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.
Wednesday, March 21, 2012
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 http://www.dos.ny.gov/corps/llccorp.html#artorg 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 http://www.dos.ny.gov/forms/corporations/1239-f-l.pdf. 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.
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 http://www.dos.ny.gov/corps/llccorp.html#artorg 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 http://www.dos.ny.gov/forms/corporations/1239-f-l.pdf. 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.
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 http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html 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.
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 http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html 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.
(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.
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.
(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.
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.
Wednesday, January 25, 2012
Operating Agreements: Ten Important Provisions
If you are starting a business or have an established business and are bringing in a new partner, you need a written Operating Agreement. In fact, the New York Limited Liability Company Law (NY LLCL) requires that an LLC have an Operating Agreement, failing which the members of the LLC are subjected to an agreement that is essentially created from the provisions of the NY LLCL. See Limited Liability Company Law 417(a). Aside from the statutory requirement of a written agreement, you do not want an operating created from the provisions of the New York LLC law because there are discretionary provisions that the members can change, thereby addressing the particular interests of the members. Below are ten key provisions a business should include or consider including in the Operating Agreement.
1. Member Managed vs. Manager Managed. If you do not specifically address whether the LLC is managed by the members or a manager then by default it is deemed managed by the members. A member managed entity means that each of the members has management rights, and if this is not want the parties desire then it needs to be changed through the Operating Agreement -- indeed, it is unlikely that the majority member wants each member to have control authority. The simple solution is to state in the Operating Agreement that the entity is manager-managed and then expressly state the name of the manager.
2. Having a Vote on Material Matters. Even when the LLC is manager managed (by the majority member) the minority member(s) should try to negotiate to retain a right to veto material financial and business decisions. The manager can still make day-to-day decisions but major issues would require approval of super majority of the members. Among important (material) issues that typically require super-majority approval are (a) a material change in the business of the company, (b) a merger, sale of the business or significant assets, dissolution, bankruptcy or reorganization (c) transactions in excess of a certain amount, (d) amendments to the Operating Agreement, (e) incurring loans in excess of a defined amount, (f) entering into transactions with the LLC members or officers, (g) redemption of membership interests, (h) employment or consulting agreements or increases in compensation of employees/consultant in excess of a certain amount, and (i) even admission of new members. It is not unusual for a minority interest to demand that material issues can only be decided based on approval of a super-majority; therefore, do not assume that because you will own a small (minority) interest you are overreaching in asking for voting rights with respect to material business and financial matters.
3. The Membership Percentage Need Not Dictate Economic and Voting Rights. If the intention is to allocate profits and losses other than based on the percentage of interests a member owns in the LLC or to create separate classes of voting rights, then define the terms in the operating agreement. The Operating Agreement can vary the financial rights of members and create different classes of members, giving partners the flexibility to grant interests in the business that are not strictly defined by percentage of ownership.
4. Tax Provisions. The members can choose to include (or not to include) several significant tax provisions and elections affecting treatment of contributions of property, capital accounts, allocations and distributions and other tax issues. These tax provisions should not be overlooked and should be discussed with an accountant as well.
5. Transfer of Membership Interests. The Operating Agreement should address restrictions on transfer of membership interests, and will often include:
(a) A right of first refusal giving other members the right to purchase offered interests pro rata based on a member's percentage interest in the LLC. The right of first refusal prevents a member from selling its shares to a third party without giving the other members an opportunity to purchase the shares. The right is as much about a chance for members to increase their ownership as it is about excluding the transfer of interests to an undesirable new partner. If you include a right of first refusal, make sure the operating agreement clearly sets forth the procedure and time periods relating to exercise or waiver of the right.
(b) Co-sale rights give members the right to sell a percentage of their interests along side a selling member so that a partner cannot liquidate its interests without giving other members an opportunity to sell some of their shares as well. As with the right of first refusal, be sure to define what is necessary to meet each member's obligations under the co-sale terms.
(c) An exception for transfers made to related parties since an operating agreement will generally require a member obtain approval of for any transfer; however, you may not want your partner's son or husband as a partner so before agreeing to such a provision consider if transfer to a related partner is acceptable.
(d) Although technically not a transfer, a restriction on the pledge or encumbrance of a member's interests. The restriction prevents an involuntary transfer of a partner's interest to a lender or other lien holder that would otherwise occur if the the member defaults on its obligations to the lien holder.
Note: The restrictions on transfer of a member's interests in an Operating Agreement boils down to the simple point that you entered into a business relationship with a partner (or partners), and you do not want a partner to hand over its interests to someone you do not know (or worse, do not like).
6. Buy/Sell Provision. Business partners can grow apart, their involvement or desire to be involved in the business can change, a partner can fail to meet expectations, or a number of other issues can arise whereby a partner wants to leave the business or the other partners want a partner out of the LLC. A Buy/Sell provision will avoid the disputes, distractions, and (yes) legal costs that otherwise inevitably will arise during a business divorce. The Buy/Sell provision should set the terms under which a the LLC or other partner can buyout a partner or a partner can require the LLC to buy its interests. The structure and mechanisms of a Buy/Sell provision are discussed in prior posts, emphasizing the importance of clear terms as to when the provision can be invoked, how the selling interests to be valued, and the procedure for completing the transaction. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html
7. Termination. Include the grounds for termination/dissolution of the LLC. Under New York law if you are a minority or equal partner in the LLC a court will not grant an application to dissolve the entity simply because you cannot "get along" with your business partner. In fact, a dysfunctional partnership that still manages to be a successful business generally will not be dissolved by judicial decree under New York law. Therefore, the Operating Agreement should delineate the circumstances under which dissolution of the LLC can occur, including (without limitation) a defined time period, the occurrence of a certain event, or a vote of a majority (or super-majority) of interests. Indeed, if you include a buy/sell provision (as discussed above) and one partner wants to end the business while another does not, then there will be an avenue to address the issue through a buyout.
8. Non-Compete. You may want to include a non-compete clause, and if so it must comply with New York law in terms of geographic scope, time and scope.
9. Dispute Resolution. The dispute resolution clause should set forth the body that will decide any dispute (i.e., a court or arbitration), the venue (place) the matter will be tried (including not only the geographic location but, for example, in the case of an arbitration the arbitral institution), and perhaps that the losing party will be responsible for the legal fees of the prevailing party.
10. Flexibility. The Operating Agreement is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. As such, there are a number of other financial and control terms that can be addressed in the Operating Agreement so be sure to take advantage of this flexibility in structuring the rights and obligations of the members when drafting the Operating Agreement.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
1. Member Managed vs. Manager Managed. If you do not specifically address whether the LLC is managed by the members or a manager then by default it is deemed managed by the members. A member managed entity means that each of the members has management rights, and if this is not want the parties desire then it needs to be changed through the Operating Agreement -- indeed, it is unlikely that the majority member wants each member to have control authority. The simple solution is to state in the Operating Agreement that the entity is manager-managed and then expressly state the name of the manager.
2. Having a Vote on Material Matters. Even when the LLC is manager managed (by the majority member) the minority member(s) should try to negotiate to retain a right to veto material financial and business decisions. The manager can still make day-to-day decisions but major issues would require approval of super majority of the members. Among important (material) issues that typically require super-majority approval are (a) a material change in the business of the company, (b) a merger, sale of the business or significant assets, dissolution, bankruptcy or reorganization (c) transactions in excess of a certain amount, (d) amendments to the Operating Agreement, (e) incurring loans in excess of a defined amount, (f) entering into transactions with the LLC members or officers, (g) redemption of membership interests, (h) employment or consulting agreements or increases in compensation of employees/consultant in excess of a certain amount, and (i) even admission of new members. It is not unusual for a minority interest to demand that material issues can only be decided based on approval of a super-majority; therefore, do not assume that because you will own a small (minority) interest you are overreaching in asking for voting rights with respect to material business and financial matters.
3. The Membership Percentage Need Not Dictate Economic and Voting Rights. If the intention is to allocate profits and losses other than based on the percentage of interests a member owns in the LLC or to create separate classes of voting rights, then define the terms in the operating agreement. The Operating Agreement can vary the financial rights of members and create different classes of members, giving partners the flexibility to grant interests in the business that are not strictly defined by percentage of ownership.
4. Tax Provisions. The members can choose to include (or not to include) several significant tax provisions and elections affecting treatment of contributions of property, capital accounts, allocations and distributions and other tax issues. These tax provisions should not be overlooked and should be discussed with an accountant as well.
5. Transfer of Membership Interests. The Operating Agreement should address restrictions on transfer of membership interests, and will often include:
(a) A right of first refusal giving other members the right to purchase offered interests pro rata based on a member's percentage interest in the LLC. The right of first refusal prevents a member from selling its shares to a third party without giving the other members an opportunity to purchase the shares. The right is as much about a chance for members to increase their ownership as it is about excluding the transfer of interests to an undesirable new partner. If you include a right of first refusal, make sure the operating agreement clearly sets forth the procedure and time periods relating to exercise or waiver of the right.
(b) Co-sale rights give members the right to sell a percentage of their interests along side a selling member so that a partner cannot liquidate its interests without giving other members an opportunity to sell some of their shares as well. As with the right of first refusal, be sure to define what is necessary to meet each member's obligations under the co-sale terms.
(c) An exception for transfers made to related parties since an operating agreement will generally require a member obtain approval of for any transfer; however, you may not want your partner's son or husband as a partner so before agreeing to such a provision consider if transfer to a related partner is acceptable.
(d) Although technically not a transfer, a restriction on the pledge or encumbrance of a member's interests. The restriction prevents an involuntary transfer of a partner's interest to a lender or other lien holder that would otherwise occur if the the member defaults on its obligations to the lien holder.
Note: The restrictions on transfer of a member's interests in an Operating Agreement boils down to the simple point that you entered into a business relationship with a partner (or partners), and you do not want a partner to hand over its interests to someone you do not know (or worse, do not like).
6. Buy/Sell Provision. Business partners can grow apart, their involvement or desire to be involved in the business can change, a partner can fail to meet expectations, or a number of other issues can arise whereby a partner wants to leave the business or the other partners want a partner out of the LLC. A Buy/Sell provision will avoid the disputes, distractions, and (yes) legal costs that otherwise inevitably will arise during a business divorce. The Buy/Sell provision should set the terms under which a the LLC or other partner can buyout a partner or a partner can require the LLC to buy its interests. The structure and mechanisms of a Buy/Sell provision are discussed in prior posts, emphasizing the importance of clear terms as to when the provision can be invoked, how the selling interests to be valued, and the procedure for completing the transaction. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html
7. Termination. Include the grounds for termination/dissolution of the LLC. Under New York law if you are a minority or equal partner in the LLC a court will not grant an application to dissolve the entity simply because you cannot "get along" with your business partner. In fact, a dysfunctional partnership that still manages to be a successful business generally will not be dissolved by judicial decree under New York law. Therefore, the Operating Agreement should delineate the circumstances under which dissolution of the LLC can occur, including (without limitation) a defined time period, the occurrence of a certain event, or a vote of a majority (or super-majority) of interests. Indeed, if you include a buy/sell provision (as discussed above) and one partner wants to end the business while another does not, then there will be an avenue to address the issue through a buyout.
8. Non-Compete. You may want to include a non-compete clause, and if so it must comply with New York law in terms of geographic scope, time and scope.
9. Dispute Resolution. The dispute resolution clause should set forth the body that will decide any dispute (i.e., a court or arbitration), the venue (place) the matter will be tried (including not only the geographic location but, for example, in the case of an arbitration the arbitral institution), and perhaps that the losing party will be responsible for the legal fees of the prevailing party.
10. Flexibility. The Operating Agreement is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. As such, there are a number of other financial and control terms that can be addressed in the Operating Agreement so be sure to take advantage of this flexibility in structuring the rights and obligations of the members when drafting the Operating Agreement.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
Wednesday, January 18, 2012
Websites: Seven Deadly Sins a Business Owner Should Avoid.
You can hardly be in business in this day without a website, but before the website goes live you need to take the appropriate steps to protect the website content and reduce exposure to claims by persons accessing the website. Below are seven important areas a business should address before the final version of the website becomes available to the public. Do not commit any of the Seven Deadly Sins of website development as any one of them can create substantial liability or damage to your business.
1. Failing to Make Sure You Own What Others Develop. You need to take proper measures to ensure you own all the underlying intellectual property and other rights relating to the website. If you are outsourcing the website development, do not execute an development agreement or accept the services of the developer until a written agreement is in place which gives your business ownership of all of the content, rights and intellectual property associated with the website. If an employee or consultant is handling the website development, review the employment agreement or consulting agreement to make sure it grants the company ownership of all the rights. I have reviewed many website development agreements for clients only to find that the agreement does not clearly address the issue, leaving open the possibility that a third person can claim it owns the intellectual property and content of your business website. Similarly, do not let the developer incorporate any content or intellectual property of a third party without your approval and a proper license/permission to use the content.
2. Not Protecting Your Content. Take the following steps to protect the website content:
a. Copyright the Website: Include a proper copyright notice on each page of the website, similar to the following: Copyright © 2012 The Berkman Law Firm, PLLC. All Rights Reserved.
b. Trademarks: If you are using any trademarks you have registered include the registered superscript ® symbol after the mark; and if you are applying for a trademark, include the superscript ™. You should also determine whether you want to seek registration of any trademarks.
c. Patent: If your site has a unique function or capability, speak to a patent attorney as to whether you have any patentable aspect before you upload the website -- while there are rules allowing you to go public before applying for a patent, there are time limitations and other issues that you should discuss with a patent attorney to ensure you do not jeopardize any of your potential patent claims.
3. Failing to Include Relevant Terms and Conditions of Use. Your website should include Terms of Use that are posted in easily accessible manner. These Terms of Use not only spell out rights of users in accessing the website, but the restrictions, limitations, disclaimers on access and use of the website -- i.e., your business policies. As I have written in a prior post, do not just cut and paste the terms from another website as the Terms of Use (and the Privacy Policy) should be tailored to your business and your website. For example, if your website sells a product, it may not be sufficient to have a link to the Terms of Use at the bottom of the home page (referred to as bellow the fold) if the terms contain an important restriction a customer should be advised of prior to placing an order. http://mybizlawyer.blogspot.com/2011/08/website-policies-one-size-does-not-fit_23.html
4. Failing to Include an Appropriate Privacy Policy. Similar to the Terms of Use, the Privacy Policy should be drafted in accordance with the nature of your business operations and policies. As an example, there are important restrictions and disclosure required if you are marketing to your customers or wish to store their customer information for future use. You do not want to violate the privacy rights of customers/users, as the exposure can be devastating to the business.
5. Not Incorporating an End User License Agreement. If a user is downloading any software or application from the website, as a condition of the download the user should consent to an end user licensing agreement (EULA). While the terms of a well-drafted EULA are for another discussion, the important point is access to any downloads should be preceded by the user's consent to the EULA.
6. Failing to Make any Necessary Disclosures? Aside from certain standard information or disclosures you might need to include in the Terms of Use or the Privacy Policy, there may be disclosures you will want to prominently include in the website. For example, a retail business may want a separate link to its return policy; or if your website recommends goods or services, the fact that you receive a fee for the recommendation must now be disclosed under Federal Trade Commission rules.
7. Oops, Do I Own the Domain Name? You would think that this issue would have been discussed as the first topic, but it is meant to illustrate how ridiculous it is that some businesses start developing a website, branding and promoting their products/services before checking if the domain name is available. It is a simple process to check the availability of a domain name: check the WHOIS link on the site of any domain registrar, and it will tell you if the domain name is available. If it isn't, unless you have a case for trademark infringement or cybersquatting, move on and find another available domain before you waste time and money. And, before you choose a domain name, make sure no one else owns a trademark so you do not face an infringement or cybersquatting claim. After you register a domain name, consider filing for a trademark to protect your rights.
As a business owner, you do not want to make any of the above seven mistakes when putting up a website because the liability, and/or the cost of rectifying, one mistake can be substantial and even destroy a business.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
1. Failing to Make Sure You Own What Others Develop. You need to take proper measures to ensure you own all the underlying intellectual property and other rights relating to the website. If you are outsourcing the website development, do not execute an development agreement or accept the services of the developer until a written agreement is in place which gives your business ownership of all of the content, rights and intellectual property associated with the website. If an employee or consultant is handling the website development, review the employment agreement or consulting agreement to make sure it grants the company ownership of all the rights. I have reviewed many website development agreements for clients only to find that the agreement does not clearly address the issue, leaving open the possibility that a third person can claim it owns the intellectual property and content of your business website. Similarly, do not let the developer incorporate any content or intellectual property of a third party without your approval and a proper license/permission to use the content.
2. Not Protecting Your Content. Take the following steps to protect the website content:
a. Copyright the Website: Include a proper copyright notice on each page of the website, similar to the following: Copyright © 2012 The Berkman Law Firm, PLLC. All Rights Reserved.
b. Trademarks: If you are using any trademarks you have registered include the registered superscript ® symbol after the mark; and if you are applying for a trademark, include the superscript ™. You should also determine whether you want to seek registration of any trademarks.
c. Patent: If your site has a unique function or capability, speak to a patent attorney as to whether you have any patentable aspect before you upload the website -- while there are rules allowing you to go public before applying for a patent, there are time limitations and other issues that you should discuss with a patent attorney to ensure you do not jeopardize any of your potential patent claims.
3. Failing to Include Relevant Terms and Conditions of Use. Your website should include Terms of Use that are posted in easily accessible manner. These Terms of Use not only spell out rights of users in accessing the website, but the restrictions, limitations, disclaimers on access and use of the website -- i.e., your business policies. As I have written in a prior post, do not just cut and paste the terms from another website as the Terms of Use (and the Privacy Policy) should be tailored to your business and your website. For example, if your website sells a product, it may not be sufficient to have a link to the Terms of Use at the bottom of the home page (referred to as bellow the fold) if the terms contain an important restriction a customer should be advised of prior to placing an order. http://mybizlawyer.blogspot.com/2011/08/website-policies-one-size-does-not-fit_23.html
4. Failing to Include an Appropriate Privacy Policy. Similar to the Terms of Use, the Privacy Policy should be drafted in accordance with the nature of your business operations and policies. As an example, there are important restrictions and disclosure required if you are marketing to your customers or wish to store their customer information for future use. You do not want to violate the privacy rights of customers/users, as the exposure can be devastating to the business.
5. Not Incorporating an End User License Agreement. If a user is downloading any software or application from the website, as a condition of the download the user should consent to an end user licensing agreement (EULA). While the terms of a well-drafted EULA are for another discussion, the important point is access to any downloads should be preceded by the user's consent to the EULA.
6. Failing to Make any Necessary Disclosures? Aside from certain standard information or disclosures you might need to include in the Terms of Use or the Privacy Policy, there may be disclosures you will want to prominently include in the website. For example, a retail business may want a separate link to its return policy; or if your website recommends goods or services, the fact that you receive a fee for the recommendation must now be disclosed under Federal Trade Commission rules.
7. Oops, Do I Own the Domain Name? You would think that this issue would have been discussed as the first topic, but it is meant to illustrate how ridiculous it is that some businesses start developing a website, branding and promoting their products/services before checking if the domain name is available. It is a simple process to check the availability of a domain name: check the WHOIS link on the site of any domain registrar, and it will tell you if the domain name is available. If it isn't, unless you have a case for trademark infringement or cybersquatting, move on and find another available domain before you waste time and money. And, before you choose a domain name, make sure no one else owns a trademark so you do not face an infringement or cybersquatting claim. After you register a domain name, consider filing for a trademark to protect your rights.
As a business owner, you do not want to make any of the above seven mistakes when putting up a website because the liability, and/or the cost of rectifying, one mistake can be substantial and even destroy a business.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
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