Wednesday, January 25, 2012

Operating Agreements: Ten Important Provisions

If you are starting a business or have an established business and are bringing in a new partner, you need a written Operating Agreement.  In fact, the New York Limited Liability Company Law (NY LLCL) requires that an LLC have an Operating Agreement, failing which the members of the LLC are subjected to an agreement that is essentially created from the provisions of the NY LLCL. See Limited Liability Company Law 417(a).  Aside from the statutory requirement of a written agreement, you do not want an operating created from the provisions of the New York LLC law because there are discretionary provisions that the members can change, thereby addressing the particular interests of the members.  Below are ten key provisions a business should include or consider including in the Operating Agreement.

1.  Member Managed vs. Manager Managed.  If you do not specifically address whether the LLC is managed by the members or a manager then by default it is deemed managed by the members.  A member managed entity means that each of the members has management rights, and if this is not want the parties desire then it needs to be changed through the Operating Agreement -- indeed, it is unlikely that the majority member wants each member to have control authority.  The simple solution is to state in the Operating Agreement that the entity is manager-managed and then expressly state the name of the manager.

2. Having a Vote on Material Matters.  Even when the LLC is manager managed (by the majority member) the minority member(s) should try to negotiate to retain a right to veto material financial and business decisions.  The manager can still make day-to-day decisions but major issues would require approval of super majority of the members.  Among important (material) issues that typically require super-majority approval are (a) a material change in the business of the company, (b) a merger, sale of the business or significant assets, dissolution, bankruptcy or reorganization (c) transactions in excess of a certain amount, (d) amendments to the Operating Agreement, (e) incurring loans in excess of a defined amount,  (f) entering into transactions with the LLC members or officers, (g) redemption of membership interests, (h) employment or consulting agreements or increases in compensation of employees/consultant in excess of a certain amount, and (i) even admission of new members.  It is not unusual for a minority interest to demand that material issues can only be decided based on approval of a super-majority; therefore, do not assume that because you will own a small (minority) interest you are overreaching in asking for voting rights with respect to material business and financial matters.

3. The Membership Percentage Need Not Dictate Economic and Voting Rights.  If the intention is to allocate profits and losses other than based on the percentage of interests a member owns in the LLC or to create separate classes of voting rights, then define the terms in the operating agreement.  The Operating Agreement can vary the financial rights of members and create different classes of members, giving partners the flexibility to grant interests in the business that are not strictly defined by percentage of ownership. 

4. Tax Provisions.  The members can choose to include (or not to include) several significant tax provisions and elections affecting treatment of contributions of property, capital accounts, allocations and distributions and other tax issues.  These tax provisions should not be overlooked and should be discussed with an accountant as well.

5. Transfer of Membership Interests.  The Operating Agreement should address restrictions on transfer of membership interests, and will often include:

           (a) A right of first refusal giving other members the right to purchase offered interests pro rata based on a member's percentage interest in the LLC.  The right of first refusal prevents a member from selling its shares to a third party without giving the other members an opportunity to purchase the shares.  The right is as much about a chance for members to increase their ownership as it is about excluding the transfer of interests to an undesirable new partner.  If you include a right of first refusal, make sure the operating agreement clearly sets forth the procedure and time periods relating to exercise or waiver of the right.

          (b) Co-sale rights give members the right to sell a percentage of their interests along side a selling member so that a partner cannot liquidate its interests without giving other members an opportunity to sell some of their shares as well.  As with the right of first refusal, be sure to define what is necessary to meet each member's obligations under the co-sale terms.

          (c) An exception for transfers made to related parties since an operating agreement will generally require a member obtain approval of  for any transfer; however, you may not want your partner's son or husband as a partner so before agreeing to such a provision consider if transfer to a related partner is acceptable.

          (d) Although technically not a transfer, a restriction on the pledge or encumbrance of a member's interests.  The restriction prevents an involuntary transfer of a partner's interest to a lender or other lien holder that would otherwise occur if the the member defaults on its obligations to the lien holder.

Note:  The restrictions on transfer of a member's interests in an Operating Agreement boils down to the simple point that you entered into a business relationship with a partner (or partners), and you do not want a partner to hand over its interests to someone you do not know (or worse, do not like).

6.  Buy/Sell Provision.  Business partners can grow apart, their involvement or desire to be involved in the business can change, a partner can fail to meet expectations, or a number of other issues can arise whereby a partner wants to leave the business or the other partners want a partner out of the LLC.  A Buy/Sell provision will avoid the disputes, distractions, and (yes) legal costs that otherwise inevitably will arise during a business divorce.  The Buy/Sell provision should set the terms under which a the LLC or other partner can buyout a partner or a partner can require the LLC to buy its interests.  The structure and mechanisms of a Buy/Sell provision are discussed in prior posts, emphasizing the importance of clear terms as to when the provision can be invoked, how the selling interests to be valued, and the procedure for completing the transaction. See  

7.  Termination.  Include the grounds for termination/dissolution of the LLC.  Under New York law if you are a minority or equal partner in the LLC a court will not grant an application to dissolve the entity simply because you cannot "get along" with your business partner.  In fact, a dysfunctional partnership that still manages to be a successful business generally will not be dissolved by judicial decree under New York law.  Therefore, the Operating Agreement should delineate the circumstances under which dissolution of the LLC can occur, including (without limitation) a defined time period, the occurrence of a certain event, or a vote of a majority (or super-majority) of interests.  Indeed, if you include a buy/sell provision (as discussed above) and one partner wants to end the business while another does not, then there will be an avenue to address the issue through a buyout.

8. Non-Compete.  You may want to include a non-compete clause, and if so it must comply with New York law in terms of geographic scope, time and scope.

9. Dispute Resolution.  The dispute resolution clause should set forth the body that will decide any dispute (i.e., a court or arbitration), the venue (place) the matter will be tried (including not only the geographic location but, for example, in the case of an arbitration the arbitral institution), and perhaps that the losing party will be responsible for the legal fees of the prevailing party.

10. Flexibility.  The Operating Agreement is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL.  As such, there are a number of other financial and control terms that can be addressed in the Operating Agreement so be sure to take advantage of this flexibility in structuring the rights and obligations of the members when drafting the Operating Agreement.

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.

Wednesday, January 18, 2012

Websites: Seven Deadly Sins a Business Owner Should Avoid.

You can hardly be in business in this day without a website, but before the website goes live you need to take the appropriate steps to protect the website content and reduce exposure to claims by persons accessing the website.  Below are seven important areas a business should address before the final version of the website becomes available to the public.  Do not commit any of the Seven Deadly Sins of website development as any one of them can create substantial liability or damage to your business.

  1.  Failing to Make Sure You Own What Others Develop.  You need to take proper measures to ensure you own all the underlying intellectual property and other rights relating to the website.  If you are  outsourcing the website development, do not execute an development agreement or accept the services of the developer until a written agreement is in place which gives your business ownership of all of the content, rights and intellectual property associated with the website.  If an employee or consultant is handling the website development, review the employment agreement or consulting agreement to make sure it grants the company ownership of all the rights.  I have reviewed many website development agreements for clients only to find that the agreement does not clearly address the issue, leaving open the possibility that a third person can claim it owns the intellectual property and content of your business website.  Similarly, do not let the developer incorporate any content or intellectual property of a third party without your approval and a proper license/permission to use the content.

2. Not Protecting Your Content.  Take the following steps to protect the website content:

                  a.  Copyright the Website:  Include a proper copyright notice on each page of the website, similar to the following:  Copyright  © 2012 The Berkman Law Firm, PLLC.  All Rights Reserved.

                  b. Trademarks:  If you are using any trademarks you have registered include the registered superscript ® symbol after the mark; and if you are applying for a trademark, include the superscript .  You should also determine whether you want to seek registration of any trademarks.

                  c. Patent:  If your site has a unique function or capability, speak to a patent attorney as to whether you have any patentable aspect before you upload the website -- while there are rules allowing you to go public before applying for a patent, there are time limitations and other issues that you should discuss with a patent attorney to ensure you do not jeopardize any of your potential patent claims.

3.  Failing to Include Relevant Terms and Conditions of Use.  Your website should include Terms of Use that are posted in easily accessible manner.  These Terms of Use not only spell out rights of users in accessing the website, but the restrictions, limitations, disclaimers on access and use of the website -- i.e., your business policies.  As I have written in a prior post, do not just cut and paste the terms from another website as the Terms of Use (and the Privacy Policy) should be tailored to your business and your website.  For example, if your website sells a product, it may not be sufficient to have a link to the Terms of Use at the bottom of the home page (referred to as bellow the fold) if the terms contain an important restriction a customer should be advised of prior to placing an order.

4. Failing to Include an Appropriate Privacy Policy.  Similar to the Terms of Use, the Privacy Policy should be drafted in accordance with the nature of your business operations and policies.  As an example, there are important restrictions and disclosure required if you are marketing to your customers or wish to store their customer information for future use.  You do not want to violate the privacy rights of customers/users, as the exposure can be devastating to the business.

5. Not Incorporating an End User License Agreement.  If a user is downloading any software or application from the website, as a condition of the download the user should consent to an end user licensing agreement (EULA).  While the terms of a well-drafted EULA are for another discussion, the important point is access to any downloads should be preceded by the user's consent to the EULA.

6. Failing to Make any Necessary Disclosures?  Aside from certain standard information or disclosures you might need to include in the Terms of Use or the Privacy Policy, there may be disclosures you will want to prominently include in the website.  For example, a retail business may want a separate link to its return policy; or if your website recommends goods or services, the fact that you receive a fee for the recommendation must now be disclosed under Federal Trade Commission rules.

7. Oops, Do I Own the Domain Name?  You would think that this  issue would have been discussed as the first topic, but it is meant to illustrate how ridiculous it is that some businesses start developing a website, branding and promoting their products/services before checking if the domain name is available.  It is a simple process to check the availability of a domain name:  check the WHOIS link on the site of any domain registrar, and it will tell you if the domain name is available.  If it isn't, unless you have a case for trademark infringement or cybersquatting, move on and find another available domain before you waste time and money. And, before you choose a domain name, make sure no one else owns a trademark so you do not face an infringement or cybersquatting claim.  After you register a domain name, consider filing for a trademark to protect your rights.

As a business owner, you do not want to make any of the above seven mistakes when putting up a website because the liability, and/or the cost of rectifying, one mistake can be substantial and even destroy a business.  

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.

Monday, January 9, 2012

Licensing Agreements: Ten Important Provisions

Licensing can be a very important aspect of a company's business, whether as a licensor granting a person or entity the right to exploit or use intellectual property, products or services; or as a licensee needing to use or exploit the rights.  If you are a business that either will be licensing its rights or needs to license rights of a third party, below are ten key points you should understand with respect to licensing agreements.

1.  Determine the Proper Licensor.  This may seem obvious, but if you are the licensee, conduct the due diligence to ensure that you are licensing the rights from the actual owner.  While its is very unlikely this would be a concern when licensing from Apple, companies do not always make sure they have properly obtained the licensed rights to the exclusion of third parties.  You certainly do not want to find you have been paying royalties to the wrong party.  

2. Describe What is Being Licensed.  OK, this also may seem obvious, but be sure to clearly define the rights that are being licensed.  For example, the license to a song may be for use in a movie, but not on an album containing songs from the movie or licensing a logo may be for use on a hat but not on a t-shirt.

3. Define the Scope of the License.  When defining the scope of the license, consider the following topics:

        a.  Limitations:  Are there any limitations on the license:  for example, if intellectual property rights are involved, the license may only allow use of the rights in a particular product or service of the licensee but not in other products or services of the licensee (for example, having the right to use one's trademark on t-shirts you sell, but not on any other type of garment).
        b.  Territory:  the geographic limits of the license, i.e., where the licensee can use/exploit the rights.
        c.  Time:  how long does the license last; is it renewable, and if so what are the terms for renewal.
        d.  Revocable/Irrevocable:  some licenses can be revoked and others cannot; if it is revocable, define the events that lead to revocation.
4. Licensing Fees/Royalties.  Licensing fees can be structured in many different ways rather than simply monthly or annual payments.  As the Licensor, you might want a one-time fee upon execution of the agreement or an initial payment plus a a monthly set fee or a fee based on a percentage of sales.  As the licensee, if you are concerned about cash flow, a percentage of sales might make sense, but if you think sales could sky rocket, maybe you feel a flat fee is preferable.

5.  Updates and Fixes.  You see it all the time; new versions of software are issued or product or service bugs are corrected.  So, if you are the licensee make sure the agreement includes the right to receive all updates to whatever you are licensing.  If you are the licensor, you miay want to offer updates as you would much prefer to have properly working goods/services in the marketplace rather than allowing inferior products to tarnish your reputation.  On the other hand, the licensor may want require additional licensing fees or exclude the use of new versions containing significant changes to the licensed goods or services.

6. Assignment.  Consider how you want the license to be treated in the event of the sale of the company or of its assets.  As licensor, you may be agreeable to any assignment as long as the new licensee can demonstrate financial ability to make the royalty payments, on the other hand you might want to require consent as a condition of any assignment. 

7. Licensor Bankruptcy/Escrow Protection for Intellectual Property.  The license agreement absolutely should address the issue of the bankruptcy of the licensor.

        a.  Assumption of License.  Under the Bankruptcy Code, licenses are generally held to be executory contracts, giving the licensor the right to reject (i.e., terminate) or assume (i.e., continue in force) the license if it can meet the terms of the license agreement.  If you are the licensee in such a scenario, and there are assurances the licensor can continue to perform its obligations under the license, then you are unlikely to object to assumption/continuation of the license.

       b.  Rejection of Licensee.  The bigger issue arises if the licensor rejects the license, but licensee wants to continue as it needs the license for its business.  Under section 365(n) of the Bankruptcy Code, the licensee actually has the right to require the license remain in force provided licensee continues to make all royalty payments.  However, there are a few important caveats: 

                    (i) the license will remain in force but the licensor is released from any obligations to update which may existed under the licensing agreement -- if continued development is important, the licensee should consider if there are other alternatives before continuing a rejected license under Section 365(n);

                   (ii) Section 365(n) cannot be invoked by trademark licensees;
                   (iii) The application of 365(n) is limited to US bankruptcies, so if the licensor is a foreign company, the licensee may not have any way to preserve the license.       
      c.  Escrow of Source Code.  In technology licenses, a great avenue of protection for licensees is to require the licensor to deliver the licensed intellectual property to the licensee at the commencement of the license.  A licensor may object to the turnover of the IP to the licensee in this manner, in which case the licensee should demand a technology/source code escrow whereby the technology or source code (as applicable) is turned over to an escrow agent who holds it for release in the event of certain defined events (like a bankruptcy).  Also, be sure the license agreement requires the licensor to give you updates or deposit them with the escrow agent as they are issued so that you always have the latest versions.

8.  Indemnification.  Each party should include indemnifications protecting them from wrongdoing by the other party.  Among other things, the licensee should be indemnified from infringement claims asserted by third parties who assert intellectual property rights; while the licensor should be indemnified from misuse by licensee.

9.  Representations/Covenants.  The licensing agreement should include representations and covenants protecting each party.

     a. Licensee.  The licensee should be sure the agreement includes: (i) a representation by the licensor as to the ownership of the licensed rights and non-infringement, (ii) an obligation to continue to maintain as current all intellectual property filings, and (iii) any warranties as to licensed goods or services.

    b. Licensor.  The licensor will want the licensee (i) to comply with any laws regulating its products or services and obtain any permits as may be required, (ii) not do anything that infringes the rights of third parties, and (iii) maintain high standards with respect to quality of its use, marketing, packaging of the licensed goods/services or of products/services incorporating licensed intellectual property.    

10. Audit Rights/Termination.

  a.  Audit Rights.  If the royalties are based on sales by licensee, the licensor should require a right to receive periodic sales reports and to audit sales information.

 b.  Termination.  The Agreement should expressly state the conditions under which either party will have a right to terminate the license agreement -- even if it is an irrevocable license.  Termination can be based on obvious events such as a defined termination date, bankruptcy or in the event of a material breach by a party, but it can also be based on financial terms such as the failure to reach certain minimum sales or the failure to actively exploit/market the goods/services. 

Most businesses will need to execute a licensing agreement at some point; it may be simply as part of an agreement to use standard software or an application and as to which there is no room to negotiate the terms.  However, when the licensed rights, goods or services are essential part of the business itself make sure to consider the above ten issues before executing the license agreement.

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.


Monday, January 2, 2012

The Independent Contractor Trap: Don't Misclassify Your Employees

Many start-up and expanding companies prefer to engage the services of a independent contractor rather than hire an employee because of the high costs relating to employment taxes, health insurance and other benefits.  Recognizing the cost savings of hiring a contractor, businesses will often seek to classify a new hire as a independent contractor believing all that is needed is a few revisions to their standard contract that identifies the person as an "independent contractor" and just like that the company has saved thousands of dollars.  In reality, the company may have created a huge red flag for a potential audit that could result in the obligation to pay susbtantial taxes plus penalties.  To avoid the Employee/Independent Contractor trap, consider the below guidelines for determining whether in fact you have hired an employee rather than engaged an independent contractor.

I.  Why do Businesses Often Prefer to Classify a Person as an Independent Contractor?

Whether because a company may be a start-up or an emerging or larger company is concerned about the difficult economic environment, businesses often prefer to classify a person as an independent contractor for the simple reason of cost.  Hiring an “employee” means the company has to withhold taxes and pay social security, and will have to offer health insurance and possibly other benefits (i.e., vacation/maturity leave, etc.)

II. Can't I Just Label the Person an Independent Contractor?

No, it is a common misconception that employees/companies can avoid the "employee" label by simply stating the person is an independent contractor in a services agreement between the parties.  Moreover, the fact that the person waived any rights as an employee, signed a statement asserting he/she is an independent contractor or is issued a 1099 instead of a W-2 does not give the employer any cover.  The tax authorities (and courts) examine the nature of the relationship between the person and the company, look at the facts as to how the person provides the services, and does not care about labels or other efforts made to classify an employee as an independent consultant.

III. What Distinguishes an Employee from an Independent Contractor?   

There is no single factor distinguishing an employee from an independent contractor.  Instead, courts examine all the facts to determine the degree of supervision, direction and control the company exercises over the services.  If the company controls the manner and means by which the person provides the services, the worker is likely an employee rather than an independent contractor.

      A.  An Employer-Employee Relationship May Exist if the Employer:

            1.  Controls when, where and how the services are to be performed
            2. Provides the tools to perform the services (facilities, equipment, tools, supplies)
            3.  Engages and requires the person to work exclusively for the employer
            4.  Exercises supervision over the person, requiring reports, setting the work schedule, establishing the pay rate, retaining the right to review and approve the work product and/or evaluate the person's performance

            5.  Offers compensation in the form of a salary or an hourly rate, and/or reimburses expenses
            6.  Engages the persons who are unskilled or casual workers (therefore requiring supervision).

    B.  Independent Contractors Generally Supervise, Direct and Control the Performance of their Duties.

            1.  When performing the services, the independent contractor is not supervised or subject to the direction of the company, instead controlling its performance of the services.

            2.  The independent contractor generally offers his/her services to the public, operating their own business separate from the company engaging the services.

            3.  Indicia of independence include:
                  (a)  Using own tools, equipment and supplies   
                  (b)  Operating under a business entity (has a business) that assumes risks
                  (c)  Seting fees, project schedule, paying own expenses
                  (d)  Offering services to other companies
                  (e)  Marketing the services
                  (f)   Engaging own employees or third parties to assist
For additional guidance, see the following IRS publications:,,id=99921,00.html

IV.  What if a Company Misclassified an Employee as an Independent Contractor?

If the IRS determines that your company has misclassified en employee as an independent contractor you need to be prepared to pay substantial taxes and potentially interest and penalties, especially if it was not an honest mistake.

Where the IRS finds that the misclassification was an honest mistake on the part of the employer, and the employer filed proper returns, the employer will be liable for (a) the employer FICA obligation that should have been paid in the first instance, (b) 20% of the employees FICA that should have been withheld, (c) 1.5% of the total compensation paid to the person, (d) any amounts due for unemployment tax, and (e) possibly interest and penalties.

If the employer fails to file proper returns and cannot demonstrate reasonable cause, the liability can be doubled.

But, if the misclassification is found to have been intentional, then look out because the above limits do not apply, and the exposure can run to the individual officers/directors of the company.

Now, on top this, add your state tax liability, and the fact that there may have been obligations under other laws (including relating to health care benefits) that the company violated by misclassifying the employee as an independent consultant.

The classification of an employee as independent contractor is carefully scrutinized by Federal and State tax authorities and is a common red flag giving rise to an audit.  Do not let the potential savings lead you into the independent contractor trap as your company will pay dearly for misclassifying its employees.

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.