Wednesday, February 22, 2012

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

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

          1.  Reason #1: The tax advantages of the LLC versus the corporation;

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

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

A comparison of the arguable tax advantages of the LLC was the subject of the previous post, while this post focuses on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.

Reason #2: The extremely flexible nature of the LLC, allows wide-latitude in structuring the rights and obligations of the members (i.e., the partners).

The document governing the rights and obligations of the members of an LLC is the Operating Agreement.  The key aspect of the Operating Agreement is that it is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL.  Therefore, the members can utilize the Operating Agreement to structure the economic and control rights to fit the needs of the members and the business.

            A.  Do you want the entity controlled by all the members or a manager?  Under New York law, LLCs are by default deemed member managed, and thus each member has management authority; however, New York law also allows the members to instead choose to have the LLC managed by a manager or a board of managers, and the manager does not need to be a member of the entity.

           B. Do you want all the members to have the same rights?  If not, different classes of members can be created based on voting or economic rights, and in fact some members can be given economic but not voting rights.  Additionally, economic and voting rights need not be based on ownership percentage in the LLC. Contrast this flexibility with an SCorp which prohibits creating different classes of shareholders.  Another alternative is to require super majority or even unanimity for key decisions, leaving the manager to run the day-to-day operations but limiting the authority to protect the rights of minority members when it comes to important substantive issues.

          C.  Do you want to restrict the transfer, pledge or sale of membership interests?  Through the Operating Agreement, the members can elect to include provisions restricting the transfer, pledge or sale of membership interests.  Adding provisions such as a right of first refusal, a co-sale right and a prohibition on the pledge of one's membership interests not only (i) limits the ability of a member to dispose of its interests  without an opportunity for the other members to also monetize, in part, their interests, but also (ii) means the existing members can preclude the admission of a third party who they may decide is not good for the business.

          D. What can be done if I have a dispute with my partner?  The members will have an opportunity when drafting the Operating Agreement to include a Buy/Sell provision addressing the rights of the members if a serious and seemingly unresolvable dispute arises. The Buy/Sell provision should detail the procedure for exercising the right and the methodology employed for valuation of the membership interests. See  In addition, include a clear dispute resolution clause, as you would in any contract, which states the venue for resolving claims both in terms of the type of tribunal (i.e., court, arbitration, mediation) and the actual geographic location (for example, New York County or Nassau County).

         E. What are other examples of what can be included in the Operating Agreement and what are the limitations?  Simply put, the the Operating Agreement can include any provision the members decide to incorporate provided it is not prohibited by the New York Limited Liability Company Law (or is otherwise unlawful).  Therefore, the members may decide to include, among other clauses, (i) a non-compete clause, (ii) confidentiality restrictions, (iii) provisions adjusting the application of certain tax provisions, (iv) provisions relating to the allocation and distribution of profits and losses, (v) grounds for termination of the LLC, expulsion of a member, or addition of new members and (vi) creation of officer positions (such as a President or CFO), to name a few examples of typical Operating Agreement terms. 

       F.  But I have heard that it is harder to raise funds from investors when you have an LLC as opposed to a corporation?  The argument that it is harder to raise funds if you are an LLC as opposed to a corporation does not carry much sway nowadays.  The fact is that it is extremely difficult, even in the best economic environment, to raise financing from third party investors.  If you are fortunate enough to find investors, it is unlikely they would be dissuaded by the fact that the business is an LLC as opposed to a corporation.  Remember, the highly flexible nature of the LLC allows the members to bring in investors with different economic and voting rights, and the LLC is so common place it is rarely a reason investors will be uninterested in your business.   

In sum, the Operating Agreement is a contract among the members of the LLC, and therefore the members have the right to adjust the terms to fit their business needs, reflect the contributions of the members, and make the LLC attractive to potential investors. 

The final installment on this topic will discuss the operational simplicity and ease of use of the LLC. 

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.


Thursday, February 16, 2012

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

An unscientific survey of the most often asked question posted on the web by start-ups is:  "What type of entity should I form for my new business?"  In most cases, lawyers and entrepreneurs will suggest the limited liability company.  While compared to a corporation, LLCs are a new form of business organization, but start-ups more often choose the LLC over a corporation.  Therefore, what is it about the LLC that makes a preferred structure for start-ups?  The answer:  favorable tax structure, flexibility and ease of use.  The next three posts will review:

          1.  Reason #1: The tax advantages of the LLC versus the corporation;

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

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

Reason One:  Why Start-Ups often Prefer an LLC over a Corporation:  No Double Taxation.

As a quick primer on business entities, there essentially four types of entities most businesses consider utilizing:  (a) a corporation, (b) a limited partnership, (c) an S Corp or (d) an LLC.  As a simple explanation, a limited partnership is generally not as popular for start ups because it requires at least one partner have the status of a General Partner, meaning that partner has unlimited liability (which most entrepreneurs do not want to risk for obvious reasons).  An S Corp is formed as corporation but is taxed like a partnership, and thus the business entity is not subject to a separate tax (discussed more fully below); however, there are restrictions on S Corps (including that they are limited to 100 shareholders, none of which can be foreigners, and there is no ability to create separate classes of shares), which may restrict the ability to bring in additional shareholders.  Essentially, then, that leaves the corporation and the LLC as the popular choices for structuring a business.   

             1.  Taxation of a Corporation:   A corporation is taxed on any net income (profit) at the corporate entity level, and if there is a distribution to the shareholders (of net profit), each shareholder is then taxed on this distribution (a dividend).   The result, is a double taxation:

                   (a) corporate level: 15% to as high as 35% depending on level of net income, and

                   (b) shareholder level 15% on the dividend distributions to shareholder.

The double taxation arises from the fact that the entity itself and the shareholders each have a separate taxable identity and each are required to file a tax return and pay taxes on net income (as to a corporation) or dividends/distributions (as to a shareholder).  Of course, the corporation generally does not have to make a distribution to shareholders, but that may not be a satisfactory solution for a closely held company where the shareholders are expecting distributions of profits.  

           2.   Taxation of a Limited Liability Company:   LLC’s provide all the protection of a corporation (thus unlike a partnership, the members of an LLC have limited personal liability for the LLC’s debts).  But, in contrast to a corporation, an LLC is not classified for tax purposes as a separate entity, rather it is a “pass through”. 

               (a) Single-Member LLCs: 

                    (i) Unless the member makes a different tax election, single member LLCs are classified as a disregarded entity.  As such, the LLC entity is not subject to a tax separate from the member and all income or deductions of the LLC go on the owner's tax return.  For LLCs that operate an active trade or business, this means the income and deductions are listed on "Schedule C Profit or Loss From Sole Proprietorship" of the sole member.  If rental property is held through the LLC, then the owner would include income and deductions on the owner's "Schedule E Supplemental Income and Loss."

                   (ii) Self-Employment Tax:  As a single member LLC, the owner also must pay self employment tax consisting of FICA and Medicare at a rate of 13.3% for 2011 and 15.3% for 2012.  While self employment tax is an additional burden that corporation shareholders don't pay, the single-member gets a deduction on their income of fifty percent of the self employment tax.  However, often a shareholder in closely held/small companies will be paid a salary for services provided to the corporation.  While the corporation will pay part of FICA and Medicare, there may ultimately no real savings as compared to the  LLC because the owner is responsible for the taxes, whether it is paid through the business (as with a corporation), or directly by the owner (for a single member LLC).  One common thought is to avoid any payroll tax in a corporation by not paying the sole shareholder a salary; however, this defeats the tax benefit gained from reducing the taxable net income of the corporation itself.  

               (b) Multiple Member LLC:

                    (i) An LLC with more than one member is by default classified as a partnership.  Like single-member LLCs, co-owned LLCs do not pay taxes on business income.  Instead, the income and deductions of the LLC are reported on a partnership return.  However, the LLC still does not pay a separate entity tax. The limited liability company itself files an informational LLC tax return (Form 1065) and issues a K-1 to each member.  Instead, the income and deductions are divided among the members based on the economic terms set forth in the Operating Agreement (or, if there is no operating agreement, in accordance with each membership percentage in the LLC).  The members in turn receive a K-1 from the LLC, which shows the allocation of the member's share of the income and deductions of the LLC.

                    (ii) Self Employment Taxes.  A member in a multi-member LLC also pays self-employment taxes.  LLC taxes are paid by each member according to his/her share of the profits and losses.  Like in a single-member LLC, each member files a Schedule C and calculates self-employment tax on Schedule SE.
             (c) Non-resident Alien:  Unlike an S Corp, a non-resident alien can be the member of an LLC, and therefore it is worth noting that non-resident alien LLC members do not have to pay self-employment tax.

             (d) Minimizing Self Employment Tax:  There may be ways to minimize the self employment tax owed by LLC members, including

                    (i) if a member is a passive owner (i.e., not involved in management of the LLC), the distributions may be exempt from self employment tax, but the tax regulations are complicated and the exemption should be discussed with your tax advisor;

                    (ii) an owner who receives repayments of a loan and payments on lease from the LLC may be able to avoid self employment tax on such payments.   

       3. Start Up Expenses and Losses:  When starting a business there is an expectation that the partners will have substantial start up expenses, and for most businesses it may be months or years before it shows a profit or can make distributions to its owners.  For a corporation, the expenses/losses are deductions from income of the entity for determining the tax liability of the corporation.  The LLC has the advantage that, as with the profits, the expenses/losses are similarly allocated to the members individually who thereby benefit from the ability to take these allocated deductions on their individual tax return. 

Of course, before deciding the appropriate entity for your business, issues such as taxes and other aspects of the various types of entities should be discussed with your professional advisor.  Your particular financial or tax situation may favor choosing one form of entity over another. 

The next installment of this Article will discuss how the flexibility of the LLC has made it an attractive business structure for new businesses.    

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, February 6, 2012

A Word to Small Business Owners: Don't Be Afraid to Negotiate Contracts

All too often small business owners readily accept the terms of a contract or are concerned about pushing back on both economic and legal terms because either they fear losing the deal or simply don't fully understand the terms.  As a business owner, you need to recognize that in most circumstances there is an opportunity to negotiate terms of an agreement, and therefore you should not be afraid to seek the best deal possible even if the other party initially seems unwilling to consider your position on key aspects of the contract.  So, here is the advice, Don't Be Afraid to Negotiate. 

Negotiation skills are one of the most important tools a business owner should have in its toolbox.  Therefore, if you receive a contract from a party, read it carefully, and then proactively respond in writing with your comments.  One negotiating trick that vendors often try is to provide a form contract, creating the impression that the terms are non-negotiable -- indeed, if I am representing the vendor, I will often suggest creating a form agreement.  Any contract, even a form, can be revised by an amendment, so do not automatically assume the agreement must be accepted "as is".  The following are among the material terms that business owners should not only fully understand, but seek to negotiate.

1.  Term.   If you want a longer or shorter contact term, then ask for it.  One alternative is to get an option to renew, which should be exercised within a certain number of days prior to expiration of the contract.  The mechanics of the option and financial terms should be clearly spelled out as well. 

2. Fees.  There are many different ways to skin this cat, and you should consider what best works for your business over the term of the agreement.  The financial terms can be based on (a) a set periodic payment, (b) an up front payment and then installments, (c) fees that scale up or even down over the life of the contract, (c) revenues, (d) milestones, or (e) a combination of several different fee structures.  If the payments are based on revenues, then it is essential that the parties clearly define not just the percentage by the term "Revenue."   For example, is it based on Gross or Net, and what is to be included in the Gross and what can be deducted as a legitimate expense when determining Net Revenues?  A Net Revenue contract may refer to overhead expenses, like a businesses' borrowing costs, which can be a killer for a party who is being paid based on Net.  Make sure you understand the definition, and if you don't ask for professional advice rather than assume the definitions are fair or standard.

3.  Financial Reports/Audit.  If the consideration under the contract is based on revenues or certain milestones, require periodic financial reports. In addition, you should have the opportunity to review and audit (i.e., challenge) such reports rather than simply accepting the information provided by the other contracting party.  In addition, provide a dispute mechanism in the event of a challenge, such as CFO's meet and try to resolve, appointing independent third party, or even arbitration -- and if the audit reveals you were in the right, include a requirement that the other party pays your costs.     

4.  Termination of the Contract/Suspension.  Of course the contract will expire at the end of its term, but include other events that will result in termination:  (a) non-payment, (b) material breach, (c) bankruptcy, (d) failure to achieve defined milestones, including financial ones, (e) assignment/sale of the business (see below), (f) departure of personnel if the business relies on certain key employees, or (g) force majeure.  Termination clauses will often allow the breaching party an opportunity to cure a default, provided it is one that can be cured.  In the case of a force majeure event, the contract can be suspended pending passage of the event or terminated if the contract becomes impossible to continue due to the event.  

5.  Assignment/Sale of the Business.  Do you want the contract to be assignable to a third party, including in the event of the sale of the business. This is an important issue for many types of agreements, such as licensing agreements or service contracts.  You can require consent for the assignment, but if you want the contract to be assignable, as an alternative you can propose that it is assignable to an assignee with financial ability to meet the contractual obligations.    

6. Warranties/Limitations on Liability.   Suppliers/service providers will often provide a lengthy provisions denying all warranties and limiting their liability -- and if you are the vendor, you generally want to push for these provisions.  If you are purchasing the the services of a large company, there may be no room to push back on any of the limitations, but whether the other contracting party is a small or large company, there is no harm in trying -- even if they send you the form or the "Master Service Agreement."  For either party, it is all about the bargaining power, and how much the other party wants your business versus how much you need the agreement.  Even if you cannot get the other party to budge, ask at least for an exception for gross negligence, and regardless a court may negate the limitation based on intentional misconduct or even gross negligence.               

7. Dispute Resolution.   Avoid an issues as to how disputes are to be resolved by negotiating the applicable (a) governing law, (b) venue for the dispute (meaning both the tribunal that will handle the matter, such as a court or arbitration/mediation, and the geographic location), (c) if there is to be mediation or arbitration, the procedures, and (d) will the parties impose legal fees and costs on the losing party.

8. Remedies.  Among the remedies you can include are (a) specific performance, which is important if money cannot cure a default, (b) liquidated damages, if you prefer to define the damages to avoid disputes as to proof the proper compensation for a breach, and (c) equitable remedies (other than specific performance), like an injunction.    

9. Non-Compete/Non-Solicitation.  Simple vendor/supplier agreements generally won't include these terms, but many other contracts will, including licensing agreements, consulting/employment, certain service agreements, or more major transactions (like sale of a business) to name a few.  Enforcement, especially as to non-competes, is a key legal issue, and it is highly advisable to have the provisions reviewed by counsel that understands the law in the applicable jurisdiction as it can vary greatly from state-to-state.

10.  Other Terms/Conclusion.   If there are other terms included or, for that matter, missing from the agreement, then make these part of the punch list of issues to be addressed with the other party.  The reality is that the worse response you can receive is "no", and then you can decide how important the provision is from your perspective.  A bad contract is NOT better than no contract.  In a competitive economy, even larger/established businesses are often willing to negotiate and "the last and final", "take it or leave it" or "as is" response may be just a bargaining tactic.

The Lesson: Read the Contract, Understand Each Provisions and Don't Be Afraid to Negotiate the Terms.

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.