Wednesday, March 21, 2012

Ready to Sell: Have You Done Due Diligence of Your Company?

Even if you have very little experience purchasing a business or its assets, you are likely aware of the importance of doing due diligence on the target's business.  In fact, in a prior posting I discussed the importance of due diligence, and the essential legal and business issues that require careful investigation before purchasing a company, its assets or the stock of a company from an existing shareholder.  Now, let's say you are the selling company:  have you ever considered the importance of conducting due diligence of your business before seeking potential purchasers?  It is important for a company contemplating a sale of its business to do a meaningful evaluation and due diligence of its legal, financial and business operations before putting the company on the market to avoid issues arising after a potential suitor has been found.  In the sale of a home, a buyer will use the inspection report and appraisal to try to knock down the negotiated price, and in the sale of a company the buyer will try to do the same with information learned in the due diligence investigation.  Therefore, a thorough review of your company's business, legal and financial operations prior to seeking to sell your business will allow you to both address potential obstacles to a sale and reduce the chances the buyer will try to renegotiate the purchase price for the business.

1.  Is the Company's Legal House in Order?   Legal due diligence is a significant aspect of the investigation that any potential buyer will perform.  There are numerous legal areas the buyer will review, and the scope and of the due diligence will vary greatly depending on a number of factors, including the nature of the business, its location and markets.  Obviously, there are some common questions relating to organizational structure, material contracts, existing or threatened litigation, ownership of assets, intellectual property, labor/employment, and environmental questions.  But, there are also some less obvious issues that should be carefully vetted. 

While not an exhaustive list, consider the following:

         (a)  Corporate Structure:  Of course, you will want to make sure the company's organizational documents and records are in order, but also that there are no potential obstacles to the transaction.  For example, do any of the shareholders/members or any other third parties have a right of first refusal, or other rights, that could interfere with the transaction?  Is there anything in the By Laws/Operating Agreement mandating a super majority or even unanimous approval of a sale?  These kinds of rights are often freely granted when emerging companies are desperate to obtain financing, and may come back to haunt the company when trying to sell.

        (b)  Permits/Compliance with Laws:  The company will need to show it has the necessary permits or licenses as may be required for the business, but it also that it is in compliance with the laws of any jurisdiction where it operates.  If you have an Internet presence, is the company in compliance with properly drafted terms and conditions and privacy policies?

        (c) Assets/Intellectual Property:  Can ownership/title to assets be demonstrated?  Does the company own or properly license necessary intellectual property?  If your business is licensing any key intellectual property or other assets, make sure the license is assignable/assumable in a sale or rights do not revert to licensor upon a "change of control" of the business.  Another major concern is that the company has Invention Assignment Agreements or can otherwise establish its rights to intellectual property developed by third parties or even by partners, employees or consultants.

      (d) Material Contracts:  All material contracts should be reviewed to ensure they are assignable/assumable and that they don't terminate in the event of a sale of the business or change of control.

      (e) Employment/Labor Matters:  Make sure all the company's records are in order detailing information as to employees, including salary, sick/vacation time, and benefits.  Is there an employee manual?  Are there open employment or labor issues?

      (f) Litigation:  If there are pending litigation matters, be prepared to summarize the claims, and procedural status for a potential buyer.  Also, consider, how you will propose to address these claims in the Purchase Agreement (i.e., who will assume responsibility for these claims and related costs).  Has the company been threatened with any lawsuits or other claims?

      (g) Loans/Liens/Encumbrances:  Are any of the assets subject to any liens, are there company loans, and what are the obligations of the conmpany in event of a sale of the business.

 2.  Are the Financial Records Properly Maintained?    Work with your company's accountant and internal finance department (if you have one) to make sure all of the financial records are organized and financial events properly recorded.  The buyer will ask to see balance sheets, tax returns and audits, profit and loss statements, accounts, ledgers and all the back up information.

3.  Keep Company Books and Records Well Organized.  Make it part of good corporate procedures to maintain orderly books and records from the start.  Do not wait until there is possible exit opportunity to then run around trying to gather the due diligence materials the buyer will certainly request -- for example, the company does not want to have to chase down an employee for a copy of an Invention Assignment Agreement or a release from a litigation that settled many years ago.

4. Back Up Files, Processes and Key Software.  Maintain copies of key documents and files.  Prepare a road map of important business processes as a buyer will appreciate anything that makes for a smooth transition.  Keep back up copies of computer code.  The point:  for all important aspects of the business have in place a disaster recovery plan.

In sum, a company does not want to learn from a potential buyer that a major issue has been discovered -- especially if it could have been addressed by the company prior to the buyer's due diligence.  Inevitably, due diligence issues will result in a reduction of the purchase price or create obstacles to closing the transaction.  At the very least, due diligence issues discovered by a buyer will raise transaction costs as the parties, accountants and lawyers try to resolve and then document any agreed solution.  Additionally, it is generally less expensive for a lawyer to draft the Purchase Agreement and accompanying disclosures and schedules if company records are well maintained and the Seller's attorney is aware of the issues, if any, at the outset of the transaction.  Lastly, retain professionals (an accountant, a lawyer, a business consultant/coach, payroll company, etc.) who understand your business and work with you from the start of your company.  By doing so, you are reducing the chance that the buyer's due diligence will uncover legal, financial or business issues that either dramatically undermine the value of the company or result in a termination of the sale.

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, March 5, 2012

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

This post is Part III 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.  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 Part I of this discussion, and Part II focused on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.  This final installment examines the user friendly nature of the LLC, which imposes very few compliance requirements in order to maintain the entity.   

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

For consumers, one trademark of good technology is whether it is user friendly.  Similarly, the LLC has become a preferred choice of many entrepreneurs because it requires very little to form and then maintain the entity.

   A.  Formation.  The formation of a limited liability company requires very little:

                  (i) In New York, the form for the Articles of Organization is available online at and can be filed by anyone (the "Organizer") without the need of a lawyer or a legal service.  The Organizer forms an LLC by filing the Articles of Organization, pursuant to Section 203 of the Limited Liability Company Law, with the Department of State.  Any person or entity may be an organizer and the the Organizer does not have to be a member of the LLC.

                 (ii) Operating Agreement.   Pursuant to Section 417 of the New York Limited Liability Company Law (NYLLCL), an Operating Agreement must be entered into by the members.  Part II of this series discussed the importance of the Operating Agreement, and the flexibility allowing the members to construct the rights and obligations as the members wish, subject only to express restrictions in the NYLLLCL or as otherwise prohibited by law.  The limited liability company Operating Agreement is not filed with the State. 

               (iii) Publication Requirement.  New York maintains an arcane requirement that LLC's publish a notice of the formation of the entity in two newspapers (as designated by the county clerk) for six consecutive weeks.  See NYLLCL Section 206.  The publication fees vary by county, but regardless are expensive and, quite frankly, an unjustifiable but legally required expense.  Upon compliance with the publication requirement, the newspaper will provide an affidavit of publication to be filed with the State.  With this ridiculous requirement comes the obvious question:  What are the ramifications of failing to publish and can it be corrected?  If you have not met the publication requirements, "the authority of such limited liability company to carry on, conduct or transact any business in [New York] shall be suspended."  NYLLCL Section 203.  However, some courts have held that if the LLC cures the failure after filing the action, the lawsuit can be maintained, and a suspended entity can cure the default.  The other major concern is whether the members lose the protection of the LLC, and since the answer is uncertain the ambiguity means it is sensible to comply with the publication requirement.
             (iv) Comparison with Corporation.  Formation of a corporation is also relatively simple requiring only the filing of the Certificate of Incorporation using a pre-printed and form approved by the New York State Department, see  Unlike the LLC, no publication requirement exists, which obviously saves a considerable expense over formation of the LLC.  However, as publication is a one-time requirement, other factors (such as tax advantages) often mean entrepreneurs still prefer the LLC.
    B.  Tax Filings.  Because an LLC does not have a tax status separate from its members, the LLC does not file an entity tax return.  While the LLC must prepare an informational filing showing the profit and losses of the LLC's business, see IRS Form 1065, there is no separate determination of tax liability for the LLC and thus no separate tax calculation.  The absence of a separate tax existence of the LLC is in contrast to the corporation, which is required to calculate the tax liability of the corporate entity and file a actual (rather than an informational return).  Of course, the shareholders also will have an individual tax liability based on any distributions (dividends) received from the corporation.  The tax returns of the corporation and the informational return of the LLC must be retained with the records of the entity.

   C. Management of the Entity.  An LLC is not required to have more than one manager regardless of the number of members.  In contrast, a corporation with three or more shareholders must have at least three directors.  The requirement of three directors increases the cost of operations, creates additional administrative burdens, and affects the dynamics of managing an entity which is obviously much simpler in the case of an LLC managed by one manager.     

   D.  Maintenance/Administrative Requirements.

         (i) Annual Meetings.  A corporation must hold an annual meeting of its Directors and of its shareholders.  Contrast that with the LLC, which requires no annual meeting, unless the Operating Agreement provides otherwise.  And, just because the corporation is only required to hold one annual meeting, significant business decisions should be handled by formal resolutions.  Although not required, t is advisable for an LLC to document important resolutions thereby demonstrating that the members observe formalities in the event of an attempt by a third party to pierce the protection afforded the members by the LLC structure.

        (ii) Minutes of Meetings.  New York State also requires that corporations keep and maintain copies of all meeting minutes.  Accordingly, proper Minutes of meetings need to be recorded by a designated person, which preferably is a Corporate Secretary elected annually.  Not only are minutes required by law, they may be required by your bank or even parties to a transaction as proof of corporate approval.  Additionally, shareholders have a right to review these records upon reasonable demand.  If you have a corporation, the record book should contain at a minimum the Articles of Incorporation, by-laws, stock certificates, and copies of resolutions and minutes of corporate meetings.   LLCs do not have a requirement to record minutes of meetings, although it is a good idea to do so from a record keeping standpoint and also to demonstrate adherence to corporate formalities.
       (iii) Shareholder/Member Lists.  Corporations must maintain a list of all of its shareholders, the number and class of shares held by each and the dates when they respectively became the owners of record thereof; LLC's are required to keep a list of its members (together with the contribution and percentage interest) and managers.

       (iv) Organizational Documents.  Both the corporation and LLC need to keep a copy of the organizational documents, i.e., the Articles of Organization and all amendments of the LLC and Certificate of Formation of the corporation.  Further, a copy of the LLC's Operating Agreement or Corporation By Laws shall be kept with the entity records.

        E.  "But I Heard VCs don't like LLCs."  It is often suggested that businesses looking to raise third party financing from VCs or Angels should not form an LLC as the structure will be an obstacle to attracting financing.  While this may have been the case a few years ago, the prevalence of the LLC, tax advantage and the flexibility of the LLC as evidence by the ability to draft the Operating Agreement to fit the rights and obligations of the members has, for the most part, put this concern to rest.  Importantly, if a future investor insists on a corporation, the LLC members have a right to convert the entity to a corporation.  Be forewarned, however, that conversion of an LLC to a corporation gives rise to important tax considerations which should be discussed in advance with a tax professional.

The LLC has certain obvious advantages when compared to a corporation, but choosing the proper entity for your business can be driven by a number of factors, including those that are particular to the nature of your business or your tax situation.  Therefore, it is important to consult a lawyer and often a tax advisor before proceeding with the formation of the business structure.

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.