Issues to Consider When Offered Stock Options

It is commonplace for start-ups and emerging companies to offer stock option to employees, consultants and service providers in conjunction with, or often in lieu of, cash compensation. For the employee, consultant or service provider, the offer of stock options can be an opportunity to share in the potential success of the company, but a potential recipient of stock options should be aware of certain important considerations before simply accepting stock options in a start-up or emerging companies. This discussion summarizes key aspects of stock options and issues you should consider when negotiating terms relating to the possible grant of stock options in a privately-held company.

1.    Stock Options.

Before discussing the implications of receiving a grant of stock options as an employee or service provider, it is essential to understand the differences between stock options and other forms of equity  -- such as Restricted Stock and Warrants.  Stock options are issued to key employees, directors, and other service providers in exchange for services rendered to the company.  Options are a compensatory vehicle intended to increase the compensation of the recipient through an appreciation (hopefully) in the value of the company.  The recipient of the Options is given a right to acquire stock in the issuing company (the "issuer" or "grantor").  It differs from the actual grant of stock as the recipient (the "grantee", "optionee" or "option holder") does not actually acquire any stock in the issuer as a result of the grant, but only the right to acquire stock based on the terms and conditions set forth in the instrument granting the options.

The instrument granting the Option, often titled the Option Grant or Notice, provides the terms upon which the recipient of the Option has a right to actually acquire stock in the Issuer. The key components of any Option are as follows:

        • Date of Grant:  date upon which the grant is made to the Optionee

        • Type of Grant: Incentive Stock Options versus Non-Statutory Options

        • Number of Shares:  the number of shares that can be potentially be acquired by Optionee

        • Exercise Price:  the amount per share, if any, that the Optionee must pay to acquire the shares

        • Vesting Schedule:  the point(s) upon which all or a portion of the grant can be exercised          

        • Term:  the length of the options/expiration period, which is often 10 years

In addition, if an Option Plan has been adopted by the Company, the Notice of Option will state that the terms of the Plan are deemed incorporated in the Notice of Option.  The Plan (which may also cover other forms of equity grants authorized by the Company in addition to Options), will address important administrative and tax issues as well as issues relating to (i) the types of equity authorized for issuance, including the nature of the Options (Incentive Stock Options and Non-Statutory Options), (ii) the effect of the death, disability, termination for cause of the option holder, (iii) the right, if any, of the Company to clawback vested options upon certain events, (iv) the effect if a corporate restructuring or similar event; and (v) the treatment of grants upon a change-in-control or similar corporate transaction.   If the Issuer has not adopted a Plan, then these concepts should be addressed in the Option Grant or the Option Agreement -- which will also Option exercise procedure.

2.  How Restricted Stock and Warrants Differ from Options.

In contrast to Stock Options, Restricted Stock gives the grantee the right to purchase shares at fair market value or a discount, or at no cost.  While the grantee acquires the shares at the time of the grant (subject to payment of the purchase price, if any) the grantee cannot actually take possession of the stock until the specified restrictions lapse, otherwise referred to as vesting.  The vesting requirements can be based on the lapse of a period of time, the occurrence of a defined event or based on any other terms.  Even after the vesting occurs, the company may still have a right to repurchase the shares from the grantee upon the occurrence of specified events (such as termination of employment or a "for cause" event).  

Warrants are often confused with or seen as interchangeable with Stock Options, primarily because warrants have many of the features of Stock Options.  A Stock Warrant gives the recipient the right to acquire stock in the Company either immediately or at a future date at a specified price.  However, unlike options, warrants are not intended as compensation for services; instead, they are granted in the connection with a capital raise (equity or debt) as an added benefit to induce the investor/lender to provide the capital to the company.   Options and Warrants may look similar, but they have markedly different tax treatments, you should always consult a tax advisor, but in the simplest terms:

• Upon the exercise of an option, the employee/service provider is taxed at ordinary income tax rates on the spread between the exercise price (i.e., price paid) and then fair market value of the stock on the date of exercise and ton a sale of the stock, the appreciation is taxed at capital gains rates;
• There is no tax at the time of exercise of a warrant and only capital gains on the appreciation in the value of the stock

As a serious admonition, you cannot avoid the tax liabilities relating to options by simply labeling the grant as warrants.  If the grant is compensatory in nature, namely given to an employee or service provider as compensation for services, it will be deemed an Option and taxed accordingly.

3.  Key Considerations and Possible Terms to Negotiate When Offered Stock Options.

If you are offered stock options, do not just accept them until you fully understand the Option terms.   This means discuss the offer with a lawyer and your accountant so you understand the option terms and potential tax implications.   The company may argue that the terms are non-negotiable, but this is generally not the case for two reasons:  (i) even if the options are issued pursuant to a Plan, the company generally has the authority to set the option terms, is not required to offer all option holders the same terms, and can even deviate from the Plan as long the terms do not negatively affect other participants or create tax issues for the company, and (ii) if a Plan has not been adopted, the company may argue it is constraint by terms offered other option holders, but unless there is a contractual restriction or tax concern, the company has broad authority when setting the terms of the options.

The review of the option terms should the following topics.

           A.  Type of Options -- Are they Incentive Stock Options (ISOs) or Non-Statutory Options (NSOs).  ISOs can only be offered to employees/directors and non consultants and other service providers.  ISOs generally have a more favorable tax treatment since only the profit on the sale of the shares is taxed at capital gains rates the requisite holding periods are satisfied (as opposed to an NSOs, as to which the spread between the exercise price and fair market value on exercise is  taxed as ordinary income and any profit on a subsequent sale is then taxed again at capital gains rates). Again, there are nuances, including application of the AMT to ISOs, and thus the tax treatment of the grant should be reviewed with an accountant.

           B.  Amount of Shares -- The amount of shares offered can be stated as an exact number or as a percentage of the outstanding shares.  If the offer is for a specified percentage, there are two questions:  (i) as of what date is the percentage calculated -- the date of the grant or at the time of exercise, understanding that your ownership percentage will be diluted if additional shares are subsequently issued by the company; and (ii) how is the number of outstanding shares calculated -- if not on a fully-diluted basis (which would include the total potential option pool, warrants, convertible notes, other rights convertible into stock), then be prepared to be significantly diluted.

         C.  Vesting -- While for employees, vesting is usually tied to continued employment, with a portion often vesting upon hire and the remainder vesting over time (often 3 or 4 years), it can be based on on certain events or milestones.  For example, revenues, profit, growth in area of the business (such as number of customers, opening of new locations) and a wide-variety of other business metrics. If the vesting is based on continued employment, the terms should address issues with respect to temporary interruptions of employment, termination for reasons other than "cause," and  termination (by the employee) "for good reason".  If vesting is tied to conditions other than continued employment, the conditions should be clearly defined -- for example, how will "revenue"  or "profit" be calculated or what if the milestones are not met due to changes in company business strategy or policies.

       D.  Death and Disability -- The terms of any option grant should address how any unvested options are treated in the event of death or disability of the option holder.  A Plan or the grating instrument can state that the options terminate or that the company has the right to determine how they will be treated.  Of course, as the option holder, you would want accelerated vesting, but a partial vesting may be a way to compromise.

      E.  Change-in-Control -- What happens to unvested options if the company is sold?  In a word, it depends.  If there is an option plan, does it provide for acceleration of vesting and, if so, under what circumstances?  Is accelerated vesting left to the discretion of the company?  If there isn't a plan, then the granting instrument may or may not address the matter.  You may hear that there is a "Single Trigger" or "Double Trigger" acceleration, and you need to understand those terms and which one applies.   A Single Trigger means that unvested options automatically vest upon the change-in-control whereas a Double Trigger adds the requirement of a termination within a period of time after the change-in-control.  Other important issues include, to state a few, how is a "change-in-control" defined (f.e., not only sale of a controlling interest but also sale of all or substantially all of the assets of the company), what if the corporate transaction is a cash buy-out (and there is no surviving ore replacement stock in an acquisition) and there is a Double Trigger acceleration requirement, and what if there aren't specified terms addressing change-in-control or if acceleration is at the discretion of the company.

    F.  Term.  Most options have a ten-year term, but make sure it isn't a shorter period.

    G.  Right of First Refusal/Repurchase Rights --  The ultimate goal is that you will want to exercise the option (assuming the exercise is not simply in the course of a liquidity event, like an acquisition) and become a shareholder because the increase in the valuation of the company.  While you will not be a shareholder upon at the time of the grant, you need to be aware of any restrictions on the shares upon becoming a shareholder.  The rights and obligations of a shareholder in a company are usually set forth in a Shareholder's Agreement (or, they can be in the Plan document, Company's Certificate of Incorporation or in the Option Agreement).  Often the Company (and/or the shareholders) will have  a right of first refusal in the event a shareholder seeks to sell its shares to a third party. Separately, the Company may have a right to repurchase the shares upon termination of an employee-shareholder or of any shareholder upon the occurrence of certain events (such as death, divorce or a "for cause" event).  A Voting Agreement may also be a condition to becoming a shareholder.  The simple point is that due diligence is necessary before deciding to accept options as a component of the compensation.

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

     

     


         

The Essentials of a Good Shareholders' Agreement (Part II): Right of First Refusal

I recently received a kind email regarding a post I did some time ago regarding the importance of the Shareholders Agreement:  http://mybizlawyer.blogspot.com/2012/12/why-you-need-shareholders-agreement.html.  The comment noted, however, that I had indicated there would be subsequent entries discussing key components of a good Shareholders' Agreement.  In the vein of better late than never, the next several posts will focus on the key provisions of a Shareholders/ Agreement.  The focus of this post is the Right of First Refusal.

1.  Why is a Right of First Refusal Important?

A well-drafted Shareholders' Agreement should include a Right of First Refusal, granting the right of the corporation and/or other shareholders to purchase the shares of a selling shareholder before those shares can be legally sold to a third party.  Absent the right, a selling shareholder can simply sell the shares to a third party -- which in theory does not sound like an issue, but in reality can be a nightmare for the business.  Consider the issues that can arise when a shareholder is not restricted from selling its shares to whomever it wishes on whatever terms:  the shares could be sold to someone you do not want to be in business with at a price that is substantially below the value of the business.  Moreover, what if the selling shareholder is a founder or selling a controlling stake in the corporation -- regardless of the person's character, you may not see the purchaser as the right person to be holding the reigns of the business.  Shareholders in a privately held company invest in a business because of a belief in the founders, and if a founder can just sell its interests to anyone without restriction, the very reason for owning the shares can be at risk.  On the other side of the coin, as a founder, you often take in investments from others not only because of financial needs but also the expertise, reputation or relationships that an investor may bring to the business.  When an investor sells without the restrictions of a Right of First Refusal, the founders should be concerned whether the purchaser is an appropriate partner for the business, and should not overlook the fact that as controlling shareholders the founders will owe a fiduciary duty to this new shareholder. Thus, the Right of First Refusal is essential to protect the interests of both the founders and investors.

2. Who Can Have the Right of First Refusal?

The Right of First Refusal can be granted to the corporation, the shareholders or both.  Often, the corporation will be granted the option to purchase the shares before they are required to be offered to the non-selling shareholders.  Vesting the initial right in the corporation has the following advantages:

                    (i) it allows the corporation to "clean up" the capitalization table; in other words, reduce the number of shareholders and outstanding shares.  By reducing the number of outstanding shares, the other shareholders benefit because their percentage of ownership will increase (i.e., if there are 200 outstanding shares, four shareholders each with 50 shares, they thereby each own 25% of the corporation; if a shareholder sells 50 shares to the corporation, the total outstanding shares drops to 150, and the three remaining shareholders would then each own 33% of the company);
                 
                   (ii) the corporation now has additional shares it can offer to existing or a new investor, without diluting the existing shareholders, and
                 
                  (iii) the corporation can prevent an existing shareholder from increasing its stake to a level that may not be viewed as ideal for the business.

If the Right of First is not given to, or exercised by, the corporation then the existing shareholders will have a right to purchase the shares. Note, that in a more complex structure where there are different classes of stock, holders of a particular series of stock (for example, Class A Preferred Shares) may be granted the Right of First Refusal in priority to, or exclusive of, other classes of stock).  Again, giving the Right to the shareholders allows them to prevent a third-party buyer from becoming a shareholder and affords an opportunity to increase ownership in the business.

3. When is the Right of First Refusal Triggered?

Of course, the Right of First Refusal is triggered upon a "sale" of the shares by an existing shareholder; however, what constitutes a "sale" or triggering event?  Obviously, the Right should arise if a shareholder has an offer from a third party to purchase all or a portion of the shares owned by the selling shareholder.  Other events can also trigger the obligation, such as an involuntary sale that is triggered by the occurrence of an event set forth in the Shareholders Agreement.  These involuntary events can include the death, disability or retirement of a shareholder or for "cause" events like conviction of a crime, fraud, misappropriation, violation of non-compete or confidentiality requirements or breach of material company policies.   In some circumstances, the selling shareholder may hold a particular license, and the suspension or loss of the license would jeopardize the status of the company as a professional services corporation, requiring the sale of the person's shares in the company.  When drafting the Right of First Refusal, consider not only the events that, aside from a voluntary sale, should trigger the right, but also when is a triggering event deemed to occur -- f.e., what constitutes and who determines if a "disability" or a material breach of corporate policies has occurred.

4.   What are the Key Aspects of the Right of First Refusal?

• First, as noted above, identify who has the right:  the corporation, the shareholders, and which shareholders (if any).
• Second, detail when the right is triggered:  (i) for a voluntary sale it is typically upon an offer to a third party and (ii) for an involuntary sale, the clause should explain what constitutes an (involuntary) triggering event and who will make the determination that it has occurred.  For example, will a physician make the decision about whether a shareholder has a "disability" and if so how will that physician be selected.
• Third, provide clear notice provisions:  consider what details must be included in the bona fide third party offer, how long does the corporation/non-selling shareholder have to exercise its rights, and include a clear statement that the failure to exercise within a defined time period constitutes a waiver of the right.
• Fourth, if the corporation does not purchase any or all of the offered shares, what are the rights of the non-selling shareholders, and if one or more non-selling shareholder does not exercise the right, can the others who exercised the right purchase a greater portion of the offered shares.
• Fifth, in the case of an involuntary sale, how is the purchase price to be determined:  this is the most difficult aspect of drafting a Right of First Refusal, requiring terms that address who makes the determination (such as an accountant, investment bank or other person with a particular expertise relating to the business) and what formula should be used (such as a multiple of gross or net revenues, net profit, discounted cash flow, book value or a host of other valuation procedures),
• Sixth, if the right is exercised, what are the terms for closing the sale:  (i) when must the corporation or non-selling shareholders close on the purchase of the shares; and (ii)  is there a defined structure for payment of the purchase price (such as partial payment at closing and the remainder as a loan or are the proceeds of a Buy-Sell Insurance policy available).
• Seventh, if the third party does not close the sale by a certain time period, must the shares be re-offered to the corporation/non-selling shareholders.

5.   A Word about Buy-Sell Insurance.

A dilemma can arise if the corporation or non-selling shareholders want to exercise the right but do not have the financial ability to do so at the time.  As noted above, one way to address the issue is by including provisions for structuring the purchase through installment payments or a loan, alleviating the issue that arises when the corporation/non-selling shareholders want to exercise the right but lack the funds.  Another mechanism that should strongly be considered is obtaining Buy-Sell Insurance.  With Buy-Sell Insurance, the corporation (and the shareholders, if they obtain a policy as well), can fund the purchase the insurance proceeds of the policy.  The insurance proceeds are used to purchase the shares upon defined events, which are usually death or disability of a shareholder (but can include other events).  In the course of drafting the Shareholders' Agreement, the shareholders should consider the option of purchasing a Buy-Sell Insurance policy.  If the company/shareholders are not in the position to do so, then the Right of First Refusal should include a provision that if a policy is obtained down the road, it will in the first instance be used to fund the purchase of the shares from the departing shareholder.

Needless to say, a well-drafted Right of First Refusal clause is an essential component of the Shareholders Agreement.  As a word of caution, however, make sure the provision addresses the specific interests of the company and the shareholders rather than simply relying on a one-size-fits all approach.  Considering who can exercise the right, when it is deemed triggered, how valuation is determined, and the options for funding the buy-out are crucial when drafting the provisions of a Right of First Refusal.  


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

Valuation Terms for a Buy/Sell, Operating Agreement and Shareholder Agreement

In prior posts, I stressed the importance for business owners to enter into an agreement that sets forth the right to require a redemption or buy-out of a owner's equity interest upon the occurrence of certain triggering events.  Ideally, business owners should have a well-drafted document that addresses the buy-out rights as well as a number of other key issues relating to management and control, financial terms, restrictions on transfer of interests, and a number of other matters.  Whether in the form of an Operating Agreement (for an LLC), a Shareholder Agreement (for a Corporation), the Partnership Agreement or in a separate Buy-Sell, it is imperative that the owner's of a business address these fundamental issues in writing.  A major area of concern is the right to buy-out a partner upon the occurrence of certain triggering events, including death, disability, and "for cause" termination.  Now let's say the partners have agreed that upon defined triggering events either the company (through a redemption of the interests) or the other partners can force a buy-out/termination of a partner or the partner's legal interests, the questions becomes how is that interest valued?  Below are some thoughts about how to address the difficult issue regarding valuation in the context of a partner "buy-out."

1.  Include a Valuation Method in the Governing Agreement Between Business Partners.

Before examining how valuation should be addressed in the governing document among the partners,  it is important to state what may be obvious but is often overlooked in these agreements:  actually include provisions that detail the method or procedure for determining valuation.   On many occasions, the governing agreement will only go half way -- it will include a redemption and/or buy-out right but not include how to value the departing owner's interest.  As you can imagine, this invariably leads to costly litigation over the proper valuation of the business.  Avoid creating a problem by including the valuation method in the governing document.

2.  There is no Single Valuation Method that is Appropriate for all Businesses.

The next question is what is the appropriate valuation method.  The bottom line is there is no single correct answer, as it depends on a number of factors, including (i) the nature of the business, (ii) the operating history and status, and (iii) the perception of the partners.  The nature of the business matters because, for example, you would not value a real estate holding company in the same way you would an online retailer.  The operating history/status of the business is significant because it may not make sense to apply the same valuation method to a mature company with an established operating history and revenues to a pre-revenue start-up.  Finally, there is the perception of the partners, which can create some of the biggest issues in determining valuation.  For example, the partners of an early stage company may believe that even without any current revenues, they have a new technology or concept that will attract substantial investment and eventually substantial revenues, requiring the valuation to take into account their understanding of the potential market for their product.

3.  What are the Possible Valuation Methods or Procedures?

So, if no single method of valuation applies, how is the issue then addressed in the governing document?  The answer is really a matter of the partners agreeing on the appropriate method.  In some cases, the agreement will actually state a formula for calculating the valuation:  whether it is book value, a multiple of gross or net income, an income multiple that looks at historical earnings, or a calculation based on discounted cash flow.  In other circumstances, the partners may recognize that they are cannot determine the appropriate methodology or feel it may need to adjust as the company develops, and instead would rather leave it to a third party to determine the valuation.  If the parties decide that engaging a professional to determine the valuation upon the triggering event, then they must next decide who would be engaged:  obvious choices include a CPA, investment bank, or a company specializing in business valuations.  Assuming a professional is to be engaged, the next question is how is that person/firm chosen?  One possibility is to specifically name them in the agreement, but what if they are no longer in business at the time the valuation is needed.   The parties can instead state that they will mutually agree who should be retained at the time of the triggering event, but what if they don't agree?  An alternative which is often utilized is to set a time by which the parties have to agree, barring which they each choose a person to conduct the valuation, and subject to the reasonableness of the issued valuation opinions the final valuation is the average.  Or, the agreement can provide that each party chooses their expert and the two experts then choose a third, with average of the three constituting the final valuation.   Recognize, however, that engaging three experts can be costly, and the parties need to set forth how the fees will be paid (likely, they each pay their own expert and share the cost of the third one).

Lastly, the governing agreement should include provisions about timing -- in other words, when   the valuation must be completed if the methodology is set forth in the agreement or when the experts must be chosen and their valuation opinion issued.  Without clear deadlines, the process can drag-on without a timely resolution.

Disclaimer:  The above does not create any attorney-client relationship and is for informational purposes only.  It is important to retain a knowledgeable business lawyer before entering into any business relationship .

Recovering Lost Profits In Business Litigation

Today's post features a guest entry by James T. Hunt, Jr., a business litigator and a partner at Slater, Tenaglia, Fritz & Hunt, P.A.

Business lawsuits involving the claim of “lost profits” as damages can present unique challenges, especially if your business cannot identify specific transactions or deals that were lost due to the defendant’s wrongful conduct or breach of a contract. Some states have strict guidelines governing the ability to recover lost profits, while others actually prohibit lost profit recovery in certain circumstances.

A Tale Of Two States: New York vs. New Jersey

Despite their proximity and the similarity in contract caselaw, New York and New Jersey have somewhat different standards regarding recovery of lost profits. In New York, any business can recover its lost profits in a lawsuit, regardless of how long the company has been operating.  In fact, lost profits are somewhat treated the same way as any other type of damages.  New Jersey courts, however, have steadfastly refused to permit recovery of lost profits in cases involving a new business, which known as the “new business rule.”  Only an established business with a history of revenue and profits can recover lost profits.

New York

New York courts require a plaintiff to prove its lost profits in the same manner as any other damages. Lost profits, therefore, must be proven with a “reasonable certainty.”  This does not mean that absolute precise mathematical accuracy is required. Rather, courts are mindful that a prediction of future profit is inevitably speculative to some degree. 

In essence, there must be some rational basis on which to support an award of lost profits.  But a request based on pure speculation will most certainly be rejected.  Generally, three criteria need to be satisfied to obtain an award of lost profits: (1) the damages were actually caused by the breach, (2) the particular damages were fairly within the contemplation of the parties to the contract at the time it was made, (in other words, the damages were foreseeable), and (3) that the alleged loss is capable of proof with reasonable certainty.  New York falls in the majority of states that permit recovery of lost profits even if it is a new business with no track record of profitability.  A new business endeavor is held to the same standard – it must prove lost profits with reasonable certainty.  At the same time, however, a New York court will not allow an award to be based on pure conjecture or speculation. While the standard is the same for an existing business or new business, in the case of a new business a stricter standard is imposed because there is no experience from which lost profits may be estimated with reasonable certainty and other methods of evaluation may be too speculative. The more risky and speculative the industry, the less likely a new business could prove lost profits with such certainty. 

What constitutes “reasonable certainty” can be nebulous and difficult to pin down. For example, in a leading New York case, the court rejected a claim for lost profits arising from a domed stadium that was never constructed. The court concluded that the multitude of assumptions required to quantify the lost profits award contained an impermissible level of “speculation and conjecture.”  Some of these questionable assumptions included that the facility would be completed, available for use, and operating profitably for over 20 years. In another federal New York case, the court rejected as speculative a lost profit calculation that assumed the occurrence of numerous successive hypothetical transactions. The court found this constituted precisely the sort of conjecture that the reasonable certainty standard prohibits.

In a Second Circuit Court of Appeals case, Trademark Research Corp. v. Maxwell Online, Inc.,  a trademark search service brought suit against a software design firm for alleged breach of a contract that required the defendant to create for the plaintiff a trademark database and search system. The Second Circuit held that plaintiff's claim for future profits from in-house trademark searches and sales of disks providing direct access to plaintiff's database should not have been presented to the jury because it was incapable of proof with reasonable certainty as a matter of law.  For example, the plaintiff's accounting expert had assumed an abrupt expansion of the market for trademark search services, assumed that plaintiff would reverse the long decline in its market share, assumed that plaintiff's historically aggressive competitors would take no measures to counter plaintiff's ascendancy, and predicted which choices customers would make among a variety of new and old search technologies. To cap it off, all of these assumptions were reduced to speculative exact dollar amounts and spun out to the year 1998. Even though there was a significant amount of evidence submitted, the court found that it consisted of a “network of conjecture.”

By contrast, an established business often is in a good position to offer evidence of past experience as a reasonable basis from which a jury may determine lost profits with the requisite degree of certainty. For example, in a case involving a sidewalk café seeking lost profits for breach of contract, the New York Court of Appeals upheld a jury award for lost profits. The Court of Appeals held that the evidence of the past experience and profits of the established restaurant to which the cafe would be attached was sufficient “to remove plaintiff's lost profit claim from the realm of impermissible speculation.”  In a federal New York case, a company in the business of selling costume jewelry through the mail brought suit for breach of contract to distribute 8,000,000 advertising supplements in newspapers. The company had been in business for over forty years.  The company offered statistical evidence of its past performance in a remarkably similar advertising program. The court found this evidence was sufficient to prove its lost profits with reasonable certainty.

New Jersey

Just across the river, New Jersey courts allow recovery of lost profits but not if the business is new and has no history of generating revenue.  This rule is called the “new business rule,” and is the law in a minority of states. Generally, profits lost by reason of breach of contract may be recovered if there are any criteria by which probable profits can be estimated with reasonable certainty. Indeed, New Jersey courts do permit considerable speculation by the trier of fact as to damages. As one court has stated, “[t]he rule relating to the uncertainty of damages applies to the uncertainty as to the fact of damage and not as to its amount, and where it is certain that damage has resulted, mere uncertainty as to the amount will not preclude the right of recovery.”  Courts have pointed out that the mere fact a plaintiff cannot pinpoint its damages with laser preciseness should not get a breaching party off the hook, since the breaching party caused the problem in the first place.  Accordingly,  the  fact that a plaintiff may not be able to fix its damages with precision will not preclude recovery of damages. But a request for damages that is based on pure speculation and on mere opinion evidence without factual support will not succeed. Again, “reasonable certainty” is the touchstone.

A lack of past performance is why New Jersey continues to apply the New Business Rule, which prohibits a new business from recovering lost profits. The reasoning behind the new business rule is that lost profits cannot be determined with a reasonable degree of certainty because there is not an established history of revenue and profits. Under the New Business Rule,  prospective profits of a new business are considered per se too remote and speculative to meet the legal standard of reasonable certainty.  The short existence of the entity makes a determination of lost profits too speculative. A New Jersey appellate court acknowledged it is in the minority of states that preclude lost profits in new business cases, and conceded that it was without any power to award such damages unless the New Jersey Supreme Court changed the law.

So what constitutes a “new business”?   The answer is decided upon a case-by-case analysis of the individual factual circumstances involved and the type of industry in which the business operates. For example, in one case an appellate court deemed a 2 ½ year old business to be “new.” The business offered educational, recreational and entertainment services for children, teens, and adults in one modern community center.  In so doing, the court deemed the business “new and unproved.” Under other circumstances, courts have permitted an award of lost profits where the business had operated only two years (from 1996 to 1998). In fact, the Third Circuit Court of Appeals has permitted lost profits for a business operating for only 1 ½ years. Obviously, the more risky and speculative the industry, the less likely a newer business could prove lost profits.

Past Is Prologue

So how important is it to demonstrate past performance? In fact it is the key to recovering lost profits. Past experience of an ongoing, successful business can provide a reasonable basis for the computation of lost profits with a satisfactory degree of definiteness.   Past profit experience on other projects is widely accepted as relevant to a determination of damages based on lost profits.  Courts have held that evidence of such a past performance may form the basis for a reasonable prediction as to the future.  In addition, courts have accepted other evidence of the profitability of a business, such as industry-wide information and projections and even revenue data of a competitor. While a newer business with no track record may ultimately be able to recover lost profits, it will be a much more difficult task than a business with a solid, several-years record of profitable performance.

Proving Your Damages: The Battle of the Experts

Proving a company’s lost profits to a reasonable degree of certainty will most likely require expert testimony. In most cases, if the stakes are high, a battle of the experts will ensue, where both parties retain experts who submit differing and contradictory expert opinions.  Victory will then hinge on which side retained the most convincing expert.  While it is possible to use the owner of the business as a sort of “expert” given his or her deep knowledge of the business and the industry, it is far too risky to go it alone without a qualified expert. Experts will have to analyze the company’s operating and revenue history, its costs and expenses, and forecast a lost profit figure that can pass muster. Retaining a highly competent, qualified, and trial-experienced accountant as your expert is a necessity. 

Jurisdiction is Important

If you have the option to file a lawsuit in several different jurisdictions, it is always important to confer with an experienced business law attorney to determine which jurisdiction will be most beneficial to you. This is especially true if you have a new business that intends to claim lost profits as part of the damages suffered. Certain factors may dictate where you can sue and what state law applies to the case. For example, if the matter involves an inter-state transaction across jurisdictional lines, determining “where” the transactions occurred as a legal matter will impact your case. Further, your contract may contain a choice of law provision that requires application of the law of a particular state.  You need an experienced business lawyer to assess the ramifications of such a provision and the hurdles the applicable state’s law would raise in your case.

About the author: James Hunt is a business litigator and a partner at Slater, Tenaglia, Fritz & Hunt, P.A., a commercial and business litigation firm with offices in NY and NJ. To learn more about claiming lost profits, contact Slater, Tenaglia, Fritz & Hunt, P.A., to schedule a free initial consultation

My Biz Lawyer: Due Diligence and the Business Transaction: Making...

My Biz Lawyer: Due Diligence and the Business Transaction: Making...: Even fledgling entrepreneurs are aware of the importance of conducting due diligence in a business transaction, but possessing a true und...

Due Diligence and the Business Transaction: Making the Examination Fit the Deal

Even fledgling entrepreneurs are aware of the importance of conducting due diligence in a business transaction, but possessing a true understanding of the process is another story.   A simple dictionary definition of the meaning will generally focus on analyzing a company in the context of corporate mergers or a stock purchase.  However, as with any simple definition, reducing an understanding of a due diligence investigation to a few words paints a woefully incomplete picture of its significance in a business transaction. If there is any one concept that should be emphasized before entering into any business transaction, it is this:  Do not engage in any important business transaction until a due diligence investigation that is tailored to the the nature, scope, and terms of the transaction has been completed. 

We conduct due diligence all of the time in our daily lives.  We make decisions about purchasing goods or engaging someone's services based on certain considerations with or without consciously realizing that what we are actually doing is a form of due diligence. It is common for us to conduct due diligence and make decisions about familiar and not-so-familiar transactions—such as trying a new restaurant, downloading a smartphone application, buying the latest high-definition television, hiring a lawyer, and so on— and although we might not realize it, we routinely engage in legal, financial, technology, personal, and other forms of due diligence depending on the product or service we are considering buying.  the legwork required to be a well-informed consumer and to ensure you are getting the right product or service at the right price is simply a less structured and less detailed form of the due diligence an entrepreneur should perform before entering into a business transaction.

Before purchasing a product or engaging a service, diligent consumers research the company/service provider, research the product or the services, try to determine the value of the product or services being offered, and, sometimes, conduct a background check or investigation of potential hires. Parties to a potential business transaction apply due diligence criteria similar to those precautions consumers perform before buying products or hiring professional services:  they will investigate the company and its business operations, research the products or services offered by the company, determine the appropriate valuation of the target business, examine management capabilities and perform background checks and investigations of founders and key personnel.  Due diligence therefore involves the process of examining and developing the necessary level of understanding of (i) the company and (ii) its business operations (in other words, its products, assets, and/or services and how the company functions); (iii) determining an appropriate valuation of a business and the transaction; and (iv) vetting personnel (management capabilities, key personnel and employment matters) before entering into a business transaction with, investing in, licensing assets or services of, or purchasing all or part of a business or its assets. I call these four aspects of any business the business cornerstones.

Whether you are buying or investing in a business, entering into a joint venture or partnership, considering making a business loan, or entering into a variety of other business transactions, you should focus on these business cornerstones before entering into any type of transaction.  While the amount of focus given to each of these areas varies greatly depending on the nature of the transaction and the goals of the parties, these four aspects of any business should comprise the basis for the due diligence investigation. What should you learn from your examination of the cornerstones? The goals of a due diligence examination corresponding to each of the four business cornerstones are shown in the Table below:

Table:  Due Diligence Goals

The Business Cornerstone	The Due Diligence Goal
The Company	To understand the legal and financial structure of the company and identify potential organizational or structural risks
The Business Operations	To understand the nature of the business and its products, assets, and services; the operational aspect of the business, and to identify potential legal, financial, and business risks
Valuation	To determine an appropriate valuation of the company and/or the transaction and identify potential financial risks
Personnel	To identify the key personnel and ascertain whether they are capable of operating the business, executing business plans, and/or fulfilling post-closing obligations

The common denominator of these four goals is that the due diligence process impart to you a level of understanding of the company, its business and operations that is sufficient to enable you to decide whether to engage in the contemplated transaction. To achieve this appreciation, the due diligence investigation necessarily involves, not only examining materials and data provided by the company or your potential business partner but also information obtained from various sources, including public and private information and the advice of professional consultants. 

Simply put, think of due diligence as a process of first hearing the company’s business story—as it may have been provided in an investment presentation or business plan—and then conducting an investigation to corroborate the story. A proper due diligence examination will focus on the four business cornerstones, and includes not only broad-based legal and financial questions, but also requires that you identify the critical areas of the business and thereby gear your inquiries to the specific business and the nature of the transaction involved. It is not enough rely on the standard due diligence set of questions; instead, tailoring the due diligence to the target company’s business operations and the underlying facts of the transaction is essential to conducting a productive due diligence examination. 

For a a comprehensive discussion of the role of due diligence in a wide variety of business transactions, please see Due Diligence and the Business Transaction:  Getting a Deal Done, by Jeffrey W. Berkman (Apress 2013) (available on Amazon and Barnes & Noble) 

Disclaimer:  The above is for informational purposes only and does not constitute legal advice.  You are advised to consult an experienced business lawyer before entering into any business transaction.

Due Diligence is Important in a Variety of Business Transactions.

The due diligence process should not be limited to buying or investing in a business. It should be conducted in a variety of business transactions, including if you are becoming a partner in a new or existing business, licensing intellectual property, or a taking on a new business partner. And, if you are considering selling your business or taking on new investors, conduct due diligence on your business first so that potential issues can be resolved before they are discovered by a potential purchaser or investor.

Due Diligence and the Business Transaction: Getting a Deal Done (Apress 2013) is a practical guide to due diligence for anyone buying or selling a privately held business or entering into a major agreement with another company or business partner. The book will help you understand when to conduct due diligence, whom to include, and how to spot the red flags that signal danger. In addition, you will learn:

· How to conduct due diligence when contemplating a variety of business transactions, including a business loan, purchase of a business, investment, commercial real estate transaction, franchise opportunity, or licensing deal

· How to calibrate the correct scope and breadth of the due diligence investigation depending on your situation

· How the results of due diligence may and often will change the elements of the final deal

· How to draft due diligence documents so they protect your interests.

The book is available at http://www.apress.com/9781430250869 or on Amazon.