May 2011 Archives

Merger and Acquisition Letters of Intent - Binding the Nonbinding

May 30, 2011,

In negotiating a recent acquisition for a client selling a business in Santa Cruz, we were presented with a letter of intent outlining the terms of the transaction. The letter was well-constructed, and contained the material aspects of the deal, all of which were nonbinding. There were, however, a number of terms that were expressly made binding.

There are four binding terms most commonly used in nonbinding letters of intent for acquisitions of privately held companies. The first is that the parties will agree to standard nondisclosure obligations. The second is that the acquirer will be allowed to conduct a diligence investigation of the target. The third is that each party will pay its own fees incurred in connection with the transaction. If the transaction is a stock transaction, there may be some negotiation over whether the target can pay fees, under the theory that a stock deal is a deal among stockholders, rather than the corporation.

The fourth is the most hotly negotiated term - the "no shop" or "exclusivity" provision. The no shop is just as it sounds: the target company agrees not to "shop" itself while the transaction is in process. Acquirers usually demand this term so that their offer is not used by the target to get a better deal, and so that the time and expense they spend in the due diligence and negotiation process is not thwarted by another suitor. An acquirer will also ask that the target company stop any discussions with any other potential acquirer, and notify the acquirer if the target company receives any other acquisition inquiries.

Target companies attempt to insert a number of qualifications and limitations to the no shop clause. First, the target will request a "fiduciary out". In this exception, the no shop is ineffective where an unsolicited alternate offer must be accepted in order for the target's board of directors to satisfy its fiduciary duties. Second, the target will attempt to impose strict time deadlines which, if not met, will cause the no shop to expire. The primary deadline will be on the parties entering into a definitive agreement. Other deadlines include the acquirer's completion of its due diligence investigation, and the closing of the acquisition.

Other binding terms include break-up fees where one party, typically the acquirer, will pay the other party, typically the target, if the acquirer decides not to proceed with the transaction.

As with most deals, the extent of number and type of binding terms in a letter of intent depends on the relative bargaining strength of the parties.

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Professional Corporations for California Doctors

May 23, 2011,

I was recently working with some doctors who co-owned their Sunnyvale medical office building. They were concerned about the liability of having the property in their own names, so we worked with their lender and transferred the property into an LLC. Then, I suggested forming a professional corporation to operate their medical practice. Although doctors cannot avoid personal liability for their own malpractice, the corporation will limit their vicarious liability for the acts of their professional partners.

The California Professional Corporations Act allows licensed professionals in the fields of law, medicine, dentistry and accountancy to conduct business in a corporation, through the licensed individual shareholders. The Articles of Incorporation must include special language about the professional corporation. In addition to registering with the California Secretary of State, the corporation must also follow the naming and registration rules of the professional agency. The shareholders must be licensed, and transfers may only be to other shareholders or back to the corporation.

If a shareholder dies, the shares must be transferred within six months. If a shareholder is no longer qualified to practice medicine, the shares must be transferred within 90 days. For these reasons, I always recommend a shareholder buy-sell agreement to give the corporation or the remaining shareholders time to pay for the shares so it does not create financial difficulties for the company. Ideally, the corporation will also obtain life insurance on the professionals to fund a cash buy-out of a deceased shareholder's shares.

My clients were concerned because they had heard that professional corporations were taxed at a high flat rate. I explained that they were correct in understanding that professional corporations are taxed at a flat 35% tax rate on all of the income. However, taxable income can be avoided for the professional corporation by either paying out all of the gain in salaries, or by electing S corporation ("S-corp") status. I also recommended they put special language in their agreements with patients to avoid being subject to the personal holding company rules.

Based on my advice and joint consultation with their accountant, the doctors now hold their medical office building in their limited liability company, and are operating as a professional corporation. In addition to their malpractice insurance, these planning measures took away a lot of their liability concerns.

Tax Break for Investors in Qualified Small Business Stock

May 16, 2011,

I was talking to a client in Cupertino this week about helping his friend with a start-up business in San Jose. Originally, my client wanted to form a corporation online by himself, but he was not sure if the company should be an S corporation ("S-corp") or a C corporation ("C-corp"). He was only thinking about the pass-through implications of an S corporation and the "double taxation" of a C corporation, but was unaware of the small business stock tax exclusion in C corporations and the potential benefit to investors.

I explained that as an incentive to investors to make long term investments in small businesses, for investments made after September 27, 2010 but before January 1, 2012, 100% of the capital gain from qualified small business stock held for more than five years will not be taxed. The amount of gain excluded is the greater of $10 million or ten times the taxpayer's basis in the stock (usually the amount paid for the shares).

To qualify for this incentive, there is a list of rules. The taxpayer must acquire the stock upon its original issuance for cash, property or services. The corporation must be a C corporation with a maximum of $50 million in assets, including the investment. It must not be a regulated investment company, real estate investment trust, real estate mortgage investment trust or other type of entity with special taxation, must not own investments or real estate with a value exceeding 10% of its total assets, must not own portfolio stock or securities with a value exceeding 10% of net assets, and must use at least 80% of the value of its total assets in the active conduct of a trade or business. The corporation's trade or business cannot include professional services, banking, insurance, financing, leasing or the hotel or restaurant business.

Because this start-up company qualified for the small business stock exclusion, and the client was hoping to grow the company with investment from third parties, he decided a C corporation was the right choice. Also, because he realized how much he did not know about forming a new corporation, he asked me to do the formation for him. Once it is formed we will talk about the best way for him to get his promised share of the company.

Merger and Acquisition Letters of Intent - Don't Hold Me To It

May 9, 2011,

Any Silicon Valley mergers and acquisitions lawyer helping clients buy and sell high technology companies is invariably provided with a simple letter of intent, happily signed by a couple of companies without input from their tax and legal advisors, and asked to prepare binding documents. In one case, my San Jose business client was not too worried about the lack of detail in the letter because, after all, it was just a "letter of intent". She was less than happy when I told her that she had actually signed a binding agreement, particularly since very little due diligence had been performed on the target company and a number of 'minor' issues that were important to her still required resolution.

A letter of intent (also called "LOI", or memorandum of understanding, or "MOU") is usually a short letter that outlines the basic business terms of a deal. Without language expressly stating that the letter is nonbinding, and that no obligations arise except under a definitive agreement, however, that letter you signed may be a legally binding contract. Even with this kind of language, a letter of intent can morph into a binding contract IF the parties conduct themselves as if the target company has been acquired. Announcing a deal (when not otherwise legally required), combining operations before a closing, and similar actions, can create a contract from conduct. With no definitive agreement signed, the letter of intent may be used as evidence to set the terms of the deal.

Why do you want an LOI to be nonbinding? Letters of intent are usually prepared and signed after the initial business proposition and marketing analysis have been performed. They are typically signed before the acquirer has a chance to really investigate the target. This is because neither party will want to conduct an expensive diligence investigation until each is sure they have a deal. If the letter of intent is binding, then the acquiring company may find itself purchasing a lot of problems of which it wasn't aware when it signed the letter of intent.

Even in a nonbinding letter of intent, there are a number of provisions which should bind the parties. In my next blog, I'll discuss the importance of having binding terms in a nonbinding letter of intent.

Owners of Single Member LLCs Doing Business in California Must Also Be Registered in California

May 2, 2011,

I was recently asked by a Cupertino real estate investor whether he should form his limited liability company in Nevada or some other state in order to avoid California taxes. I had to tell him that if anything, this would just increase his overall costs and taxes.

California franchise taxes can be much higher than taxes in other states, and include a minimum tax of $800 per year. As a result, companies often do not want to be classified as doing business in California. One way to avoid this classification used to be to form your entity in another state, and not register it in California. Some of my clients have numerous Delaware LLCs or Nevada LLCs. Often, those LLCs own other LLCs, which own property in California. In order to avoid the California minimum franchise tax for multiple entities, they just register the entity that actually owns the property in California.

However, a new ruling says that if the entity is doing business in California, owns property in California, or is managed by people in California, this exemption is no longer available at the parent LLC level.

The California Franchise Tax Board just issued FTB Legal Ruling 2011-01, stating that activities of a disregarded entity will be attributed to the entity's sole owner. A disregarded entity is a single member LLC or a Qualified Subchapter S subsidiary ("QSub") which is disregarded for income tax purposes so that its income passes through to its parent for tax reporting purposes. Therefore, if the disregarded entity is doing business in California, the 100% owner will be considered to be doing business in California and, if it is an entity, will have to register with the Secretary of State in California. This is true even if that owner entity has no other activities in the state, other than owning the disregarded entity.

This ruling is in addition to a previous California Franchise Tax Board ruling that an entity will be considered to be doing business in California if its managing person(s) are in California, even if all of its other activities are out of state.

For real estate investors, lenders often require a special purpose entity ("SPE") to hold the property, which is structured as a single member Delaware LLC. Under these new Franchise Tax Board rulings, the single member LLC holding the property must be registered in California, and its 100% owner parent company must be registered in California as well. The bad news is that both entities are required to pay the $800 minimum franchise tax to California. However, the LLC gross receipts tax is not incurred twice on income that flows through from one LLC to another.

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