Monday, December 19, 2011

What Provisions of an LOI Should be Binding?

The Letter of Intent is an often use document intended to serve as an expression of interest of the parties to enter into a binding business transaction, including an investment, acquisition, distribution, licensing or other contractual relationship.  In essence, it serves as an outline of the important economic and legal aspects of the transaction and becomes the roadmap for the drafting of the definitive contract or transactional documents.  As the Letter of Intent (LOI) is usually intended as a non-binding document, the question is whether any of the provisions of the LOI should be binding on the parties.  As with any legal question, the answer depends on the specific facts and the desire of the parties, but in most cases there are provisions of the LOI that parties will likely want to be binding:  (1) No Shop Clause, (2) Confidentiality, (3) Remedies, (4) Due Diligence, and (5) Governing Law/Venue.    

The concept behind the LOI is that the parties have negotiated the essential terms of a business transaction and therefore wish set down these key terms in a writing that can be used to then draft the binding agreement.  In most circumstances, the LOI is a non-binding document because the parties anticipate that the eventual contract will need to spell out in detail the agreed terms.  Some people question the usefulness of the LOI since it is not binding, but in addition to providing a basis to then draft the binding agreements, it forces the parties to first negotiate the terms and then creates some accountability if a party seeks to drastically alter the terms when it comes to the final contract.  As an example, if a company agrees to sell its assets to a potential dollar for an agreed price, and then later in the contract changes it to more, the potential purchaser can point to the LOI and argue that the seller should stick to what it agreed.  Is that a legally enforceable claim?  No, but in most circumstances the party may recognize that it is bad business practice to renege on an agreed fundamental term.

While the parties may enter into a a non-binding LOI, there are provisions that they should still make binding.  As a practical matter, the LOI can include a statement that it is not binding, except with respect to certain expressly listed provisions.  Of course, the parties can then choose any of the sections to be deemed binding, but the following are the most common terms that will be included in an LOI.

1.  No Shop Clause.  A No Shop Clause is a provision in an agreement between a seller and potential buyer that precludes the seller from seeking other potential buyers during the period of the No Shop.  In simple terms, the seller cannot shop around the business or assets during the prescribed period.  The rationale behind the No Shop is that the potential buyer does not want the seller from using its offer to seek to obtain better offers from a third party or create a bidding war, resulting in a substantial waste of time and money for the potential buyer who is likely expending legal and accounting fees assessing the business opportunity.  The risk for the seller is that the potential buyer decides not to proceed, but this is a term a potential buyer will generally require and therefore a risk the seller will need to accept to move the process forward.  The No Shop clause will include a definite time period, and should include a clear statement as to the remedies available to the potential buyer in the event of a breach.  The remedies may be in the form of equitable relief (i.e., an injunction) or even a stated liquidated damages amount intended to reimburse the potential buyer for the costs incurred in connection with the broken deal.

2. Confidentiality Clause.  In many instances the Confidentiality Clause will have already been part of a Non Disclosure Agreement entered into prior to the LOI.  At the very least, the LOI can refer to the existing NDA and reiterate that the LOI is subject to the NDA, and a breach shall give rise to remedies as set forth in the NDA.

3. Remedies for a Breach.  If the LOI has provisions that are binding then there should be a separate provision setting forth the rights of the non-breaching party in the event of a breach of the LOI's binding provisions.  Therefore, inlcude a section stating in what circumstances equitable relief (injunctive or even specific performance) can be sought or if there is a right to specific liquidated damages for a breach of a binding provision.    

4. Due Diligence.  You may want to include a binding clause that requires the seller to provide the potential buyer an unfettered opportunity to conduct due diligence and have access to the information necessary to conduct the due diligence.  Unlike a No Shop, for example, including a binding due diligence clause is less common place, but if you are concerned about the seriousness of the seller or that it is just using the LOI to solicit offers after the No Shop expires, then you might want to consider requiring reasonable access and an opportunity to conduct due diligence.  The seller may balk on the theory that it is too difficult to define what constitutes adequate compliance, but the easy answer is that as buyer you should have unlimited due diligence, subject only to reasonableness as to notice and non-interference with the operations of the seller's business.           

5. Governing Law/Venue/Attorney's Fees.  The LOI should state the law that governs the (binding terms) and the court where claims can be instituted in the event of a dispute or a need to enforce the LOI.  Depending on certain factors such as whether you are likely to be the one bringing the claim and how deep your pockets are, you may want to include a requirement that the court award attorney's fees and costs to the prevailing party.  If you win the lawsuit, you can seek reimbursement of your legal fees and costs but the risk is that if you lose, you will be responsible for fees of the other party -- which no doubt can be quite substantial.

The lesson here is do not take the LOI for granted or view it as a waste of time.  First, if you spend the time to negotiate the fundamental terms of the transaction and then put the terms in an LOI, the parties will have a good structure to draft the definitive documents.  Of course, terms can change, as they often do, as a result of due diligence, but at least the LOI provides a starting point for the further negotiations.  Second, even a non-binding LOI should contain certain binding provisions that protect the parties in the interim period between signing the LOI and execution of the definitive agreement.   

Disclaimer:  This Article is for discussion purposes only and does not constitute legal advice or create an attorney-client relationship.  You should seek the counsel of an experienced lawyer with respect to your business law matters.


Thursday, December 15, 2011

Small and Large Companies Need to Understand Open Source Software

The development, licensing and/or use of software has become essential to the operation of many businesses.  Whether a company is in the business of selling a new application, platform or program or relies on such for its business operations, it may choose to (a) develop the software in house, (b) outsource the development to a third party or (c) it may obtain the proprietary products in connection with the purchase of a business.  One of the big issues to emerge with respect to the development of software is the integration of open source software in the application, platform or program.  Any company developing software, outsourcing the development thereof, or obtaining software through an acquisition, must properly diligence whether the software incorporates open source code, understand the risks associated with its use, and establish precautions to prevent the unknown integration of open source software into its key technologies.      

1.  What is Open Source Software?

Open source software is distinguished from the compiled ready-to-run version of software in that the program must include the source code, and it can be modified and redistributed as any developer desires.  If you are not technology savvy, then imagine a screenplay for a movie that is open for use to the general public, can be revised and then freely redistributed/incorporated into another movie.  This all sounds great since it seems you are getting the fruits of the labor of a software developer without having to pay for it.  The issue, however, is that the use (i.e., the free license allowing the incorporation of open source into another program) is subject to certain conditions which can create big issues for a company unfamiliar with these issues.

2.  How Does A Company End Up Having a Program with Open Source Source Software?

A company will end up with a program incorporating open source code if the company (a) develops a program in house and the developer(s) rely in part on open source for the development of the program, (b) outsources the development and the third party incorporates it into the program, or (c) acquires the business of a third party that is using programs developed in whole or part with open source software.

3. Why Should a Company Care if it Has Open Source Software in a Program? 

Use of open source software raises three significant issues relating to:  (a) legitimacy, (b) weakening of intellectual property rights and (c) licensing obligations.

              (a)  Legitimacy of the Code:  The essence of open source software is that it is created through the contributions of many different developers.  Again, think of the movie script written by a community of unaffiliated screenplay writers who contribute ideas and dialogue through the Internet, eventually creating the final screenplay.  The writers never meet each other, and no one can be certain if the ideas are even original.  With open source software, the community of programmers develop the program over time, without any certainty as to the original source of the code or the developer's rights, if any, to the contributed code.  If you are a company that has software incorporating open source code, you have to be concerned about whether the program infringes the intellectual property rights of a third party.  Because the intellectual property rights to the programs cannot be verified, and are made available generally on an "as-is" basis (i.e., without any warranties), the company using the program risks (i) infringement claims arising from its own use and (ii) indemnification claims asserted by end users (i.e., customers) and licensees of the company's technology.   

            (b) Intellectual Property Rights:  Software not only is protected by copyright laws but may also can be patented.  However, if the software contains open source, the program may be subject to obligations arising from an express or implied patent license whereby users are granted a license with respect to any claims -- in layman's terms, aspects of the patent -- incorporating open source.  Moreover, some open source licenses are contingent on an understanding that use of the program precludes any patent infringement claims against a third party using and/or distributing a program incorporating the open source into their products.

           (c) Licensing Issues:  The fact that open source software is developed by a community of developers does not mean the program lacks any intellectual property rights.  Instead, those incorporating open source into other works are utilizing the open source based on a license.  Understanding the parameters of the license is important as this will dictate the license you may have to grant to third party's in your own products.  The conditions relating to the redistribution of of products containing open source differ  depending on whether it is subject to a permissive free software license or the copyleft licenses:

                  (i) Permissive:  The BSD license is a permissive free licenses having relatively little requirements with respect to redistribution of the software.  Permissive licences permit the redistributor to combine the licensed material with non-open source code, effectively adding restrictions to a program derived from the open source code.

                  (ii) Copyleft:  Contrast the BSD with the GNU General Public License ("GPL"), which is a reciprocal "copyleft" license requiring that the entire source code for any programs/products incorporating the open source becomes freely available to be used, modified, and distributed by your licensees.  The derived works from the source code must be distributed under the same license terms as the open source license.  The result is that any modifications and derived works must be offered free under the same terms as the relevant GPL.   Therefore, if source code is used in a proprietary product under a GPL, it is not only the open source but the entire source code that can be used, modified and redistributed, by your licensees.  Conversely, if you distribute copies of the work without abiding by the terms of the GPL you can be sued for copyright infringement (arising from a breach of the license terms) by the original author under copyright law. 

Also, be ware that there are different versions of Permissive and Copyleft licenses so the terms and conditions of the licenses can vary within each type of license. 

4.  How Should a Company Address Open Source Issues?

Since open source has become a significant aspect software development, below are some considerations for addressing potential issues relating to open source software.

      (a)  Developing Software in-house or through outsourcing:   If you are developing software through your in-house programmers or outsourcing the development, take the following precautions:  (i) all employee-developers and third party developers should be advised of the importance of discussing with appropriate management personnel the need or desire to incorporate open source; (ii) management and legal counsel need to review the relevant open source license(s) to determine the ramifications of using the open source code; (iii) if the company decides to proceed, the developers need to document properly the open source code that has been used; and (iv) the company needs an Invention Assignment Agreement with its employees or a clause in the outsourcing contract detailing the company's procedures with respect to integration of open source into its programs.

    (b) Business Acquisition:  In the context of a business acquisition, a company must due diligence the programs/technology of the target company to determine if any of the proprietary products include open source.  Once the acquirer gets the complete picture with respect to open source matters, your counsel should include representations, warranties and indemnities in the purchase agreement to protect the acquirer.  From a standpoint of the economics of the transaction, the acquirer also needs to determine if the utilization of open source by the target company has a negative impact on the value of the target's products and intellectual property portfolio.  In addition, counsel needs to consider whether the target has properly documented the use of open source, is adhering to the relevant licenses, and if there exists a potential for claims based on misuse of the open source resulting in a revocation of the license.

The availability of open source software has provided companies with a more efficient means, both from  financial and development time standpoints, to create new programs, platforms, applications and other products.  However, with these new technology development opportunities comes new risks that both small and large companies need to understand.  In sum, if your company is developing new technologies have proper policies and procedures in place with respect to use of open source; or if you are acquiring a company with proprietary products, scrutinize the software programs and address all open source issues before proceeding with the acquisition.  

Disclaimer:  The contents of this blog are for discussion purposes only and do not constitute legal advise or create an attorney-client relationship.

Monday, December 12, 2011

The Miscellaneous Contract Terms: They Aren't Boiler Plate (Part II)

The previous installment discussing the terms generally relegated to the "Miscellaneous" article of the contract reviewed the meaning and importance of the (1) Severability, (2) Notice, (3) Amendments and Waiver, (4) Counterparts and (5) Construction and Headings sections.  See the prior Installment  This installment concludes the discussion of the common "Miscellaneous" provisions by reviewing the (6) Remedies, (7) Third Party Beneficiaries, (8) Assignment, and (9) Integration provisions of an agreement. 

6.  Remedies.  Some contracts will include a separate section with respect to "Remedies" available to the parties in the event of a breach.  The section requires particular attention because, to the extent not addressed elsewhere, it will set forth the remedies the parties can seek for breach and enforcement of the contract.  The section may detail specific damages a party can seek in the event of a breach (for example, liquidated damages), but the other points to be on watch for include:

             a.  Specific Performance:  Does the clause provide the parties the right to seek specific performance of the agreement.  In some circumstances, a party may be equally or even more concerned with the other party actually performing the services or obligations under the agreement and not just obtaining damages for a failure to perform (i.e., breach).  An obvious example might be a contract to purchase a home.  If actual performance is important to you, then make sure the contract includes specific performance as a right in the "Remedies" section, if not in another section  Without the specific performance remedy, a court may only be able to award damages, which may not be satisfactory in the mind of the person seeking performance.

           b.  Equitable Remedies:  The contract may make reference to the right of the parties seek other equitable remedies, like an injunction, in the event of a breach.  This is common, for example, in licensing agreements.  In addition, the clause may state that the parties waive the obligation of posting a bond even if it would otherwise be required as a precondition to seeking the remedy.  The bond provides security to the defendant and a means to obtain damages in the event of a false injunction.  If you are the party against whom the remedy is more likely to be sought -- in the case of a licensing agreement that would be the licensee -- you may not want to agree to waive the necessity of posting the bond.  Again, another reason why you need to read carefully all terms of the contract.         

          c.  Cumulative Remedies:  Some contracts state that the remedies are cumulative and do not require a party to seek one type of remedy before seeking alternative remedy.  You will often see this provision in a promissory note, giving the lender the right to enforce the note in any manner without any precondition that one remedy be sought before another type of remedy.  
7.  Third Party Beneficiaries.  Often the agreement will expressly state that there are no third party beneficiaries.  The section means that no one other than the actual parties to the agreement can claim any rights or seek to enforce any obligations under the agreement.  it may seem an obvious point that only the parties have rights under an contract, but there can be circumstances where a contract may appear to confer a benefit on a third party.  The inclusion of the clause will make clear that the contract should not be read to offer any benefits to anyone else.  Less frequently, the clause can be included for the the opposite purpose and actually confer the benefits of the contract on a third party where the parties desire such an effect.

8.  Assignment/Successors and Assigns.  

          a.  Assignment:  There are some contracts that one or more of the parties may wish to be able to assign and there are others which may not be appropriate for assignment.  If you are contracting for the services of a software developer, for example, you probably spent a great deal of time vetting the developer and therefore would be unhappy if the developer then assigned the contract to someone else.  Thus, you can understand why it is important to set forth whether the contract is assignable or requires consent of the parties.  Another context where assignment can be an issue is the event of a sale of the business where the absence of a right of an assignment can be an issue if the contract is important to the buyer:  one typical example is a license.  Bottom line:  think about whether you would prefer to have a right to consent to the assignment of the contract.

         b.  Successors and Assigns:   The "Successors and Assigns" clause determines whether the successors and assigns of a party or of the parties under the agreement are subject to the rights/benefits and obligations of the agreement. The clause may (i) bind the non-assigning party to perform the contractual obligations in the favor of the assignee, and (ii) bind the assignee to perform the contractual obligations in favor of the non-assigning party.

9. Integration/Entire Agreement
The "Entire Agreement" or "Integration" clause essentially provides that unless set forth in the contract an obligation, right, or term is not considered part of the agreement.  The clause incorporates the concept found in the parol evidence rule that the final agreement as made by the parties supercedes any terms that may have been discussed in prior negotiations.  A party cannot make an argument that it negotiated for a right if it is not included in the contract because the parties (and courts) must look to the "four corners" of the contract -- of course there are exceptions to this rule but the Integration concept incorporates the parties' intention that the contract is the final expression of the terms agreed to by the parties.     

While you should at least generally understand the meaning of these Miscelleaneous provisions, if there is just one take away it should be that they are not simply boiler plate just because they are found at the end of the contract.  As with any section of a contract, the ultimate meaning and effect of each of these sections depends on how they are drafted, and therefore each clause should be read with the same scrutiny applied to the other terms of the agreement.  

Disclaimer:  This Article is intended for informational purposes and does not constitute legal advice nor create any attorney-client relationship.

Wednesday, December 7, 2011

The Miscellaneous Contract Terms: They Aren't Boiler Plate

A prior post discussed the concept that notwithstanding the fact that the governing law and forum selection clauses are usually at the end of a contract they should be reviewed and negotiated with the same emphasis as the business terms.  In the same vein, there are several provisions that will often fall under the "Miscellaneous" section or article of a contract, and therefore you may (erroneously) believe they contain boiler plate language not requiring much attention.  To be clear, do not ignore or give little attention to these miscellaneous contractual provisions simply because they come at the end of the agreement.  This two-part discussion reviews the meaning and importance of the "Miscellaneous" sections of a contract.  In this instalment, the (1) Severability, (2) Notice, (3) Amendments and Waiver and (4) Counterparts, and (5) Construction/Headings clauses are discussed, and the next installment reviews the (6) Remedies, (7) Third Party Beneficiaries, (8) Assignment, and (9) Integration provisions of an agreement.    

1.  Severability.  What happens to the contract if the parties included a provision that is later found unenforceable or invalid under law?  If the agreement includes a Severability clause, in most cases the remainder of the contract will be saved.  The provision is important to prevent the entire contract from being rendered void or unenforceable.  The Severability provision will state that the remainder of the contract and the application of the deficient provision to other persons or circumstances shall not be affected and shall be enforced to the extent permitted by law so long as the economic or legal substance of the transactions is not affected in any manner materially adverse to any party.  Further, if a term or other provision is invalid or unenforceable, make sure the Severability clause states that the parties will negotiate in good faith to modify the agreement to cause the  original intent of the contract is fulfilled to the greatest extent possible.

2. Notice.  The Notice clause defines the method(s) for providing notice to the parties.  OK, that is obvious, but what you include in that provision can actually avoid the failure to provide or receive timely notice under terms of a contract. 

         Example:  You enter into a contract with a printer for the printing a brochure.  The contract includes a provision requiring you to give the printer ten days notice from the date of receipt of draft brochure of any defects.  If you do not provide notice of any defects, the printer will then make 1000 copies.  You receive the brochure by overnight delivery on December 12, 2011.  You find a defect and send the printer an email on December 23, 2011.  He calls and notifies you that it is too late, you need to take delivery of the 1000 brochures, and you owe the full fees under the contract.  You call back and tell him you understood ten days to mean ten business days, and so your notice was timely.  Problem:   the contract does not say business days, and so you made the wrong assumption.

Issues like the above regularly occur, and so here are good ideas for the Notice provision: 

                 (a) all notices must be in writing (not oral);

                 (b) when referring to days, state whether this means business or calendar days;

                 (c) if time periods run from delivery of a product, service or notice, define the permissible delivery methods (i.e., regular mail, certified with return receipt, fax, email, overnight, personal delivery) and when delivery is deemed to have taken place (regular mail:  "x" days after mailing in the US or "y" days outside the US; fax:  upon confirmation of successful transmission; overnight mail:  upon proof of delivery; and personal delivery:  upon proof of personal delivery); 

                 (d) as a precaution, require that copies of all notices to be sent to your attorney; and
                 (e) expressly state the addresses for delivery, and that if the address changes that the party must notify the other parties to the agreement.
3.  Amendments and Waiver.  Contracts should include a provision addressing how (a) amendments to the contract can be made, and (b) provisions/rights in the agreement can be waived by a party.

                (a) Amendment -- The contract should state that any amendments must be in writing signed by all the parties. 

                (b) Waiver -- The provision should state that that:  No waiver by any party of any default, misrepresentation, or breach of warranty or covenant, whether intentional or not, shall extend to any prior or subsequent default, misrepresentation, or breach of warranty or covenant or affect any rights arising as a result of any prior or subsequent occurrence.

4.  CounterpartsThe section entitled "Counterparts" allows for the agreement to be signed separately by the parties on different copies of the signature page, and will generally include that delivery of the signature page can be accomplished by fax. 

            Sample clause:  "This Agreement may be executed and delivered (including by facsimile transmission) in one or more counterparts, each of which shall be deemed an original but all of which together will constitute one and the same instrument."

5. Construction/Headings

              (a)  The "Construction" provision provides the rules of interpreting the contract in the event of the dispute, including an important concept that the parties have deemed the contract to have been jointly drafted and therefore no presumption or burden of proof should be deemed to arise favoring or disfavoring any party by reason of being labeled the drafter of the agreement.  Why is this important?  Without it, all the parties would either need to sit in a room and sign the document or the one, original signature page would need to be circulated to all parties, who would each be required to sign on the same page.
            (b)  The "Headings" clause precludes any party from giving any meaning to the headings, and therefore the headings are simply to facilitate organization of the document.

The next installment discusses the meaning and importance of several other Miscellaneous contract provisions, including the Remedies, Third Party Beneficiaries, Assignment, and the Integration provisions.Disclaimer:  The information in this blog is for discussion only and does not constitute legal advice nor create any attorney client relationship.  You are urged to consult with an experienced lawyer concerning your business/corporate law matters. 

Friday, December 2, 2011

Venture Capital Terms: A Primer

Before you get involved with venture capital financing, whether as a company looking to raise financing, or as a potential investor, make sure you understand important terms and concepts that you will invariably be confronted with in a venture capital transaction.  Even if your business is not at the juncture of raising financing, understanding the key terms in now as they relate to a private equity transaction will help you start to position company for an eventual financing round down the road.  Accordingly, this discussion provides an overview of some of the important terms in a venture deal.

1.  Venture Capital:  You have heard the term thrown about, but what does it mean?  Simply put, venture capital is a broad term used to describe financing provided to startups and early stage businesses as well as turn around situations.  However, the manner in which the financing is provided to a company is where the many variations on potential deal structures arise.  The financing can be raised through debt (i.e., a loan), equity (i.e., shares) or a combination of the two (such as a convertible loan or a loan with stock options).

2. Private Equity:  Equity securities of a company that are not listed on a public market are referred to as private equity.  However, the term is also liberally used to refer to any venture capital deal where the financing does not involve any purchase of shares listed, or any listing of any shares, on a public exchange (i.e., stock market).

3. Valuation:  The value of the company.  A simple statement, but that is the only thing simple about it.  Valuation is usually one of the most important issues in any venture deal, with the company arguing for a high valuation and the investor looking to push valuation as low as possible.  As an investor, you may receive a term sheet with a stated valuation for the company, however, any valuation decision should be based on your independent assessment.  Further, the valuation should adjust based on information you may learn in the due diligence process.

                 a.  Post-Money Valuation:  The valuation of a company immediately after the most recent round of financing. If an investor provides $1 million in a company valued at $3 million "pre-money" (before the investment was made), the post-money valuation of the company is $4 million.

                 b. Pre-Money Valuation:  The valuation of a company prior to the investment. This amount is determined by using various possible formulas (book value, discounted cash flow, multiple of future earnings etc.). 

                 c.  Fully Diluted Basis:  All securities, including preferred stock, options and warrants, that result in additional common shares on a converted basis, are counted in calculating the total amount of shares outstanding for determining ownership or valuation.4. Common Stock:  A security (stock) that evidences proportionate ownership in the company and gives the owner voting rights and proportionate right in the assets and income of the company (after all obligations of the company).

5. Preferred Stock:  Like common stock, preferred stock represents proportionate ownership in the company, but stands a higher position (preferred) to common stock with respect the claims on the asserts and earnings.  Preferred shares may or may not have voting rights depending on what the parties negotiate.  Preferred shares generally will have a number of additional rights that common stockholders do not have, including a dividend preference and liquidation preference.  There are different types of preferred stock, including:

               a.  Participating Preferred:  giving the owner the right to additional dividends if a certain predetermined financial event occurs

               b.  Convertible Preferred:  which convert into common stock either at the option or can occur upon an event requiring mandatory conversion to common stock

               c. Cumulative Preferred/Dividend Preference:  Preferred shares have a dividend preference giving the holder the right to dividends before common stock holders.  Cumulative Preferred Stock gives the holder a right to dividends at a fixed rate of return, and that dividend accumulates each year until paid (before common dividends, if any).  Non-cumulative preferred means if no dividends declared, then the dividend is lost (rather than accumulates until declared).  

6.  Liquidation Preference:  Preferred shareholders will have a right to receive a payment upon a triggering event, such as the winding down of the company or a merger or acquisition.  The question is what is the nature of the preference:  (a) how much is paid, (b) what is the priority among different classes (common vs. preferred) and series (like Series A vs. Series B, and (c) the right, if any, of the preferred to share in any remaining amounts (i.e., along side the common shareholders).

7. Series A, etc.:   Stock of a company can be divided into different series, which will occur when there is more than one round of financing.  For example, if preferred (Series A) shares were already issued, and the company does another round it can call the new preferreds Series B.  The other important aspect is that each Series can have different dividend, liquidation, voting and other rights.

8. Convertible Stock:  Most people are aware of convertible stock or convertible rights which gives the holder of preferred shares to convert them into common stock upon a triggering event.  However, the real issue is negotiating the conversion ratio/formula, for example will it be 1:1 meaning one common for one preferred or another formula where the preferred gets more than one share of common for each preferred share. 

9. Anti-Dilution Protection:  One of the biggest concerns of any investor in a company is that it will be diluted if the company subsequently issues more shares at a lower price.   As a result, investors often demand an antidilution right, and then the question is what is the nature of that right:

                  a.  Full Ratchet gives the shareholder the right to always retain its percentage of ownership in the company.  Therefore, the shareholder is given a right to a number of shares necessary to maintain its ownership percentage in the company.  While this term is very favorable for the investor, it has the effect of substantially diluting other shareholders without the right and thus the full-ratchet provision is less common.

                  b.  Broad-Based Weighted Average results in dilution of the holder of the right, the percentage decline is tempered so as to not result in the full dilution that other shareholders will experience.  The issuance of new shares at a lower price will result in a re-weighting of the average share price, and the investor with the anti-dilution protection will have a right to additional shares to lessen the effect of the new round (however, the investor will still see a reduction in its ownership percentage).

10. Tag Along/Co-Sale:  The Tag Along right gives a minority shareholder the right to sell its shares upon the sale by a majority shareholder on a percentage basis.  If you are a minority shareholder, this is an important right because you do not want the founders or majority to be able to exit the company without giving you a right to exit in part as well.

11. Drag Along:  Means that if a set percentage of shareholders wish to sell the company's share to a third party, the other shareholders must agree and are dragged along into accepting the deal and the negotiated terms.

12. Right of First Refusal/Preemptive Right:  This right can work to the benefit of the shareholder, giving it a right to buy shares on the same terms offered to a third party.  It also can benefit the company, providing the company a right to purchase its shares rather than allowing a third party to buy them from an existing shareholder.

13. Right of Redemption:  A right of redemption gives the holder the right to demand that the company repurchase its shares at a specified price upon the occurrence of a triggering event.

14. Registration Right:  Investors with registration rights are given the right to require the company to register its restricted shares either on demand (subject to certain terms) or a piggyback right (when the company files a registration statement).  For a company, allowing the demand right is not generally favored
because registration is expensive, complex and the timing may not be right for a registration.

15. Board Seats:  A company seeking to raise funds should be aware that an investor may seek one or more seats on the company's board of directors.

16. Restrictive Covenants:  It is common place for loans to include restrictive covenants limiting certain the company from taking certain actions while the loan is outstanding, but an investor may also ask for such rights, including limitations on spending, sale of important assets, issuing additional shares, increases in salaries and other major business decisions.

17. Non-Compete Clause:  A company may want to require an investor to sign a non-compete, especially a large investor.  The investor will likely push back arguing as a passive investor it is not necessary.
Above are some of the more important terms you will need to address in a venture financing transaction.  Of course, the investor will take a markedly different position regarding some of the rights as the company.  Therefore, as your company is moving toward the financing stage, begin considering how you will address the important rights that the investor will likely demand.

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.


Sunday, November 27, 2011

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.



Wednesday, November 23, 2011

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.

Monday, November 21, 2011

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. 

Friday, November 18, 2011

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.

Wednesday, November 16, 2011

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

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.

Monday, November 14, 2011

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.