions? If part of the purchase price is payable in stock, what preferences, conversion rights, anti-dilution protection, dividend rates, and registration rights will the securities have?

• Will there be any right to adjust the purchase price based on future operations of the business?

• Will any assets of the target be excluded from the acquisition?

• To what extent will the purchaser inherit the target’s liabilities and obligations?

• Will the seller give representations and warranties concerning the target? Will they be qualified with reference to knowledge and materiality? What sort of indemnification will be given in the event of a breach of the representations and warranties?

What sort of covenants will the parties agree to regarding the operation of the target’s business before and after the closing?

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All companies look to forge strong relationships with their distributors. These affiliations are particularly important in industries where distributors add value through education, showrooms, installation or other service elements.

The first question in any distributor affiliation is how much control the supplier should exercise over the relationship. This question often turns on whether the manufacturer produces a commodity product or a proprietary one and the relative size of the parties. Distributors usually will not accept efforts to control the distribution of a product that can be obtained from a number of sources. However, a manufacturer that produces a proprietary product that is in demand has the ability, if it wishes, to exercise important controls over its distribution network.

Some manufacturers build a distribution control system into their marketing plan by setting up franchise systems or exclusive distributorships from the start. Whatever the name, these systems share a common goal from the point of view of the manufacturer: to shape the way its products are distributed in the marketplace.

The past 20 years have seen a marked increase in the control exercised by manufacturers over their products. Antitrust law and policy have adopted the view that consumers benefit when a manufacturer exercises control over its network of distributors in certain ways. Of course, it remains illegal to control pricing policies. That said, there are a wide variety of measures that manufacturers can adopt to shape the way their products get to market.

Perhaps the simplest measure is to grant a customer the exclusive right to sell products in a territory. This is often necessary to entice a well-capitalized distributor to take on a new product line. Other permitted controls include customer restrictions, advertising and trademark policies, stocking requirements for inventory or samples, and full line or exclusive requirements.

Distribution Agreements

Distribution agreements are a popular way to cement the relationship between a manufacturer and its distributors. Contracts are often drafted by the manufacturer and presented to the distributor as a finished deal. However, it is generally possible to negotiate these agreements, especially where the manufacturer is launching a new product or is trying to capture a new market.

Checklist of Material Terms in Distribution Agreements

The following is a checklist of the material items that should be addressed in a distribution agreement:

• What trademarks or trade names may the products be sold under? May the distributor use the trademark as part of its business name? What sort of approvals must be obtained in connection with the use of the trademark?

• Territory: exclusive, a designated primary area of responsibility or wide open? What happens if sales are made outside the prescribed territory? 

• May the manufacturer make direct sales in the territory?

• Are any accounts reserved to the manufacturer, such as national accounts?

• Must the business be conducted from a specific location? Can new locations be added in the future?

• What happens if other distributors sell within the protected territory?

• Can the distributor handle the products of competitors?

• Is the distributor required to carry the full line of products?

• What is the term of the agreement? How is the term renewed?

• Are there minimum purchase requirements?

• Must the distributor maintain a minimum quantity of inventory?

• May the distributor sell to other distributors or only to end-users?

• How are prices determined?

• What protections, if any, are there for price increases?

• Is the distributor required to participate in promotional allowances or other rebate programs instituted by the manufacturer?

• Must the distributor disclose its financial information to the manufacturer? Are there any minimum financial criteria to maintain the distribution?

• Under what circumstances may the distributor be terminated? May either party terminate the agreement without cause? What happens to unsold inventory following termination?

• What training or ongoing technical support is the manufacturer required to provide?

• Is the distributor authorized or required to provide warranty service? What parts will be stocked? How is payment for warranty service to be structured?

• Under what circumstances can the distributor return merchandise to the manufacturer?

• What are the terms of delivery? What are the distributor’s rights to inspect and test?

• Does the manufacturer promise continuous availability of products, spare parts and/or service?

• Will the manufacturer hold the distributor harmless from and actions for patent, trademark or copyright infringement?

• What insurance are the parties required to maintain?

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Sherman Act

The Section 1 of the Sherman Act states that every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce is illegal. There must be an agreement or conspiracy among two or more people and the restraint of trade must be “unreasonable”. Examples of agreements that result in an unreasonable restraint of trade include price fixing; allocations of customers or territories; group boycotts; and certain tying arrangements.

The requirement of an “agreement” in Section 1 means that the law does not apply to actions taken by a company unilaterally. However, the courts over the years have been liberal in the interpretation of the agreement or conspiracy requirement. An agreement or conspiracy has been inferred from circumstances such as:

• Meetings attended by competitors followed by collective action (without evidence of discussions).

• An aura of secrecy surrounding meetings among competitors.

• Actions taken by competitors that appear to go against normal self-interest.

• Simultaneous adoption of identical practices by competitors.

The law assumes, cynically perhaps but with some justification, that when competitors get together, they will try to eliminate or reduce any competition that exists between them.

That said, there is no agreement under antitrust law if a company simply announces a policy and independently carries it out. It is also legal for a company to receive complaints and act on them. Further, a corporation cannot combine with itself or one of its subsidiaries. The line between unilateral action and collective action can get blurred in the real world.

Continue Reading...

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The buyer of a company will often make specific promises regarding hiring and retaining employees of the business. If so, the purchase agreement will identify the buyer’s obligations in this regard and identify the benefit plans, severance obligations, and accrued bonus and vacation rights of the transferred employees. For example, the buyer may agree to grant service credit to employees for purposes of vesting in benefits, even though these credits may not be required by law.

The purchase agreement will specify the circumstances under which the agreement can be terminated.  Both parties will be able to terminate if the other party breaches the agreement and fails to cure the breach after being given the opportunity to do so. Also, the contract can be terminated if the closing does not occur by a defined date. This may occur, for example, if a third party or governmental approval is needed but can’t be obtained, or if financing can’t be obtained within a defined time period. This outside termination date is usually negotiated in the term sheet.

As the parties generally conduct the transaction across the borders of several states, the laws of one state will be chosen to govern the contract. Also, the courts of a specified jurisdiction will be chosen to hear disputes arising under the contract. In lieu of court adjudications, the parties may elect to implement an alternative form of dispute resolution, such as mediation and arbitration.

The purchase agreement will often have a number of things attached to it, such as schedules of information, forms of notes, or equity instruments delivered as part of the purchase price and allocations of the purchase price. These items are specifically incorporated in the purchase agreement and often constitute part of the items delivered by the parties at the closing.

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The sale of a company to a buyer typically begins with a term sheet spelling out the major terms of the transaction and setting out a timetable for due diligence, document preparation, and closing. The parties then negotiate a definitive purchase agreement containing representations and warranties, covenants controlling actions before and after the closing, and indemnification provisions. The time between contract signing and the closing is devoted to obtaining consents of third parties, waiting for clearance under the Hart-Scott-Rodino Act, securing financing to pay the purchase price, or concluding other tasks that are required to be completed before closing.           

One of the key issues in the sale of any company is who will manage the company after it is sold. Sometimes the answer is quite simple, as where the prior owners intend to retire. Other times the answer is more complex, as where the prior owners are required to remain involved in the company to ensure a smooth transition or to secure an earn-out.

Most of the time, the current senior managers of the target company are very important to sustain a core business, such as relationships with customers, product development, or brand name. In that case, the buyer may insist that these people sign independent employment contracts. They in turn acquire substantial influence over the transaction and may even have an impact on the sale price.

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Although office and manufacturing leases are generally recorded on the books as a liability, they are in fact critical business assets. Substantial investments are made in preparing an office or manufacturing center for occupancy. Also, a company generates good will associated with its location.

When leasing office or manufacturing space, an initial matter to consider is the difference between rentable and usable square footage. Prices are usually quoted on an annual square foot basis, so it is important to know whether the quote is based on actual useable space. Tenants should verify the square footage number provided by the landlord before signing the lease.

It’s also important to make sure that the uses planned for the space are permitted under the lease. The permitted uses should be broad enough to allow possible changes in the business, or to allow for a possible assignment or subletting of the space to a third party. The best use description is “any lawful use.” If the owner’s consent must be obtained to a change in use, it should be given readily unless there is a reasonable objection.

The commencement date of the lease is often different than the signing date to allow for necessary improvements in the space. What happens if the space is not ready on the commencement date? At a minimum, rent should be abated, and if the problem continues for a period of time, the lease should be cancelable at the option of the tenant. The termination date must also be spelled out clearly.

The base rent for the primary term is usually clear enough. What about escalations during the term of the lease, such as annual increases? Are there other escalations, such as cost of living increases? Leases often add a supplemental charge for the expenses of maintaining common areas, heating and air conditioning and operating costs. Care must be taken to make sure that any expenses are directly related to the occupancy of the space (excluding the owner’s overhead expenses). The owner should be required to account for the expenses and justify any requested increases. There should also be provisions for audits of expenses. It is prudent to negotiate clear provisions on any escalations or increases and even to cap any such increases.

The owner generally demands a security deposit for the lease. Sometimes a letter of credit can be substituted for a cash deposit. If cash is required, the interest should accrue to the tenant.

Tenant is generally responsible for the cost of the utilities that it uses when occupying the space. There should be separate utility meters so that the tenant doesn’t end up paying for other occupants or common area utility charges.

It is usually necessary to make certain improvements to the space before the tenant can move in. What will be the cost of these improvements and who will pay them? The owner will sometimes provide a work letter for improvements as an inducement to secure a long-term lease. If so, the owner sometimes wants to specify the company that will provide the contractor services. If that’s the case, it is important to prepare a detailed construction letter setting out all the requirements of the renovation, as with any contractor. Whoever is the contractor should be responsible for obtaining any necessary permits and approvals. At the end of the lease term, the owner will generally own the improvements, but if there are any special fixtures that the tenant wishes to take away, these should be specified in the lease.

If something goes wrong with a structural element of the space or one of the mechanical systems, whose responsibility is it to fix the problem and who pays? It is important to detail these responsibilities, and to factor them into the cost of the lease if the tenant is forced to assume responsibility for them. Leases generally contain a requirement that the space be returned at the end of the lease in the same condition as at the beginning, subject to ordinary wear and tear. Is this consistent with the use that tenant intends to make of the space? The tenant should consider the costs of returning the facility to its original condition if major modifications were made during the course of the lease.

The tenant should have the right to sublet or assign the lease, as long as the new tenant is reasonably acceptable to the owner. The lease will generally spell out the standards of what is an acceptable subtenant or assignee. The tenant should be allowed to assign to an affiliate without the consent of the owner, as long as it remains primarily liable under the lease. The assignment clause should be read carefully to determine if there is a deemed assignment in the event of a change in control of the tenant. If the assignment or sublet is at a higher rental, the owner will often try to keep all or most of the increase.

The owner should warrant certain basic conditions, such as quiet enjoyment, ownership and class of building, if appropriate. If the building is destroyed or rendered unfit for occupation, the tenant should of course have the right to cancel the lease.

Tenants should generally negotiate for options to renew the lease at the end of the basic term. The tenant may also want to secure rights of first refusal on contiguous space in case the space becomes available and the company is outgrowing its initial quarters. Attention should be paid to the rules and regulations of the building as well as things like weekend and evening access, security and exterior lighting, signage and parking spaces.

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No one cares about the law of sales and collections until something goes wrong.   When disputes arise, the parties dust off the “boilerplate” provisions printed on the back of their purchase orders and invoices. Often these provisions are in conflict with one another or do not cover the issue that actually exists. In these circumstances, where the contract involves the sale of goods, the parties must look to the provisions of the Uniform Commercial Code for answers. This Code, adopted in every State, provides a uniform body of rules for sales of goods. For sales of services, the common law of contracts applies. 

The success of the Uniform Commercial Code in regulating the sale of goods has crossed over into general contract law, and many provisions of the Code have influenced the development of general contract law.

Article 2 of the Uniform Commercial Code: Contract Terms and Conditions

Article 2 of the Uniform Commercial Code covers how and when contracts for the sale of goods are formed; warranty obligations; how contracts must be performed; what happens when a party breaches a contract; and what remedies are available when a breach occurs.

Forming Contracts

Any sale of goods for a price of $500 or more must be reflected in written form. The writing must be sufficient to indicate that a contract for sale has been made by the parties and must be signed by the party against whom enforcement is sought. However, this requirement is waived in sales between merchants if one party sends a written confirmation of the contract and the other party fails to object within 10 days of receipt.

Apart from this requirement of a “writing,” the rules of contract formation are very liberal. A contract may be made in any manner sufficient to show agreement, including conduct by both parties that recognizes the existence of such a contract.

A written offer by a merchant to buy or sell goods which gives assurance that it will be held open cannot be revoked during the time stated in the offer. If no time is stated, then the offer must remain open for a reasonable period of time, but not in excess of three months.

If the customer’s purchase order contains one set of terms and conditions, and the acceptance or invoice contains another set, the additional terms of the invoice become part of the contract unless the offer limits acceptance to the terms of the offer or they materially alter it. In addition, conduct by the parties that recognizes the existence of a contract will be sufficient to establish a contract, even though the writings do not establish one. Accordingly, written exchanges and conduct must be tightly controlled to avoid inadvertent contracts.

A party may delegate performance of a contract to someone else, unless the other party has a substantial interest in having the original party perform the contract. Either party may assign its rights under a contract except where the assignment would materially impact the other party’s duties, burdens or risks.

Warranties

Unless the parties otherwise provide, the following warranties are assumed to be made by the seller as to the goods:

1. Seller has title to the goods and the right to transfer them.

2. The goods are delivered free from any security interest or other lien (other than those the buyer actually knows of).

3. The goods are “merchantable” (generally, the goods are fit for the ordinary purposes for which they are used).

4. When seller has reason to know any particular purpose for which goods are required and buyer is relying on seller’s skill or judgment to select goods, there is an implied warranty that the goods are fit for such purpose.

5. A statement of fact relating to goods creates an express warranty that the goods conform to the statement.

6. A description of the goods creates an express warranty that the goods conform to the description.

7. A sample creates an express warranty that the whole of the goods conform to the sample.

Special care must be taken to exclude or modify these warranties if they cannot be supported. Generally, the contract should contain express language that excludes warranties, or states that goods are sold “as is” or “with all faults.”         

Performance

The UCC spells out how contracts are to be performed in cases where the parties have omitted the details. For example, if a buyer has paid all or part of the price of goods and the seller becomes insolvent, the buyer may recover the goods from the seller if the seller’s insolvency occurred within 10 days after receipt of the first installment of the price. Also, the buyer has the right to inspect goods at a reasonable place and time and in any reasonable manner before payment is due.

Breach of Contract

When there are defects in the goods, or a defect in their method of delivery, the buyer has the option to reject or accept all the goods or accept any portion that is acceptable and reject the rest. A notice of rejection must be delivered “seasonably,” the buyer cannot delay unreasonably.   In addition, if the buyer rejects the goods while they are in his possession, he must follow the reasonable instructions of the seller with respect to the rejected goods. If no instructions are received, the buyer may store the goods for seller’s account, reship to seller or resell for seller’s account.

On the other hand, once the buyer has accepted the goods, he must pay at the contract price for any goods accepted. Acceptance occurs when the buyer after a reasonable opportunity to inspect the goods signifies to the seller that the goods are conforming, or fails or make an effective rejection (after having an opportunity to inspect). Although accepted goods may not be reshipped to the seller, buyer retains any claim based on non-conformity of the goods to warranties.

When reasonable grounds exist that make one party feel that performance by the other may be impaired, that party may demand assurances of due performance from the other party. Until he receives such assurances, he may suspend his performance. If the cost of performing the contract suddenly increases dramatically due to an event that undermines a basic assumption of the contract, the seller may delay its delivery or even fail to deliver the goods.

Remedies

When a seller discovers that buyer is insolvent, he may refuse to deliver goods except for cash, including payment for all goods previously delivered. When a buyer receives goods on credit while insolvent, the seller may reclaim the goods on demand made within ten days after the receipt.

When a buyer breaches the contract, typically by not accepting goods or failing to pay for goods already received, the seller may recover damages for non-acceptance or cancel. Damages in the case of non-acceptance of goods is the difference between the market price at the time and place of delivery and the unpaid contract price, less expenses saved as a consequence of buyer’s breach. However, if this measure of damages is inadequate to put seller in as good a position as performance would have done, then the measure of damages is the profit (including reasonable overhead) which seller would have made from full performance. Damages, in the case of non-payment, are the price of goods accepted, plus incidental damages. Alternately, when the buyer has failed to accept goods seller may resell the goods in a commercially reasonable manner and recover the difference between the resale price and the contract price, plus incidental damages. The seller does not have to account to buyer for any profit made on the resale.

When a seller breaches the contract by failing to make delivery or when the buyer rightfully rejects goods, then buyer may cancel and recover so much of the price as has been paid. In addition, the buyer may purchase goods in substitution of those due from seller and recover from seller the difference between the cost of the substituted goods and the contract price, together with incidental and consequential damages, but less expenses saved. Alternately, the buyer may recover damages for non-delivery equal to the difference between the market price at the time the buyer learned of the breach and the contract price, less expenses saved.

The measure of damages for breach of warranty is the difference between the value of the goods accepted and the value they would have had if they had been as warranted. The parties may specify liquidated damages in the agreement, but the measure must be reasonable in light of the harm caused by the breach. Unreasonably large liquidated damages are void as a penalty. Any action for breach of any contract for sale of goods must be commenced within four years after the breach occurs. The parties may shorten the period to one year (but not less).

Article 9 of the Uniform Commercial Code: Security Devices

Article 9 of the Uniform Commercial Code contains a powerful tool to aid in the collection of accounts, although many companies do not take advantage of it. It gives sellers of goods the right to retain a security interest in the goods (or other assets of the buyer) until payment. Without a security interest, the seller must take a back seat to creditors (typically banks) that do take advantage of this law.

Security Interests

A seller of goods can retain a security interest in the goods if the following procedures are adopted:

1. The buyer signs an agreement granting a security interest in the goods.

2. A financing statement is filed in the office of the Secretary of State of the state in which the buyer is located or incorporated.

The advantage of a security interest is that the secured party has a priority to the goods in the event the buyer becomes insolvent. Proceeds from any sale of the secured goods must be paid first to the seller in satisfaction of its account. A security interest in goods disappears once the goods are resold to another buyer in the ordinary course of business.

If buyer defaults in payment, a seller with a security interest in goods may take possession of the goods either by judicial process or without judicial process if it proceeds without breach of the peace. A secured party may also require the debtor to assemble the collateral and make it available to the secured party. The secured party may dispose of the collateral by public or private sale in a commercially reasonable manner. Any proceeds of such a sale must be applied first to the expenses of sale and then to the satisfaction of the debtor’s obligations. The secured party may also accept the collateral in full or partial satisfaction of the obligation under certain circumstances.

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A trade secret is any information that derives its value by virtue of remaining secret and is in fact the subject of efforts to maintain its secrecy. A trade secret is a secret piece of information that provides a competitive advantage over those who do not know the information. A trade secret can be virtually anything: a formula, pattern, program, method, technique, process, sources of supply, customer lists, business and marketing plan, or new product under development. Once the secret is disclosed, it ceases to be a trade secret.

Trade secrets are a product of state law. There is no registration procedure for trade secrets and no formal procedure exists for filing an application with any governmental authority. Trade secrets can include matters that are patentable, and indeed many companies choose to rely on trade secret protection rather than patents for their inventions, as trade secrets are not publicly disclosed.

A trade secret must be generally unknown in the industry. Absolute secrecy is not required. The information must generate some independent economic value by virtue of being known only to the possessor. A company must take affirmative steps to keep the information secret, such as locked facilities, security measures, confidentiality agreements for employees, and other similar measures.

Trade secrets are not necessarily exclusive, as patents and trademarks are. It is possible for two companies to independently develop and protect the same confidential information. Trade secret law only entitles the owner to prosecute those who acquire the secret through unlawful or improper conduct.  Unlawful or improper conduct includes bribery, theft, fraud, electronic surveillance and breach of contract or company policies. 

It is perfectly lawful for a competitor to purchase a company’s product and tear it apart to see how it works, thereby discovering a trade secret independently. A competitor can use any trade secrets it finds in the course of such an examination, or at a trade show or in product literature. Patent protection should always be obtained if the possibility of “reverse engineering” by competitors is high. 

Trade secrets can last as long as the information remains a secret. The theft of trade secrets can be stopped through injunctions and the owner may also sue for actual damages, punitive damages, the competitor’s profits and attorneys’ fees. Trade secret litigation often poses the danger that the secret will be leaked to the public in spite of a court’s secrecy orders.

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Copyright law protects "works of authorship."  This means that there must be an author—a human being—and work created by the author. Works are typically thought of as pieces of literature, music, drama, choreography, photography, graphic arts, sculpture, motion pictures, videos, architecture, and computer software, although virtually any other work that is fixed in a tangible medium can be protected by copyright law.

To receive copyright protection, a work must be "original" and must be "fixed" in a tangible medium of expression. The originality requirement is easy to satisfy. A work is original for copyright purposes if it owes its origin to the author and was not itself copied. A work can incorporate preexisting material and still be original. When this happens, the copyright on the new work covers only the original material contributed by the author.

A work is "fixed" in a tangible form when it is made sufficiently permanent or stable to permit it to be perceived, reproduced, or otherwise communicated for a period of time.  It makes no difference what the form, manner, or medium is.  An author can "fix" words, for example, by writing them down, typing them into a computer, dictating them into a tape recorder, or scratching them on a tablet. A live television broadcast is "fixed" if it is recorded simultaneously with the transmission. But a Homeric bard, reciting The Iliad around an ancient fire, does not fix his work in a tangible medium, and therefore is bereft of copyright protection.

The design of an object, such as furniture, is protected by copyright only if the design incorporates features that can be identified separately from, and are capable of existing independently of, the useful aspects of the article. For example, while the design of a basic chair is not protected by copyright, a chair that uses antlers as arms may qualify for certain protection.

Copyright protection arises automatically when an original work of authorship is fixed in a tangible medium. Registration with the Copyright Office is optional, though it is virtually essential in connection with litigation. The use of the copyright notice is optional for works distributed after March 1, 1989. Copyright notices generally take the following form: © followed by a date and name.

Exclusive Rights of Copyright Owner

A copyright owner has five exclusive rights in the copyrighted work:

1. Reproduction: the right to copy, duplicate, transcribe, or imitate the work in fixed form.

2. Modification: the right to modify the work to create a new work (also called the derivative right). A new work that is based on a preexisting work is known as a "derivative work."

3. Distribution: the right to distribute copies of the work to the public.

4. Public Performance: the right to perform the work in a public place.

5. Public Display: the right to show the work in a public place.

Anyone who violates any of these exclusive rights is an infringer. A copyright owner can recover actual or, in some cases, statutory damages from an infringer. The federal district courts have the power to issue injunctions to prevent or restrain copyright infringement and to order the impoundment and destruction of infringing copies.

Under current law, the copyright term for works created by individuals is the life of the author plus 70 years. The copyright term for works “made for hire" is 95 years from the date of first "publication" (distribution of copies to the general public) or 120 years from the date of creation, whichever expires first. Works “made for hire” are works created by employees for their employers and certain types of works commissioned from independent contractors.

Exceptions to Copyright Owner's Exclusive Rights

The copyright owner's exclusive rights are subject to a number of important exceptions. These are:

1. Ideas. Copyright protects only the unauthorized taking of a protected work's "expression." It does not extend to the work's ideas, concepts, principles, or discoveries. Ideas that are inventions may be covered by patent law.

2. Facts. The facts contained in a work are not protected by copyright, even if the author spent large amounts of time discovering them. Copyright protects originality, not effort.

3. Independent Creation. A copyright owner has no claim against another person who, working independently, creates an exact duplicate of the copyrighted work. The independent creation of a similar work or even an exact duplicate does not violate any of the copyright owner's rights.

4. Fair Use. The "fair use" of a copyrighted work, including use for purposes such as criticism, news reporting, teaching, scholarship, or research, is not an infringement of copyright. The Copyright Act does not define fair use. Instead, whether a use is “fair” is determined by balancing the purpose and character of the use, the nature of the copyrighted work, the amount and substantiality of the portion used in relation to the copyrighted work as a whole, and the effect of the use on the value of the copyrighted work. Lots to litigate here.

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Trademarks are an important tool for companies that develop and maintain brand names. Well-known brand names are used to forge direct ties with consumers or a diverse distribution system. Brands reduce the marketing costs of companies as end users rely on the reputation for quality embodied in the brand.

A trademark is any word, name or symbol used by a manufacturer to identify and distinguish its products from those manufactured by others. A trademark identifies the source of the product rather than the product itself. For example, DELL® is a trademark for a generic product—the computer. The DELL® trademark indicates that the Dell Corporation is the source of the computer bearing the trademark, which serves to distinguish it from computers manufacturer by others.

Unlike patents, where the federal government is the only power that creates and enforces the rights, trademarks exist and can be protected under state and federal law. Also unlike patents, legal rights in a trademark are established only by using the mark in commerce. Finally, it is not necessary to register a trademark with the government to obtain legal rights, although federal registration provides a number of advantages. 

Federal Trademark Registration

Federal trademark registration gives a company the exclusive right to use the mark throughout the entire United States, even though the product may be sold only in one region. Federal registration plus five years of consecutive use is conclusive evidence that the mark is valid and that the owner has the exclusive right to use the mark in commerce. Finally, a registered trademark often deters others from using the same or a confusingly similar mark, as most companies search the register of federal marks when making a name selection.

A trademark must be distinctive. A distinctive mark is one that is unique when used with a particular type of goods. Distinctiveness is measured along a spectrum, from those that are fanciful (like EXXON for gas) and arbitrary (like APPLE for computers) to those that are merely descriptive (like YELLOW PAGES for phone directory). Marks that are descriptive, like TENNIS SHOE for tennis shoes, are not trademarks at all, since they merely describe the goods. In the middle of this spectrum lie suggestive marks, words that tend to reveal or hint at an attribute of the goods, such as COPPERTONE for suntan lotion. Marks can upgrade their status over time if they acquire secondary meaning as consumers grow to recognize the mark as identifying the source. Substantial expenditures on advertising and continuous use for a number of years can create secondary meaning.

A trademark must not cause confusion with a pre-existing mark. Conflicts may arise where two marks will be used in the same market for related products or services. Similar trademarks that are used on very different products can generally be registered, unless one of the marks is very famous. The following factors are used to determine whether one trademark is confusingly similar to another:

1. Whether the marks are similar in appearance, sound, and impression.

2. Whether the products to which the marks are attached are similar.

3. Whether the channels of trade in which the goods are distributed overlap.

4. How consumers purchase the goods.

5. The fame of the prior mark.

6. The extent of any actual confusion among consumers

A federal trademark owner has the exclusive right to use the mark on the specified products throughout the United States. The right can last forever, but it can be lost if the mark is no longer used or if the mark becomes generic. Marks can become generic if the owner is not vigilant about enforcing the mark against obvious infringements. The trademark owner can sue the infringer to stop the conflicting use and may also recover damages, profits, court costs and attorneys’ fees.

Federal trademark protection is secured by filing an application with the Patent and Trademark Office. Trademark examiners review the application and the database of prior registrations to determine whether to grant the application. Although federal registration provides certain advantages, only actual use of the mark grants enforceable rights.

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A patent is often compared to an agreement between an inventor and the United States government. The government gives the inventor the exclusive right to practice the invention for a period of time, generally 20 years. In return, the inventor discloses all the details of the invention to the public through the patent application process. The inventor gets to exploit the invention for 20 years without competition. After that, the invention can be freely used by the public. 

Patents are usually applied for by individuals and then assigned to the companies that support the research and development. Manufacturers typically seek utility patents, which cover the useful or functional aspect of an invention. The legal rights awarded to an inventor are spelled out in a formal document issued by the United States Patent and Trademark Office. In addition to sections describing the invention and the way it has solved problems hitherto unsolved, the patent document spells out the exact protection of the invention, in the same way that a deed describes the metes and bounds of a piece of land.

Patents can also be granted for the design of a product. Design patents are granted to protect designs that are new, original and ornamental. An element of a product that is predominantly functional, such as the blades of a propeller, cannot receive a design patent, since it is not primarily ornamental. Design patents last only fourteen years and are generally easier to obtain than utility patents, although their coverage is generally less powerful.

A patent is only granted to inventions that are novel and not obvious to one skilled in the field in which the invention exists. An invention is not novel if it is already known, or the invention was already patented or appeared in a printed publication before the date of invention. The rules on novelty are quite technical and it is important to conduct a thorough search of the prior art before filing a patent application. Unless an investor is familiar with the procedures for conducting these searches, they should be conducted by experienced patent attorneys.

An invention must not be “obvious” to someone skilled in the field in which the invention exists. An invention may be novel, but if it is an obvious variation of known technology, it will not receive a patent. To make this assessment, the patent office or the court (if the patent is challenged) must imagine a hypothetical person skilled in the relevant art, and ask whether the invention would have been obvious to that person. This assessment is very fact intensive and open to dispute, and the requirement is responsible for a good deal of litigation.

Finally a patent must disclose in clear and complete terms how one with ordinary skill in the technology field could make and use the invention. This is part of the bargain with the federal government. If the disclosure is incomplete or too obscure, leaving the public without the ability to practice the invention when the patent expires, the patent will be denied or invalidated by a court. 

The owner of a patent has the right to exclude others from making, using or selling the invention. There is no requirement that the patent owner actually use the invention in order to exclude others. As with a piece of land, the owner can elect to let it sit fallow and still keep others from trespassing. But unlike land, the patent gives the owner the right to keep others from producing products that are “equivalent” to the invention. This keeps others from making a trivial change to an invention just to avoid infringement. A product is considered equivalent if it performs substantially the same function, in substantially the same way, to achieve substantially the same result as the invention. 

Patents issued today are granted a 20-year period of protection from the date the application is filed with the federal government. The owner must pay maintenance fees to keep the patent in force. Under patent treaties with other countries, the patent can be registered in foreign jurisdictions and protected or licensed there. If someone infringes a patent, the owner can sue in federal court and obtain an injunction, monetary damages and an award of attorneys' fees.

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A private placement is a process, not a source of funding. A private placement simply means that the stock is sold in the private market, and cannot be resold in any public stock markets. As a practical matter, no private placement can occur without a placement agent, underwriter or direct source of capital, such as a venture capitalist. Although a private placement is not itself a source of capital, the phrase has become a shorthand way of referring to capital that is provided by private investors, rather than the public stock market.

Private placements must be structured to comply with State and federal securities laws. These laws, dating back to the 1930s, say that a stock offering must be registered with or approved by a government agency, unless it meets a specific exemption. An offering or sale of the securities that is conducted privately, without a public offering, will generally be exempt, as long as the offering is made only to sophisticated and wealthy investors. The safe harbor most often relied on for private sales of securities is Regulation D adopted by the Securities and Exchange Commission under the Securities Act of 1933. Many States also incorporate the thinking behind Regulation D in their own regulatory scheme.

"Accredited Investors" under Regulation D

Regulation D includes a number of exemptions from registration, depending on the size of the issuer, the number of investors and the manner in which the offering is conducted. One popular exemption under Regulation D allows a company to offer and sell its securities to an unlimited number of "accredited investors” and up to 35 unaccredited investors. Specific classes of information and financial statements must be furnished to unaccredited investors and no general advertising or solicitation is allowed.

An “accredited investor” includes:

• Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer or general partner of a general partner of that issuer.

• Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000.

• Any natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

• Any trust with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase of the securities is directed by a person who has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.

• Any organization that was not formed for the purpose of acquiring the securities being sold, with total assets in excess of $5,000,000.

• Any entity in which all of the equity owners are Accredited Investors.

The scope of State securities laws has been cut back in recent years. Now, a securities offering under Regulation D that is made only to accredited investors is automatically exempt from State securities laws, as long as notice filings are made with the SEC and the State regulators within prescribed time frames.

In practice, most private placements are offered or sold only to accredited investors. A private placement made only to accredited investors has no specific information requirements. For most purposes, there is no limit on the number of accredited investors that can be involved in the offering. The issuer usually prepares and hands out a private placement memorandum that outlines all of the risks of the offering and the material information about the company. Assuming willing investors are found, the private placement mechanism is a popular way to raise equity capital and one that follows a tried and true procedure and legal requirements.

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Companies that have burned through what cash friends and family have been willing to provide, and still can’t get a bank loan, turn to strangers for money. These strangers go by many names, one being “venture capitalists”. 

Venture capitalists provide money when other sources are not available. Most venture capital financing goes to companies in a narrow band of industries:  technology, information services, life science and telecommunications. Because so many start-up ventures fail, venture capital tends to adopt a collective mentality, flocking toward those deals and industries that are perceived to have the greatest chance of a quick and profitable exit.

A common requirement for venture capital is a founder or CEO who has had previous successful experience with venture capital money. Also, venture capital tends to favor companies that are already far along in the development process and need funding to get a product to market.  Finally, venture capital needs to see that projected revenues will accelerate very quickly, like a hockey stick, once product development and launch are complete. New ventures in mature industries with slower growth prospects, no matter the brilliant the business plan, are not a target of venture capital investors.                                  

Once a decision is made to provide venture capital financing, the venture capitalist typically prepares a term sheet for the investment, setting out the principal terms of the transaction. The term sheet is later reflected in formal legal documents. Whatever negotiations transpire between the company and the venture capitalist occur as the term sheet is circulated. 

Venture Capital Term Sheets

The following provisions are typically covered in venture capital term sheets:

1. Fixing the “pre-money” value of the company in order to determine how much equity the new investors will receive. For example, if the company has a pre-money value of $3 million and the venture capitalist provides $1 million of capital, the company will be worth $4 million after the investment, and the venture capital will receive shares equal to 25% of the outstanding stock.

2. Defining the terms of the security the venture capitalist will receive—generally preferred stock. The term sheet will spell out the rights and preferences of the preferred stock, such as dividends (often payable in more shares of preferred stock), liquidation preference, conversion rights (how the preferred stock is converted into common stock), and anti-dilution protection (in case the common stock is split or additional shares of common stock are issued at a price that is less than the conversion price of the preferred stock).

3. Actions that require the consent of the preferred stock voting separately as a class, such as a merger or sale of the company, amending the terms of the preferred and the issuing securities with rights senior to those of the preferred. Generally, the approval of the venture capitalist will be required in order to undertake any significant event.

4. A right to demand that the company file a registration statement with the Securities and Exchange Commission covering the stock so that it can be sold in the public markets. Also, the right to participate in any registration statements filed by the company on behalf of other investors.

5. The right to elect one or more members to the board of directors.

6. Who will serve as CEO and chief technology officer of the company.

7. How much stock management will own, generally through incentive stock options, including lock up provisions prohibiting the sale or transfer of such stock except in connection with a transaction in which all shareholders participate.

8. Rights of first refusal and preemptive rights with respect to new shares offered by the company.

9. The right of the investors to participate in any sale of stock by the original founders of the company.

Venture capital generally comes in stages. Each round of capital is designed to get the company to the next stage of development. As the stages proceed, different venture capitalists may become involved, as the industry has firms that specialize in different stages of development.

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A company with stable growth, revenues and cash flow and assets to serve as collateral can usually get bank financing. This is the least expensive form of capital. Banks charge interest rates keyed to various indexes. Interest costs have been low recently, and look to remain that way for the foreseeable future.

Bank financing documents can appear lengthy and complex, although the lending relationship is quite simple. After providing the funding, the lender is primarily concerned with receiving scheduled payments of interest and principal. The many protective clauses in the loan agreement are designed to maximize the lender’s chances of getting repaid in the event of a default and giving it an early warning if financial problems start to develop before an actual payment default occurs.

Asset Based Financing

Companies often seek “asset based financing” from lenders. In this financing, a company borrows against its tangible assets, such as fixed assets, receivables and inventory. The amount available to loan is tied to the appraised value of assets or the amount of eligible receivables and inventory a company has at the end of a measurement period.  The availability of funds for fixed assets is determined at the start of the loan, and the loan amount remains constant, subject to repayment through amortization. The availability of funds for liquid assets such as inventory and receivables is constantly changing. A formula is used to determine the exact amount of funds available to borrow. These borrowing limits are the critical measures of credit availability. Typically, borrowing limits don’t exceed 80% of the eligible receivables and 50 to 60% of eligible inventory. 

A typical definition of an eligible receivable is one that arises in the ordinary course of business; is not disputed or subject to any right of set off, allowance or adjustment by the customer; is not more than 60 days old; and is owed by a customer whose financial condition is satisfactory to the lender in its sole discretion.

Eligible inventory has similar contractual limitations as to the quality, age and condition of the goods. Generally, a borrower must have a perpetual inventory system that keeps close track of inventory levels. The inventory may be subject to a fair market valuation if that measurement is lower than cost. Although these definitions and the discretion given to the lender to cancel the loan raise concerns, in practice the lender is subject to an obligation of good faith and fair dealing which tempers arbitrary lending practices.

Receivables Financing and Factoring

The financing of accounts receivable is the linchpin of asset-based lending. Receivables are popular with lenders because they are self-liquidating and provide short-term sources of cash. The assets cannot be stolen, lost or damaged. However, problems can arise when the account debtor (the customer) has offsets or counterclaims against the borrower. These can compromise the collection of the receivable and reduce the lender’s collateral base. Lenders typically perform some due diligence on account debtors to make sure there are no hidden defenses to collection of the receivables.

Receivables financing is structured so that the account is immediately assigned to the lender without notifying the customer. The borrower merely acts as a conduit for the collection from the customer, and payments are applied directly to repayment of the loan. The lender monitors the collection of accounts daily and bases it’s lending on the amount of outstanding accounts. Another form of receivables financing is "factoring", where the receivable is actually sold to the factor at a discount to face value. The customer is notified that an invoice has been sold and the seller must repurchase the receivable if non-payment is due to a manufacturing problem. The credit risk is absorbed by the factor.

Customary Terms of Loan Agreements

A typical loan agreement will cover the following topics, in a fashion that strongly favors the rights of the lender:

1. The interest rate, how interest is computed and how often interest is paid.

2. The schedule for repaying principal.

3. Any fees payable to the lender at the closing or during the term of the loan.

4. Affirmative covenants such as delivery of financial statements and other reports on a periodic basis; allowing inspections of major facilities and assets; payment of other obligations and taxes when due; compliance with applicable laws and maintenance of net worth and other financial ratios.

5. Restrictive covenants prohibiting the borrower from entering into merger or acquisition transactions; incurring other obligations for borrowed money; paying dividends or making distributions to shareholders; making loans to third parties or selling assets other than in the ordinary course of business.

6. Defining the events of default such as failure to pay interest or principal when due; breach of representations or covenants; and becoming insolvent or declaring bankruptcy.

Security Interests and Guarantees

To secure a bank financing, the borrower must provide credit supports, such as pledging specific assets or providing guaranties of third parties. A pledge of assets simply means the lender has a preferential right to be repaid out of the proceeds of the asset in the event borrower fails to repay the loan. The pledge is accomplished by granting a security interest in the assets, if they are personal property such as accounts receivable, inventory or equipment, or by granting a mortgage if the assets are land or buildings.

A guaranty is the promise of another party to make good on the loan if the primary obligor defaults. The guarantor may be a stockholder or subsidiary of borrower or some other company under common control with borrower. Most guaranties give the secured lender the right to pursue the obligation directly against the guarantor if the borrower defaults. There is usually adequate consideration for a guaranty if it is required by the lender as a condition of making the loan.

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LBO deals are typically done through limited liability companies, while venture capital deals are typically done through corporations. The difference is governed by tax considerations and the expected exit strategy.

Leveraged Buyout (LBO) Deals

In LBO deals, the acquired company is typically generating taxable income—the same taxable income used to repay the debt incurred to buy the company in the first place. In venture capital deals, the company is typically not generating taxable income, as it is spending money on people and technology at least as fast as it is generating revenues. When revenues do catch up, it can shelter the income awhile longer as it burns through the accumulated net operating losses. As a result, LBO deals typically favor a legal structure that minimizes tax liability (such as the limited liability company), while venture capital deals typically don’t care about taxes, and therefore use a taxable corporation.

Venture Capital Deals

Venture capital deals, and other companies that expect to be publicly traded, are typically organized as corporations.  Corporate shares are designed to be liquid and easily traded on national stock exchanges. For this reason, most venture capital deals are made through corporations with multiple classes of preferred stock, each convertible into common shares, as hope springs eternal that the company will one day go public and mint money for the original investors.

At the present time, corporate law is more thoroughly developed than LLC law and is therefore more predictable from a legal standpoint, although this difference is quickly fading away.

Another reason that corporations are favored in venture capital deals is that they better accommodate stock options. It is difficult to grant traditional stock options to key management of an LLC. The tax code does not permit LLCs to issue incentive stock options, which are treated as capital assets rather than ordinary income, and therefore provide a significant advantage in recruiting management. Also, the exercise of the options in the LLC context can raise tricky tax issues, as capital accounts must be rearranged.  

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The limited liability company, or LLC, is by far one of the most favored legal entities for businesses. LLCs enjoy the distinct tax advantage of passing through tax attributes, such as income, loss and gain, to owners. At the same time LLCs are infinitely flexible, offering the ability to create a private world of terms and conditions governing the relations of the members. Only the limits of human imagination restrict the scope of provisions that the limited liability operating agreement can contain. Limited partnerships, which LLCs have largely replaced, have the same flexibility, but they also have a number of annoying structural and capital requirements in order to pass tax scrutiny. 

The owners of an LLC are allowed a wide degree of latitude in fashioning the limited liability company operating agreement to meet their needs. In particular, the agreement may contain provisions establishing multiple classes of membership interests, limiting the transfer of interests in the company, requiring that members elect certain parties to the board of managers of the company, and requiring greater than majority approval for designated material transactions. These provisions are useful to keep control of the organization within the hands of the founding partners, while allowing key members of management to have equity positions in the company.

An LLC structure allows flexibility in allocating distributions of income and loss among the partners. This enables flexible arrangements between the suppliers of capital and managers in a tax-neutral setting. In a limited liability company, interests in profits can be allocated and reallocated more or less as the parties agree, without regard to the respective contributions of capital. In this regard, they are more flexible than corporations, which generally require that profits be allocated and distributed pro rata according to share ownership.

The owners of an LLC must pay tax on income whether or not cash is distributed by the company to pay taxes. This can be a hotly contested issue for highly leveraged companies, as the lenders typically block any cash distributions to equity when there is a covenant default. Although the instances of a company having taxable income and experiencing loan covenant defaults are fairly rare, it can and does happen. If distributions are blocked, the owners would have to dip into their own pockets to pay the tax liabilities—not a pretty picture. 

Sub-chapter S Corporations

Companies that expect to maintain a simple capital structure can in theory be set up as a corporation that elects to be treated as a sub-chapter “S” corporation under the Internal Revenue Code. All tax items of a sub-chapter S corporation are passed through to the owners, as in a limited liability company. Shareholders must report these items on their personal income tax returns and pay taxes on those items. Any income or gain of the corporation so attributed to the shareholders increases the tax or cost basis of the stock. As a result of this increase in cost or tax basis, a lower capital gain is realized when the shares are sold or liquidated. 

Sub-chapter S corporations have a number of limitations that make them relatively useless for several types of business owners. They can only have one economic class of stock, which rules out the complex capital structures often found in venture capital or private equity deals. And they can only have natural persons or certain trusts as shareholders, precluding the involvement of institutional investors, such as lenders who frequently secure warrants.

With the recent adoption of state laws enabling the formation of limited liability companies, many problems associated with limited partnerships and sub-chapter S corporations were solved. An LLC has all the advantages of a limited partnership while providing a flexible vehicle for business operations.

Formation of an LLC

An LLC is formed by filing a one-page certificate with the appropriate state office. The owners then sign a private operating agreement setting out the provisions governing management, transferability of interests, voting rights, allocation of profits and losses, distributions, issuing new interests, and other matters.  The internal ownership structure and control of the entity remains private because the LLC operating agreement is not required to be filed with any government agency. That said, the agreements do become visible if the company goes through the process of becoming a publicly traded company.

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