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.

Position
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.

Confidentiality/Non-competition/Non-solicitation
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.

Compensation
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.

Term/Termination
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.

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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.

Merger and Acquisition Letters of Intent - Don't Hold Me To It

May 9, 2011,

Any Silicon Valley mergers and acquisitions lawyer helping clients buy and sell high technology companies is invariably provided with a simple letter of intent, happily signed by a couple of companies without input from their tax and legal advisors, and asked to prepare binding documents. In one case, my San Jose business client was not too worried about the lack of detail in the letter because, after all, it was just a "letter of intent". She was less than happy when I told her that she had actually signed a binding agreement, particularly since very little due diligence had been performed on the target company and a number of 'minor' issues that were important to her still required resolution.

A letter of intent (also called "LOI", or memorandum of understanding, or "MOU") is usually a short letter that outlines the basic business terms of a deal. Without language expressly stating that the letter is nonbinding, and that no obligations arise except under a definitive agreement, however, that letter you signed may be a legally binding contract. Even with this kind of language, a letter of intent can morph into a binding contract IF the parties conduct themselves as if the target company has been acquired. Announcing a deal (when not otherwise legally required), combining operations before a closing, and similar actions, can create a contract from conduct. With no definitive agreement signed, the letter of intent may be used as evidence to set the terms of the deal.

Why do you want an LOI to be nonbinding? Letters of intent are usually prepared and signed after the initial business proposition and marketing analysis have been performed. They are typically signed before the acquirer has a chance to really investigate the target. This is because neither party will want to conduct an expensive diligence investigation until each is sure they have a deal. If the letter of intent is binding, then the acquiring company may find itself purchasing a lot of problems of which it wasn't aware when it signed the letter of intent.

Even in a nonbinding letter of intent, there are a number of provisions which should bind the parties. In my next blog, I'll discuss the importance of having binding terms in a nonbinding letter of intent.

Owners of Single Member LLCs Doing Business in California Must Also Be Registered in California

May 2, 2011,

I was recently asked by a Cupertino real estate investor whether he should form his limited liability company in Nevada or some other state in order to avoid California taxes. I had to tell him that if anything, this would just increase his overall costs and taxes.

California franchise taxes can be much higher than taxes in other states, and include a minimum tax of $800 per year. As a result, companies often do not want to be classified as doing business in California. One way to avoid this classification used to be to form your entity in another state, and not register it in California. Some of my clients have numerous Delaware LLCs or Nevada LLCs. Often, those LLCs own other LLCs, which own property in California. In order to avoid the California minimum franchise tax for multiple entities, they just register the entity that actually owns the property in California.

However, a new ruling says that if the entity is doing business in California, owns property in California, or is managed by people in California, this exemption is no longer available at the parent LLC level.

The California Franchise Tax Board just issued FTB Legal Ruling 2011-01, stating that activities of a disregarded entity will be attributed to the entity's sole owner. A disregarded entity is a single member LLC or a Qualified Subchapter S subsidiary ("QSub") which is disregarded for income tax purposes so that its income passes through to its parent for tax reporting purposes. Therefore, if the disregarded entity is doing business in California, the 100% owner will be considered to be doing business in California and, if it is an entity, will have to register with the Secretary of State in California. This is true even if that owner entity has no other activities in the state, other than owning the disregarded entity.

This ruling is in addition to a previous California Franchise Tax Board ruling that an entity will be considered to be doing business in California if its managing person(s) are in California, even if all of its other activities are out of state.

For real estate investors, lenders often require a special purpose entity ("SPE") to hold the property, which is structured as a single member Delaware LLC. Under these new Franchise Tax Board rulings, the single member LLC holding the property must be registered in California, and its 100% owner parent company must be registered in California as well. The bad news is that both entities are required to pay the $800 minimum franchise tax to California. However, the LLC gross receipts tax is not incurred twice on income that flows through from one LLC to another.

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Convertible Notes

April 25, 2011,

Bridge financing for Silicon Valley start-up companies is a fairly standard, relatively inexpensive method to raising money pending a larger investment round. This type of financing is typically provided in the form of debt that converts into shares issued in the next funding round, often at a discount from the per share purchase price.

Recently, the simple convertible bridge loan has changed to provide substantial tax incentives to investors. For any qualified small business stock, or QSBS, purchased before December 31, 2011, the recently enacted 2010 Tax Relief Act allows 100% of the gain recognized from the stock to be excluded from taxable income.

Although a convertible loan will not qualify as QSBS, the stock that a start-up company issues normally will. Bridge loan investors have a great incentive to purchase stock in exchange for their bridge funds instead of a convertible note. Designing stock that has many of the same attributes as convertible debt has provided some additional complexities to what was formerly a plain vanilla transaction.

Because debt is not being issued, the investor will have no right to return of its funds, barring securities violations. Most bridge loan investors, however, provide funds on the expectation of ultimately holding stock. As a result, the lack of a repayment feature is not a concern. If it is, a redemption feature could be designed, but it is unlikely the Company would be able to legally redeem the stock if it couldn't otherwise raise money.

The key advantage to a convertible note, that value need not be negotiated, is eliminated because stock is issued. This creates the need to negotiate a valuation, which adds time to the transaction. This can be solved, in a sense, by requiring the stock to convert into stock issued in the next round if the next round is expected to close soon. If this approach is used, a separate and forced conversion rate must be established to make sure the bridge stock converts into the next round.

As a result of the above items, and the need to issue stock, a new series of stock will need to be created. This requires charter documents to be amended and corresponding board and stockholder approval to be secured.

Price-based antidilution adjustments may be triggered. If so, capitalization estimates have to take account of corresponding changes in the conversion rate of the applicable series of preferred stock.

Tax benefits will come at some cost in the deal due to more complex documentation and expense. The structure, however, may provide just the right push to close that extra funding.