Processing Delays at the California Secretary of State Continue for Business Documents Filings

July 31, 2012,

In the past couple of years, corporations and limited liability companies that were formed or registered in California have had to deal with long delays from the Secretary of State in getting their documents processed. Whether the document that is being filed is a Statement of Information, Certificate of Dissolution or Cancellation, or Articles of Incorporation or Organization, the Secretary of State is taking weeks or even months to process a filing. As a business lawyer in San Jose, I have seen a multitude of problems resulting from such delays.

Statements of Information are experiencing the greatest delays, as the Secretary of State is taking several months to process a filing. This has actually created problems for some businesses that pay the filing fee with a check that contains an expiration or "void-by" date. If the check expires before the Secretary of State is able to process the Statement of Information, the Secretary of State will either reject the Statement or treat the payment as a dishonored payment.

Since many of my San Jose clients are newly formed LLCs, I frequently see these delays cause another type of problem. Very often, my client's bank will require a copy of the LLC's filed Statement of Information before opening a bank account or approving a loan. Because of the significant amount of time that it is taking for the State to process Statements, I often have to work with my client to take advantage of a relationship with the bank and ask the bank to accept a copy of the Statement that the LLC has submitted for filing.

I can avoid this situation in several ways if I am aware of the need to provide a filed copy of a Statement of Information by a certain date.

For a corporation, we can file the Statement of Information online with the Secretary of State and then request a copy of the record (this option is currently not available to LLCs). This avoids the usual queue. In addition, most regional state offices offer the opportunity for a corporation or LLC to pay an expedited service fee for filing a Statement of Information in person at the Secretary of State's Sacramento office. We can email the document to our agent in Sacramento who actually walks it into the Secretary of State and files it on an expedited basis over the counter. The benefit to using the expedited service is that we can receive a filing confirmation or response within a guaranteed time frame (usually 24 hours).

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When the Minimum Franchise Tax is Not the Minimum Franchise Tax

July 25, 2012,

Every corporation, limited liability company and limited partnership, that either forms in California or registers to do business in California must pay an annual minimum franchise tax of $800. However, I just read an article in Spidell's California Taxletter that really annoyed me (Volume 34.7, July 1, 2012, pages 75-76). The article, entitled "Midyear switch from S to C corporation means an extra $800" says that when a corporation files two short year returns for one calendar year, each return is subject to the $800 minimum tax even though the corporation is the same entity for civil law purposes. Because it is changing its tax status, it is two different entities for tax purposes and therefore must pay the minimum tax twice in one year. As a corporate and business attorney, I am sensitive to this issue since many of my clients are small businesses or partnerships in San Jose, Santa Clara and other parts of Silicon Valley, and every dollar counts when you are running a small business.

This could be an issue in many midyear circumstances, including:
• When an S corporation loses its S election
• When an LLC switches from single member to multiple member
• When an LLC switches from multiple member to single member
• When a limited partnership changes into a limited liability company
• When 50% of the ownership of a limited partnership or limited liability company changes hands
• When an LLC elects to be taxed as a corporation, or revokes such an election
• If an entity changes accounting periods resulting in two short-period returns

Although this may look reasonable on the surface of one tax return independently, when you look at both returns together this looks like double-dipping to me. If one entity has to file two tax returns for one calendar year, I think the entity should get credit in the second tax return for any minimum tax already paid for that entity for that year. However, with California's ongoing budget crisis, I know this argument will fall on deaf ears. Therefore, I applaud Spidell's California Taxletter for informing tax practitioners of this tax trap. I'm hoping California business owners, as well as out of state owners with businesses registered in California, will read this blog and avoid inadvertently paying double minimum taxes. As a California business lawyer, I will do what I can to structure deals for my clients to avoid this double tax.

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U.S. Market Entry - The Flip-Up

July 17, 2012,

San Jose and Santa Clara are such vibrant places to do business that many foreign companies want to relocate to Silicon Valley. As a corporate lawyer working with start-up companies, I have helped a number of ventures enter the U.S. market, and have worked with companies from Australia, Canada, China, Denmark Finland, India, and Israel, among others.

In past blogs, I have discussed some of the threshold considerations faced by companies leaving their home countries and relocating in the U.S. I have also discussed some of the entity forms that companies can adopt when deciding to access the U.S. market merely to sell their products or services.

Companies that decide that they want to access the private equity markets and managerial and technical talent resident in Silicon Valley often relocate their headquarters here in the U.S. For these companies, a "flip-up" will allow them to grow their company in the U.S. by being in a position to access local capital and hire a sophisticated workforce.

A flip-up is essentially a corporate reorganization. At its simplest, owners of the foreign company will exchange their interests for shares in a U.S. company. When the transaction closes, the foreign company is a wholly-owned subsidiary of the U.S. company, and the U.S. company is owned by the former owners of the foreign company.

A successful flip-up will require coordination among a company's U.S. and foreign tax advisors, legal advisors, and advisors for the foreign company's stockholders.

Flip-ups occurring during the early stage of a company are typically easier to accomplish than late-stage flip-ups. This is because the number of affected stockholders is usually smaller, as is the number of outside relationships that require special attention. If a company is considering a flip-up and a financing transaction, it should flip-up first and then close the financing. Often, U.S. investors will require that a company flip into the U.S. as a condition to a funding transaction.

A related reason for engaging in a flip-up early is that older companies usually have a capital structure and stockholder agreements that can be challenging to manage through a transaction. Companies that have closed numerous financing rounds often are subject to constraints that add complexity to closing. These constraints include stockholder rights enabling particular groups to have veto rights over reorganization transactions, outstanding options, warrants, and other convertible securities, and large numbers of stockholders. In addition, securities laws compliance can become relatively more expensive because the laws of the jurisdiction where the issuer (i.e., the U.S. company) resides, and the laws of the jurisdiction where each of the stockholders reside, must be followed.

On the other hand, new companies may face unique constraints. For example, young foreign companies may have received government grants to help them develop technology and grow their operations. Because these grants often require that the company be owned by citizens of the funding government, the terms of each grant must be reviewed carefully to determine whether the terms of the grant will permit a flip-up.

Whether accomplished when the company is young or more mature, a flip-up's structure needs to be carefully reviewed by experienced tax advisors to minimize or eliminate any tax impacts, particularly on the stockholders. This is particularly important because flip-ups rarely generate cash for any stockholders, and any tax liability would have to be paid out of a stockholder's other resources. Tax advisors should also be consulted in connection with determining where the company's intellectual property should reside for tax purposes after the flip-up is closed.

Flip-ups almost always require the approval of a company's stockholders. This will require the company to review its stockholder approval procedures, especially any voting agreements that might exist, and any relevant law. Likely, there will be minimum notification procedures that must be followed. In addition, disclosure documentation may be required. The cost and time of each of these must be built into the transaction so that the parties have a realistic expectation of the closing schedule.

Flip-ups are one of the best methods for a company that wants to take advantage of U.S. private funding opportunities and enter the U.S. market. The earlier the company can make the decision to reorganize as a U.S. company, the easier the transaction will be for all concerned.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific Questions relating to this article should be addressed directly to the author.

California's Corporate Requirements - Electing and Removing a Director

July 5, 2012,

As a business lawyer representing many closely held corporations, I often see shareholders elect board members without much thought, either because they are family members or employees of the business. The board of directors serves a very important management role for a corporation and the decision of who you put on the board should not be taken lightly. If an elected board member is no longer a good fit for your company, do not wait too long to replace him/her or you could be missing an opportunity to find a board member who will add value to your company.

Electing a Director

In most corporations, the bylaws provide that directors will be elected at each annual shareholders' meeting and will hold office until the next annual shareholder meeting and until their successors are elected and qualified, unless they are removed from the board before that time. Each year when it is time to renew your board, make sure you stop to consider whether the same directors should continue serving the company, or if it is time for some new blood. It is much easier to not re-elect a director, than it is to remove one during his/her term.

Removing a Director

Directors can be removed for cause, which means the director being removed did something wrong. The board can declare a director's seat to be vacant if that director is convicted of a felony or declared incompetent. A director can also be removed for cause by a court order, but the court will require at least 10% of the outstanding shares to petition for removal, and a showing of fraudulent or dishonest acts or gross abuse of authority by the director to be removed.

Shareholders may remove directors without cause if the removal is approved by a majority of the outstanding shares entitled to vote for the election of directors. However, no individual director can be removed over an objection by one or more shareholders who, collectively, have enough votes to elect that director under cumulative voting.

Filling a Vacancy on the Board

Generally, the shareholders are supposed to elect the board of directors. However, depending on how the seat was vacated, either the board itself, or the shareholders, can fill a vacant board seat. If a director dies, is incapacitated, or resigns, the remaining directors can usually appoint a replacement director (unless the corporate documents say otherwise). If a director is removed, the vacancy must be filled by the shareholders unless the corporate documents authorize the board to fill such a vacancy. In the event that a majority of the directors have been appointed by the board, there is a safeguard to make sure the shareholders have the ultimate authority. Holders of 5% or more of the outstanding shares may call a special meeting of the shareholders and elect an entirely new board.

Whether or not your entire board is in place, in order to maintain your corporate liability shield, the corporation must follow the statutory rules regarding regular and special board meetings for the board to make decisions on behalf of the company. The rules for board meetings will be covered in another blog.

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U.S. Market Entry - Legal Structures for Foreign Startups

June 13, 2012,

In my last blog concerning market entry into Silicon Valley by foreign companies, I discussed some of the basic issues and tasks surrounding the effort. As an attorney practicing corporate law and representing technology startup companies, I am often asked to assist in designing and implementing the legal structures that enable a foreign-owned company to access the US market.

There are a number of factors that guide a company's decision to enter the US market. First, what is it trying to sell? Second, does the company hope to generate its return on investment through a cash-flow from sales, or by building value and ultimately selling the company or taking it public? Third, does it need funding from US private investors? Let's look at how each of these factors guide entity form.

The first factor focuses on the best method for product distribution. If the company is trying to sell simple, commodity type products using an established distribution network, it may be able to get by with no entity at all. In other words, it can sell its products directly into the US through a distributor or independent sales representative. Even if the product is complex, but does not require a sophisticated domestic marketing, sales, or support organization, an independent sales representative could be used.

Where the product requires more than a sales representative to adequately exploit the US market, the company will need to consider forming some kind of entity. This is where the second factor comes in.

If the foreign company only wants its US company to generate sales and build up revenues for possible distribution to the parent company, and does not expect to use profits to drive expansion, it should explore forming the US company as a pass through entity, such as a limited liability company or partnership. Subject to certain exceptions, this will allow the US entity to avoid income taxes at the entity level. The extent of the overall tax burden, however, to the company as a group will need to be explored with an international tax professional.

If, on the other hand, the US company is expected, among other things, to grow on its own, secure outside funding, or be sold to another company, then a corporation is the preferred entity. A corporation, particularly if incorporated in Delaware, is a well-recognized method of doing business and can be created and organized easily. The US company will also be able to use operational profits to grow without the phantom income issues associated with pass through entities, and can avail its stockholder of beneficial tax treatment if it is later acquired.

Foreign startup companies often outgrow their home market, and look to the US, particularly Silicon Valley, as a beachhead into the US. This is where the third factor comes in. Many of these companies have built their technology, and have generated sales that validate the market for their products. They are stymied in their home countries, however, by the lack of expansion capital and become attracted to the established and sophisticated private investor market in the US. Knowing that investors prefer to invest locally, foreign startup companies soon realize they must relocate their headquarters to the US. The process by which they accomplish this is often referred to as a "flip-up", and will be the subject of a subsequent blog.

Analyzing basic distribution, return on investment, and funding requirements is necessary to determine the best approach to entering the US market.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific Questions relating to this article should be addressed directly to the author.

U.S. Market Entry - Foreign Startups Coming to Silicon Valley

June 5, 2012,

Silicon Valley is a magnet for foreign technology companies seeking to expand their offerings into the US market. As a San Jose-based attorney specializing in corporate law, I have seen an uptick in US-based management talent being solicited by foreign companies to help the companies start up their US operations. When faced with the question of what to do, many of the same issues arise in structuring the US market entry of foreign-owned companies.

The first issue is why the company is coming to the United States in the first place. If the company merely wants to sell widgets, it may be able to make do with a simple contractual relationship with a sales professional or distributor. If, on the other hand, the company wants to access US management talent and venture investors, it might look at reorganizing, or flipping-up, its legal headquarters into the US.

The second issue involves taxes. If the company is a mature company and expects to generate significant revenue from its US operations, there are a number of tax planning opportunities that may enable the company to minimize its international tax burden. Understanding the company's existing structure and its goals, and designing an appropriate corporate and technology ownership and use structure is a necessary task. It can, however, be an expensive undertaking depending on the nature of the company and its products and services.

The third issue involves the need to allocate resources to basic housekeeping. For example, it is surprisingly time consuming for a foreign company to open a simple bank account. This is because an account will require, among other things, a Federal Employer Identification Number, and the IRS will require that an individual provide some form of US-recognized personal tax number. Although this is easy for a US citizen with a social security number, it is more difficult for a company with no US contacts. A foreign company will usually need to coordinate the filing with the IRS to determine precise requirements, and its own foreign agencies to secure the necessary documentation to satisfy IRS requirements.

Another important housekeeping task is assembling the necessary team of advisors. If the foreign company hopes to enter the market through a sales representative or distributor, its group of professional advisors can be limited to an attorney and an accountant. If the entry strategy is more involved, the advisor group will likely extend to international tax professionals and bankers, among others.

The fourth common issue is making sure the foreign company understands the dynamic US business culture, especially here in Silicon Valley, and the rapid swings prompted by the business cycle. Many foreign companies are enamored with the potential market size of the United States, but may not have the stomach for the roller coaster life of a US technology company. Any entrepreneur working with a foreign company must probe beyond the usual discussions to determine the amount of funding and other resources that the foreign company is willing to devote to the effort, and whether that funding will be provided all at once, or dripped over time.

The Silicon Valley area will continue to attract foreign technology companies hoping to establish a beachhead in the US marketplace. In an upcoming blog, I'll discuss the legal structures that are often used in US market entry.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific Questions relating to this article should be addressed directly to the author.

California's Corporate Requirements - Shareholder Meetings

May 29, 2012,

As a corporate lawyer representing small businesses here in San Jose and throughout Silicon Valley, I often need to walk my clients through the process of forming a corporation, whether in California, Delaware, or another state, but also the ongoing requirements of maintaining their corporation. It is important to remember that California law provides limited liability to shareholders, so long as the corporation is treated appropriately. When corporate formalities are not followed, creditors and claimants can "pierce the corporate veil" to allow for a judgment against shareholders for a liability that should only have been an obligation of the corporation. One of the most important corporate formalities is the shareholder meeting.

Every California corporation is required to have an annual meeting of the shareholders, and can have additional 'special' meetings at any other time when properly called. In order to hold a proper meeting, the meeting must be properly called, noticed, and held. This is a general roadmap on how to do that, but any corporation is subject to the specifics of its corporate documents and should only rely on legal counsel familiar with its documents for requirements specific to its company.

When should the annual shareholder meeting be held?
The annual meeting should be held on a date and time that is stated in the bylaws. Recently I began representing a client that controlled multiple different corporations formed by his previous corporate attorney. Each of the corporations had a different annual meeting date, making it much more difficult for the client to remember to hold his meetings on time. We held a special meeting of the shareholders to amend the bylaws of each corporation to have the meetings on the same date, and then held the meetings back to back in his office. In this case, the shareholders and the board of directors were essentially the same people, so we actually noticed and held a joint annual meeting.

What action is required at the annual shareholder meeting?
The only action required to be taken by the shareholders at an annual meeting is the election of the board of directors. Any other proper business may also be acted upon, so long as it was included in the meeting notice.

Required Notice - What should the notice say?
All shareholders who are entitled to vote are entitled to written notice of the annual meeting (and any special meeting). The bylaws cannot override this requirement. However, most of the time, my small business clients with closely held corporations hold their meetings without formal notice, and we just have the shareholders sign a written waiver of the notice requirement at the meeting. Of course, you should not depend on this if there is any hint of a potential disagreement between the shareholders. Otherwise, a disagreeable shareholder could refuse to waive the notice requirement, and delay or block the shareholders from taking any action at the meeting.

The notice to shareholders must include the date, time and place of the meeting, and whether shareholders can attend by telephone or electronic meeting. For annual meetings, or any other meetings where directors will be elected, the notice must also state the names of the persons nominated for the election. Any other matters the board intends to present to the shareholders for any action at an annual meeting must also be stated in the notice. Although at an annual meeting the shareholders may still be able to act on a matter that was not included in the notice, certain matters may require the unanimous vote of the shareholders, including those not attending the meeting, if the shareholders were not given notice of them in advance.

At a special meeting, the shareholders are not allowed to act on business not included in the notice unless all shareholders provide written waiver of notice for that matter. For this reason, if the corporation has any adverse interests among its shareholder, I recommend that a very specific agenda be provided with the notice of any special meeting. The safest method is to provide the actual language of proposals the board will be presenting to the shareholders at the meeting.

In addition to providing notice before the meeting, in California the corporation must provide an annual financial report to the shareholders at least 15 days before the annual meeting, and no later than 120 days after the end of the corporation's fiscal year. However, if the corporation has less than 100 shareholders, this requirement can be waived in the bylaws.

Required Notice - How do you give notice?
You should always check to see what the corporation's bylaws say about notice, but for most corporations, notice can be given by first class mail, in person, or by electronic delivery such as facsimile or e-mail. Notice should go to the address or contact information provided by the shareholder to the corporation. If you do not have an address, or if the electronic notice gets rejected twice, you can mail the notice to the shareholder care of the corporation at its principal executive office, or you can publish it in a local newspaper. In other words, if you cannot find a shareholder you do not have a legal requirement to spend your time looking for them.

The corporation is considered to have provided notice as of the date it mails the notice, or delivers it personally, by fax or electronically. I recommend that the secretary of the corporation sign an affidavit of mailing or electronic transmission for the corporate minute book. I may be able to provide notice and sign the affidavit as the transfer agent for corporations that are my clients.

Required Notice - When should it go out?
Written notice of a shareholder meeting must be given no less than 10 days and no more than 60 days before the scheduled meeting. Corporations will often provide at least 15 days notice so that the annual financial report can be sent to the shareholders at the same time.

Improper Notice
As I mentioned earlier, shareholders can waive the required meeting notice if they did not get notice, or they can waive any problem with the notice they received. If a shareholder does not attend a meeting, they can waive notice in writing either before or after the meeting. If a shareholder shows up at a meeting and does not actually object to the improper notice at the beginning of the meeting, the shareholder is deemed to have waived the notice requirement. However, a shareholder can still object at any time during the meeting if a matter is raised that was not included in the meeting notice. Be very careful about the content of the waiver. Although usually the waiver does not have to include information about what was supposed to be considered at the meeting, certain matters do require a more specific waiver, otherwise unanimous vote of the shareholders may be required on those matters.

Once a company has set a date for its shareholder meeting and either provided proper notice or had the notice requirement waived, the company must now determine who has the right to vote at that meeting, and what votes are required.

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The Brinker Case: Employers Receive Clarification on Meal and Rest Breaks

May 23, 2012,

As a business litigation attorney in San Jose, I am always concerned when clients are confronted with murky or unclear regulations. For many years, employers have been awaiting clarity on California's confusing meal and rest break laws. There has been uncertainty as to whether employers must force their non-exempt employees to take their meal breaks, or whether the employer meets its obligations by simply providing employees the opportunity to take their breaks. The California Supreme Court very recently provided much needed clarification on this important employment law issue in the case of Brinker Restaurant Corporation v. Superior Court of San Diego County.

The Court also addressed the proper method to calculate the timing of both meal and rest breaks, putting an end to the guessing game of how many breaks must be provided, and when the breaks must be given.

Employers Do Not Need To Police Employees During Meal Breaks
The Court decided that employers, while under a legal duty to provide meal breaks at appropriate intervals, are not obligated to ensure that employees do no work while on their breaks. The employer's obligation is simply to relieve its employees of their work duties, relinquish control over the employee's activities, and permit the employee a reasonable opportunity to take an uninterrupted 30-minute break. Of course, the employer must not impede or discourage the employee from taking the provided break.

Also of great importance was that the Court stated quite clearly that employers are not required to police meal breaks to ensure that no work is performed during the break. In fact, employees are free to work during their meal break, if they decide to do so.

Timing of Meal Breaks
The Court also provided clear guidance on the timing of meal breaks. The first meal break must be provided no later than the end of an employee's fifth hour of work. A second meal period must be provided no later than an employee's 10th hour of work. Meal periods can be scheduled prior to the end of the fifth hour of work, including in the first hour of work, and can occur before the first rest break.

Timing of Rest Breaks
The case also clarified when employees are entitled to rest breaks. Employees must be given one 10-minute rest break for shifts from three and one-half to six hours in length, two 10-minute rest breaks for shifts of more than six and up to 10 hours in length, and three 10-minute rest breaks for shifts more than 10 hours and up to 14 hours in length. Employees who work less than three and one-half hours are not entitled to a rest break. The Court also stated that there is no requirement for an employer to give a rest break before a meal break.

Overall, the business community and employer-side employment attorneys view the Brinker case as a common sense legal opinion that offers clear guidelines for handling employee meal and rest breaks. Furthermore, the case may have the effect of curtailing potential class-action lawsuits against California businesses that, prior to the Court's ruling, could have been accused of meal and rest break violations.

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California B Corporations Disclosures

May 4, 2012,

I recently taught a program in San Jose to lawyers concerning California B corporations, a subject I covered in prior blogs. As a corporate lawyer, I have been asked by current and prospective business owners whether this new type of entity was the right choice of entity for them. B corporations were created to enable a for-profit company to include as a criteria in its management decisions its pursuit of a public purpose. The B corporation, however, must disclose its public purpose activities.

California recently created two types of B corporations, a "Benefit Corporation" and a "Flexible Purpose Corporation". Although there are a number of differences between the two, each requires that a company list in its formation documents that it is devoted, among other things, to a public purpose. Each type of B corporation must also discuss its activities directed toward satisfying its public purpose. Each type of B corporation must also post the required disclosure on its website, although financial or proprietary information can be excluded in the website posting, and the company must send the disclosure to its shareholders within 120 days after its fiscal year end. If the disclosure is not posted on its website, a free copy must be made available to anyone, in the case of the Benefit Corporation, or must be made available to anyone through "similar electronic means," in the case of the Flexible Benefit Corporation.

Benefit Corporation Disclosures

The content of the disclosure differs with the type of B corporation. The Benefit Corporation must provide an Annual Benefit Report. In the report, the company must discuss the process and rationale behind choosing the third party standard which it uses to assess performance toward providing a public benefit. The company must also explain how it pursued the benefit, the extent to which the benefit was achieved, and the circumstances that hindered achievement. Last, the company must list the names of all persons owning 5% or more of the Benefit Corporation's outstanding stock.

Flexible Purpose Corporation

The disclosure requirements of a Flexible Purpose Corporation roughly parallel those that exist for publicly held companies. The company must provide a Special Purpose Management Discussion and Analysis. The Special Purpose MD&A must identify and discuss short and long term objectives relative to its special purpose, and any changes made during the prior fiscal year. Among other things, the company must also disclose the material operating and capital expenditures required over the next three years to achieve its purpose.

In addition to the annual Special Purpose MD&A, a Special Purpose Current Report must be disclosed no later than 45 days after certain events have occurred. These events include such things as making or withholding a material operating and capital expenditure for achieving the corporation's purpose, or a determination that the special purpose has been satisfied or should no longer be pursued. Because the law is so new, the extent of the disclosure required is a bit unclear, and best practices are expected to develop that will serve as the basis for a presumption that disclosure is complete.

One "advantage" of the Flexible Purpose Corporation, as opposed to the Benefit Corporation, is that the disclosure can be waived, but it is tricky. The waiver option only exists for corporations with less than 100 holders of record. Holders of 2/3 of the shares of record must waive the disclosure requirements, and the waiver must be provided annually within set time limits. The waiver is also revocable. Disclosure cannot be waived for a Benefit Corporation.

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New Rules for Business Entities Change of Ownership Reporting for Real Property

April 27, 2012,

As a Silicon Valley business lawyer, I have many clients that are limited liability companies, partnerships, and corporations which own real property in California. It is common knowledge that when property changes hands in California, the property will be reassessed (unless an exception applies). However, people often forget that similar rules apply for business entities like corporations, partnerships and LLCs that own real property, when interests in the business entity change hands. As of January 1, 2012 there are some new rules and some higher penalties regarding reporting a change of ownership or control of real property in California. The required period for reporting has been extended from 45 to 90 days. The maximum penalty is now $5,000 for property eligible for the homeowners' exemption and $20,000 for property not eligible for the homeowners' exemption.

A change of ownership can happen in one of two ways:

1. Change in Control of a Legal Entity: If real property is owned by an entity and any person or entity gains control of that entity through direct or indirect ownership of more than 50% of the voting stock of a corporation or a majority interest in a partnership or LLC, the real property owned by that entity is considered to have undergone a change in ownership and must be reappraised.

2. Cumulative Transfers by Original Co-Owners: If real property is owned by an entity and over time voting stock or ownership interests representing more than 50% of the total interests are transferred by the original co-owners (in one or more transactions), the real property owned by that entity is considered to have undergone a change in ownership and must be reappraised.

There is no change of ownership when the direct or indirect proportional interests of the transferors and transferees do not change.

For legal entity transfers, the Form BOE-100-B Statement of Change in Control and Ownership of Legal Entities must be filed with the Board of Equalization in three circumstances. The personal or legal entity acquiring control of an entity must file when there is a change in control and the legal entity owned California real property on the date of the change. The entity must file when there is a change in control and it owns California real property. An entity must file upon request by the Board of Equalization. Source: Spidell's California Taxletter, Volume 34.2, February 1, 2012

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Fighting Over Profits - The Earnout, Part 2

April 13, 2012,

Although most of my career as a merger and acquisition and corporate lawyer has been spent in San Jose, issues involving earnouts do not have geographic boundaries. While many companies are acquired for their team or their technology, other companies are acquired because they make money for their stockholders. Earnouts provide an opportunity for a buyer to be assured that the company it has just bought will meet its objectives for the deal.

To construct an earnout that measures a company's success in making money, a tension arises between allowing the selling company to operate on its own, thereby mimicking its performance as it existed before it was sold, and integrating the seller's operations with the buyer. Buyers will want to integrate the seller as quickly as possible, but doing so will prevent the parties from determining how well the seller itself is performing.

The most important issue to determine is how profits will be calculated. As discussed in a previous blog, issues involving the use of GAAP become much more important as more revenue and expense items are measured. A detailed approach to calculating profits will help reduce disputes and provide guidance for the seller's managers to use in maximizing the earnout.

Earnouts constructed to measure profits typically require the seller to operate as a separate division, or even a separate entity. To take advantage of synergies, some operations are centralized with the buyer, such as finance and administration. The first area of dispute involves the manner in which administrative overhead, and the type of overhead, will be charged against the earnout. Outside of textbook ratios, there is no magic number and the result is usually reached through negotiation.

Often sales forces are consolidated, and the allocation of sales-related expenses and commissions can be very difficult, especially when the buyer's existing sales department is leveraged to produce sales for the seller. As with overhead, there are no easy answers and the approaches ultimately used are reached through negotiation.

Because of their complexity, earnout amounts are often disputed. Because of this, care must be taken to create an appropriate dispute resolution mechanism. Regardless of the dispute resolution process used for the acquisition agreement as a whole, arbitrating any earnout disputes has a number of advantages. First, the arbiter, or arbiters, can be specified as having expertise in accounting issues, or even in calculating earnouts. Relevant industry experience can be listed as a necessary attribute. Second, the arbitration can focus solely on determining the arbitration amount. Third, the parties can be required to go through nonbinding mediation. If successful, mediation can avoid the expense of an arbitration proceeding. Fourth, the proceedings can be kept confidential.

Earnouts, especially those based on profits, can be very complex and prone to dispute. Because of this, care must be taken by all parties to create a mechanism that will adequately measure performance while minimizing the opportunity for controversy.

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Is a B Corporation the Right Choice of Entity for Your New Company?

April 3, 2012,

I recently taught a program to California lawyers for the Santa Clara County Bar Association concerning B corporations, a subject I covered in a previous blog. As a Silicon Valley business attorney, with an increasing number of clients forming new companies, I want to discuss some attributes of these corporations that should be considered by anyone starting a new business.

The first consideration is whether becoming a B corporation will assist in a company's funding and operations. B corporations arise from a national movement to allow companies to consider factors other than just profits and shareholder value in making their decisions. Certain types of investors and employees are drawn to companies that share similar values. Because of the attractiveness of value-driven organizations to these constituencies, start-up companies should strongly consider whether becoming a B corporation can provide them with a unique story when soliciting investment, and an edge when recruiting employees.

The second consideration is whether the goods or services "fit" with the concept of a B corporation. Fortunately, a B corporation does not necessarily need to exist solely to pursue its social goal. Almost any business can be a B corporation if it adopts the kind of public purpose that is required under one of California's two B corporation statutes. For a "benefit corporation", the purpose needs to one which creates a material positive impact on society and the environment, taken as a whole. For the "flexible purpose corporation", the purpose needs to be one which could be pursued by a California nonprofit benefit corporation, or one which promotes or mitigates the effect of the corporation's activities on the corporation's stakeholder, the community or society, or the environment. The open ended nature of these purposes allows a wide variety of businesses to organize as a B corporation.

Because California created two different types of B corporations, you will need to consider which type of B corporation your new company should form. One way to approach this decision is to ask yourself how much the corporation should be forced to consider its public purpose. In the "benefit corporation", the board of directors MUST consider the impacts of any action on the company in the short term and long term, and its shareholders, employees, customer, community, and environment, and its ability to accomplish its public purpose. This will force the board to deliberate very carefully, and will require your counsel to prepare corporate documentation carefully to record the board's deliberations. By contrast, the "flexible purpose corporation" merely allows the board to consider its public purpose when making decisions, but does not require that furthering the purpose be a component of its decision.

In making your decision to conduct your business using a B corporation, you can avoid some common misconceptions. One common myth is that a B corporation needs to be certified. There is nothing in any of California's B corporation laws that require any type of third party certification. There is, in the "benefit corporation", a need to compare the efforts toward meeting public purpose to a third party standard, but this falls short of requiring actual certification. Another common question that often arises is whether B corporations are taxed differently. At this time, they are not. Of course, a B corporation does not need to be a nonprofit corporation for tax purposes.

In a future blog, I will cover one of the most critical considerations you face when adopting a B corporation - the disclosure of your company's activities.

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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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