Legal Issues When Buying a Business: Due Diligence

As discussed in prior installments of this series on buying a business, there are a number important legal issues you need to consider before signing the purchase agreement.  The first installment discussed the role of the Exclusivity Agreement, the second installment examined the differences between structuring the transaction as stock purchase as opposed to a purchase of assets, and the third examined the importance of escrowing a portion of the purchase price to cover any issues that may arise post closing.  Part IV of this series explores important aspects of due diligence and how to address legal or financial issues in the purchase agreement.

Due diligence is a fundamental part of any purchase transaction as its purpose is to verify valuation assumptions (i.e., if the purchase price makes sense) and identify risks (whether they are legal, financial or operational).

1.  Conducting Legal Due Diligence.

The purchaser will obviously want to conduct due diligence of the business or assets being purchased.  The legal due diligence will examine an an array of legal issues, including:

      (a) Business Entity.   

• Are the company's organizational documents and records are in order and the entity in good standing.
• Are there any obstacles to the transaction such as a right of first refusal held by a shareholder or third party.
• Is there anything in the By Laws/Operating Agreement mandating a super majority or even unanimous approval of a sale.
• If the purchaser is buying the entity rather than the assets it is important to ensure there are no liens and that there aren't any third party's with rights with respect to the ownership interests.

     (b)  Permits/Compliance with Laws/Regulatory Matters.

• Are any permits, licenses or governmental approvals required by any jurisdiction where the business operates. 
• If permits or approvals are required, are the one's held by the seller assignable and if so what must be done to obtain the transfer of the permit.
• Does the business operate in a number of states or foreign countries, and if so what is necessary to operate the business in each jurisdiction.
• Are there particular regulatory concerns.
• Is any aspect of the business governed by privacy rules which mabe implicated by the purchase.  

      (c) Ownership and Transfer of Assets/Intellectual Property.

• The seller will need to prove good title to the assets of the business.
• Are any of the assets encumbered or pledged.
• Does the company own or license intellectual property. 
• If there is intellectual property, have the rights been registered, such a s trademark or are there pending or issued patents.
• Does the seller own the domain name(s) as often companies will overlook this issue and the domain will be registered in the name of the original web developer, an employee or a shareholder.
• All licenses that are key to operating the business must be assignable by the terms of the license agreement as the licensor could otherwise refuse or require additional payment for consent to the assignment.
• Have Invention Assignment Agreements been executed giving the seller rights to intellectual property developed by third parties or by partners, employees or consultants.
• Customer and Customer Information are important assets and therefore before purchasing the business the buyer must be sure customers and customer account information can be transferred to the purchaser without violating privacy or other laws, especially in the event of an asset sale. 

     (d) Material Contracts.  The material contracts must be reviewed to ensure they are assignable/assumable and that they don't terminate in the event of a sale of the business or change of control of the business.

     (e) Employment/HR Matters. 

• Make sure all the company's records are in order detailing information as to employees, including salary, sick/vacation time, and benefits.  
• Is there an employee manual. 
• Are there open employment or labor issues.
• Is there a stock option or similar employee incentive plan, and if so what are the obligations of the company under the plan.
• If there are employees in other countries, what are the foreign laws particular to those employees and what rights to employees have in those countries that are different from the US (for example, Hong Kong requires payment of an additional "13th Month" as an employee bonus).
• What is the status of the personnel -- employees vs. consultants, and are these employees being properly classified for purposes of FICA, etc. since improperly classifying an employee as a consultant will result in sever financial penalties.
• Are there any restrictions on the termination of employees.

      (f) Litigation. 

• If there are pending litigation matters, how you will these claims be addressed in the Purchase Agreement.
• Who will assume responsibility for these claims and related litigation costs.
• Has the company been threatened with any lawsuits or other claims, and if so how will these be addressed in the Purchase Agreement.
• Are there claims asserted by the company, and if so who has a right to receive the damages or insurance recovered on such claims.

     (g) Nature of the Business.

• Does the particular nature of the business give rise to areas of due diligence in addition to standard due diligence questions.
• An example of where additional due diligence will be required is environmental issues:  for example, a gas station, dry cleaner, manufacturing business will require specific environmental assessments.
• The business may implicate specific employee safety requirements under OSHA.
• The main point is that due diligence must be modified and/or expanded to address the particular nature of the business and therefore buyer should clearly understand what additional due diligence is required to properly vet all relevant issues.   

2.  Financial Due Diligence.  The buyer will need to conduct financial due diligence of the business, and therefore should engage an accountant or other financial professional who can examine the financial records.  A word of advice:  engage an accountant and/or other financial consultant that understands the business being purchased and has experienced with business buyouts.  It is not enough to understand a profit and loss statement (P&L) and ledgers, as an experienced financial consultant will be able to determine if revenues and expenses are properly booked, the method of accruing revenues and expenses (which will affect how the P&L looks), what tax obligations exist or may arise from the transaction, how the tax basis in the assets will be affected by the transaction, and a myriad of other issues.  Understanding these issues is important as it will reveal (a) if the profits/losses are being properly stated and (b) if any issues need to be addressed in the Purchase Agreement.  

3.  Technology Diligence.  Nowadays, most companies rely on technology for some aspect of the business.  In some cases, it is the essence of the business and for others it is simply an operational necessity. Therefore, technology due diligence is a must.  If the essence of the business is a technology company, the level of due diligence is obvious.  However, even where technology is more a matter of part of the operations, there are a number of due diligence concerns.

• Are there back-ups of key records, data and information.
• Are there back up copies of computer code and software. 
• Are the necessary redundancies in place.
• Does the business have in place a disaster recovery plan.

4.  Operational Due Diligence.  The buyer should conduct due diligence of the business operations, examining issues such as:

• Does the seller have a road map (manual) of important business processes as a buyer will appreciate anything that makes for a smooth transition.
• Will transitioning of the business require continued assistance from the seller or seller's key personnel post-closing.
• Will there be any issues with respect to the transfer of customers/clients.

5.  The Due Diligence is Completed, Now What?

Once the due diligence is completed, the buyer needs to consider how it wishes to proceed in light of any issues that may have been discovered.

    (a) Terminate the Transaction.  If the due diligence has disclosed material legal, financial or other issues, the buyer can choose simply to walk away.  The decision will be a function of how material the issues are and whether they can be resolved.

    (b) Reduce the Purchase Price.  In many cases, the due diligence issues can be resolved by adjustments to the purchase price (assuming the Seller is amenable).

    (c) Detail terms for transition of the business to the buyer, including any requirement that the seller or key personnel assist with the transition post-closing.

    (d)  Address the Issues in the Purchase Agreement.  The parties can agree to address any due diligence concerns in the Purchase Agreement by (i) requiring the Seller correct the issue(s) by a defined date, (ii) escrowing a portion of the purchase price, and (iii) defining the rights and remedies of the buyer in the event the issue(s) cannot be resolved.

Due diligence is an essential aspect of any purchase transaction, regardless of the size of the deal or whether the purchaser is buying assets rather than the company itself.  The above is by no means an exhaustive list of due diligence topics, but it should demonstrate the importance of:

• Tailoring the due diligence to the nature of the business (or business assets) being purchased.

• Engaging experienced professionals who can assist with the investigation of legal, financial, operational and technology matters relating to the business.

• Conducting thorough due diligence to ensure that any issues can, where possible, be addressed in the purchase agreement. 

Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters

    

Legal Issues When Buying a Business: Indemnification Basket

As discussed in prior installments of this series on buying a business, there are a number important legal issues you need to consider before signing the purchase agreement.  The first installment discussed the role of the Exclusivity Agreement, and the second installment examined the differences between structuring the transaction as stock purchase as opposed to a purchase of assets.  This Part III stays on the theme of key provisions of the purchase agreement by exploring the importance of escrowing a portion of the purchase price to cover any issues that may arise post closing whether the deal is structured as a stock or asset purchase transaction.

 

When buying a business, the purchase agreement will include a number of covenants requiring a party to specifically perform certain actions post closing, representations, and indemnifications which may survive the closing of the transaction.  Covenants can include such significant post-closing obligations as assisting the buyer with transition of customers, completing and delivery tax documents, the resolution of outstanding litigation, filing of intellectual properly assignments, and the Seller's completion of items that could not be resolved prior to closing.  Similarly, the purchase agreement will also include representations that survive closing and indemnification rights protecting the Buyer against third party claims arising from pre-closing events (think: environmental representations).  What happens, however, if the Seller fails to perform the post-closing obligations, breaches a representation that survived the closing or a thrid party asserts a claim against the purchased assets giving rise to indemnification rights?  Of course, the Buyer can file a lawsuit to enforce its rights, but resolution of litigation can be very costly and drag out for years.  And, even if the Buyer eventually prevails on the claim, very often the Seller no longer has the financial ability to satisfy the claim.

 

The solution to addressing post-closing liabilities is to create a basket of segregated funds to be available for post-closing claims.  In other words, the parties should agree to escrow a reasonable portion of the purchase price for a defined period of time after the closing.  The time period will vary:  of course the Buyer will demand a longer period and the Seller a shorter post-closing escrow, and this will often be an important negotiated aspect of the purchase Agreement.  An alternative to setting up an escrow is simply allowing the Buyer to hold back a portion of the purchase price to cover post-closing claims.  The Buyer would likely prefer a hold back because it will continue to control a portion of the purchase price, but the Seller should require an escrow arrangement rather than leaving part of the purchase price in the hands of the Buyer.  Under the escrow arrangement, a third party ("escrow agent") holds the portion of funds set aside from the purchase price and can only release the escrowed funds in accordance with the provisions of the purchase agreement.

 

If the parties agree to include an escrow of funds to cover post-closing claims, they must carefully draft the terms of the escrow and be sure to address:

• The amount of the escrow, which can be further broken down based on the type of claim asserted (for example, the inability to settle an outstanding litigation may allow Buyer to use a defined amount of the escrowed funds to settle the claim).
• The time period for holding the funds in escrow, and even the time period by which certain types of claims must be asserted before they are deemed waived.
• The actual procedure for the Buyer to assert a claim, the notice required to the Seller, and the right of the Seller to dispute the claim.
• How disputes are to be resolved, which can include referral to a mediator or arbitration.
• When the escrow agent is permitted to release all or a portion of the funds to seller or buyer, as applicable.

Both the Buyer and Seller need to pay particular attention as to how post-closing claims are to be handled under the terms of the purchase agreement.  The parties need to set forth clearly what claims can give rise to an obligation on the part of the Seller post-closing and the mechanism for the enforcement of those claims.  The escrow of a portion of the purchase price is a common tool for addressing these issues, but the parties must make sure the purchase agreement clearly spells out when the Buyer can assert a claim against the escrowed funds and the procedures for making post-closing claims.

 

 

Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters

    

Legal Issues When Buying a Business: Asset Purchase vs. Stock Purchase

As discussed in Part I of this series on buying a business,  regardless of the scope of the operations and purchase price, there are a number important legal issues you need to consider before signing the purchase agreement. The first installment discussed the role of the Exclusivity Agreement when considering the potential transaction and the terms that should be included if the parties agree to exclusivity while the due diligence is conducted and the purchase agreement is being negotiated.  In this Part II, the structure of the transaction is discussed, contrasting the stock purchase transaction from the purchase of assets of the business.  The take away is that it is usually preferable for the acquiror to purchase the assets of the business rather than the stock of the company because of the (a) tax advantages and (b) potential risks and liabilities in connection with purchasing shares of a business.

1.  Tax Advantage of Purchasing Assets of a Business.

The acquiror will obtain a tax benefit from purchasing the assets of the seller rather than the equity of the business entity.  When the acquiror purchases the assets, it gets the right to step-up the tax basis in the acquired assets.  This means the basis is not what the seller paid to acquire the assets (often many years prior to the transaction) but what the buyer pays for the assets. Also, note, that it is very important to work with your accountant when allocating the purchase price to the purchased assets -- for example, assets depreciate at different rates (and some cannot be depreciated at all), which will affect your profits and losses.       

2. Purchasing Assets Reduces the Chance that Buyer has Assumed the Seller's Liabilities. 

When the purchaser acquires the stock of the business entity by way of a stock purchase transaction or merger, the buyer is deemed to have assumed the liabilities of the seller.  In contrast, the parties to an asset purchase transaction can assign liabilities in such a manner as expressly stated in the asset purchase agreement.  In most circumstances, the purchaser will expressly deny the assumption of any of the liabilities of the selling entity. There may be liabilities the buyer elects to assume (for example, a promissory note or perhaps the risks from a pending litigation), and because the liabilities can be assigned as the parties agree in the purchase agreement, the asset purchase transaction gives the parties greater flexibility to negotiate existing or potential liabilities.      

3.  There are Some Liabilities the Purchaser Cannot Avoid.

Even if the parties adopt the structure of the asset purchase transaction, some liabilities will by operation of law become the obligation of the purchaser -- this is referred to as the doctrine of successor-liability.  The doctrine of successor liability precludes a buyer from avoiding certain types of liabilities Among the liabilities which the buyer will be deemed to assume regardless of the structure of the purchase transaction, include (a) environmental liability, (b) certain taxes, such as sales taxes, employment related taxes, and other taxes as provided under state law, (c) certain employee benefits and labor matters, and (d) liability under “bulk sales” law, which can arise, depending on applicable state law, in connection with unpaid sales taxes or an attempt to avoid creditor obligations  -- as a word of warning, do not overlook the bulk sales law of your state as this often missed and can result otherwise avoidable liability for the purchaser.

4.  Indemnification Basket for Liabilities.

As a purchaser, you can address the risk of unforeseen liabilities by creating a basket (or escrow) for the indemnification of the buyer with respect to such liabilities.  The buyer and seller should agree to escrow a portion of the purchase price to address post-closing liabilities that the purchaser did not agree to assume.  Whether the escrow is the sole recourse for a buyer to be indemnified is often a sticking point the parties will need to negotiate -- obviously the buyer would prefer not to be limited to the recourse of the escrowed funds.  Whatever the parties negotiate as to amount of the escrow (or alternatively a hold back) and if it is the sole avenue for indemnification, the escrow (or hold-back) rights need to be properly drafted, detailing the terms and procedures for asserting a claim for indemnification.


Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters

Legal Issues When Buying a Business: Exclusivity (Part #1)

If you are buying a business, regardless of the scope of the operations and purchase price, there are a number important legal issues you need to consider before signing the purchase agreement.   The next several installments of the blog will address the issues that a buyer should address when purchasing a business.  The first installment in the series discusses the role of the Exclusivity Agreement when considering the potential transaction and the terms that should be included if the parties agree to exclusivity while the due diligence is conducted and the purchase agreement is being negotiated.

1.  What is an Exclusivity Agreement/No Shop?

An Exclusivity Agreement or No Shop is a separate agreement or a provision in an Letter of Intent between the seller of a business and the potential buyer prohibiting the seller from seeking to transfer the business or assets to anyone else during a defined period.  In simple terms, the seller cannot shop around the business or assets during the prescribed period. 

2. If You are the Buyer, You Should Demand Exclusivity.

If you are considering the purchase of a business or its assets, you should demand exclusivity for a reasonable period necessary to complete due diligence, negotiate and finalize the purchase agreement.  As a purchaser, you want to preclude the seller from using your proposed deal as an opportunity to shop around the business.  Without the exclusivity restrictions, the seller can freely seek a better offer from a third party or even create a bidding war between you and another interested buyer.  The minute you begin engaging in due diligence and enter the process of negotiating the purchase agreement, you not only will be incurring substantial costs in terms of actual out-of-pocket expenses (business advisers, lawyers, accountants, etc.), but also the intangible loss of time and the inevitable distraction to your current business operations.  The seller's initial reaction to a demand for exclusivity may be to refuse to enter into a No Shop, in which case you need to decide whether to demand exclusivity as a non-negotiable condition.  If the seller is refusing to agree to exclusivity, another approach is to let the seller know you are exploring other similar businesses -- assuming this is a viable argument -- and you will simply switch your efforts to other potential opportunities.

3.  What is the Proper Place for the Exclusivity Terms. 

The exclusivity terms can be incorporated as a provision of a Letter of Intent (i.e., the No Shop Clause) or as a stand-alone agreement.  Generally, however, the LOI is not a binding agreement but rather a road map for the potential transaction.  Therefore, the LOI should clearly state that notwithstanding its non-binding nature, the provisions of the No Shop Clause (exclusivity, term and remedies, as discussed below) are binding on the parties.  

4.  What are the Essential Terms of the Exclusivity Provision/No Shop Clause?

The exclusivity agreement should be carefully drafted, but that does not mean it needs to be complicated; instead just make sure there is a clear and concise agreement/clause that defines (a) the Term (period) of the exclusivity, (b) the remedies in the event of a breach by the Seller, and (c) governing law/forum for disputes and enforcement.

           (a)  Term:  The exclusivity agreement should set a clear time period that commences on signing the agreement and terminates in a specific number of days.  Often, parties will agree to ninety days for the exclusivity period, but whatever the period be sure if you are the purchaser that there is sufficient time to conduct due diligence, draft and negotiate the purchase agreement. 

          (b)  Remedies for Breach:  The No Shop should expressly set forth the remedies available to the potential buyer in the event of a breach.  The remedies can include a right to equitable relief (such as an an injunction), a right to damages or (as I often prefer) a stated amount for liquidated damages which reimburses the potential buyer for reasonable costs of due diligence, attorney's fees and other reasonable costs.  The remedies provisions should require the seller reimburse the buyer for attorney's relating to enforcement of its rights and a waiver of any bond (i.e., deposit of a bond with the court) that may otherwise be required to seek equitable relief.

         (c)  Forum:  Include a governing law clause and forum selection provisions so that you can require the breaching seller to defend any claim in a convenient forum.  Also, since the buyer is looking for ease of enforcement of its rights in event of a breach of the no shop, incorporate a provisions allowing for service of process by regular mail (to the extent permitted by the law of the jurisdiction where the seller is located in the case of a foreign party).

5.  Exclusivity is Not the Same as a Requirement to Sell.

In the same way it is important to understand what a No Shop is, it is equally important to understand what it is not.  The exclusivity required by a No Shop is not the same as an obligation for the seller to complete the transaction and sell the business or assets.  The exclusivity requirement only precludes the seller from marketing the sale of the business or entertaining other offers during the exclusivity period. While you should include language requiring the seller provide the potential buyer a reasonable opportunity for the to conduct the due diligence, in reality if the seller decides not to proceed it can let the exclusivity period expire without executing a binding purchase agreement.  This does not mean the exclusivity agreement has no value, as in fact it is an important aspect of negotiating the purchase of a business (or the assets of the business) because it prevents the seller from shopping your potential deal while giving the parties the opportunity to finalize the transaction.  

The next installment in this series discussing issues relating to buying a business willexamine transactions involving the purchase of stock of the seller compared with a purchase of the business assets.


Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters. 

The Buy-Sell Agreement is Essential for All Closely Held Businesses with Multiple Owners

If you own a piece of a business and have one or more partners, it is essential that the partners enter into a Buy-Sell Agreement.  The Buy-Sell Agreement is intended to address what happens in the unfortunate event of the demise or disability of you or one of your partners as well as other events resulting in the departure of an owner.  If you view the Buy-Sell as unimportant because you have an excellent relationship with your other partners, consider the nightmare scenario that one of the owners dies, and the only surviving heir is her dead-beat brother or her fifteen year old son.  Without a Buy-Sell Agreement in place, the result of taking on an unwanted partner could be devastating to the business operations; or the cost of buying out the new partner could increase dramatically, or obtaining the funds to pay for a buy out could put a substantial drain on the finances of the business.  A properly drafted Buy-Sell Agreement can eliminate these issues, ensuring the business continuity that is desired upon the disability, death of an owner or other triggering event.  Below is an overview of the essential components of a Buy-Sell Agreement. 

1.  What Events Should Trigger the Application of a Buy-Sell Agreement?  

The Buy-Sell Agreement addresses "what happens if ......" or, in other words, becomes essential upon the occurrence of a triggering event.  The key triggering events that should be included within the Buy-Sell include:

              (a) Disability or death of a partner:  It is very common to include death or disability of partner as an event requiring invocation of the Buy-Sell.  The Agreement should specify when a "disability" is deemed to have occurred.  In the event of disability or death, specify who is obligated to purchase the interests of the disabled/deceased partner -- is it the company itself or the surviving partners, and under what formula.  A major issue for all triggering events is how will the buy out payment be financed because the entity itself or the surviving members may not have the resources to pay the buy out price.  Therefore, the entity or the shareholders can anticipate the issue by purchasing life insurance.  Other issues, which apply to all triggering events, include how the purchase price is to be determined and timing for payment of the purchase price.

              (b)  Retirement of a Partner:  It is important to include retirement as an event triggering the Buy-Sell.  The Agreement should detail what constitutes legitimate retirement, in other words, when does an owner have a right to retire.  While price, payment terms, and timing must be detailed, owners need to be aware that the funding will need to come from the entity or other owners, as applicable, rather than relying on a life insurance policy.

             (c)  Divorce or bankruptcy of a partner:  Be sure to include divorce and bankruptcy as a triggering event because either of these can lead to an unwanted, or even unknown, person becoming an owner in the business.

             (d) Voluntary Decision of a Partner to Sell to a Third Party:  Provide a detailed procedure in the event an owner decides to offer her ownership to a third party.  The agreement should detail the mechanism, including the right to receive and match any third party offer; timing; the methodology for valuation of the interests; payment and closing terms; and rights of the parties in the event of the failure to close the transaction by the third party or the company/owners.    

             (e) Gift of Stock:  The Buy-Sell could allow a gift of stock upon consent of the corporation/shareholders or even a right without consent to certain defined persons (such as family members or a living trust), but in such instances the donee should be required to execute the Buy-Sell.

             (f) Pledge of Interests:  The Buy-Sell should address the right of an owner to pledge its shares, and if permissible, the obligation of a pledgee to comply with the Buy-Sell in the event of a default.

             (g) Material Breach of a Key Agreement:  One event that is often overlooked in a Buy-Sell is an involuntary termination of a partner.  Termination events include, for example, breach of a material term of an LLC operating agreement, breach of confidentiality, or a "for cause" event. 

2.  Valuation Methodology.   The biggest fight in any buy out of another owner is how to value the departing member's ownership interest since in a closely held company there is no public market to determine the value.  Valuation should be viewed in terms of three concepts:  (a) who is making the determination, (b) the procedure, and (c) what actual methodology should be employed?  As to whom is making the determination, consider whether an accountant or a person with expertise in valuation of your particular type of business makes sense.  When considering the procedure, issues include timing, will each party appoint the valuation expert, what if the valuations differ among the appointed experts, and how will the expenses of conducting the valuation be handled.  As to the methodology, consider whether it would make sense to choose a particular expert based on the nature of the business. 

The actual formula for the valuation varies as well, and the parties should consider identifying the applicable formula rather than leaving it up to the valuation experts:  book value, adjusted book value, a multiple of revenues or net income, or discounted cash flow.  The owners could actually fix a price in the Buy-Sell and update it as needed, but this requires a diligent effort to perform the annual or periodic update (so have a fall back formula in the event an update has not been performed in an unreasonably long time).  Be sure to consider all of these issues and then detail the valuation methodology in the Buy-Sell Agreement.

3.  Funding the Buy Out/Types of Agreements.  Where a buy out is triggered by death of a partner, regardless of whether the buy-out right is held by the entity or the other partners, funding of the purchase price can be arranged through a life insurance policy.

             (a) Entity as Purchaser/Entity Redemption.  The entity can purchase a life insurance policy which is distributed tax free to the entity upon the death of a partner, and the proceeds of which are then used to pay the estate of the deceased for the stock.  Understand, however, that there are several disadvantages to funding the buy out with a life insurance policy, including: 

                  (i) The proceeds and policy are not immune from the entity's creditors;

                  (ii) The basis in the stock of the surviving owners will differ depending on whether the entity is a corporation (no step up) or a pass-through, like an LLC (basis will increase in part);

                  (iii) There is a potential for the redemption to be viewed as a taxable dividend;

                  (iv) A majority owner could change the insurance policy beneficiaries; and

                  (v) The AMT (alternative minimum tax) may apply to the company's receipt of the insurance proceeds.

             (b) Cross Purchase Arrangement.  Under a Cross Purchase Arrangement, each owner purchases a policy on the life of the other owners, providing a tax free source of funding to pay for the decedent's stock upon his death.  Significantly, a cross purchase arrangement eliminates the above-mentioned disadvantages of the entity redemption arrangement.  However, disadvantages include:

                  (i)  The need for multiple policies if there are multiple owners, and premiums will vary depending on age and insurability of each partner;

                  (ii)  Transfer for Value Rule:  The transfer-for-value rule provides that, if a policy is sold by its owner after the policy is issued, the income tax exclusion for life insurance proceeds will be lost and the beneficiaries will pay income tax on the amount of the death benefit less the purchase price and premiums paid.  Thus, owners swapping policies to implement a cross purchase agreement results in a transfer for value.  For example, A might want to transfer his policy to B (and vice versa) to fund the cross-purchase obligation.  Upon A's death, B would collect the proceeds on A's life insurance and distribute them to A's estate in exchange for A's shares. Since there has been a transfer of the policies for value, B would be required to pay income tax on the insurance proceeds, less the amount subsequently paid in premiums.  Under an equity redemption arrangement, this problem would not exist.  Unlike with a corporation, notably partners in a LLC (taxed as a partnership) escape the effects the transfer for value rule.  Another possible work around is the appointment of a trustee to own the policies on each shareholder, otherwise known as a trusteed buy-sell, but there is a possibility that this could also be viewed as violative of the transfer for value rule.

          (c)  Hybrid Agreement.  Also referred to as the "wait and see" agreement, this situation gives the entity and its owners flexibility at the time of the triggering event to decide whether to exercise the buy-out right.  The entity may also purchase life insurance on the owners (or it may decide not to).  If the entity does not purchase the shares, the surviving owners can do so under a cross-purchase agreement (and also may purchase insurance for this purpose).

The Buy-Sell Agreement is a necessary document for any business with multiple owners, but it is also an essential tool for estate planning.  Without an agreement, you may find your new partner is that crazy brother of your old partner, and without a properly drafted Buy-Sell Agreement you may be exposed to unwanted tax liabilities.




Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.  

Ready to Sell: Have You Done Due Diligence of Your Company?

Even if you have very little experience purchasing a business or its assets, you are likely aware of the importance of doing due diligence on the target's business.  In fact, in a prior posting I discussed the importance of due diligence, and the essential legal and business issues that require careful investigation before purchasing a company, its assets or the stock of a company from an existing shareholder.  Now, let's say you are the selling company:  have you ever considered the importance of conducting due diligence of your business before seeking potential purchasers?  It is important for a company contemplating a sale of its business to do a meaningful evaluation and due diligence of its legal, financial and business operations before putting the company on the market to avoid issues arising after a potential suitor has been found.  In the sale of a home, a buyer will use the inspection report and appraisal to try to knock down the negotiated price, and in the sale of a company the buyer will try to do the same with information learned in the due diligence investigation.  Therefore, a thorough review of your company's business, legal and financial operations prior to seeking to sell your business will allow you to both address potential obstacles to a sale and reduce the chances the buyer will try to renegotiate the purchase price for the business.

1.  Is the Company's Legal House in Order?   Legal due diligence is a significant aspect of the investigation that any potential buyer will perform.  There are numerous legal areas the buyer will review, and the scope and of the due diligence will vary greatly depending on a number of factors, including the nature of the business, its location and markets.  Obviously, there are some common questions relating to organizational structure, material contracts, existing or threatened litigation, ownership of assets, intellectual property, labor/employment, and environmental questions.  But, there are also some less obvious issues that should be carefully vetted. 

While not an exhaustive list, consider the following:

         (a)  Corporate Structure:  Of course, you will want to make sure the company's organizational documents and records are in order, but also that there are no potential obstacles to the transaction.  For example, do any of the shareholders/members or any other third parties have a right of first refusal, or other rights, that could interfere with the transaction?  Is there anything in the By Laws/Operating Agreement mandating a super majority or even unanimous approval of a sale?  These kinds of rights are often freely granted when emerging companies are desperate to obtain financing, and may come back to haunt the company when trying to sell.

        (b)  Permits/Compliance with Laws:  The company will need to show it has the necessary permits or licenses as may be required for the business, but it also that it is in compliance with the laws of any jurisdiction where it operates.  If you have an Internet presence, is the company in compliance with properly drafted terms and conditions and privacy policies?

        (c) Assets/Intellectual Property:  Can ownership/title to assets be demonstrated?  Does the company own or properly license necessary intellectual property?  If your business is licensing any key intellectual property or other assets, make sure the license is assignable/assumable in a sale or rights do not revert to licensor upon a "change of control" of the business.  Another major concern is that the company has Invention Assignment Agreements or can otherwise establish its rights to intellectual property developed by third parties or even by partners, employees or consultants.

      (d) Material Contracts:  All material contracts should be reviewed to ensure they are assignable/assumable and that they don't terminate in the event of a sale of the business or change of control.

      (e) Employment/Labor Matters:  Make sure all the company's records are in order detailing information as to employees, including salary, sick/vacation time, and benefits.  Is there an employee manual?  Are there open employment or labor issues?

      (f) Litigation:  If there are pending litigation matters, be prepared to summarize the claims, and procedural status for a potential buyer.  Also, consider, how you will propose to address these claims in the Purchase Agreement (i.e., who will assume responsibility for these claims and related costs).  Has the company been threatened with any lawsuits or other claims?

      (g) Loans/Liens/Encumbrances:  Are any of the assets subject to any liens, are there company loans, and what are the obligations of the conmpany in event of a sale of the business.

 2.  Are the Financial Records Properly Maintained?    Work with your company's accountant and internal finance department (if you have one) to make sure all of the financial records are organized and financial events properly recorded.  The buyer will ask to see balance sheets, tax returns and audits, profit and loss statements, accounts, ledgers and all the back up information.

3.  Keep Company Books and Records Well Organized.  Make it part of good corporate procedures to maintain orderly books and records from the start.  Do not wait until there is possible exit opportunity to then run around trying to gather the due diligence materials the buyer will certainly request -- for example, the company does not want to have to chase down an employee for a copy of an Invention Assignment Agreement or a release from a litigation that settled many years ago.

4. Back Up Files, Processes and Key Software.  Maintain copies of key documents and files.  Prepare a road map of important business processes as a buyer will appreciate anything that makes for a smooth transition.  Keep back up copies of computer code.  The point:  for all important aspects of the business have in place a disaster recovery plan.

In sum, a company does not want to learn from a potential buyer that a major issue has been discovered -- especially if it could have been addressed by the company prior to the buyer's due diligence.  Inevitably, due diligence issues will result in a reduction of the purchase price or create obstacles to closing the transaction.  At the very least, due diligence issues discovered by a buyer will raise transaction costs as the parties, accountants and lawyers try to resolve and then document any agreed solution.  Additionally, it is generally less expensive for a lawyer to draft the Purchase Agreement and accompanying disclosures and schedules if company records are well maintained and the Seller's attorney is aware of the issues, if any, at the outset of the transaction.  Lastly, retain professionals (an accountant, a lawyer, a business consultant/coach, payroll company, etc.) who understand your business and work with you from the start of your company.  By doing so, you are reducing the chance that the buyer's due diligence will uncover legal, financial or business issues that either dramatically undermine the value of the company or result in a termination of the sale.




Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.


  

Why the LLC is a Favorite for Start Ups (Part III)

This post is Part III of a discussion as to why lawyers suggest, and entrepreneurs often prefer, the structure of the limited liability company over other business entities.  While the LLC is relatively new in comparison to the corporation, start-ups more often choose the LLC when forming their business.  What is it about the LLC that makes a preferred structure for start-ups?  As explained in the first installment, there are three reasons the LLC has become so prevalent:

          1.  Reason #1: The tax advantages of the LLC versus the corporation;
         
          2.  Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);

          3. Reason #3:  The user friendly nature of an LLC.  

A comparison of the arguable tax advantages of the LLC was the subject of Part I of this discussion, and Part II focused on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.  This final installment examines the user friendly nature of the LLC, which imposes very few compliance requirements in order to maintain the entity.   

Reason #3:  The user friendly nature of the LLC.

For consumers, one trademark of good technology is whether it is user friendly.  Similarly, the LLC has become a preferred choice of many entrepreneurs because it requires very little to form and then maintain the entity.

   A.  Formation.  The formation of a limited liability company requires very little:

                  (i) In New York, the form for the Articles of Organization is available online at http://www.dos.ny.gov/corps/llccorp.html#artorg and can be filed by anyone (the "Organizer") without the need of a lawyer or a legal service.  The Organizer forms an LLC by filing the Articles of Organization, pursuant to Section 203 of the Limited Liability Company Law, with the Department of State.  Any person or entity may be an organizer and the the Organizer does not have to be a member of the LLC.

                 (ii) Operating Agreement.   Pursuant to Section 417 of the New York Limited Liability Company Law (NYLLCL), an Operating Agreement must be entered into by the members.  Part II of this series discussed the importance of the Operating Agreement, and the flexibility allowing the members to construct the rights and obligations as the members wish, subject only to express restrictions in the NYLLLCL or as otherwise prohibited by law.  The limited liability company Operating Agreement is not filed with the State. 

               (iii) Publication Requirement.  New York maintains an arcane requirement that LLC's publish a notice of the formation of the entity in two newspapers (as designated by the county clerk) for six consecutive weeks.  See NYLLCL Section 206.  The publication fees vary by county, but regardless are expensive and, quite frankly, an unjustifiable but legally required expense.  Upon compliance with the publication requirement, the newspaper will provide an affidavit of publication to be filed with the State.  With this ridiculous requirement comes the obvious question:  What are the ramifications of failing to publish and can it be corrected?  If you have not met the publication requirements, "the authority of such limited liability company to carry on, conduct or transact any business in [New York] shall be suspended."  NYLLCL Section 203.  However, some courts have held that if the LLC cures the failure after filing the action, the lawsuit can be maintained, and a suspended entity can cure the default.  The other major concern is whether the members lose the protection of the LLC, and since the answer is uncertain the ambiguity means it is sensible to comply with the publication requirement.
       
             (iv) Comparison with Corporation.  Formation of a corporation is also relatively simple requiring only the filing of the Certificate of Incorporation using a pre-printed and form approved by the New York State Department, see http://www.dos.ny.gov/forms/corporations/1239-f-l.pdf.  Unlike the LLC, no publication requirement exists, which obviously saves a considerable expense over formation of the LLC.  However, as publication is a one-time requirement, other factors (such as tax advantages) often mean entrepreneurs still prefer the LLC.
   
    B.  Tax Filings.  Because an LLC does not have a tax status separate from its members, the LLC does not file an entity tax return.  While the LLC must prepare an informational filing showing the profit and losses of the LLC's business, see IRS Form 1065, there is no separate determination of tax liability for the LLC and thus no separate tax calculation.  The absence of a separate tax existence of the LLC is in contrast to the corporation, which is required to calculate the tax liability of the corporate entity and file a actual (rather than an informational return).  Of course, the shareholders also will have an individual tax liability based on any distributions (dividends) received from the corporation.  The tax returns of the corporation and the informational return of the LLC must be retained with the records of the entity.

   C. Management of the Entity.  An LLC is not required to have more than one manager regardless of the number of members.  In contrast, a corporation with three or more shareholders must have at least three directors.  The requirement of three directors increases the cost of operations, creates additional administrative burdens, and affects the dynamics of managing an entity which is obviously much simpler in the case of an LLC managed by one manager.     

   D.  Maintenance/Administrative Requirements.

         (i) Annual Meetings.  A corporation must hold an annual meeting of its Directors and of its shareholders.  Contrast that with the LLC, which requires no annual meeting, unless the Operating Agreement provides otherwise.  And, just because the corporation is only required to hold one annual meeting, significant business decisions should be handled by formal resolutions.  Although not required, t is advisable for an LLC to document important resolutions thereby demonstrating that the members observe formalities in the event of an attempt by a third party to pierce the protection afforded the members by the LLC structure.

        (ii) Minutes of Meetings.  New York State also requires that corporations keep and maintain copies of all meeting minutes.  Accordingly, proper Minutes of meetings need to be recorded by a designated person, which preferably is a Corporate Secretary elected annually.  Not only are minutes required by law, they may be required by your bank or even parties to a transaction as proof of corporate approval.  Additionally, shareholders have a right to review these records upon reasonable demand.  If you have a corporation, the record book should contain at a minimum the Articles of Incorporation, by-laws, stock certificates, and copies of resolutions and minutes of corporate meetings.   LLCs do not have a requirement to record minutes of meetings, although it is a good idea to do so from a record keeping standpoint and also to demonstrate adherence to corporate formalities.
      
       (iii) Shareholder/Member Lists.  Corporations must maintain a list of all of its shareholders, the number and class of shares held by each and the dates when they respectively became the owners of record thereof; LLC's are required to keep a list of its members (together with the contribution and percentage interest) and managers.

       (iv) Organizational Documents.  Both the corporation and LLC need to keep a copy of the organizational documents, i.e., the Articles of Organization and all amendments of the LLC and Certificate of Formation of the corporation.  Further, a copy of the LLC's Operating Agreement or Corporation By Laws shall be kept with the entity records.

        E.  "But I Heard VCs don't like LLCs."  It is often suggested that businesses looking to raise third party financing from VCs or Angels should not form an LLC as the structure will be an obstacle to attracting financing.  While this may have been the case a few years ago, the prevalence of the LLC, tax advantage and the flexibility of the LLC as evidence by the ability to draft the Operating Agreement to fit the rights and obligations of the members has, for the most part, put this concern to rest.  Importantly, if a future investor insists on a corporation, the LLC members have a right to convert the entity to a corporation.  Be forewarned, however, that conversion of an LLC to a corporation gives rise to important tax considerations which should be discussed in advance with a tax professional.


The LLC has certain obvious advantages when compared to a corporation, but choosing the proper entity for your business can be driven by a number of factors, including those that are particular to the nature of your business or your tax situation.  Therefore, it is important to consult a lawyer and often a tax advisor before proceeding with the formation of the business structure.


Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.