Drafting the Legal Disputes Provisions of a Contract

Often parties negotiating an agreement are quick to gloss over or even ignore the importance of the several provisions that address the rights of the parties in the event of a dispute.  It is not unusual for the parties to spend a great deal of time negotiating the substantive terms, and seemingly pay little attention to the dispute related clauses.  It is unclear if this a result of deeming these provisions less important because they are generally at the end of the the agreement or because the parties fail to recognize that these clauses can (and should) be negotiated to arrive at agreed terms just like the other important provisions of the agreement.

There are several provisions of a contract that should be considered as falling under the umbrella of dispute-related clauses.  Therefore, for purposes of this post, I am referring to (1) Governing Law clause, (2) Forum selection, namely the legal body where the action will be heard, such as the court, mediation, or arbitration, (3) Venue, (4) service of process, (5) attorney's fees and costs of litigation, and (6) Remedies.

1.  Governing Law:  The parties have a right to choose the law of what state, or if applicable, of what country, applies to the interpretation of the agreement and any disputes arising under the agreement.  If both parties are from New York and or the performance of the agreement is to be in New York, then agreeing that New York law should govern the agreement is fairly clear.  But, what if one party is from New York, the other is from California, or performance of the contract in in yet another state, then there may be conflicting viewpoints from each party as to the law a party may prefer.  The laws of one state can differ from the laws of another state on material issues, and thus before agreeing to the application of the laws of a state (or country), it is essential to understand if such laws will adversely affect your rights and obligations.

2.  Forum.  Consider forum in terms of what body will have the authority to hear and adjudicate the dispute.  Generally, the parties can choose between having the dispute heard by a court (provided it has legal  jurisdiction over the claim) or choose an alternative dispute resolution (like mediation and arbitration) before a named dispute resolution institution (such as the American Arbitration Association).  Lawyers can argue all day about what forum is preferred for what type of claims, but in my view the decision depends on the nature of the underlying contract and the potential claims that could arise thereunder as certain claims/contracts are best handled by a court while others are well-suited for arbitration.  Thus, do not simply agree to "arbitrate" all disputes because you have heard it is less expensive and results in a faster resolution of the claims.  Instead, careful consideration should be given to such issues as what is the best forum in light of the nature of the contract, the parties, and the likely disputes that could arise.  And, as a word of caution, if you agree to arbitration, make sure the arbitration provisions are well-drafted as there are a number of issues that should be addressed, including the arbitral body, applicable procedural law, how many arbitrators, how costs are shared, right to seek injunctive or other equitable relief, and enforcement of the final award.

3. Venue.  Decide not only what body is to her the dispute, but where it should be heard.  For example, if you just state the courts of New York will have jurisdiction, then you could end up litigating the issue in New York City (because the plantiff is headquartered there) even though you live in Buffalo.  The simple fix is include a venue provision that expressly refers to a court or arbitral institute located in say, Buffalo, New York, if that is where you prefer and the other party agrees.  On the other hand, do not automatically believe that where you operate or reside is the preferred jurisdiction for adjudicating a dispute.  Take, for example, a contract entered into with a party from another country.  Just because you live in New York and the other party is located in a foreign country, it does not mean you always need to fight vigorously to have New York as the venue for any claims.  In some circumstances, like enforcement of a promissory note, it may be better to have the foreign venue and governing law because it may be very difficult to enforce a New York State judgment in the foreign jurisdiction as opposed to enforcing the judgment in place where it was rendered.  The point here is not to suggest in this post what is the preferred venue for each type of contract or potential dispute, but to realize you need to think through the venue clause as carefully as the financial or other terms
of any agreement.


4. Service of Process.  Notwithstanding the fact that state, federal and foreign country laws dictate methods for service of process in connection with a lawsuit, the parties can agree to a particular method in the agreement.  By way of example, consider including a (non-exclusive) right to serve a person by mail as it can be a lot less costly and much simpler than arranging for other methods of service.   If it turns out the laws of a foreign country require service under expressly defined procedures, then follow those rules, but if there is no prohibition, then you may have saved yourself substantial costs and time by providing for an alternative service method in the contract.

5.  Attorney's Fees/Costs.  Like it or not, under the U.S. system, in all but a few situations (for example, where provided by statute) each side is responsible for its own costs, including attorney's fees.  However, the parties can alter this rule and instead require the loser pay the prevailing party its costs and fees.

6. Remedies.  The contract can include provisions detailing specific remedies a party may seek in the event of a breach.  While the prevailing party has a right to any damages it proves, the agreement may also address equitable remedies (like, injunctive relief), a right to demand specific performance or include a liquidated damages clause.  

Clearly, the dispute related provisions in any agreement should be carefully reviewed.  If a contract does not include such provisions, insist that they be incorporated into the agreement before you execute it.  Do not just assume these clauses are boiler plate only to be confronted with very unfavorable dispute related provisions if a legal issue arises down the road.

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.
  

           

         

Private Equity Financing: The Convertible Note

The Convertible Note is often used by companies seeking private equity financing. The reason the Convertible Note is well-received by investors is that it provides the opportunity to lend funds at a favorable interest rate for the lender, while providing the lender the option to participate in any increase in the value of the equity of the issuer.  From the issuers standpoint, it can be a good method of attracting financing from investors who are uncertain about taking equity in a company from the outset.  This post explores some of the common provisions of a Convertible Note, but recognize that the issuer may have a very different set of expectations than the lender/investor with respect to some very important terms, and this will require negotiation or simply acquiescence by an issuer who requires the financing.

Consider the Convertible Note as having two major aspects (a) the Promissory Note itself under which the funds are loaned to the company and (b) the Equity Purchase and related rights of the investor upon becoming an equity holder.

I.  The Promissory Note

Of course, a Convertible Note includes the terms of a promissory note, and therefore should cover the following financial and business terms.

      1. Loan Principal Amount/Advances:  How much is the principal amount of the loan and, when and under what terms are loan advances to be made to the company?  Often, the investor will opt for a series of advances based on achieving defined milestones (as opposed to one lump sum payment).

      2. Interest rate/when payable:  What is the applicable interest rate and when is it payable?  The rate can be paid on a defined schedule or can accrue and be payable at the end of the term or upon a triggering event (such as sale of the business, obtaining additional financing).

      3. Term of the Loan/prepayment:  What is the term of the loan?  Simply put, the term defines when the principal must be repaid.  In addition, the company will want a right of prepayment, and the investor may want an additional fee in the event of prepayment.

     4. Is it a secured loan?   The lender may require a security interest in all or some of the assets of the company.

     5. Default Provisions/Remedies.  What triggers a default/right to repayment and what are the remedies upon default?  Obviously, the failure to repay the loan, bankruptcy, dissolution and similar events should be grounds for a default, but lender may demand other triggers like, merger or sale of all or substantially all of the assets or stock of the business.  In addition, the Note, especially if a secured note, will include the various remedies available to the lender upon a default, including sale of the collateral.

II. Equity Purchase and Related Rights.

    6. Conversion Trigger.  When is the note convertible?  The Convertible Note will define what event(s) trigger the investor's right to demand conversion.  There may be optional and/or mandatory conversion events, depending on what the parties negotiate.  Also, if I represent the company, I will try to get an option to pay the loan within a certain time following an exercise by the Lender of the conversion right -- if the company is in the financial position, it may prefer to pay the loan (even with a fee) to avoid dilution resulting from the issuance of shares to the lender.

    7. Conversion Formula.  How much equity is issued upon conversion?  The parties must agree on a conversion formula which determines how many shares the lender receives in exchange for the outstanding principal (and perhaps the interest, if agreed). The conversion formula can be one of the most contentious issues as it invokes the need to explore valuation of the company.    

    8. Equity. What class of equity will the loan convert into?  The parties need to set forth the type of stock the lender will receive upon conversion:  common stock, preferred stock and any class thereof.
  
    9. Equity Rights.  What will be the rights associated with the shares received upon conversion?  Some of the common rights a potential equity holder may demand include, liquidation preference, voting rights, dividend rights, anti-dilution protections, right of first refusal, tag along, registration rights, information rights, a board seat, and redemption rights.  As the company, be prepared for a list of demands from the lender.

   10. Additional Covenants.  When representing a lender I may negotiate for a number of covenants that the issuer must observe, including right to approve budgets, management salary, and extraordinary transactions, to name a few.
 
The Convertible Note is a common financing method for companies, but the company (especially early-stage issuers) will have to try to balance the need for the funds versus the desire to avoid relinquishing  substantial financial and ownership rights in exchange for the convertible loan.

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.

Buying a Business: The Purchase Agreement

In prior posts, I discussed legal issues to consider before buying a business, and then discussed major areas to focus on when conducting due diligence with respect to the target business.  Generally, the structure of the transaction will be either a purchase of the stock of the entity that owns the business or a purchase of its assets. This post explores important terms that should be incorporated in the purchase agreement, regardless whether it is a stock or asset acquisition.

The purchase agreement is not just full of boiler plate language that you can adopt from an acquisition agreement you find on the Internet.  Instead, it needs to be tailored to the deal, and significantly, address any issues discovered during the due diligence.

1.  Proper Seller or Sellers.  Make sure the Asset Purchase Agreement (APA) or Stock Purchase Agreement (SPA) names the proper seller(s).  Through the due diligence, you will learn who actually owns the business.  For example, are the assets all owned by one company or are some assets (like real estate or intellectual property) owned by an affiliate or subsidiary.  If buying the stock of a private company, the SPA is not just between buyer and the company, but also must include the shareholders owning 100% of the stock.  Therefore, the APA/SPA must include all the persons or entities with ownership in the assets/stock of the selling business.

2. Consideration.  Clearly state the purchase price (consideration) and the structure for the payment.  Is the purchase price to be paid in installments or subject to any conditions?  Will there be an escrow set up?  Will there be a holdback to secure performance of the Seller or compliance with representations and warranties?  Will there be credits to buyer in the event certain financial targets are not met?

3. Holdback/Basket.  If possible, a portion of the purchase price should be placed in escrow to (a) ensure Seller's compliance with any obligations it may have to Buyer, (b) create a basket that Buyer can access if Seller breaches any representations, warranties or covenants under the APA/SPA, and (c) address any milestone payments or credits to buyer in the event certain financial performance representations are not satisfied.  But, the holdback is not enough as there must be clear language as to when/how the escrowed monies are released to either party.  Push for a reasonable holdback because if there is a breach or non-performance, it will be very time consuming and expensive to go after the Seller for any money owed the buyer, assuming the Seller(s) even still has the funds.

4. Representations and Warranties.  The SPA/APA needs to include a number of important representations and warranties relating to the business, its assets, financials, liabilities, contracts, employment, environmental, intellectual property, litigation, capital structure, 3rd party rights, licenses/permits, technology, labor, taxes, to name just some of the common representations and warranties.  However, you should also address any issues discovered in the due diligence process -- a common example, a consulting agreement that granted a service provider options in the company, which Seller claims the consultant has released.  The representations and warranties protect the Buyer, and careful consideration needs to be given to drafting them in any APA/SPA.

5. Covenants.  A number of covenants are standard, for example that Seller will cooperate with Buyer as far as executing any documents post closing that are reasonably necessary to effectuate the transaction.  The deal, however, might include certain obligations on Seller, and those should be expressly set forth in the APA/SPA.

6.  Liabilities.  Is the Buyer assuming any liabilities.  If you are buying the stock, you are assuming all of the liabilities in the absence of a special carve-out.  If purchasing the assets, Buyer can exclude all or some of the liabilities.  Detail who is repsonsible for what liabilities.

7.  Transfer/Assignments.  If any tangible/intangible assets, stock, licenses, contracts, customers need to be specifically transferred/assigned to the Buyer, there needs to be a provision addressing these issues and it might even require a separate assignment agreement or approvals of third parties (i.e., for intellectual property registrations, domain registrations).

8. Transition. It is often a good idea to have key individuals agree to assist with transition of the business to the buyer, especially if the customers have long-standing relationships with certain owners or employees or if there are particular technology issues.  If a transition term is part of the deal, specifically define the scope and term of the obligations of the Seller so there is no dispute later on.

9. Tax Matters.  Aside from the usual tax representations, consider whether any post closing cooperation will be necessary on tax matters to ensure favorable tax treatment or otherwise.

10.  Indemnification.  The APA/SPA should include terms regarding the right of and process for obtaining indemnification from the Seller(s) in the event of any breach of the agreement.

11.  Schedules/Disclosures.  The APA/SPA will likely have a number of disclosures made by the Seller(s) as to exceptions or detailing required information to complete the representations and warranties.  Review these schedules carefully to be sure no additional due diligence is required or additional representations/warranties.

12.  Termination/Remedies.  Set forth any occurrence/event giving the Buyer a right to terminate the transaction, and perhaps any payment/liquidated damages to Buyer if the transaction is terminated due to fault of Seller or even a right to specific performance if Seller is dragging its feet or refusing to close.   

13. Confidentiality/Non-Compete.  To protect the company's proprietary information and the deal terms, include a confidentiality provision.  In addition, demand a reasonable non-compete to avoid the Seller(s) from turning around and opening a competing business with your money.

14. Governing Law/Venue/Attorney's Fees.  If an issue arises and you need to pursue a claim you will be happier if in the APA/SPA there are express provisions with respect to the governing law, venue for any claims (what court or alternative dispute mechanism) and perhaps even a clause requiring the loser to pay attorney's fees). 

The above is not an exhaustive list of provisions that should be included in the APA/SPA, but it should get a Buyer thinking about the need for not merely a standard APA/SPA, but a well-drafted agreement based on the information gleaned about the business through the due diligence investigation.

Disclaimer:  The information is for discussion only and does not constitute legal advice or create any attorney-client relationship. 

Buying A Business: Do Your Due Diligence

In the previous post, What to Think About When Buying a Business, among the topics raised was the importance of doing due diligence.  In this post, I drill down on several key areas that should be the focus of the due diligence review:  (1) financial, (2) legal, (3) product/services, (4) customers/clients and (5) employees.

1.  Financial Review

Obviously, when buying a business you need to review the financial books and records of the company, and you will likely have an accountant to assist you.  However, as an entrepreneur, you should understand what are the major financial aspects that need to be examined.

   (a) Revenues.  Certainly it is important to look at the revenues of the business, but also you need to understand what is the source of those revenues and how stable are those sources.  Thus, consider:
      
         (i) Are the revenues primarily from one/only a few customers or accounts?
         (ii) Are the revenues growing, stagnant or worse yet, shrinking?
         (iii) How are the revenues derived?
         (iv) Were there extraordinary events that negatively/positively affected revenues?

  (b) Expenses.

       (i) Is the overhead high and can anything be done to lower it without negatively affecting business?
       (ii) What are the costs of the goods or services sold?
       (iii)  Is the business burdened by expensive debt service/interest liability?
       (iv) What are the sources of the expenses and are they in line with revenues?

   (c)  Assets.  Consider, what does the company really own?

      (i) Does the business own any assets, and what are they?
      (ii) Asked a different way, are you sure the business owns the key assets and not one of founders or a third party?
      (iii) Are the key assets licensed, and if so how long is the license, and how stable is the licensor?
      (iv) Who owns the intellectual property?
      (v) Who owns the domain names?

   (d) Liabilities:  What are the long and short term liabilities?

   (e) Taxes:  What is the structure of the company and is it structured in a tax efficient manner?


2.  Legal Due Diligence.  Below are just some of the legal issues to consider.

  (a) Is the ownership of the assets properly documented?
  (b) If there are licenses, are they properly documented?
  (c) What type of entity owns the business?
  (d) Are the formation/governing documents of the business entity properly drafted and do they include an provisions a buyer should be concerned about; have all minutes/resolutions been reviewed?
  (e) Does the company have all the necessary permits and licenses?
  (f)  Has the company met all compliance obligations, including with respect to corporate matters?
  (g) Does the company own the intellectual property it needs to operate the business, and what is the status of any applications or registrations?
  (h) Are the assets encumbered in any manner?
  (i) Are there any claims, lawsuits, proceedings, defaults pending or judgments/awards outstanding?
  (j) What contracts/licenses/undertakings has the company entered into and do you understand them?
  (k) Are the important contracts/licenses/customers assignable?
  (l) Are there any environmental or other regulatory issues particular to the business?
  (m) Did the company grant any rights, options, warrants or the like to third parties?
  (n)  Has the company made any warranties and what are the obligations thereunder and does it hold any rights under any warranties?
  (o) Are the the website policies properly drafted?
 

3. Products and Services.  This may seem a ridiculously obvious point, but before buying a business make sure you understand the products or services being offered by the company.  A business may seem attractive from the outside looking in, but drill down and become an expert as to that business before deciding to become financially responsible for it.  One way to address any lack of expertise is to requires the prior owners to help your transition the business to the new owners.

4. Customers/Accounts. 

  (a) Are the customers/clients transferable either by contract or otherwise?
  (b) Are there privacy issues that may create issues as to transferring customers/accounts or data about them, including credit card information.
  (c) Who has the relationship with the customers?  For example, if the old owner(s) leave the business, will the customers stay or leave as well?
  (d)  Non-compete/Non-solicitation.  Try to obtain a non-compete from the sellers of the business.

5.  Employees. 

  (a)  Review any employment/consulting agreements and understand the obligations thereunder.
  (b)  Make sure all employees/consultants have signed confidentiality agreements and invention assignment agreements.
  (c)  Are there collective bargaining agreements or particular issues failing under Labor Laws?
  (d)  Is there an employee option plan?
  (e)  Are you sure the key employees will stay with the company if sold?

The above is by no means an exhaustive list of due diligence issues and, without a doubt, there are many others that should be included.  However, what the list demonstrates is the importance of conducting proper due diligence when buying a business.  The more you understand the business, the better you are able to not only determine if you should proceed with the transaction but address any concerns in negotiating the purchase price as well as draft the purchase agreements. 

When you buy a used car, you look under the hood and may even have it inspected by a mechanic. When you buy a house, you walk through it many times and usually get a home inspector to do a thorough inspection.  So, if you are considering the purchase of a business, don't overlook the importance of obtaining experienced counsel to assist you with the due diligence because it is not what you know, but what you don't know that can create material business issues down the road.      

Disclaimer:  Nothing herein constitutes legal advice, and is for discussion purposes only.
  

What to Think about when Buying a Business

Let's say you have been approached about purchasing a small business but you are not sure if it is a wise investment. What are the right questions to ask and legal issues?  What is the best structure for the deal?  

You need to ask certain questions and get sufficient information before deciding whether to proceed.  In business terms, this means do your due diligence by considering the following non-exhaustive list of issues. 

I.  Understand What You are Buying 

     A.  What type of business is being purchased?

         1.  Is it a business that is regulated by any particular federal, state or municipal laws?   Does the owner and/or employees need any special license or permit.  For example, a beauty salon, auto mechanic or a restaurant/deli all require certain state licensing. 

         2.  Do you have prior experience operating a similar business, and if not how do you plan on educating yourself. 

  

    B.  What is actually being purchased?  Yes, a business, but what does that mean.

         1.  Is it the business lock, stock and barrel or does the seller intend on keeping any of the assets.

         2.  Determine what are the assets of the business.

                 a.  Hard/tangible assets:  i.e., equipment, furniture, computers, inventory, supplies, fixtures

                 b.  Intangible assets: 

                        (i)  Customers, customer lists, databases

                        (ii) Intellectual Property:  patents, trademarks, tradenames, business names, copyright.

                        (iii) Website and website content

                        (iv) Domain names

                        (v) software and related licenses

                c.  Cash and Accounts

                d.  Contracts: customer agreements, licenses, vendor agreements

                e.  Loans/Guarantees

                f.   Accounts Receivable

                g.  Permits and licenses

                h.  Claims/Lawsuits/Judgments

                i.   Books and Records of the business; marketing plans, etc. 

  C.  Liabilities:  what obligations are being assumed, if any?

      1.  Loans/Guarantees

      2.  Accounts Payable

      3.  Leases

      4.  Claims/Lawsuits/Judgments

      5.  Contracts

      6.  Employment related obligations

        

    

II.  Is it a Good Buy/Valuation Issues.

   A.  Review the financial information of the business

     1. Revenues (are they growing, decreasing or stagnant, and ask yourself why)

     2. Expenses

     3. Liabilities

     

  B.  Understand the market for the goods and services

  C.  Understand the customer/client base

 

  D.  If the business is not doing well, is there a reason and is it something you can address  

  E.  Obtain professional advice:  accountant, consultant who understands the business, a business lawyer who can assist with the valuation

  F.  Gut Check:  consider what attracts you to the investment, is there something telling you that it is not a good idea (or a fair price)

III.  Legal Due Diligence

  Before signing any agreement to purchase the business, be sure a lawyer conducts proper legal due diligence, including the following:

 A. The legal requirements for operating the business 

 B. Ensuring the business actually owns the assets (and not someone else)

 C. Are all of the assets assignable/transferable

      1. Permits 

      2. Licenses:  intellectual property licenses, software licenses, product licenses

      3. Customers/clients: are there any legal/privacy issues with respect to the customers/clients

      4. Contracts:  not all contracts are assignable or may require consent of the other party

D. Liabilities/Obligations

 

     1.  Loans, Obligations, Guarantees

     2.  Contractual Obligations

     3.  Employment Obligations

     4.  Lawsuits/claims/judgments

     5.  Contractual rights with respect to the business itself:  warrants, rights of first refusal, options

     6.  Tax liabilities   

E. Employment contracts

    Aside from the obligations, you need to make sure that all employees/consultants have signed  confidentiality agreements and invention assignments (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_26.html)

IV.  Deal Structure/Taxes

  There are different ways to structure the purchase of a business, and it is essential you work with legal counsel who can determine the appropriate structure.  Below are the two general methods to purchase a business, but the actual structure of the transaction can vary based on legal and tax issues. 

 A.  Stock Purchase

    1. Transaction explanation:  the purchaser buys from the owner(s) the stock/equity interests in the business entity that owns the business.

    2. What this means:  you own all of the assets as well as all of the liabilities of the business, even those arising before you purchased the business.

B.  Asset Purchase

  

  1.  Transaction explanation:  purchaser buys all or some of the assets of the business and may or may not assume some or all of the liabilities.

  2.  What this means:  purchaser owns the purchased assets and is only liable for those obligations it expressly assumes.

C.  Taxes:  make sure you have considered all of the possible tax issues relating to purchasing the business.


Final Thoughts:  Please understand that the above discussion is certainly not an exhaustive explanation of all of the issues that need to be considered in buying a business.  Issues as to what the purchasing is buying, valuation, due diligence, tax matters and deal structure should be addressed in consultation with an accountant, an experienced business/corporate lawyer and perhaps other consultants  The important point is know what you are buying, due your due diligence and make sure the deal is properly structured to best protect you and your new business.   

Disclaimer:  As always, the above discussion is for informational purposes and does not constitute legal advice or create an attorney-client relationship.

Ten Legal Mistakes Made By Start-Ups: Failing to Select Competent Counsel (#10)

The previous posts have detailed nine common legal mistakes made by start-ups.  While there are certainly other issues facing entrepreneurs starting new businesses, mistake number ten focuses on the failure to retain experienced professional advisers.  It may sound (a bit) self-serving for a business lawyer to raise the issue of engaging experienced legal counsel, but the reality is that the serious mistakes often made by start-ups can easily be avoided by engaging competent legal, tax and perhaps other professional advisers.

Myth #10:  "I don't need a lawyer or other professional adviser at the start-up stage as they are costly, and I can get all the information and documents I need on the Internet."     

When starting a business, entrepreneurs need to focus on numerous business issues and often are operating on a shoestring budget.  However, the potential liability arsing from the failure to obtain competent legal and tax counsel fair outweighs the perceived cost savings from a do-it-yourself strategy.  Here are some examples:

1.  Choosing the Proper Business Structure.  The first post in this series explained the risk of failing to choose the proper corporate structure for your business, stressing the importance of engaging professionals that can advice as to proper tax planning and the formation of the best legal structure to protect your business.

2. Drafting the Operating Agreement/Shareholder Agreement.  The second post in this series explained why it is a serious mistake to not adopt a Operating Agreement (for an LLC), Shareholder Agreement/By Laws (for a Corporation) or a Partnership Agreement (for a Partnership) or to simply use one found on the Internet.  In addition to the fact that New York LLC law requires the adoption of an Operating Agreement, these agreements set forth the financial and management rights and obligations of the partners and therefore should address the interests of the partners.  Mistakes include adopting 50-50 management control without realizing it, failing to detail buyout rights and mechanisms, and mistakenly choosing a member-managed entity instead of a manger-managed entity, to name just a few common issues.

3. Failing to Address Intellectual Property Issues.  The monumental mistake of failing to protect intellectual property rights from the outset is addressed in the third post, noting that experienced corporate counsel that understands your business can ensure this common error is avoided.  You need to make sure not to miss your opportunity to timely file patent applications, that you properly protect trademarks, you do not allow employees to claim rights in intellectual property, and focus on the legal issues relating to your website (including properly drafted website policies).

4. Employment Issues.  If you are hiring even an at will employee or a consultant, the fourth post details the importance of at least requiring the employee/consultant to sign a Confidentiality and Invention Assignment Agreement.  Properly drafted, the agreement can ensure that not only your proprietary information remains protected but also that the business owns any inventions/intellectual property created by the employee/consultant.  You don't want to find out later, for example, that a former employee is claiming rights in a key software program.

5. Don't Just Give Away Equity.  The fifth post in the series discusses the need for founders to consider carefully the ramifications of using equity in the business as currency.  Even the cash-strapped start-up should discuss with legal counsel the pros and cons of using equity as currency, and if the decision is to proceed then the issuance of the equity for products or services, then it should be properly documented.

6. Tax Issues/Section 83(b) Election.  Just as experienced legal counsel is a must, as discussed in the sixth post there is no substitute for good tax advice from an accountant well-versed in working with start-ups.  Among the issues is making sure shares vest over a period of time and that persons receiving restricted shares understand the importance of the the Section 83(b) Election to reduce tax liability.

7. Vendor/Customer Agreements.  The seventh post in this series discusses the problem that small businesses often think that they don't need contracts with their customers or that a very simple order form is sufficient.  However, many costly issues can arise without a properly drafted customer agreement.

8. Bringing in New Business Partners.  As explained in the eighth post on common start up mistakes, don't bring in a new business partner without proper legal documentation.  Start-ups understandably feel the pressure to attract new partners who can offer financing, professional services, or even play an advisory role.  However, the desire to attract such a partner may lead you to put aside execution of documents detailing the rights and obligations of the partner.  The additional legal costs, or simply feeling that asking the potential partner to sign an agreement will scare the partner off, are not reasons to delay obtaining experienced legal assistance -- the time and legal costs to resolve a potential dispute with the partner will far outweigh the cost of properly documenting the rights and obligations from the outset.  

9. Don't Violate the Securities Laws.  The ninth post in this series outlines the civil and potential criminal exposure from violating the securities laws with respect to the offer and sale of securities in your company.  The bottom line is that even innocent mistakes and "friends and family" investments can lead to corporate and individual liability under federal and state securities laws.  Therefore, you absolutely should consult legal and tax counsel when the company is initially considering offering any equity interests or debt in the company to third parties.    

 10. Experienced Legal, Tax and Perhaps other Advisers, is a Must.  OK, you are convinced about the need to engage legal and tax advice, now make another smart decision and engage advisers who have extensive experience working with new businesses.  Just like it is a mistake to ask your general practitioner/internist to perform brain surgery, don't assume your lawyer is qualified to assist with the myriad legal and tax issues facing start-ups.  Engage a seasoned business lawyer and a experienced tax adviser as these trusted advisers will assist in proper structuring of your business, prevent unnecessary disputes, protect your key business assets, avoid potential liabilities, ensure a good tax strategy, and help you plot a course for well-structured business operations.   

Ten Legal Mistakes Made by Start-Ups: Violating Securities Laws (#9)

If you have the opportunity to raise financing for your start-up by issuing securities in your corporation/ membership interests in your limited liability company, don't make the mistake of believing the securities laws don't apply because it is a private company or you are not raising a lot of capital.

Myth #9:  "The Securities Laws do not apply to private companies raising money from friends and family." 

Many founders fall into the trap of believing that the state and federal securities laws do not apply to their business because they are only raise a small amount of money in the context of a non-public company.  One common example is raising funds from “friends and family” who, as you later discover, do not fall within any exemption to the application of the securities laws.  You will not find any protection in arguments such as, "these were my close friends and they knew all about my company" or "we did not think the securities laws applied because we are a small, private company."  Worse yet, the failure to comply can result in severe liability, including returning the funds to the investors, plus interest, injunctive relief, fines and penalties – and possible criminal exposure.

Does this mean you cannot raise money?  Of course not, but it does mean you need a clear understanding of how raising fiancning can be done in compliance with state and federal securities laws.  If there is only one take away from this posting, it is that any decision to raise funds from outside investors should be done in consultation with corporate counsel.

   1.  You Need to Generally Understand When the Securities Laws Apply.  The rule is that if you are offering securities (including stock in a corporation or LLC interests) the securities laws always apply, but there may be an exemption from the need to register the offering.  Simply put, you must register the offering or preferrably find an exemption to the registration requirement.  The reality, however, is that registering an offering is an arduous, time consuming and expensive process that start-ups generally cannot undertake so really what you want to do is be able to make the offering without the registration because of an applicable exemption.  Also, a security is not just common or preferred shares in a corporation or membership interests in an LLC, but includes warrants, options, and convertible notes.

   2. The Exemption Must Apply to the Offer and each Sale of the Securities.  What this means is while you might find an exemption to registering the offering, even one sale that does not qualify for an exemption will result in a violation of the securities laws.  So, each sale/purchase must be exempt. 

  3.  What are the Exemptions and Which One Applies to Our Company's Offering.  There are several exemptions, but a full discussion of each is for another posting and absolutely requires that the company work through the exemptions in consultation with experienced corporate counsel.  Remember, securities are subject to federal and state law ("Blue Sky Laws"), and therefore even if there is a federal exemption you will also need a state exemption for each state in which any of your purchasers resides.  Also remember that even one non-exempt offer/purchase will destroy the application of any exemption to the offering.  Further, rules prohibiting public solicitation and advertising must be observed, as applicable, and the restricted securities will affect the purchasers right of resale.      

      a.  Intrastate Offering (Section 3(a)(11) of the Securities Act:  the offer and sale is made only to residents of the state where the business is incorporated

      b.  Private Offering (Section 4(2) of the Securities Act):  applies to transactions by an issuer not involving a public offering.  The focus of the exemption is on the type of offeree/purchaser and the nature of the offering. 

          The Offeree :

            (i)  must be a "sophisticated investor," meaning the investor has sufficient knowledge and experience to evaluate the risks and merits of the investment, or be able to bear the investment's economic risk;

            (ii) have access to the type of information normally provided in a prospectus; and

            (iii) agree not to resell or distribute the securities to the public.

The parameters of the Private Offering exemption are hard to delineate, and thus the SEC adopted Rule 506 of Regulation D as a "safe harbor" that sets forth  standards for meeting the exemption.

     c.  Regulation D:  This regulation sets forth a number of exemptions to the registration requirement through Rules 504 through 506 based.  A quick snapshot of the Rules:

           (i)   Rule 504:  offer and sale of up to $1million of restricted securities in a 12-month period

           (ii) Rule 505: offer and sale up to $5million of restricted securities in a 12-month period to an unlimited number of accredited investors and 35 others

           (iii) Rule 506:  is the "safe harbor" for the private offering under 4(2), and does not have a limitation on the amount of the raise or number of accredited investors and is limited to 35 others who must be sophisticated investors

    d.  Accredited Investor (Section 4(6):  offering up to $5million to accredited investors (as defined in Regulation D)

    e.  Regulation A (Section 3(b) of the Securities Act):  Exempts small securities offerings, not exceeding $5 million in any 12-month period. But, the company must file an offering statement, consisting of a notification, offering circular, and exhibits, with the SEC for review

    f.  Employment Benefit Plan (Rule 701):  applies to certain employee benefit plan offerings.

  4. We Found an Exemption So Can the Company Just Proceed with the Offer?  Understand that determining that an exemption applies does not mean the company can just proceed with the offering or sale of the securities; there are are still certain regulatory filings you will need to make and the company likely will need to prepare and provide potential investors with a private placement memorandum (PPM).  The PPM is a key document in the private placement and needs to be properly drafted to include certain information and disclosures.

  5.  Even Exempt Transactions are Subject to Antifraud Rules.  All securities transactions, even exempt transactions, are subject to the antifraud provisions of the securities laws. This means that the company, its directors and officers will be responsible for false or misleading statements, whether oral or written.

  6. What Happens if the Company Violates the Securities Laws?  There are significant penalties for violating federal and/or state securities laws.  It is very important to understand that a violation of the registration requirements under the securities laws arises regardless of the company's lack of intent to violate the law or attempt to argue good faith.  Determining liability in the context of any securities offering is an issue of whether the company complied with the registration requirements or was excused from registering the offering under one of the exemptions to registration.  In the event of a violation, the company and its officers and directors could be subject to both civil and criminal sanctions under federal and state law.

        a.  Recission:  In the event of recission, the company essentially must contact all purchasers and offer to repay them.

       b. Fines/Sanctions:  Fines and sanctions can be imposed on the company, and this can include precluding the company from making further offerings.

        c.  Founder/Officer Liability:  Fines and sactions can be imposed on officers and directors, including the possibility of liability for the recission. 

              Translation:  founders can be exposed to personal liability. 

       d. As noted above, even an exempt offering does not shiled the company and its officers/directors from civil and criminal liability if they violate the antifraud provisions of the securities laws. 

BOTTOM LINE:  DO NOT OFFER OR SELL SECURITIES IN YOUR COMPANY WITHOUT PROPER LEGAL ADVICE, AND DO NOT THINK YOU CAN FIGURE THIS OUT FROM THE INTERNET.  LASTLY, MAKE SURE YOUR COUNSEL HAS THE REQUISITE EXPERIENCE AS A MISTAKE CAN DESTROY THE COMPANY AND EXPOSE YOU TO PERSONAL LIABILITY. 

My Biz Lawyer: Ten Legal Mistakes Made by Start-Ups: Violating Securities Laws (#9)

My Biz Lawyer: Ten Legal Mistakes Made by Start-Ups: Violating Securities Laws (#9)

Ten Legal Mistakes Made by Start-Ups: Bringing in a Partner Without a Proper Agreement (#8)

Often start-ups are so excited about bringing in a partner who can offer financing, desperately needed services, or play an advisory role/provide professional advice that the start-up brushes aside the need for a proper agreement detailing the rights and obligations of the new partner.

Myth #8:  "This is a start-up and we should be happy to have this new partner so let's not worry scare the partner off by demanding a formal agreement."  

If you are involved with a start-up you certainly understand the pressure to attract partners who can offer financing, professional services, or even play an advisory role.   All too often, however, this anxious desire to attract such a partner will lead founders to opt to put aside the need to document the rights and obligations of the partner; it may be because of the desire to avoid additional legal costs or simply feeling that asking the potential partner to sign an agreement will scare the partner off.  So instead the founder decides to have a simple handshake and issue the new partner shares or membership interests representing a percentage in the business.  In no uncertain terms, this is a serious mistake for a number of reasons, including the following:

    1.  If this is an LLC, do you have an Operating Agreement?  If this is a corporation, do you have detailed by laws/shareholder agreement?  If this is a partnership, do you have a partnership agreement?  If the answer is no, then the new partner has financial and voting interests based on the interests granted in the entity; and any rights and obligations are otherwise governed by the relative state LLC, Corporate or Partnership law.  Do you know what the governing law says as far as the financial and management rights of members (LLC)/shareholders (corporation)/partners (partnership)?  If not, you may be very surprised later if a dispute arises, at which point it will be too late. 

  2.  What if the new partner fails to do what was promised, dies or becomes disabled?  You could have avoided this issue by having the interests vest over time (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_28.html) and/or giving the entity and other partners a buyout right (see http://mybizlawyer.blogspot.com/2011/10/shareholder-agreements-define-buyout.html).  If you do not attend to this issue, you could be stuck with a non-performing partner and perhaps hanging your hopes on the expensive and time consuming process of proving an oral agreement in court.

  3.  The partner decides to sell or transfer its interests to a third party you don't know or don't like (or both).  Can the partner do this?  It depends what the governing law says, but if you had a clear statement of the rights of the partners and a right of first refusal there would be no issue.

  4.  The new partner just signed a contract binding the entity, one which you would not have approved.  In New York, an LLC is deemed to be member-managed unless the Operating Agreement states otherwise, and a s a result each member has the authority to bind the entity.  Solution, an Operating Agreement setting forth that the entity is manger-managed, naming the manager, and thereby removing the authority the new member to bind the entity.  (See http://mybizlawyer.blogspot.com/2011/09/management-of-llc-member-or-manager.html).  Also, LLC and Corporations (but not SCorps) are very flexible structures allowing for the creation of different classes of partners, and therefore you can create a class that has only financial rights and no management/voting rights.

  5.  You just learned the new partner is starting a competing business or offering services to a competitor and is also trying to solicit your employees, customers, and business partners.  If the partner is using trade secrets you still can take seek legal recourse, but again proving the claim is costly and regardless does not address some of the other concerns, like solicitation of your employees.  While enforcing a non-competition agreement can be challenging and requires careful consideration before drafting, you should include confidentiality and non-solicitation provisions in the operating agreement/shareholder agreement/partnership agreement.

  6.  The partner developed services, an application or created products that include certain intellectual property rights and now claims ownership of those products/services or of the underlying intellectual property.  In fact, the partner is filing patent claims and then plans on licensing the rights to third parties.  You could have avoided any issue with an  invention agreement agreement assigning the rights to the inventions and intellectual property to the business.  (See  http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_24.html).                      

  7.  You have a dispute with the new partner, who files a groundless lawsuit in Buffalo, and the other members and the business are located in Long Island.  You realize the added burden of litigating a dispute in a court hundreds of miles from where the business is based, and while the your  lawyer explains there may be grounds for a motion arguing Buffalo is not a convenient forum for the dispute, the motion will create additional litigation costs.  You could have avoided this issue with a venue clause stating all disputes are to be filed in Nassau County, for example.  It also may have been beneficial to include a provision awarding attorney fees to the prevailing party, giving the partner pause before filing baseless claims.  

While the above is in some ways a recap of prior issues that have been discussed in this blog, the take away here should be that even a start-up has a right to demand a new partner sign an agreement clearly delineating the rights and obligations of the members of the entity.  If the new partner refuses or wants you to believe a handshake is enough, you should be very suspicious.  There is simply no substitute for a well-drafted agreement to avoid the myriad legal issues that can arise between business partners. 

Disclaimer:  The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship.  There is no substitute for legal advice from an experienced business/corporate lawyer.

Ten Legal Mistakes Made By Start Ups: Vendor/Customer Agreements (#7)

Continuing with the discussion of ten common legal mistakes made by start-ups, mistake number seven focuses on the importance of vendor/customer contracts.

Myth #7:  I don't need vendor/customer agreements or I can just copy one from a similar business.

OK, on your way to work you dropped off some shirts at the dry cleaner, and the proprietor was astute enough to give you a ticket with detailed terms and conditions relating to the laundry service provided.  When you get to work, you are happy to see one of your web developers has just finished signing up a new customer who wants your company to design an expensive website.  The customer signs your order form, which details the specs for the site, and payment terms.  Then, you start thinking: why is it that your neighborhood dry cleaner has more detailed terms and conditions with respect to dry cleaning your shirts than your company has for a several thousand dollar project?   

The problem is that small businesses often think that they don't need contracts with their customers or that a very simple order form is all that is needed.  Returning to our web developer above, think of some of the possible issues that can arise without a properly drafted customer agreement:

     1.  After three weeks work, the customer wants to terminate the project, stating it is unhappy with the progress.

          Comment:  A properly drafted customer agreement, whether for a website developer, or for any other product or service provider, should detail payment terms (i.e., progress payments), grounds for termination by each party, and may even spell out liquidated damages in the event of a breach of the contract by the client.

     2.  With each delivery of website versions, the customer asks for change, after change, after change or argues the website does not reflect what was ordered.  Does the customer have a right to require multiple changes or reject every version arguing it is just not satisfied?

         Comment:  Customer agreements should detail all material terms relating to customer changes, delivery and acceptance of the product/services.  In addition, the agreement should detail the rights of the client to review/test the deliveries and the method for requesting changes.  

     3.  What if six months after the website goes live, a feature stops working, the customer claims extensive business losses, are you responsible?

        Comment:  Any customer agreement needs clear representations and warranties and a limitation on liability provision.  Consider the following issues and include clear terms in the customer agreement:

                  a.  What representations is the vendor willing to make?

                  b.  What warranties, if any, is the vendor willing to give?

                  c.  If there is a claim under the warranty, what are the obligations of the vendor? 

                 

                  d.  What is the scope of the limitation on liability; can you restrict liability to actual fees paid to  vendor? 

      

    4.  The customer is from California and the vendor is from New York; the customer breached the contract; service of process has been difficult and expensive to pursue.

         Comment:  In addition to choice of law and venue for any lawsuit, the contract can include terms for service by mail and even the right for the prevailing party in any lawsuit to recover legal fees.

    5.  The vendor copied a contract found on the Internet or purchased one from a legal website.

         Comment:  You get what you pay for!  Don't learn the hard way (i.e., after the fact) that the vendor agreement is inadequate for your business, for example:

                  a.  The form does not state anything about who owns certain features or content included in the website, some of which are proprietary.  The question becomes who owns those features/content when the vendor intended to retain ownership and simply provide the client a license to use them.  

                  b.  A well constructed customer agreement will detail terms as to any rights the vendor wishes to retain in certain intellectual property.

                  c.  Is there an indemnification provision in the event a thrid party seeks a claim against the vendor based on a product or service delivered to the customer. 

BotTom Line:  The above are just some examples why a handshake or a simple customer receipt/order form is a mistake.  The absence of clear terms can lead to disputes and expose the vendor to liability unnecessarily.