March 2012 Archives

I'll Pay You Tuesday for Your Company Today - The Earnout, Part 1

March 29, 2012,

Whether you are negotiating an acquisition in Silicon Valley or Small Town, USA, a part of the purchase price is often deferred. I have discussed in prior blogs those portions of the purchase price that are held back to reduce the buyer's risk of liabilities and issues with post-closing audits. In future blogs, I will discuss a common purchase price deferral that will pay the seller based on the performance of the business AFTER it is sold, often called a contingent purchase price, or an "earnout."

An earnout serves two purposes. First, it can bridge a valuation gap that may exist between the buyer and the seller. In a sense, the buyer is saying "If your business is worth that much, prove it." Second, the buyer uses an earnout to protect against risks arising out of everything from insufficient due diligence to difficulty in integrating operations, that the ultimate value will be less than the purchase price.

There are a number of advisors, in addition to a merger and acquisition attorney, that are critical to creating an accurate earnout. First among equals is a CPA. An experienced CPA should be brought in early and often to provide advice concerning the general nature of generally accepted accounting principles ("GAAP"), where interpretations can vary, and how the parties have recognized revenue and expense items and the extent to which they differ. The second is both the buyer's and seller's accounting departments. Managing an earnout requires specific knowledge of the accounting functions of the parties involved, and many disputes can be avoided by understanding each party's processes and how they are to be managed through the earnout period.

In a typical earnout, the buyer and seller negotiate revenue and other operational goals, and schedule payments based on the satisfaction of these goals at the conclusion of a particular period, typically one or two years. This creates a number of challenges, and opportunities for expensive and time consuming litigation.

The first major issue is how the parties determine whether a goal is satisfied. Agreements will typically require that the parties use GAAP to determine any accounting related issues. Any accountant will tell you, however, that GAAP is more of an art than a science. In defining how GAAP will be used, the parties need to determine how GAAP will be interpreted. One approach is to say that GAAP will be interpreted consistent with how the seller has interpreted GAAP. A better, but more time consuming approach, is to use the interpretations that are used by the buyer, determine the variances from the seller's policy, and define as specifically as possible the interpretations that will be used to determine the earnout. This determination should be part of an exhibit attached to the acquisition agreement.

Technology companies, particularly those working in the software or Internet areas, often have unique revenue recognition issues. The manner in which revenue is treated for these companies needs to be defined very precisely with the assistance of the seller's CPA.

What if the buyer's books are not GAAP? There are a couple of approaches. First, the earnout can be limited to performance goals that can be relatively less difficult to define and determine, such as specific gross revenue. Second, the books can be converted to GAAP as part of a post-closing audit. Even if this method is used, however, it will be important to find those areas, such as revenue recognition, that are critical to the final amount of the earnout and define how it will be interpreted. Third, and most important, send a large retainer to litigation counsel, because the failure to use an accepted accounting method, such as GAAP, can often lead to disputes.

In a future blog, I will discuss how to calculate earnout amounts.

Stopping Illegal Acts by Current and Former Employees

March 19, 2012,

As a business litigation lawyer in Silicon Valley, I have seen quite a few employee-related issues come up for businesses in San Jose and Santa Clara. For the purpose of this blog, I have combined issues of several clients into one hypothetical owner of a small Internet company. The owner discovered that one of her employees had started a competing online business and was attempting to staff the new business with her current employees. The owner was justifiably concerned as to whether her employee's acts were illegal, and whether she, as employer, had any recourse. This blog summarizes some of the litigation issues businesses face when employees take actions that violate California's unfair competition laws. Click here to read my previous blog on unfair competition by competitors.

The owner's biggest problem was the fact that her employees were being solicited to work elsewhere. Like many small business owners, this owner had worked hard to create a business staffed by well-trained employees who provided customers with excellent goods and services. The deliberate effort by the company's existing employee to pick up her other employees caused the owner undue stress and frustration.

The soliciting employee in this case was clearly in the wrong. Under California law, while working for a company, an employee cannot solicit fellow employees to leave that company and work for a competitor. To do so is a breach of a confidential relationship, a breach of an implied obligation, and possibly even a breach of fiduciary duty, depending on the soliciting employee's position. Where the employee is a fiduciary, liability for unfair competition may also extend to the hiring competitor if it knows of the employee's actions and benefits from them.

While the owner provided a top-notch online service with an established and growing customer base, she was also concerned about her employee's competing web site. California law permits an employee to make some preparations to establish a competing business while employed. However, the employer may have good cause to terminate the employee if the acts by that employee to establish the business are such that the employee cannot give his or her undivided loyalty to the employer. Once an employee ceases work, the employee may go into direct competition with his now-former employer.

It is also important to note that employers may also sue former employees who misappropriate their ex-employer's proprietary information or trade secrets. For example, businesses expend a great amount of time, effort, and money in developing customer lists. Such lists are often the most valuable asset a company a may have, and can qualify as both proprietary information and a protected trade secret. Under California law, an employee may not take an employer's protected customer address list and then begin directly soliciting the customers.

However, to qualify as protected information, the customer list should contain specific information not generally known to the public or competitors. This information might include names of contact personnel, history of previous dealings with the customer, price quotes provided to the customer, and other particular information. A company should also maintain its customer list in a confidential manner. The more rigorous a business attempts to maintain the secrecy of its customer list, e.g. informing employees of the confidential nature of the information, protecting the information with passwords, including notices that the information is proprietary, and other steps, the more likely the court will be to find that the customer list qualifies as proprietary information or a trade secret. A non-solicitation clause in an employment contract, restricting the employee from soliciting the employer's customers for a certain period of time after leaving, may bolster an employer's argument that the employee cannot lawfully use the customer list.

Trade secrets, of course, are not limited to customer lists, and include a wide variety of formats, such as business plans, bid specifications, software code, and other documents and information. Such documents and information should be proactively protected by businesses, in case an instance occurs where litigation arises due to an employee's misappropriation of trade secrets, or other acts of unfair competition.

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New California Law Regarding Willfully Misclassifying Employees as Independent Contractors

March 13, 2012,

As a corporate and business lawyer in San Jose, I have been busy speaking with Silicon Valley business owners about a recent California law affecting companies that have misclassified employees as independent contractors. When the 2008 economic crisis hit, large high tech companies and small start-ups in San Jose, Santa Clara and Sunnyvale, among other cities, adapted by hiring workers as independent contractors to avoid paying payroll taxes and offering benefits to the new hires. Unfortunately, some companies may have inadvertently misclassified employees as independent contractors.

There has been a lot of publicity around the new IRS program allowing businesses to voluntarily correct the misclassification and pay only a low penalty. However, there has not been quite as much news about the recent California law (Senate Bill 459 signed into law by Governor Brown in October, 2011) which makes the willful misclassification of employees and independent contractors illegal and subject to severe penalties. Under the California law, the Labor Commissioner can impose penalties not just on the employer, but also on the employer's accountant or other paid advisor (other than employees or attorneys). These penalties range from $5,000 to $15,000 for each misclassified person, or $10,000 to $25,000 per violation if there is a "pattern and practice" of violations. There are still more penalties for employers that charge their misclassified employees a deduction against wages for any purpose (including space rent, goods, materials, services, equipment maintenance, etc.), which is considered as another attempt to wrongfully treat them as independent contractors.

What does "Willful Misclassification" Mean?
The definition of willful misclassification in the law is: "avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor." (California Labor Code Section 226.8 (i)(4).)

Contractors Beware
The labor agency is required to notify the Contractors State License Board if a contractor is determined to have willfully misclassified workers, and the new law requires the Contractors State License Board to initiate discipline against the contractor.

Everyone Beware
The new law also provides for public embarrassment by requiring employers who have willfully misclassified employees and independent contractors to prominently display a notice on their website (or if they do not have a website, then in an area accessible to all employees and the general public) saying that they have committed a serious violation of the law by willfully misclassifying employees, that they have changed their business practices so as not to do it again, that any employee who thinks they may be misclassified may contact the Labor and Workforce Development Agency (with contact information), and that the notice is being posted by state order.

It is not just the employer that needs to worry about misclassification. If you provide paid advice to an employer, knowingly advising the company to treat a worker as an independent contractor to avoid employee status, you can be held jointly and severally liable for the misclassification. This rule does not apply to business lawyers like myself, because attorneys providing legal advice are exempt from this liability, as are people who work for the company and provide advice to the employer.

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Proposed Filing Deadlines Could Impact Fundraising in California

March 6, 2012,

As a Silicon Valley business attorney, I often help small businesses and start-up companies in San Jose and Santa Clara with their financing transactions. Whether my client is a newly formed software corporation getting capitalization from its founders or an existing company trying to raise money by making a preferred stock offering, as my client's business lawyer, I need to counsel them in their fundraising efforts to ensure that the company complies with securities laws.

However, a bill recently introduced in the California State Senate will make it harder for small businesses and start-up companies to raise money in California. The bill, SB 978, could eliminate a securities exemption commonly used in fundraising transactions and expose a company to fines, and its controlling persons to individual liability, if a certain filing is not completed in time.

A little background is helpful to understand why this bill is such a disaster. Fundraising to start or grow a company requires compliance with both state and federal securities laws. If an offering violates the securities law, anyone who purchased the securities in that offering can rescind their purchase and get their money back. The aggrieved investor can look to the company for return of funds, or can look to any of its controlling persons individually. If you are considered to be a controlling person of a company that misses a securities filing deadline for an offering, your house may be on the line.

California's securities laws require an offering to a California resident to be "qualified" by the California Commissioner of Corporations, a somewhat time consuming and expensive process. For certain securities and securities transactions, exemptions from the qualification requirements are available. These exemptions allow a company to comply with the securities laws on an expedited and less expensive basis.

Exemptions typically outline the conditions required to use the exemption. For many exemptions, if you meet the conditions, you are good. For others, within a short period of time following the first sale in the offering, a notice has to be sent to a government agency informing the agency of the company's reliance on the exemption. The notice is typically required so that regulatory agencies can collect information about securities offerings in their jurisdiction. The notices do not really offer any particular protection for an investor participating in the offering described in the notice.

California law contains a widely used exemption for private placements. This exemption, used for fundraising transactions ranging from the initial formation of a company to a venture financing, requires an online filing 15 days after the first sale in the offering. Currently, failure to file the form does not result in the loss of the exemption, although additional fees may be required once the company realizes it has missed the deadline.

SB 978 changes existing law by saying that if a company fails to make the filing by the 15 day deadline, then the exemption is unavailable. If a different exemption is unavailable, and the company cannot get a post sale qualification (not a particularly common practice without a rescission offer), then the offering is out of compliance. This is not pretty. If a company has just violated the securities laws, then, as mentioned above, its officers' personal assets may be at risk. Even if none of the offending company's current investors sues it, the company will need to disclose this problem to its future investors.

This new law does nothing to protect investors. There is simply no logical argument that filing an online form within a particular period of time protects investors in an offering. The law will, however, severely and adversely impact fundraising in California, both for California companies and California residents investing in companies in California or other states. Here's why:

Fundraising is not a smooth process. It is not uncommon for my corporate clients to accept funds without contacting me first, or to forget to contact me once they have cashed their first fundraising check. By the time some clients get to my office, more than 15 days have gone by. Under the current state of the law, the discussion is narrowed to some theoretical risks and the need to pay additional filing fees. Under a post-SB 978 world, the discussion is more difficult because it will focus on highly expensive and potentially unsuccessful fixes and the client's exposure to personal liability. This discussion will not stimulate fond feelings for doing business in California.

The issue is even worse for out-of-state companies. Many high tech, software and medical start-ups in Silicon Valley often seek money from California investors when fund raising. Out of state counsel and companies may not be familiar with the loss of a private placement exemption, particularly in those states where there is no need to file a form in the first place. SB 978 could impair investment opportunities for California residents, especially after a company is advised by its counsel that investment funds have to be returned because no exemption is available.

Securities laws must focus on investor protection. California's private placement scheme has worked for years, and there is no showing that investors will be better protected by the draconian consequence of failing to timely file an online notice.

In a state with a large structural budget deficit, policy makers should be focused on encouraging increased business activity, rather than furthering the impression of California as an unfriendly business state. Please contact your state representatives to put a stop to this unwise misuse of the securities law.

Contact Anna Eshoo for the 14th Congressional District, who covers portions of San Mateo, Santa Clara and Santa Cruz Counties, including parts of Sunnyvale, Menlo Park, Mountain View, Saratoga, Cupertino and Santa Cruz. Contact Michael Honda for the 15th Congressional District, who covers much of the central, northeastern and southeastern area of Santa Clara County, including parts of Milpitas, Santa Clara, Cupertino, Los Gatos, Campbell, and Gilroy. Contact Zoe Lofgren for the 16th Congressional District, who covers portions of Santa Clara County, including parts of San Jose and Morgan Hill. For other Districts, go to: http://www.govtrack.us/congress/replookup.xpd?state=CA.