San Jose Business Lawyers Blog

Two recent conversations have reminded me of the importance of separating business enterprises for liability protection. I was helping a Sunnyvale real estate investor negotiate a commercial loan extension with a bank, and was thrilled that we had planned well in the past to separate all of his major properties into separate LLCs. It gave the bank a lot less power in negotiating against us - my client's other properties were safe from this potential liability, but could be used as additional collateral if he chose to do so. At the same time, I was talking to a Mountain View manufacturing client about the risk of a potential employee lawsuit and realized that, due to some bad advice in the past that my client got from another advisor, he was holding real estate in the corporation thereby making the real estate subject to any liabilities of the company.

The example I often use is that each of your business enterprises or major assets is like a domino. Putting all of your dominoes in one entity means that a single domino falling can knock the others down too. Separating your dominoes into multiple entities means that if one entity is subjected to a lawsuit, the assets in the other entities should be insulated. Therefore, if my Mountain View client is faced with a large judgment on his employee problem, thanks to the appreciation in the real estate, the company looks like a really deep pocket.

Deciding how many entities to form, and how to separate your assets, is a complex cost/benefit analysis that depends highly on your level of comfort with risk. A good rule of thumb is to separate unrelated businesses (such as manufacturing and real estate, operating companies and investments). For real estate, consider grouping properties by the level of liability and the equity in each property, as well as the location of the properties. Also check with your professional advisors, such as your attorney and CPA, for liability, tax and insurance issues that could affect your decision.

In my San Jose law practice, I often meet with clients who tell me they want to form a certain type of entity, and then proceed to tell me some facts that actually disqualify them from that form of entity. Even worse is when the client tells me that some other advisor told them they should be that form of entity. Recently, I met with a Cupertino real estate investor who said his financial advisor told him he should form an LLP for his property (he was not eligible to be an LLP). In Silicon Valley, we have a lot of do-it-yourselfers who form their own company online and then regret their ill-informed choice of entity and have to pay an attorney a lot more to fix the problem than they would have paid to do it right in the first place.

Here are some basic facts about LPs, LLPs and LLCs in California to help you make a more knowledgeable initial decision.

LP: This stands for "Limited Partnership." In a limited partnership, at least one partner must be a general partner, which means that partner will be personally responsible for any liabilities of the partnership, as well as partnership decisions. The limited partners are not responsible for partnership liabilities, but also do not have any say in the management of the partnership.

LLP: This stands for "Limited Liability Partnership." In California, only attorneys, accountants, architects, and now engineers and land surveyors are eligible to be LLP partners. The partners operate much like general partners, but have insulation from each others' liability.

LLC: This stands for "Limited Liability Company." [Note: there is no such thing as a "Limited Liability Corporation" in California.] Only certain types of businesses are eligible to be LLCs in California. You are not eligible if you are in the trust or banking business or if your business requires a license or certification under the California Business and Professions Code ("B&P Code") unless that section of the B&P Code specifically allow for LLCs. For example, as of January 1st of this year, the B&P Code provides that licensed contractors are eligible to be LLCs in California. LLCs can be managed either by designated managers, or by the members. The members and managers are not personally responsible for LLC liabilities.

Once you understand LPs, LLPs and LLCs, don't forget to still consider the corporation to see if it is the best fit for your business. Above all, make sure to run your decision by a legal professional to make sure you haven't missed any other considerations when you are ready to form an entity.

As usual, January is a time when people think about getting their business in order and consider the 'choice of entity' question. Already this month I have received calls from two contractors, one from San Jose and one from Sunnyvale, who want to form an entity for their construction business. I was able to give them the news that, as of January 1, 2011, the California Corporations Code finally allows a California limited liability company ("LLC") to operate as a licensed contractor. However, the Contractors' State License Board is only required to start processing applications no later than January 1, 2012.

For years, contractors were limited by a provision in the LLC Act that said an LLC may not "render professional services, as defined in Section 13401 and in Section 13401.3, in this state." Sections 13401 defines professional services as "any type of professional services that may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act." In addition, a section of the Contractors' State License Law provided for the issuance of contractors' licenses only to individuals, partnerships and corporations.

As of this year, the LLC law was changed to add: "...a limited liability company may render services that may be lawfully rendered only pursuant to a license, certificate, or registration authorized by the Business and Professions Code if the applicable provisions of the Business and Professions Code authorize a limited liability company to hold that license, certificate or registration." The Contractors' State License Law was changed to allow for individuals, firms, partnerships, corporations, limited liability companies, associations, organizations, or any combination thereof.

This is great news for contractors who will no longer be limited to corporations in their choice of entities for liability protection. Hopefully more sections of the Business and Professions Code will soon be revised to provide the same opportunity to other licensed professionals.

In Part 1 of this entry, I discussed the importance of a business owner choosing the right professional advisors to assist in the sale of the company, whether in San Jose or Palo Alto, and some of the different types of experts.

Although there is overlap, advisors that assist with businesses having a substantial sales price are investment bankers that specialize in mergers and acquisitions. These professionals often help in cleaning up a company's operations, provide pre-acquisition strategic guidance, act as chief negotiators in the sales transaction, and provide advice and formal opinions concerning deal valuation.

Compensation is a key issue in any agreement with an advisor. Compensation can involve payment of an initial fee, such as where acquisition solicitation materials are prepared, to a commission, such as where the broker takes an active role in negotiations that are successfully closed. Brokers and investment bankers will typically request a non-refundable engagement fee and a success fee. The latter can take many forms. One form provides for a set amount, plus a percentage commission based on the transaction value. Another form provides for a commission percentage which changes with the transaction value, often providing higher percentage commissions for higher values to encourage the advisor to be more aggressive in its pricing negotiations. Exceptions or adjustments to the fee structure are often made for introductions or transactions then in process which were not sourced with the assistance of the professional. Most advisor contracts contain a "tail", which allows the advisor to collect a success fee for transactions occurring within a certain period, typically 12 - 18 months after the advisory relationship ends. Sometimes the tail can be limited to transactions for which the introduction was made by the advisor.

Advisors can go a long way toward guiding a company and its stakeholders through a successful transaction. Management, however, can't expect that the advisor will take care of everything involved, and must be prepared to contribute extensively toward the transaction's success.

Continue reading "Bankers, Brokers and Finders, Oh My - Part 2" »

Every business owner at one time or another wants to sell their Silicon Valley business and move from Los Altos, Mountain View or San Jose to Tahoe or Tahiti. Being bogged down in daily operations doesn't leave a lot of time for an owner to make the necessary contacts to build interest in their company. Owners wish they could just have someone else sell their business.

There are a number of professional advisors that can assist in the sale of a company. Like fundraising, however, management cannot simply pass to someone else a function this important. One of the key reasons for management involvement is that a business buyer is typically found through the company's own contacts.

As with any advisor, choosing the right professional to advise on potential acquirers and transaction terms is a combination of validation by your network, expertise, and your own personal comfort with the individual with whom you will be working.

One requirement that is often overlooked is the need for the professional to be licensed. States have differing licensing requirements. Putting aside securities laws, business brokers in California typically must have some form of license. Often, a real estate broker license, or law license may be required. If the business sale is structured to involve a merger, stock transfer, or similar transaction, the broker may need to be licensed as a broker-dealer for securities laws purposes. Working with licensed professionals provides some comfort of expertise and sensitivity to legal compliance.

Advisors in transactions are typically compensated on a commission basis. Because of this, there may be a temptation for less scrupulous advisors to color their advice to allow a sale to proceed. It is always important to explore with the advisor, before he or she is hired, instances in which they have recommended clients not to proceed with deals.

Advisors that assist with businesses having a sale price in the low millions or less are generally considered either finders or brokers. A finder will simply make an introduction to a potential buyer in exchange for a fee or commission, while a broker will provide more extensive services, such as valuation determination and preparing the business for sale.

See Part 2 for more on professional advisors.

Since 1995 only attorneys, architects and accountants were eligible to practice as a limited liability partnership in California. However, as of September 30, 2010 new rules now allow engineers and land surveyors to take advantage of the LLP form of entity as well.

Although the law currently only extends until January 1, 2016, this is still great news for engineers and land surveyors that may have wanted a liability protection entity for their businesses, but did not want to deal with the hassle of annual meetings and minutes required of a corporation. These businesses are not eligible to be limited liability companies (LLCs) because of the restriction in the LLC Act preventing any business that requires a license or certification under the Business and Professions Act to be an LLC in California.

Section 16306(c) of the California Corporations Code provides in part that: "... a partner in a registered limited liability partnership is not liable or accountable, directly or indirectly, including by way of indemnification, contribution, assessment, or otherwise, for debts, obligations, or liabilities of or chargeable to the partnership or another partner in the partnership, whether arising in tort, contract, or otherwise, that are incurred, created, or assumed by the partnership while the partnership is a registered limited liability partnership, by reason of being a partner or acting in the conduct of the business or activities of the partnership."

This liability protection is a very important reason to operate your business through an LLP.

Continue reading "New Rules for California Limited Liability Partnerships ("LLP")" »

Any large business transaction, particularly a merger or acquisition, requires a well-coordinated team for success. Assembling your team early on makes a large difference between success and failure, whether you are in San Jose, California or Sydney, Australia.

The most critical advisors are your attorney and your accountant. If you are a business owner and you don't have an attorney or an accountant advising your company, you need to get one now. Although either professional can "parachute in" to assist your company in the event of a sale, their advice to you will be much more efficient and effective if they have direct and long term experience with your company. Failing to have ongoing advice in legal, tax, and financial matters will likely result in the need for remedial work and higher expense in closing a business sale.

Finding a suitable attorney will likely be your first task in assembling your business team. As with any advisor, you should use your referral network to find a professional that is appropriate to your business. You should only choose someone who you believe can act as a trusted, strategic advisor in planning, growing, and selling your business, rather than someone who can merely produce documents. An attorney who you allow to attend your board and/or shareholder meetings and generally become familiar with your business will be able to advise you on building the proper foundation for an ultimate sale of your business. He or she will also be able to tailor their advice to the realities of your business and your own risk preferences.

Businesses will often have an attorney that they use for operational matters who is unfamiliar with the specifics of a merger or acquisition transaction. In these cases special acquisition counsel is retained, often at the recommendation of company counsel, to assist in the transaction. Special counsel should be brought in as soon as possible. If you have been presented with any type of proposal to sell your business, such as a letter of intent or term sheet, you should not sign any documents until you have had an attorney who is knowledgeable in mergers and acquisitions review them.

Your accountant should be familiar with generally accepted accounting principles, or GAAP, for your industry. As mentioned in an earlier blog posting, your company should not rely on tax-oriented financials in an acquisition, but should maintain financials based on GAAP to allow for accurate business valuation and comparison. Any accountant should be experienced with the tax issues facing your business's operations and eventual sale. As your company grows, your accountant can recommend a controller and other potential employees who can perform daily accounting functions in-house. Like your attorney, it is critical that you view your accountant as a key advisor to your business, rather than as someone who merely prepares your company's financial statements and tax returns.

Whether your business is located in Silicon Valley or somewhere else, whenever you hire someone, that worker is either an independent contractor or an employee. Using the correct classification is crucial because federal and state governments are targeting businesses with incorrectly classified employees to collect substantial employment taxes and penalties. In addition, workers may sue for employee benefits they claim they should have been eligible for.

How do you determine the proper classification?
The IRS and the state governments have different tests. The IRS tells you to consider behavioral control (do you have the right to control what will be done and how?), financial control (is the worker offering their services to others and incurring their own costs?), and relationship of the parties (more than just the title of any employment contract). California boils it down to one question: Does the employer have the right to direct and control the manner and means in which the worker carries out the job? If the answer to that is not clear, there are ten secondary factors to consider.

What can a business do to protect itself?
The most important thing a business can do to protect itself from a claim of improper classification is to have a written, signed contract with every independent contractor. The process of reviewing appropriate contract terms is as important as the writing itself. Consult a corporate or employment attorney for assistance in creating a contract for your company, and before making any changes to that contract. Then, follow its terms. Give independent contractors control over how they perform their duties, maintain good records such as invoices for their services, and send them a Form 1099 if you pay them more than $600 in a calendar year. Finally, treat them consistently and treat your employees differently, and be very careful when changing a workers classification - especially when you are changing it from employee to independent contractor. If you are not sure of the proper classification, you can get help from the IRS (fill out Form SS-8) or the EDD (use Form DE-38 or file form DE-1870). Be careful - a worker can also complete Form SS-8 to determine their proper classification, and if they think they have been misclassified, they can choose to only pay employee side taxes and file Form 8919, telling the IRS to go after their employer for the other half.

What should you do to get your company documentation ready for a potential merger or acquisition? Consult your lawyer. First, he or she will assist the company in getting its basic corporate minute book updated. Important transactions, such as those involving company stock or stock options, appointment or election of directors and officers, and substantial transactions should all be properly documented. The company's stock book and capitalization table should be reviewed for accuracy, particularly if there are multiple owners. If the company has gone through equity financings or debt financings, closing binders containing the material documents in each of these transactions will need to be made available.

Second, your lawyer should review existing documentation for legal traps. The minefield that poorly prepared documentation presents is extensive, but a few examples can help illustrate the problem. Companies early on may not be able to afford employees, so they will use independent contractors to help create their basic technology. If the company does not have a signed agreement from the non-employee inventor assigning all rights to the company, the inventor, not the company, owns the technology. If the same company has licensed its technology under a purchase order that provides for a transfer of title, then the company now may not own its own technology because it just transferred to the customer title to its technology. Of course, because it didn't get an assignment from the inventor in the first place, it may not have been legally able to transfer the technology to the customer, so the company may now be in breach. Situations like this do not typically advance closing dates.

Another legal trap exists in confidentiality terms, common to many contracts. These provisions prevent you from disclosing important information you receive from the other party. Often, this information includes the contract itself. As a result, you'll need to get permission from the other party to disclose the contract. When you ask the other party to disclose, they will want to know who the recipient will be. At that point, you'll need to disclose the name of the acquirer, and likely the fact that your company is being sold. The fact that you are being sold may not make the other party to your contract very happy. All of this requires you to make sure you know where you are under confidentiality, and to have a strategy where the disclosure requires delicate handling.

It is important to start early in making sure the documentation you provide to a buyer creates the best picture for the company. Otherwise, the once in a lifetime opportunity to sell your company may prove as fleeting as the paper in an oral contract.

Even in the San Francisco Bay Area, buying a business is like buying a house. You wouldn't do it without performing due diligence and a good inspection. Unlike a house, however, strengths and challenges in a business lie in its relationships, and not necessarily in its building. For this reason, buyers will spend a significant amount of time in reviewing a company's documentation before any merger or acquisition.

A buyer reviews documentation for a number of reasons. Many are business-oriented, such as whether the company has good title to its technology, has solid supply and strategic relationships, and has not overextended itself in promises made to customers or employees.

The fastest way for the sale of your company to implode is for you to be unable to deliver a complete record of your company to a buyer. It is typical for a company hoping to sell itself to make available online their corporate documentation promptly after a letter of intent is signed. The longer it takes to make this documentation available, the longer it will take to close the sale. A long sale process is almost never to the seller's advantage. Worse, not having information readily available creates a perception that the company is disorganized. This will increase the perceived risk to the buyer and will further lengthen the time to close.

Companies that wait until the last minute will often find their documentation is, at best cobbled together, inconsistent, and nonexistent. Poorly prepared contracts or agreements often contain traps that will result in the buyer shifting any risk arising out of the deficient documentation to the seller, thereby reducing the purchase price or making the seller liable for any damages incurred by the company after the sale.

Part 2 will provide some suggestions for getting your documentation in shape for a sale of your business.

Even in the reality-distorted vortex of Silicon Valley, a company's financial statements are a critical tool in any merger or acquisition. If you are a venture-backed company, or have substantial bank loans requiring annual audits, your company's financial statements may already be in relatively good shape. If you are an owner-operator, or have otherwise been relying on a tax-oriented approach to your financials, you'll need to convert your financial statements to the standards commonly used by accountants.

Generally accepted accounting principles, or GAAP, is the method used by the accounting profession to create financial statements. If you are trying to sell your company, you will need to have GAAP financial statements to be able to attract the best buyers, and to be sure you are getting the best value. Because GAAP is so widely used and, in many cases, mandatory, failing to provide a buyer with GAAP financials will increase the perceived risk with respect to buying your company, thereby lowering the price.

An acquirer will likely require that you submit GAAP financials. As part of your agreement with the acquirer, you will represent that your company's financials are compliant with GAAP. If you are wrong and the buyer is damaged as a result, the agreement will provide that you will have to compensate the buyer, usually through a reduction of the purchase price.

Because converting to GAAP financials is not an easy process, you need to get started as early as possible. In some businesses, such as those technology start-up companies, the conversion to GAAP could take years rather than months. Complications may arise, particularly in the revenue recognition area, and prior year financials may need to be restated. This could be disastrous if, in the middle of negotiations, adherence to GAAP eliminates the year-over-year profit increases you hoped to show.

Continue reading "Sale of a Business: Jump the GAAP " »

Your company, like many companies in Silicon Valley, may suddenly find itself faced with a market window to sell and provide a liquid return for its owners. If you are an entrepreneur or other business owner, you are always on the lookout to reap the value of your business. Before you start planning the next phase of your life, however, you need to plan carefully how you will sell your company.

A company sale is typically a multi-year process, and the sooner you begin the better off you will be when a deal finally arrives. Although exceptions exist, particularly in the roulette world of high technology start-ups, a good rule of thumb is that it will take you between two to four years to sell an operating company. You should plan to begin the process no later than three years before you plan to close. Preferably you should start when you form the company.

Why so early? If you are an owner-operator, you will need to change your focus from maximizing the amount of cash and other compensation you generate from your company, to improving business valuation. A simple mathematical example drives home the point. Many companies are sold on a multiple based on earnings before interest, taxes, depreciation, and amortization (often referred to as "EBITDA"). If your business can be sold for five times EBITDA, that extra dollar in compensation will cost you five dollars in sale price.

Even if you are not an owner-operator, you need to start early to show a smooth history of revenue growth. Managing EBITDA to show constant year-over-year growth can go far in creating a perception of value, and of lower financial risk for the buyer.

Another reason to start early, regardless of whether you are a single owner or work with a number of investors, is that you will likely need to clean up a number of items. Of these, your financial statements are key. It is critical that your financial statements be expressed in generally accepted accounting principles, or GAAP, so that a buyer can compare your business with others and is comfortable that the financials have been prepared using standards acceptable to the accounting profession. Your legal documentation should also be tight. Your basic entity documentation, employment contracts, and materials agreements with key customers and vendors should be complete and fully executed. If you have a technology company, you will need a signed agreement from any person creating technology for your company assigning to the company any technology he or she has created.

Your ability to secure for yourself and your investors value for the company you have built may only occur once. Make sure you are prepared.

Recently, I have been doing a lot of work with a small business owner in San Jose. The more his business grew, the more stressed out he became. His fear of adding payroll to his company's expenses was hampering the growth of his start-up company.

When you first start your own business, you will probably handle all of the daily tasks yourself. For a start-up company, staff of any kind is a luxury you probably cannot afford. As the business grows, however, and in order for it to grow, you cannot keep trying to do everything. Eventually, you will have too much on your plate and your service will suffer. So, before you harm the reputation of this new business you have been working so hard for, you need to divide the tasks into those that you have mastered and can systematize and train someone else to do, and those that should be done by professionals.

Tasks for Staff: Examine your financial situation and figure out how much staff you can afford, then invest in hiring good people. Teach those people how to do the tasks your way and let them run with it and report back to you when appropriate. Stay in touch with them so that you always have your finger on the pulse of your business and never become too dependent on any one employee. Growing your business in this way will provide greater independence for you, greater value for your company, and larger profits. When my San Jose start-up client hired his first salesman and saw that the company could progress without being completely dependent on his efforts, he became a much happier person.

Tasks for Professionals: Sometimes doing it yourself is definitely not cheaper. Having the right professionals working for your business will save you a lot more in the long run - in time and money. Compliance and protection now can be much cheaper than fixing a problem later. When it comes to legal, accounting and tax needs, focus on creating value rather than saving money. For example, hiring a corporate or business attorney to help you choose the correct form of entity and then help you form your corporation, partnership or LLC correctly can protect you from legal and tax problems later. Using the right attorney to help draft contracts and agreements or review and revise contracts presented to you so that you get good contracts in place can save you from having to deal with onerous terms later. Hiring an accountant to help you set up your books correctly and report your income and deductions legally can save you from costly audit adjustments later.

You are the expert at what you do. Surround yourself with people who are experts at what they do. Once you have a good team of advisors, let them share information between them. It will save time, money and frustration for you and your business later.

In Part 1 of this entry, I discussed problems that some of my Silicon Valley clients have had with improper choice of entity - either because the tax consequences weren't considered, or because restrictions in the California Corporations Code or Business and Professions Code were not taken into account. Here are two more expensive mistakes that business owners make when they try to form their own corporation or LLC online.

1. Not doing the required securities filings.
Online sites may not tell you that if you fail to file California and/or Federal securities filings you could be in violation of securities laws resulting in tremendous personal liability to return funds to your investors, despite the liability shield the entity is supposed to provide. Sometimes by the time I get involved it is too late to fix this, but sometimes we can do a late filing and get some, if not all, of the protection it provides. Corporations, as well as some LLCs and partnerships, are securities and must be treated accordingly.

2. Not completing the formation - with disastrous liability consequences.
By far the most common mistake when forming an entity yourself is not having the expertise to know what needs to be done after the initial filing with the Secretary of State, or not hiring the right advisor to counsel you. I have worked with many Silicon Valley business owners who thought they had a liability shield in place because they created their corporation or LLC with the Secretary of State, but in fact they were not in compliance with the Corporations Code and therefore did not have a valid entity to protect them in case they got sued. Filing Articles of Incorporation with the Secretary of State and getting an employer identification number with the IRS is not sufficient to create an entity. LLCs must have operating agreements. Corporations must have bylaws as well as minutes documenting required annual Board of Directors and shareholder meetings, electing directors, appointing officers, and approving corporation actions.

If you are not sure if your business is in the right type of entity, and is properly formed, don't wait until it is too late. Get advice now, before it negatively impacts your business later.

I was in Los Gatos getting my hair cut this weekend and my hairdresser said something very interesting - he said that his best clients are the ones who try to do their hair themselves (especially their color) and then come to him to fix the mess they made. He said they are so grateful when he fixes the problem they created that they become clients for life. I am not the type of person to try to do my hair myself - too much risk for me. However, it struck a chord with me because it seems more and more I spend my time working with clients who have formed their own corporation or limited liability company through forms found on the internet, and then come to me to fix some problem they caused.

What is wrong with forming your own corporation or LLC online? Nothing, if you know what you are doing. However, most people who are starting a new business and need an entity do not specialize in forming companies. Here are two of the four most common (and costly) mistakes I have helped my Silicon Valley clients fix:

1. Picking the wrong type of entity -- with disastrous tax consequences.
In California, there are very different tax consequences for C corporations, S corporations, partnerships and limited liability companies. When I choose what type of entity to form for a client's new business, I consider franchise taxes amongst income and other taxes. For a real estate entity, I also consider property taxes and transfer taxes which can be quite different in Santa Clara county or another county. Fixing the type of entity can be as simple as making a tax election, or as complicated as converting to another form of entity - which can be done, but it is a lot more expensive than starting out with the right entity in the first place.

2. Forming an LLC for a business that is not allowed to be an LLC.
The California Corporations Code prohibits certain businesses from being a limited liability company. For instance, if your business is required to be licensed or certified under the Business and Professions Code, it is not eligible to be an LLC. I hate to see business owners spend their time and money on filing a limited liability company online, only to find out much later that it was not only worthless, it was giving them a false sense of security because they had no liability protection. The only fix here is starting over or converting to a corporation or partnership - both of which require new bank accounts, business cards, letterhead, etc. and are time consuming and expensive.

See Part 2 for two more expensive errors.