February 2012 Archives

Contractor State License Board Now Issues Licenses to Limited Liability Companies in California

February 27, 2012,

As a Silicon Valley small business attorney, I am regularly helping new clients with choosing their form of entity. Almost as often, I am asked to help new clients complete entity formations that they did themselves on-line. Much too often I have to tell these small business owners that their intent to save money by forming the entity on-line is going to cost them a lot more money because they picked the wrong entity for their business and we need to dissolve it and form a new one. More than once I have had licensed California contractors come to me to complete the California LLCs they formed, only to have to tell them that they are not eligible to be LLCs. There was even more confusion when the LLC law changed as of January 1, 2011 to allow LLCs to be licensed as contractors, but the Contractor State License Board was not licensing LLCs.

Back in January 2011 I wrote about the change to the California Limited Liability Company Act to allow contractors to operate as LLCs. However, until now contractors could not actually form as LLCs because the California Contractor State License Board had not yet changed their rules to allow the issuance of licenses to LLCs. Finally, the Contractor State License Board is now authorized to issue a contractor's license to an LLC.

Keep in mind that if you are going to operate as a licensed contractor in an LLC, your business will be subject to additional liability and insurance requirements. A contractor-LLC must either have a $1,000,000 insurance policy, or put $1,000,000 in cash into an escrow or deposit account. If the contractor-LLC has more than five employees, it must have an additional $100,000 of insurance or deposits for each employee (not including the first five), up to a maximum of $5,000,000.

It is also crucial to make sure your contractor-LLC stays in good standing with the California Secretary of State. In the event the licensed contractor-LLC is suspended at any time, each member who is a licensed contractor will be personally liable for up to $1,000,000 in damages as a result of the licensed activities of the LLC during a time in which it is suspended. Since one of the main reasons you would operate in an LLC is to insulate the members from personal liability, make sure you have a good LLC lawyer, or a business lawyer that is very experienced with forming and maintaining LLCs, that will remind you to file your statement of information when due, and a good accountant who will make sure your California income tax returns are filed on time and the LLC's franchise taxes and gross receipts fees are paid when due.

Source: Spidell's California Taxletter, Feb. 1, 2012, vol 34.2 p 16.

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Combating Unfair Competition By Competitors

February 21, 2012,

In fiercely competitive Silicon Valley, businesses of all sizes must be on guard to prevent unfair competition. Unfair competition consists of business piracy, theft of trade secrets, and other dishonest or fraudulent acts in the course of business. As a business litigation lawyer in San Jose, I have seen companies initiate lawsuits against offending parties when unfair competition occurs. This blog focuses on unfair competition by competitors.

While corporate espionage and spying are known to occur, most businesses encounter unfair competition through less clandestine means, and from more familiar sources, such as prior business owners and trusted partners. For example, unfair competition can occur if the owner of a Thai restaurant sells his or her business with a non-compete clause, but then sets up a new competing restaurant across the street.

The key to successfully winning a lawsuit in each of these examples begins with a well-drafted non-compete agreement (or a "covenant not to compete"). So businesses should consult with a business lawyer to help them draft such an agreement. California generally disfavors agreements not to compete, and views restraints on engaging in a lawful profession, trade, or business as harmful to the state's economy and the personal freedoms of its citizens. However, some agreements not to compete are recognized as valid under California law, including those relating to the sale of a business and the withdrawal of a partner.

In these instances, the key factors used to determine the validity of the non-compete agreement are its geography and duration. A business purchase agreement may include a clause stating that the seller agrees to refrain from operating a similar business within the specific geographic area that the purchased business operates. The duration of this agreement is usually limited to a number of years. The non-compete agreement protects the value of the purchased business - and serves to prevent the seller from selling his or her business today and then setting up shop next door tomorrow!

Similar rules apply to agreements not to compete as they relate to partnerships, and the courts have enforced agreements among partners in various professions, including physicians, accountants, and attorneys. In the case of professionals, non-compete agreements are typically enforced by requiring the competing partner to compensate his or her former partners to some extent at least for the business taken from them.

One of the benefits of a well-drafted non-compete agreement is that, if it is abided by the parties, it can prevent potentially costly litigation. If, however, litigation becomes necessary to enforce a non-compete agreement, the results of winning the subsequent unfair competition lawsuit can be twofold. First, the plaintiff may receive restitution for the money lost due to the defendant's unfair competition activities, and may also be awarded any of the defendant's ill-gotten gains. Second, if the plaintiff provides evidence showing a probability that the defendant will commit future violations of the unfair competition laws, an injunction may be issued ordering the defendant to curtail its unfair activities.

The injunction remedy stands in recognition of the fact that sometimes a defendant's unlawful conduct will continually harm the plaintiff unless the defendant is stopped. Rather than require the plaintiff to file lawsuit after lawsuit in an exhausting effort to seek money damages, the injunction empowers the plaintiff to put a stop to the defendant's unlawful activities once and for all.

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Risky Representations - Part 2

February 13, 2012,

As a merger and acquisition lawyer in Silicon Valley, I have been involved in numerous business transactions, from small startups transferring their technologies after getting acquired by other companies, to medium-sized and larger technology and pharmaceutical companies going public. With Facebook's impending IPO, many companies in San Jose, Sunnyvale, Santa Clara and Mountain View are expecting another technology boom. A company hoping to take advantage of the imminent dot-com boom and sell its business should make sure its books are in order and hire a good M&A attorney to prepare an acquisition agreement.

As discussed in my last blog, a seller will often make a number of commitments to a buyer concerning the seller's business. These commitments, known as representations and warranties, allocate between the buyer and seller many of the risks existing in the seller's business.

One of the most important documents accompanying the representations and warranties is a schedule that describes certain items requested to be disclosed, and any exceptions to the content of the representations and warranties. This document, which goes by "Schedule of Exceptions" or "Disclosure Schedule," is really a description of the main documents and key agreements of the seller, and disclosures of material facts concerning the buyer and its operations. It can often take as much time to prepare and negotiate as the acquisition agreement itself. There are a number of things the seller can do to help expedite the preparation of this document.

First, keep good corporate records. As I discussed in my blog on due diligence, organizing the seller's major documents, and making sure they are readily available, will considerably reduce the time to close the transaction.

Second, appoint someone who has intimate knowledge of the seller and its operations to assist in gathering requested documentation and answer the inevitable questions. Typically, the company's chief financial officer or controller will fill this role.

Third, get all of the documents to the company's attorney as soon as possible. The lawyers will need to review the documents and decide what types of schedules and disclosures will be required. This is a very time consuming process.

Fourth, discuss early on any areas where the company thinks a buyer might be concerned. This is not a time to sweep difficult issues under the rug, but a time to get them out in the open. There is nothing worse than being blind-sided at the last minute with the proverbial skeleton in the closet. Worse, failing to disclose difficult issues known to management can lead to a fraud claim, a claim for which the seller's liability is never limited. Areas that raise concerns include any transactions between the seller and any of its insiders, litigation and threats of litigation, and accounting irregularities.

Fifth, start preparing the Disclosure Schedule as soon as possible. Attorneys that are experienced in acquisition transactions are aware of the likely representations that will be requested, and can start organizing and preparing the substance of the Disclosure Schedule even before the acquisition agreement is distributed. Delivering a completed Disclosure Schedule to buyer's counsel sooner rather than later will surface any issues so they can be resolved in a timely manner.

Sixth, review the Disclosure Schedule with your attorney to determine if any issues exist that will delay closing. There are two major areas that need to be reviewed. The first is the approval that is required for the transaction to proceed. Almost always, this will involve approval by the board of directors and the shareholders of the Company. It may require preparation and delivery of a separate disclosure document to the shareholders to assist them in determining whether to approve the transaction. The second is the existence of any material agreements, desired by the buyer to operate the business, that require approval of the other party in order to close the transaction.

Continue reading "Risky Representations - Part 2" »

IRS Program for Employee Misclassification

February 7, 2012,

Has your business been misclassifying workers as independent contractors? If so, you should pay special attention to a recent IRS announcement of its new program giving a break to employers who voluntarily correct such misclassifications. With Silicon Valley being a technology hub, there are thousands of computer programmers and engineers working as independent contractors in San Jose, Sunnyvale, and Mountain View. High-tech companies and start-ups that employ these individuals should carefully review their HR files to see if they have misclassified any employee. If a company discovers that it has wrongly classified an employee, it should then evaluate the IRS program to determine if the company should participate in the program.

In an earlier blog, I wrote about the importance of companies classifying their workers correctly in order to avoid substantial penalties and taxes. If your company may have misclassified workers, the new IRS program will let you voluntarily correct your errors and just pay a low penalty equal to 1.068% of compensation paid to those workers last year. IRS Announcement 2011-64 provides the details. To qualify for the IRS program, your company must not be under audit, and must have consistently treated the workers as contractors for the past three years. No reasonable basis for the previous misclassification is necessary. Going forward, you must treat the workers correctly as employees. The minimal penalty may be a good idea if you consider that the Labor Department and the IRS are beginning to share leads on misclassified workers. [Kiplinger Tax Letter September 30, 2011, Vol. 86, No. 20.]

However, there are some potential downsides in addition to having to pay the penalty. So, think twice before you come clean with the IRS. First, you will lose IRS Safe Harbor protection on those workers and they will always be treated as employees going forward. Second, as part of the deal, the IRS requires you to agree to extend the statute of limitations for an extra three years, meaning you can be audited for employment taxes and misclassifications for six years. Third, the California Employment Development Department ("EDD") is not participating in the program, so it is not bound by the rules and will likely assess your identified workers for the full three year statutory period. And the EDD is likely to find out about your deal with the IRS because of their agreement with the IRS to share information, and because they will see your employer credit for paying unemployment taxes and it will not reconcile with your quarterly wage reporting, triggering an audit. [Spidell California Taxletter, vol. 33.11, November 1, 2011, pages 124-125.] California has some new misclassification penalties which are significant.

If you still feel that participating in the IRS program is a good idea and will help you sleep better at night because you have been misclassifying workers, think carefully about which workers do and do not need to be reported and re-classified. It may be that only some of your workers are misclassified, but once you claim them as employees under the new IRS program, you are stuck with that classification.

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Risky Representations - Part 1

February 6, 2012,

Those endless representations and warranties in your acquisition agreement aren't just for your merger and acquisition lawyer. Ignore them at your own risk.

Mergers and acquisitions in San Jose and elsewhere are a lot more complex than those of the past when deals were closed with a handshake. As acquisition documentation becomes more extensive, companies frequently turn to mergers and acquisitions attorneys to assist them with their transactions. One issue on which an attorney will focus deals with the representations and warranties of a seller.

A seller's representations and warranties, which are the commitments that a seller will make to a buyer concerning the state of the seller's business, make up one of the more extensive sections of an acquisition agreement and serve a number of functions. This is because they allocate between the buyer and seller many of the risks existing in the buyer's business.

Representations allocate risk in a fairly straightforward manner. The seller will make a statement of fact regarding its business. If the seller's statement is wrong, and the buyer is damaged as a result, the seller will compensate the buyer for any damages the buyer incurs.

An example helps illustrate the point. Let's say that the seller states that it has paid all of its taxes, a very common representation. After the closing, the business that was sold gets hit with a sales tax audit, and is found to have underpaid its sales taxes. Because the seller's representation was wrong (i.e., it hadn't paid all of its taxes), the buyer, all other things being equal, can look to the seller for reimbursement for the amount of the additional sales tax liability.

The situation above describes the simplest form of risk allocation in an acquisition agreement. In this form, the seller bears the risk whether the seller knew there was a problem or not.

Some types of risk allocation shift risk only if the seller knew there was a problem. These representations, sometimes referred to as knowledge-qualified representations, allow a seller to escape liability in a representation if the seller did not know a problem existed.

In our sales tax example above, let's say that the representation stated that the seller did not know of any nonpayment of taxes. Let's also say that the seller's officers were completely unaware that they had failed to pay any sales taxes. In that situation, the seller would not be liable for the sales tax liability.

Because acquisition agreements are prepared by lawyers, the concept of knowledge can mean different things. For example, does knowledge mean the subjective knowledge of the seller's CEO, or the subjective knowledge of all of the seller's employees? Does knowledge mean just what is in employees' memories, or should employees be required to look through their files? If employees are required to look through files, should they also be required to look through other documentation, such as public records and other resources? For these reasons, it is critical that the concept of knowledge be defined so that the seller knows what they have to do to satisfy the representation, and both parties know how the risk is to be allocated.

What if the seller wants to allocate the risk of an item back to the buyer? When a seller makes a representation that he or she knows may not be entirely correct, the seller will disclose an "exception." The seller provides this disclosure in a schedule commonly attached to acquisition agreements, known as a "disclosure schedule," or a "schedule of exceptions." Unless the agreement specifies otherwise, a buyer cannot recover for damages for an item that has been disclosed.

Going back to our sales tax example, if the seller knew there was a problem, the seller would describe the problem in a disclosure schedule. The seller would say something like "Seller underpaid its sales tax liability for the periods 2008 through 2010, which liability seller believes to be between $50,000 and $75,000." The buyer could not thereafter bring a claim for reimbursement for the later assessed tax liability as a result of the seller's disclosed exception.

As I mentioned above, representations and warranties, and their accompanying disclosures, are heavily negotiated. One point of contention is whether the risk of an item, even when disclosed, should be allocated to the buyer. Buyers with sufficient leverage will force the seller to remove the disclosed item, or affirmatively accept the risk associated with the item. Another point of contention is what the concept of knowledge means, and whether knowledge can qualify a particular representation. For these reasons, it is critical to spend a lot of time understanding the representations and warranties of any acquisition agreement so that you can understand the risks that may exist for you in a deal.

Continue reading "Risky Representations - Part 1" »