Employee Terminations

October 24, 2011,

Whether your company is a large manufacturer corporation in San Jose or a small service partnership in Los Gatos, you will eventually be forced to deal with terminating an employee. Terminations can be especially daunting because they are one of the most common reasons companies are sued. Therefore, whenever possible, it is important to plan and prepare for a termination before actually firing the employee.

I recently helped an LLC in Santa Clara set up a progressive discipline plan for their company in order to set up systems to assist management and employees before someone gets to the termination stage. Before an employee is fired, many companies use a form of progressive discipline when dealing with employee problems. Under progressive discipline an employee receives greater disciplinary measures when employment continues to be unsatisfactory. It is imperative that all disciplinary actions are documented in writing. If a system of progressive discipline is used, all managers should be trained on that system. If managers are not properly trained, a disgruntled employee may have a stronger claim for wrongful discharge than if the system had not been used at all. Whether a system of progressive discipline is used or not, it is critical that all disciplinary actions be documented.

If a termination is inevitable, you should have a plan in place before firing an employee. However, there are times when you must fire an employee immediately, without any prior planning, because he has done something that poses a threat to other employees, your company or your clients. Prior to termination, you should review any termination procedures in the employee handbook, to the extent they exist, to ensure that your company is following its own procedures. If you are worried about an employee making a claim against the company upon termination and you want to request the employee release the company from all claims, you should contact an attorney to assist you in preparing a severance agreement.

On termination, you must provide the former employee with the final paycheck including any accrued but unused PTO or vacation pay, a change of status notice, and the EDD pamphlet "For Your Benefit, California's Programs for the Unemployed." If the employee is a shareholder or option holder, you should review all applicable documents prior to the termination for notices or deadlines related to termination of employment. However, do not give the employee legal or tax advice regarding those documents or their rights.

When conducting a termination, conduct it in a neutral, private place such as a conference room. Have the final paycheck and change of status notice ready for the meeting. If you are offering a severance agreement, have that agreement prepared as well. Many employees will not sign the severance agreement immediately so be sure to give them the allotted time in the agreement to sign it and don't give the employee any severance payments until the severance agreement has been signed, or 8 days later if the employee is over 40 and therefore subject to age discrimination rules.

You should always have two managers present during a firing. During the meeting, tell the employee within the first few minutes that he is being fired and tell the employee why he is being terminated. Although you do not need a reason to fire an at-will employee, you may not do so for the wrong reason (e.g. discrimination), so be careful in what you say. Also, if you say the termination is a result of restructuring, but the reason is really poor performance, the inconsistency may be used against you if the company is sued. Do not argue with the employee and do not be so complimentary that the employee wonders why he is being terminated. You are not required to give employees a written reason for termination. However, if you decide to, be sure that your legal counsel reviews those reasons. Avoid any reference to anything that could be considered evidence of discrimination, especially if you are terminating someone who is in a protected class. Always be courteous to the employee. You should also explain any benefits, such as COBRA, that the employee may receive. Have someone take notes during and after the termination to document the process and what was said at the meeting. Lastly, you should remind the employee of any continuing obligations to the company, such as confidentiality.

Once an employee has been terminated, be sure to get any company keys, cell phone or laptop that the employee had. Also be sure to change phone codes, computer passwords, alarm codes or other passwords that the employee may have had access to.

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Employment Basics for Employers - Employee Performance Reviews

October 4, 2011,

Silicon Valley is experiencing a "war for talent," even as the nation struggles with unemployment. The Bay Area has not been unaffected by unemployment, but with the number of high technology startups based in cities such as Palo Alto, Mountain View, San Jose, and Santa Clara, companies are finding themselves competing for talent. The value of human capital is greater than ever, which is why it is essential for companies to perform assessments on their employees. Employees can be a company's most valuable asset or its greatest liability.

Conducting employee performance reviews is one of the most important and often most dreaded tasks of management. Employee reviews take a lot of time and cause a lot of stress for managers even if the reviews are generally positive. Many employers try to avoid employee performance reviews. However, regardless of the size of your company, not conducting performance reviews can really hurt you both in productivity and in an increased risk of employment-related litigation.

I recently worked with a San Jose consulting business that was sued by a former employee of the corporation. The company had a salesperson in their Mountain View office that was drastically underperforming, but had never documented those failures in any way. The corporation eventually fired her and the salesperson then sued the company for wrongful termination. An employee file documented with poor performance reviews could have made that case go away much faster, and kept the settlement offers much lower. Below are some suggestions to make the most out of review time.

First of all, employee reviews should be conducted at least once a year, sometimes twice a year or more depending on the company and the employee. Good performance review practices help communicate issues before they get to the point of firing. In addition, if an employee is having performance issues, don't wait until review time to bring them up. Deal with the issue immediately.

Second, when conducting employee performance evaluations, be honest. Many managers give their employees high marks, even if they're not justified, just to avoid a confrontation. If an employee is performing poorly, discuss the poor performance in their review. Don't give an employee all high marks, especially if you are not happy with their performance. This could cause a problem if you decide to fire an employee for poor performance later. The employee may claim he or she had no idea that there was a performance issue and that former employee may try to sue on the basis that the real reason for termination was something else like discrimination. Courts like to see documentation of poor performance issues and the employee review is a great place to document any problems.

Third, consider keeping notes throughout the year when your employees do something positive. You can then bring these up during the evaluation instead of just focusing on the most recent items. This helps you provide specific examples of strengths and weaknesses. Give employees goals so they have something to strive for throughout the year.

Fourth, consider having employees complete self evaluations. Self evaluations help managers know where employees may not be receiving appropriate feedback throughout the year, especially if there is a large discrepancy between a manager's evaluation and an employee's self-evaluation.

Fifth, try to use a form of evaluation that actually fits the employee's job description, rather than a pre-printed form, or a form someone else is using. The right form will enable you to objectively measure an employee's performance on specific essential taxes required for their job. When conducting several evaluations at once, be careful to avoid certain pitfalls including the tendency to evaluate all employees as outstanding, average or poor, especially if that is not a true reflection of their performance.

Finally, use the evaluation process as an opportunity to talk to your employees and allow them to provide feedback to your organization. This is an excellent opportunity to gather ideas for your business, improve your organization, reduce grievances and prevent lawsuits. It is also an excellent opportunity to train your management staff in the evaluation process.

Employment Basics for Employers - E-mail and Voicemail Monitoring

September 19, 2011,

This blog focuses on an employer's rights to monitor electronic communications.

One of my Mountain View clients recently had an employee leave and wipe out all of his e-mails before he signed off for the last time. The employer immediately had its IT group recover the e-mails, and a corporate officer read through them. They found several emails where the employee was corresponding with others in the company about leaving and forming a competitive company. They called to ask me, after the fact, whether it was okay for them to read the employee's emails and what rights they have now to act on the information.

There are a number of laws that affect access to another person's emails. One of these, the Electronic Communications Privacy Act of 1986 (the "ECPA") prohibits unauthorized persons to access electronic communications, including wire taps and stored communications like e-mails. If you violate the ECPA, you could be subject to fines and prison terms up to one year, as well as civil damages and attorneys fees. However, there are three exceptions which may allow employers to monitor employee communications.

First, there is an exception for employers to monitor communications within the ordinary course of business from telephone equipment provided and used in the ordinary course of business. So, employers can monitor calls, voicemails or e-mails employees use in their regular business affairs. However, if during your monitoring the employer finds that what it is reading is a personal communication, it must stop.

Second, there is an exception when the company has the consent of the employee. This usually means that the company has given the employees actual knowledge of a clear monitoring policy. For example, if your employee handbook says the company policy is that it can monitor and disclose calls, voicemails and e-mails whether business or personal, and the employees sign off on the receipt of the handbook using company equipment, with that policy in it, then you can listen in, read, and disclose communications whether they are business related or not. Also, note that there are differences between monitoring and disclosing information. In particular, California law requires the consent of both the originator and the recipient parties in order to disclose the contents of a message.

Third, there is an exception for the employer as the person or entity providing access to stored electronic communications. In other words, if you provide for voicemail on a telephone system you own, or e-mail on an internal system you own, you can access anything stored on those systems, but possibly only for messages sent internally.

Note that there are different rules related to union organization under the National Labor Relations Act which generally prohibit employer surveillance of protected union activities.

Despite these exceptions, this is a relatively new area of law that has not been enforced much by the courts, so I still recommend that employers only access e-mail for essential administrative and investigative purposes when there is a reasonable suspicion of employee misconduct. This is also important because studies have shown that employee monitoring can lower morale, which will likely lower productivity.

Employment Basics for Employers - Employment Agreements

September 6, 2011,

Silicon Valley employers expect a hiring boom in technology jobs in the next two years, especially in the areas of social networking, cloud computing, and mobile technology, according to a recent study headed by NOVA, a nonprofit, federally funded employment and training agency in Sunnyvale. As a result, many companies will face basic employment issues, such as recruiting qualified employees, performing reference checks on potential candidates, and having solid employment agreements in place. In my last blog I discussed when you should consider using an employment agreement rather than just a simple offer letter for a new employee. Generally employment agreements are used for top executives and high level managers. Here is a brief summary of some of the terms you should have in those high-level employment agreements.

o This can be either a general description for higher executives, or a list of tasks, authority level and who the person reports to for other employees.
o You should include expectations of performance, including statements of the amount of time and effort you are expecting. My agreements often say that the employee is expected to devote substantially all of her time and efforts to the company and may not work for any other employers without the company's permission. For some companies you may also want to say that your employees may not own stock in your competitors.
o Make it clear that the position is at-will, and explain what that means.
o Refer to any company rules and regulations like an employee handbook, if you have one, and don't forget to say that the company can change the rules and regulations at any time and that the employee must comply with any changes.

Be very careful with post-termination non-competition agreements in California, as they are generally against public policy and can only be enforced in limited circumstances. An illegal non-competition clause can actually invalidate the whole agreement if you are not careful. There are additional considerations if the company and/or the employee are outside of California. Make sure you work with an attorney if you are thinking about including a non-competition clause in your employment agreements.

o Salary or hourly? Equity compensation? Exempt or non-exempt? Bonus eligibility? Be aware that there are special rules for computer professionals in California.
o Be careful with commissions - there are a lot of traps for the unwary when dealing with compensating salespersons, including wage and hour laws like minimum wage, as well as commission accrual and payment, especially after the employee is terminated. Advanced planning and a good agreement can save your company a lot of time, money and effort when it comes to a salesperson who leaves your company.
o Expense Reimbursements - generally you are required to reimburse employees for expenses in performing their duties, but you want a clear system for pre-approval, and it is often good to set out in their agreement what expenses you expect to cover and what you will not (e.g. cell phones, professional dues, parking, equipment costs).
o List any benefits you provide such as vacation and sick leave, health insurance, life insurance, 401(k) and profit sharing plans.

o Although most companies will want the employment to be at-will, agreements with executives and senior management usually have some limits on termination without cause, including potential severance pay.
o Your employment agreement should also cover post-termination requirements such as the return of company property and continuing obligations, or a reference to a separate nondisclosure agreement.

No matter what you put in your employment agreement, make sure you include a provision that the company may change the terms without the consent of the employee. However, you should still proceed with caution before making a change so that you do not violate wage and hour laws or cause a constructive termination, potentially giving the employee rights against the company.

Short Sales - Can the Bank Still Come After You for the Deficiency?

August 22, 2011,

This year has brought some significant changes to the rights of lenders participating in short sales. In January 2011, a new California law was passed (SB 931) which required residential (1-4 units) lenders in first position who agree to accept a short sale, to accept the amount received in the short sale as payment in full on the loan. Now, effective July 15, 2011, that rule applies to junior lien holders as well (SB 458).

This is great news for short-sellers, but may not be such great news for potential short-sellers who have more than one lender on the property. Unless the loans were purchase money loans that provide protection against deficiency judgments, the new law could act as a disincentive for junior lenders to agree to a short sale.

Employment Basics for Employers - Making the Offer

August 8, 2011,

Most businesses have to deal with filling opened positions at their company at one time or another. In my continuing series on basic employment concerns for employers I have so far discussed searching for new employees, evaluating potential applicants, and doing and responding to reference checks. This blog discusses what you do once you have found someone you would like to hire.

When you have found someone you want to hire, you should always make the offer in writing. Your offer letter should, at a minimum, include their name, the position, the pay (and whether it is salary or hourly), where and when the work will be performed, what benefits are offered by your company, and that the employment is "at-will." As I discussed in my previous blog, you can condition employment on a medical examination to confirm that the potential employee is physically able to do the job, or determine if any physical limitations exist, and establish a record of medical conditions.

I also recommend conditioning employment on confirmation of the employee's identity, the results of a background check and confirmation that the employee can legally work in the U.S. Under the Immigration Reform and Control Act of 1986, employers are required to verify employment eligibility and identity. Because national origin and citizenship status could be used to discriminate against potential applicants, it is better to ask for this information only after you have made the job offer. After you confirm the employee's identity and eligibility by reviewing the various identification documents the employee provides, you must have the employee complete an INS Form I-9, and you must complete the employer's part of the I-9 within three business days of hiring the employee.

Employment Agreements
For most employees, an offer letter stating the terms of their employment is sufficient. However, for certain managers and executives and for employees that will have access to confidential information and trade secrets of your company, you will want them to sign a confidentiality and nondisclosure agreement as well as an Inventions Assignment Agreement. For top executives, they may require specific terms that should be set forth in an employment agreement. Employment agreements, if not drafted correctly, can cause a lot of liability for a company, so I definitely recommend you have your company's employment agreement drafted by an attorney or HR person who is very well informed in this area. For many of the companies I work with, I will provide them with a form of offer letter and a form of employment agreement suited for their needs, and then they can complete it for new hires and just have me review any significant changes or additions.

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Employment Basics for Employers - Reference Checks

July 25, 2011,

Whether you are a startup company in Sunnyvale or a family owned business in San Jose, as an employer, you will have some basic employment concerns. In my previous two blogs, I discussed risks in looking for employees and evaluating potential applicants. This blog focuses on reference checks, both for potential employees and when another business owner calls you with regards to an ex-employee of yours.

When you are interested in an applicant, a reference check is always a good idea. In particular, checking references may be crucial to avoiding a claim of negligent hiring. This is very important when your employee will be working with young children, like a daycare teacher, or entering homes or businesses, such as an installer or a janitorial worker. However, reference checks can be a concern both when you are the potential employer and when you are the previous employer. Any information you ask and any information you give to a potential employer must not be discriminatory or retaliatory.
Often, a good strategy as the previous employer is to have a strict policy of only providing very basic information such as confirming that the employee did work for you, dates of employment, and position.

If they are going to give more information than just basic information for former employees, employers should use the following guidelines:

Disclose only truthful information.
State facts and avoid conclusions.
Include favorable facts about the employee.
Designate a limited number of employees to give references.
Obtain a release from the employee.
Require all employees asking for references to request the reference in writing.

When checking references for job applicants, have applicants sign a statement acknowledging that it is o.k. for you to contact their previous employers for references.

California employers are also allowed to conduct background checks, including criminal background checks and credit checks, on prospective employees. Employers must provide a written notice to applicants notifying them that the company will be running a criminal and/or credit check on the applicant. This written notice must be made in a document that consists solely of the disclosure. Prospective employees must first sign a statement authorizing the potential employer to run a criminal background and credit check, as well as any other drug related testing. The signed statement should be a document separate from any employment application or offer letter.

Employment Basics for Employers - Evaluating Potential Employees

July 11, 2011,

In my previous blog, I discussed the risks faced by companies that are looking to hire new employees. This blog focuses on issues employers need to be concerned with once they have found some candidates and need to choose between them.

Once you are ready to interview candidates, you still need to be wary of a discrimination claim for the questions you ask and the information you gather, even if the information is crucial to determining whether the person would be a good fit for your company. So, you have to be very careful about how you obtain information and decide between candidates. Looking up candidates on the web through social networks is the subject of many articles itself. This blog just deals with the old fashioned methods of considering job applicants.

If you require potential applicants to complete a job application, don't just download a form from the web and think you are safe. The questions you ask must be relevant to the position you are trying to fill. This means that even within your company one application may not be appropriate for all positions. Avoid asking questions about age (including requesting date of birth!), race, religion, nationality, disabilities, gender, marital status and whether or not the applicant has kids, is a single parent, etc. When it comes time for an interview, be prepared with a list of potential questions to ask as well as ones to avoid, and have each interviewer review these questions before an interview. I strongly recommend for employees who have never been the interviewer to go through a practice interview so that he or she can rehearse the role and responses to various questions. Questions should be geared towards a candidate's past job performance and qualifications, and careful emphasis should be placed on returning the conversation to an appropriate line of questions if the applicant volunteers information that may be considered discriminatory if asked.

Here is a basic list of questions that should never be asked in an interview:
What is your maiden name?
Do you own or rent your home?
What is your birth date?
When did you complete school or what years did you attend school?
What religious holidays do you observe?
Do you have any children and what are their ages?
Where were your parents born?
Do you have any medical conditions?
What non-work related organizations do you belong to?
Do you have any debt?
Do you plan to get married or start a family?
Have you ever been treated for alcoholism or drug addiction?

However, you can ask potential employees to describe or show you how they would do job-related physical tasks. You can also ask applicants to take a drug test (for controlled substances), but you cannot require them to undergo a medical examination until after you have made them a job offer. If you conduct drug tests, make sure you get the written consent from the applicants, and that you use a reputable laboratory.

There are also certain statements that should never be made. For instance, never say anything that would imply permanent rather than at-will employment.

Employment Basics for Employers - Looking for Employees

July 5, 2011,

Silicon Valley's job market heats up even as national employment stalls, thanks to an increase in venture capital and personal investing. Large corporations are competing with small businesses and start-ups for talent. Although some of my business clients are start-up companies where the founders are the only employees, more and more of my clients are operating businesses with day to day concerns, the most common of which is employee issues. A growing business that is hiring may need employment contracts and possibly a stock option plan in place. All businesses need employment policies and possibly an employee handbook. And almost all businesses at some time or other will need to deal with employee complaints, discipline and even terminating employees. This is the start of a series of blogs on some of the basics you should know as an employer, whether here in Santa Clara County or elsewhere. Keep in mind that every situation and every employee is different and the laws of other states may be different than California. This is not a substitute for calling your company's lawyer, but more of a guide to help you spot issues and know when you need to ask for help.

Looking for New Hires:
The first rule of hiring is to be wary of discrimination. You can hire anyone you want, as long as you don't discriminate based on age, race, nationality, gender, disability or any other protected class. Discrimination can show up or be inferred from many situations where it may not have been intended. For example, I represent a janitorial company in Santa Clara that employed many people from one religion and those employees often referred their friends and family when positions opened up. When looking for new hires, the company has to be very careful to ask all their employees for referrals and not just that group of employees, or the company could be found to be discriminating against people who are not part of that religion.

Anyone that represents your company in recruiting new employees should be well trained in employment laws. Be careful about how you write your employment ads so they don't exclude any class of potential employees, and make sure to include a statement that your company is an Equal Opportunity Employer in each ad. Be careful about where you advertise. For example, I represent a bilingual English/Chinese preschool in Sunnyvale. Although it may be okay for the school to advertise in an all-Chinese newspaper when they are looking to hire Chinese teachers, it may be considered discriminatory against non-Chinese speakers when they are looking to fill any position that does not require Chinese language capabilities.

Continue reading "Employment Basics for Employers - Looking for Employees" »

Merger and Acquisition Letters of Intent - Hold Me Back!

June 28, 2011,

Most letters of intent describing acquisitions in Silicon Valley, as elsewhere, will describe the material points of a transaction. Although a properly drafted letter of intent will provide that the business points of the deal are nonbinding, it is difficult in the course of any negotiation to change a business point already agreed upon. As a result, take care to describe those points that are most important to a transaction and to leave others to be negotiated as part of the definitive agreement.

The most important point is obviously the purchase price. This can be expressed, among other ways, as an absolute amount. If the transaction is a merger, the absolute amount is converted into a conversion or exchange rate based on the market value of the acquirer's stock over a period of time preceding the closing.

It is very unusual for the price to be paid all at once. Typically, the amount ultimately paid will be subject to post-closing adjustments based on issues unrelated to financial performance (often referred to as a holdback) as well as issues related to financial performance or other milestones (often referred to as an earnout). These provisions must be considered very carefully, as they are often a source of litigation. This blog will only discuss the holdback.

The liability holdback is the most significant holdback and is used to cover any liabilities which may arise after the closing. The holdback is used to help protect the buyer when the state of the Company, often described as representations and warranties, is found to be inaccurate. These liabilities can arise when the Company is sued after the closing, e.g., when an infringement claim is made, or can arise if a representation is inaccurate, e.g., when a cost of a particular liability is found to be greater than originally disclosed. Liability holdbacks will also cover any liability arising out of the seller's failure to perform an obligation.

The percentage of the liability holdback varies considerably, although they typically are between 10% and 20% of the purchase price. For known claims that cannot be quantified yet, a separate holdback can be created, and the amount held back can vary with the amount of the claim.

The audit holdback, another common holdback, is that amount of money to be used to cover any adjustment which may be required to adjust, following a post-closing audit, an inaccurate working capital cushion. The employee retention holdback is another holdback that is used where employees are crucial to a target company, where an amount is held back for a period of time and reduced if employees depart the target company after the closing.

The amount of time that funds will be held back varies. Liability holdbacks typically run between one and two years. Audit holdbacks will typically run for 90 to 120 days after the closing to encourage the audit to be completed. Employee retention holdbacks can run to one year, and potentially longer.

My next blog will discuss the earnout, and the portions of this important mechanism that are usually found in a letter of intent.

Update: IRS Changes Mileage Rate

June 24, 2011,

The standard mileage rate is very important to my business clients because it is not only the rate at which they can deduct miles driven for business use, but it is also often the rate at which the businesses have agreed to reimburse their employees for miles driven on the job. The IRS has once again changed the standard mileage rate for the use of business vehicles. For the final six months of 2011, the standard mileage rate will be 55.5 cents per mile, up from 51 cents. The IRS made this decision due to the spike in gas prices earlier this year, but the rate is good for the rest of the year even though prices seem to be falling now. The mileage rate for medical and moving expenses also goes up by 4.5 cents to 23.5 cents per mile, but the mileage rate used when driving for charity is unchanged at 14 cents per mile.

The IRS will announce the mileage rate for 2012 in the fall.

Source: Kiplinger Tax Letter, Vol. 86, No. 13 (June 24, 2011)

Choice of State for a New Corporation

June 6, 2011,

I recently did a blog about California clients wanting to form LLCs outside of California in order to avoid California franchise taxes, and how the Franchise Tax Board has been steadily trying to eliminate those possibilities. In response to that blog, I was asked about other non-tax considerations for choosing a state for the formation of a business. So, here is a brief analysis of some of the things I consider when helping my clients choose the right jurisdiction for their new corporation.

When a client comes into my office in San Jose and asks about forming a business entity outside of California, the most common jurisdictions they are considering are either Delaware or Nevada. Delaware has traditionally been the favorite jurisdiction, and Nevada is gaining in popularity.

Why incorporate in Delaware?

• Delaware is a leader in making incorporating easy for founders, including accepting Certificates of Incorporation by e-mail and fax and without signatures, providing for expedited filings in one hour, and allowing Boards to hold meetings electronically.
• Delaware's corporate laws allow for limitations on personal liability and indemnification of the officers.
• Delaware law is well established and it has a special court, the Court of Chancery, to deal solely with corporate matters.
• Venture Capitalists are familiar with Delaware and their forms are based on Delaware law.
• A majority of companies on the NYSE are incorporated in Delaware.
• A majority of Fortune 500 companies are incorporated in Delaware.

Why incorporate in Nevada?

• Nevada does not have a franchise tax and it does not tax corporations for income earned in Nevada. (Of course, this does not get a company out of California franchise and income taxes if it is doing business in California, but a lot of people don't realize that.)
• Nevada caters to smaller, private companies.
• Protection for corporate management is very strong. Directors and officers are not compared to an objective standard of behavior, making it harder for them to be held personally liable for acts that may have otherwise been determined to not be in the best interest of the company.

Why (or why not) incorporate in California?

• For companies doing business in California, California usually makes the most sense as a jurisdiction since California law often applies to foreign entities anyway if they are doing business here.
• Franchise taxes are high in California, but forming outside of California will not exempt a business from California franchise taxes if it has a presence here.
• California does allow telephonic and electronic meetings of the board of directors.
• The California Secretary of State, despite usually long waits for filings, does have expedited filings for a fee.
• California corporate laws often protect shareholders over management - such as requiring shareholder approval for loans to officers or directors and providing for cumulative voting rights.

Of course, these choices are also impacted by the business of the company and its strategic plan for the future. In addition, choice of state is only one of many informed decisions that must be made by the founders, their business lawyer, and their CPA before jumping into the formation of a new company.

Merger and Acquisition Letters of Intent - Binding the Nonbinding

May 30, 2011,

In negotiating a recent acquisition for a client selling a business in Santa Cruz, we were presented with a letter of intent outlining the terms of the transaction. The letter was well-constructed, and contained the material aspects of the deal, all of which were nonbinding. There were, however, a number of terms that were expressly made binding.

There are four binding terms most commonly used in nonbinding letters of intent for acquisitions of privately held companies. The first is that the parties will agree to standard nondisclosure obligations. The second is that the acquirer will be allowed to conduct a diligence investigation of the target. The third is that each party will pay its own fees incurred in connection with the transaction. If the transaction is a stock transaction, there may be some negotiation over whether the target can pay fees, under the theory that a stock deal is a deal among stockholders, rather than the corporation.

The fourth is the most hotly negotiated term - the "no shop" or "exclusivity" provision. The no shop is just as it sounds: the target company agrees not to "shop" itself while the transaction is in process. Acquirers usually demand this term so that their offer is not used by the target to get a better deal, and so that the time and expense they spend in the due diligence and negotiation process is not thwarted by another suitor. An acquirer will also ask that the target company stop any discussions with any other potential acquirer, and notify the acquirer if the target company receives any other acquisition inquiries.

Target companies attempt to insert a number of qualifications and limitations to the no shop clause. First, the target will request a "fiduciary out". In this exception, the no shop is ineffective where an unsolicited alternate offer must be accepted in order for the target's board of directors to satisfy its fiduciary duties. Second, the target will attempt to impose strict time deadlines which, if not met, will cause the no shop to expire. The primary deadline will be on the parties entering into a definitive agreement. Other deadlines include the acquirer's completion of its due diligence investigation, and the closing of the acquisition.

Other binding terms include break-up fees where one party, typically the acquirer, will pay the other party, typically the target, if the acquirer decides not to proceed with the transaction.

As with most deals, the extent of number and type of binding terms in a letter of intent depends on the relative bargaining strength of the parties.

Continue reading "Merger and Acquisition Letters of Intent - Binding the Nonbinding" »

Professional Corporations for California Doctors

May 23, 2011,

I was recently working with some doctors who co-owned their Sunnyvale medical office building. They were concerned about the liability of having the property in their own names, so we worked with their lender and transferred the property into an LLC. Then, I suggested forming a professional corporation to operate their medical practice. Although doctors cannot avoid personal liability for their own malpractice, the corporation will limit their vicarious liability for the acts of their professional partners.

The California Professional Corporations Act allows licensed professionals in the fields of law, medicine, dentistry and accountancy to conduct business in a corporation, through the licensed individual shareholders. The Articles of Incorporation must include special language about the professional corporation. In addition to registering with the California Secretary of State, the corporation must also follow the naming and registration rules of the professional agency. The shareholders must be licensed, and transfers may only be to other shareholders or back to the corporation.

If a shareholder dies, the shares must be transferred within six months. If a shareholder is no longer qualified to practice medicine, the shares must be transferred within 90 days. For these reasons, I always recommend a shareholder buy-sell agreement to give the corporation or the remaining shareholders time to pay for the shares so it does not create financial difficulties for the company. Ideally, the corporation will also obtain life insurance on the professionals to fund a cash buy-out of a deceased shareholder's shares.

My clients were concerned because they had heard that professional corporations were taxed at a high flat rate. I explained that they were correct in understanding that professional corporations are taxed at a flat 35% tax rate on all of the income. However, taxable income can be avoided for the professional corporation by either paying out all of the gain in salaries, or by electing S corporation ("S-corp") status. I also recommended they put special language in their agreements with patients to avoid being subject to the personal holding company rules.

Based on my advice and joint consultation with their accountant, the doctors now hold their medical office building in their limited liability company, and are operating as a professional corporation. In addition to their malpractice insurance, these planning measures took away a lot of their liability concerns.

Tax Break for Investors in Qualified Small Business Stock

May 16, 2011,

I was talking to a client in Cupertino this week about helping his friend with a start-up business in San Jose. Originally, my client wanted to form a corporation online by himself, but he was not sure if the company should be an S corporation ("S-corp") or a C corporation ("C-corp"). He was only thinking about the pass-through implications of an S corporation and the "double taxation" of a C corporation, but was unaware of the small business stock tax exclusion in C corporations and the potential benefit to investors.

I explained that as an incentive to investors to make long term investments in small businesses, for investments made after September 27, 2010 but before January 1, 2012, 100% of the capital gain from qualified small business stock held for more than five years will not be taxed. The amount of gain excluded is the greater of $10 million or ten times the taxpayer's basis in the stock (usually the amount paid for the shares).

To qualify for this incentive, there is a list of rules. The taxpayer must acquire the stock upon its original issuance for cash, property or services. The corporation must be a C corporation with a maximum of $50 million in assets, including the investment. It must not be a regulated investment company, real estate investment trust, real estate mortgage investment trust or other type of entity with special taxation, must not own investments or real estate with a value exceeding 10% of its total assets, must not own portfolio stock or securities with a value exceeding 10% of net assets, and must use at least 80% of the value of its total assets in the active conduct of a trade or business. The corporation's trade or business cannot include professional services, banking, insurance, financing, leasing or the hotel or restaurant business.

Because this start-up company qualified for the small business stock exclusion, and the client was hoping to grow the company with investment from third parties, he decided a C corporation was the right choice. Also, because he realized how much he did not know about forming a new corporation, he asked me to do the formation for him. Once it is formed we will talk about the best way for him to get his promised share of the company.