Start-Ups & Financing

Merger and Acquisition Letters of Intent – Hold Me Back!

June 28, 2011 | Structure Law Group, LLP

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.

Tax Break for Investors in Qualified Small Business Stock

May 16, 2011 | Structure Law Group, LLP

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.

Merger and Acquisition Letters of Intent – Don’t Hold Me To It

May 9, 2011 | Structure Law Group, LLP

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.

Convertible Notes

April 25, 2011 | Structure Law Group, LLP

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.

Save Me! Purchasing the Financially Troubled Company – Part 1

April 4, 2011 | Structure Law Group, LLP

Technology start-up companies in Silicon Valley exist in a highly dynamic environment, where survival can be crushed by competition from a kid in a garage or a fund partner refusing further investment. As a last gasp, some companies may try to be acquired. Companies which have had to take refuge from their creditors may be able to sell their business through bankruptcy proceedings.

When compared to a standard sale of a business, sales of financially troubled companies require the professional advisors to manage a number of different stakeholders to successfully close a transaction. More so than in standard transactions, professional advisors play an important role in helping a transaction proceed smoothly. Under certain circumstances, their fees may be paid by the buyer or the bankrupt estate.

Most acquisitions of financially troubled companies are structured as an asset purchase. This prevents the acquirer from having to automatically assume liabilities that it doesn’t want. The existing creditors are then left with satisfying their claims out of the proceeds from the sale. Most companies, however, need the products or services of its creditor vendors to survive. In the case of technology companies, these vendors often include technology and hardware suppliers who are core to the company’s business. Irritated suppliers may not want to deal with the company even after its acquisition. Creditors and stockholders of the company may have claims against the company’s board of directors if a company is sold for less than the reasonably equivalent value of its assets. At the same time, key employees of the company, aware of the company’s financial stress, may be looking for alternate opportunities. The importance of these stakeholders, and how they are managed as part of the acquisition, is at the heart of any purchase of a financially troubled company.

An Incomplete or Improperly Formed Corporation or Limited Liability Company Can Hurt Your Silicon Valley Business in Several Ways, Part III: IRS Problems, Securities Problems, Shareholder Disputes

February 28, 2011 | Structure Law Group, LLP

In Parts I and II of this Article I talked about how important a complete and properly formed business entity is for estate planning and liability protection. There are also many other potential impacts of not having your corporation or LLC documentation in order. Here are just a few:

IRS Problems: Just over five years ago I got a call from a licensed contractor in Campbell who was being audited by the IRS and needed to present his corporate minute book to the auditor in five days time. His company had not done minutes of the shareholders or the board of directors for the previous six years. It took us much more time to go back and recreate the corporate minutes and ended up costing my client at least twice what it would have if we had prepared the minutes each year when the information was fresh. However, it was necessary to document certain shareholder loans which would not have been upheld by the IRS if they weren’t properly authorized by the corporation.

Securities: Many new business owners do not understand that an ownership interest in a corporation or a manager-managed limited liability company is considered a security and may require federal and/or state securities filings. Failure to make these required filings may result in shareholders having rescission rights whereby they can demand their investment back from the company, and any person controlling the entity could have personal liability to return those funds.

An Incomplete or Improperly Formed Corporation or Limited Liability Company Can Hurt Your Silicon Valley Business in Several Ways, Part II: Liability Protection

February 21, 2011 | Structure Law Group, LLP

Filing your Articles of Incorporation or Articles of Organization with the Secretary of State is only the first step in creating your corporation or LLC. Unfortunately, most online business formation services take your money and don’t do much more than that for you. And many do-it-yourselfers don’t perform the required tasks unless they are somehow notified that additional filings or documents are needed to complete the formation of their entity. Even some business owners that have an attorney form their company correctly initially often fail to keep up the required formalities. The problem with stopping at filing your Articles, or even your initial formation documents, is that if you do not treat the corporation or LLC properly, then the courts can do what is called “piercing the corporate veil” and look through the company to the business owners for liabilities of the business.

Some of the basic formalities required in order for the courts to maintain the liability shield of a corporation include:

• Holding annual meetings of the shareholders and the board of directors.
• Maintaining the corporate minute book, including organizational minutes, corporate resolutions authorizing or ratifying major decisions, and minutes of annual shareholders and board meetings.

• Issuing and canceling stock certificates as appropriate and maintaining an accurate stock ledger.

For both corporations and limited liability companies, requirements include:

• Having bylaws for a corporation or an operating agreement for an LLC.
• Not commingling funds with personal funds or funds of another entity, including maintaining separate bank accounts, paying company expenses out of the company only, and not running individual expenses through the company.
• Making required Secretary of State filings.
• Filing federal and state business tax returns.
• Making required federal and state securities filings

An Incomplete or Improperly Formed Corporation or Limited Liability Company Can Hurt Your Silicon Valley Business in Several Ways, Part I: Estate Planning

February 7, 2011 | Structure Law Group, LLP

I recently met with a new client from San Jose whose father was dying. My client’s father owned a small business and was a director and officer of that company. There were two immediate issues for us to deal with. First, the corporate minute book was a mess and we needed to clean up the stock certificates and minutes of the board and shareholder meetings quickly to make sure they actually said what my client’s dad intended. Second, we needed to re-title several assets that were supposed to be in the corporation but were not currently titled that way, including some real property in Campbell.

Why is the minute book important? In this case, the share certificates were inconsistent and did not agree with the Articles of Incorporation or the stock ledger. This could result in a shareholder dispute as to ownership of the company and voting control. Also, there were no minutes for the last five years. Without minutes of the shareholders and the board of directors, the corporation was risking its liability shield. [See Part II of this Article for more about Liability Protection.]

Why is the title of the assets important? Assets owned by the corporation should be in the name of the corporation and not held personally by a shareholder. In this case, assets were in dad’s name but he had always treated them as owned by the corporation. So, if dad died and left the corporation to his son, he was intending those assets go with it. But, those key assets of the company would not be included in an inheritance that leaves the corporation to the son and the other assets to other beneficiaries. In addition, property that is not titled in the name of the corporation might not carry the liability protection of the corporation in case of a lawsuit. [See Part II for more about Liability Protection.]

Finding a Buyer for Your Business: Dating Silicon Valley Style

January 31, 2011 | Structure Law Group, LLP

Finding a buyer for the sale of a business is a lot like dating. Your prospects and your ultimate happiness increases with the number of people you meet. Whether you cruise the bars in San Jose, or schmooze partners at a trade show in San Francisco, building interest in your company is a critical step in finding buyers.

One of the key tools used in building business acquisition interest is a set of documentation often referred to as a “book”. The book will describe the business, the industry, and the potential for growth. It may also include financial statements, projections, and risk factors.

The content of the book must be considered carefully. Financial projections should be accompanied by appropriate disclaimers, and competitive and other risks to the business post-sale should be outlined. If the sales transaction is in the high tens of millions of dollars, language stating that an acquisition could reduce competition or permit other forms of market dominance should be avoided.

Bankers, Brokers and Finders, Oh My – Part 2

January 17, 2011 | Structure Law Group, LLP

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.