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.

Continue reading "Is a B Corporation the Right Choice of Entity for Your New Company?" »

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.

Continue reading "Stopping Illegal Acts by Current and Former Employees" »

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.

Continue reading "New California Law Regarding Willfully Misclassifying Employees as Independent Contractors" »

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:

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.

Continue reading "Contractor State License Board Now Issues Licenses to Limited Liability Companies in California" »

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.

Continue reading "Combating Unfair Competition By Competitors" »

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.

Continue reading "IRS Program for Employee Misclassification" »

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" »

Santa Clara County Has Implemented a California Traffic Infraction Amnesty Program

January 30, 2012,

Cut the cost of your old unpaid traffic tickets in half! If one of your new year's resolutions involves clearing out that old traffic ticket that you either failed to show up in court for, or just didn't pay on time, a new Santa Clara County amnesty program may be right for you. From January 1, 2012 through June 30, 2012 you may be able to get rid of an outstanding traffic case that was due in full before January 1, 2009 by paying 50% of the fine. The case must have been within Santa Clara County, which includes the cities of Santa Clara, San Jose, Sunnyvale, Cupertino, Milpitas, Monte Sereno, Palo Alto, Mountain View, Los Altos, Los Altos Hills, Saratoga, Campbell, Los Gatos, Morgan Hill, and Gilroy.

To determine whether you are eligible for to participate in the amnesty program or to find out more information, you may go to the Santa Clara County Court's website .

Catching Up On New California Employment Laws For 2012

January 23, 2012,

With the new year comes new laws, and businesses in the San Jose area should be aware of the new California employment laws that are on the books in 2012. Ensuring compliance with these new laws is good for the bottom-line, as it will make for happy employees, who will in turn make for satisfied customers. Making sure that your business complies with the new laws put on the books each January 1st may help your company avoid employment-related litigation.

Hiring Practices
Starting in 2012, employers may no longer obtain consumer credit reports about employees and job applicants. There are exceptions to this law, particularly for positions requiring access to bank or credit card information and other personal information, positions that include access to $10,000 or more during the daily course of business, positions involving signatory authority, and management positions.

Also, at the time of hire, employers must now provide notice to new nonexempt employees of the following information: pay rate; overtime rate; form of pay (hourly, salary, commission, other); a list of allowances that are included as part of the minimum wage; name, principal address, and telephone number of the employer; and the regular pay day designated by the employer. The employer must provide written notice to employees within seven days of any changes to this information.

Finally, the penalty for willfully misclassifying employees as independent contractors is now between $5,000 and $25,000. This five-fold penalty increase underscores the importance of properly classifying new hires.

Employee Leave
All employers with five or more employees must maintain and pay for a group health plan for any eligible female employee who takes Pregnancy Disability Leave for up to a maximum of four months during a 12 month time period. These benefits must remain at the same level as though the employee had been working during the leave. These requirements extend beyond those of the federal Family and Medical Leave Act.

The law regarding organ and bone marrow donor leave has also been clarified for 2012. During a one year period, employees are allowed 30 days of leave for organ donation and 5 days of leave for bone marrow donation, with the law now stating that the leave days are to be calculated as business days.

Discrimination Law
The California Fair Employment and Housing Act (FEHA) has been amended to prohibit employers from discriminating against employees based on genetic information, including genetic tests of an employee or his or her family members, and the existence of a disease or disorder in family members of the employee. FEHA differs from a similar federal law in that FEHA applies to employers with five or more employees, while the federal law covers employers with 15 or more employees.

FEHA has also been updated to clarify that discrimination on the basis of gender identity or gender expression is prohibited. Previously, only the term gender identity was used. Gender expression is defined as, "a person's gender-related appearance and behavior whether or not stereotypically associated with the person's assigned sex at birth." Employee dress codes must allow employees to dress in a manner consistent with both the employee's gender identity and gender expression.

Additionally, health care service plans and health insurance policies issued to California residents must provide equal coverage to domestic partners as that provided to spouses. While this has been the standing policy in California, the new law ensures that employers located outside California and with a majority of employees located outside of California must comply with California law as it pertains to California residents.

Wage and Hour Laws
Employees alleging violations of the minimum wage may now recover liquidated damages as a result of a complaint heard before the Labor Commissioner. Liquidated damages, which serve to punish the employer, are permitted in an amount equal to the unpaid wages owed to the employee. Put simply, for every dollar an employee is awarded in unpaid wages, the Labor Commissioner is authorized to award an additional dollar in penalties. Previously, employees could receive liquidated damages only after filing a complaint in civil court.

In the prevailing wage arena, which applies to specified state or federal public works contracts, the minimum penalty for wage violations has been raised from $10 to $40 per day for each worker paid less than the prevailing wage, and the maximum has been raised from $50 to $200.

When it comes to new year's business resolutions, some cannot fall by the wayside. Resolving to make sure that your business is in compliance with the new California employment laws for 2012 is an easy resolution to keep, and one that will help keep your employees happy and avoid costly litigation.

Continue reading "Catching Up On New California Employment Laws For 2012" »

Update: IRS Mileage Rate for 2012, New 401(k) Maximum Contribution Amount

January 18, 2012,

Mileage Rate:

Keeping up to date with the standard mileage rate is important for me as a business lawyer because I often drive to meetings, as well as for my small business clients in San Jose and all over Silicon Valley who will be using that rate to figure out their tax deduction for miles driven in the operation of their businesses. In addition, it is also usually the rate at which businesses agree to reimburse their employees for miles driven while on the job. The IRS has confirmed that the standard mileage rate for the use of business vehicles in 2012 will remain the same as it was for the final six months of 2011, at 55.5 cents per mile (which was higher than the previous 51 cents in early 2011). The mileage rate for medical and moving expenses actually goes down by half a cent to 23 cents per mile, but the mileage rate used when driving for charity is still unchanged at 14 cents per mile.

401(k) Contribution Amount:

Another small but important change is the maximum 401(k) contribution amount, which goes up this year from $16,500 to $17,000 for 2012, with taxpayers born before 1963 being able to put in as much as $22,500.

California's New Green Corporation

January 10, 2012,

Many profit-driven companies in California interested in providing a positive social and environmental impact experienced the problem of maintaining a fiduciary duty to their shareholders and being charitable and green at the same time. Effective January 1, 2012, this should be less of a problem as the state has adopted two different types of corporations - the "flexible benefit corporation" and the "benefit corporation" - offering businesses in Silicon Valley and elsewhere in California, the opportunity to operate with a view toward both increasing shareholder value and fulfilling socially beneficial goals.

The primary differences between the two corporations, often called "B corporations", lies in the purpose flexibility allowed, and the extent of disclosure required. Greater flexibility means greater disclosure.


The flexible benefit corporation has greater freedom in defining alternate purposes for the corporation. It may engage in charitable and public purposes and, unless it is a professional corporation, add additional specific purposes.

The benefit corporation, however, must pursue a general public benefit as defined in detail in the statute. The general public benefit must also have a material positive impact on society as measured by standards developed by a third party. A director of a benefit corporation is subject to a duty of care, but is allowed to take into account the impact of a particular decision on a number of workforce, consumer, social, or environmental issues, and can consider interests of any other person or group. A director is free to change the weight the director gives to different impacts and considerations unless the benefit corporation's Articles of Incorporation provide otherwise.

Formation or Conversion

Both types of B corporations can be created at formation, or by merger, reorganization, or conversion. Both require 2/3 shareholder approval for changes, such as where a standard corporation is converted into a B corporation, or where a standard corporation is merged into, or sells all or substantially all of its assets, to a B corporation. A company interested in changing its legal status to a "B corporation" should consult with a corporate law attorney to see if a B corporation is right for it.

Disclosures Required

The flexible benefit corporation must send an annual report to its shareholders within 120 days of the end of its fiscal year. The annual report requires a special purpose management discussion and analysis, which must include, among other things, analysis of management's effort towards achieving its special purpose. Current reports are also required 45 days after the corporation makes any expenditure, excluding compensation, made to further the corporation's special purposes, or withholds a similar planned expenditure. Corporations with less than 100 shareholders are not required to prepare the above reports if 2/3 of the shareholders have provided unrevoked waivers. Subject to reasonable confidentiality requirements, the reports must be posted on the corporation's website.

Similarly, the benefit corporation must deliver an annual report to each shareholder. The report must describe a number of issues, including the manner in which the benefit corporation's general public benefit was pursued, and an assessment of its performance. Unlike a flexible benefit corporation, management's efforts must be assessed against a third party standard to determine overall corporate social and environmental performance. As with the flexible benefit corporation, the annual report must also be posted on the corporation's website, or provided free of charge.

This discussion only touches the surface. Each of the two types of corporations has highly technical requirements which need to be followed to take advantage of these new forms of doing business.

Reminder for Employers in California - Reporting New Employees and Independent Contractors

December 16, 2011,

During the past few months, we have seen an increase in hiring from small startups and larger corporations here in San Jose and other parts of Silicon Valley. At this time of year, when companies are about to review Forms W-2 and 1099 for their workers, it is a good time for a reminder about California worker reporting requirements. In California, when a company hires a new employee, it is required to report this to the Employment Development Department (the "EDD") within 20 days of hire, regardless of whether the employee is full-time or part-time, or the amount of compensation.

If a business hires an independent contractor and pays the contractor more than $600, or enters into a contract with that individual for $600 or more, within a calendar year, the business is required to report the hiring to the EDD within 20 days of making a payment. Although the hiring of a new employee need only be reported once, the hiring of an independent contractor must be reported every year. However, if a company contracts with another business that provides a tax identification number rather than a social security number, the company hiring that business does not need to report to the EDD.

It is wise for a company to report to the EDD contractors it expects to pay in January of each year (e.g. continuing contracts) when the company prepares and reviews 1099s for the prior year. There is no penalty if a company reports a contractor and then the contractor does not actually perform services in the new year. However, the EDD could assess a penalty against a business for each failure to report a contractor within the required time frames. Source: Spidells California Taxletter Vol. 33.10.