Articles Posted in Corporations

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Although most of my career as a merger and acquisition and corporate lawyer has been spent in San Jose, issues involving earnouts do not have geographic boundaries. While many companies are acquired for their team or their technology, other companies are acquired because they make money for their stockholders. Earnouts provide an opportunity for a buyer to be assured that the company it has just bought will meet its objectives for the deal.

To construct an earnout that measures a company’s success in making money, a tension arises between allowing the selling company to operate on its own, thereby mimicking its performance as it existed before it was sold, and integrating the seller’s operations with the buyer. Buyers will want to integrate the seller as quickly as possible, but doing so will prevent the parties from determining how well the seller itself is performing.

The most important issue to determine is how profits will be calculated. As discussed in a previous blog, issues involving the use of GAAP become much more important as more revenue and expense items are measured. A detailed approach to calculating profits will help reduce disputes and provide guidance for the seller’s managers to use in maximizing the earnout.

Earnouts constructed to measure profits typically require the seller to operate as a separate division, or even a separate entity. To take advantage of synergies, some operations are centralized with the buyer, such as finance and administration. The first area of dispute involves the manner in which administrative overhead, and the type of overhead, will be charged against the earnout. Outside of textbook ratios, there is no magic number and the result is usually reached through negotiation.

Often sales forces are consolidated, and the allocation of sales-related expenses and commissions can be very difficult, especially when the buyer’s existing sales department is leveraged to produce sales for the seller. As with overhead, there are no easy answers and the approaches ultimately used are reached through negotiation.

Because of their complexity, earnout amounts are often disputed. Because of this, care must be taken to create an appropriate dispute resolution mechanism. Regardless of the dispute resolution process used for the acquisition agreement as a whole, arbitrating any earnout disputes has a number of advantages. First, the arbiter, or arbiters, can be specified as having expertise in accounting issues, or even in calculating earnouts. Relevant industry experience can be listed as a necessary attribute. Second, the arbitration can focus solely on determining the arbitration amount. Third, the parties can be required to go through nonbinding mediation. If successful, mediation can avoid the expense of an arbitration proceeding. Fourth, the proceedings can be kept confidential.

Earnouts, especially those based on profits, can be very complex and prone to dispute. Because of this, care must be taken by all parties to create a mechanism that will adequately measure performance while minimizing the opportunity for controversy.

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I recently taught a program to California lawyers for the Santa Clara County Bar Association concerning B corporations, a subject I covered in a previous blog. As a Silicon Valley business attorney, with an increasing number of clients forming new companies, I want to discuss some attributes of these corporations that should be considered by anyone starting a new business.

The first consideration is whether becoming a B corporation will assist in a company’s funding and operations. B corporations arise from a national movement to allow companies to consider factors other than just profits and shareholder value in making their decisions. Certain types of investors and employees are drawn to companies that share similar values. Because of the attractiveness of value-driven organizations to these constituencies, start-up companies should strongly consider whether becoming a B corporation can provide them with a unique story when soliciting investment, and an edge when recruiting employees.

The second consideration is whether the goods or services “fit” with the concept of a B corporation. Fortunately, a B corporation does not necessarily need to exist solely to pursue its social goal. Almost any business can be a B corporation if it adopts the kind of public purpose that is required under one of California’s two B corporation statutes. For a “benefit corporation“, the purpose needs to one which creates a material positive impact on society and the environment, taken as a whole. For the “flexible purpose corporation”, the purpose needs to be one which could be pursued by a California nonprofit benefit corporation, or one which promotes or mitigates the effect of the corporation’s activities on the corporation’s stakeholder, the community or society, or the environment. The open ended nature of these purposes allows a wide variety of businesses to organize as a B corporation.

Because California created two different types of B corporations, you will need to consider which type of B corporation your new company should form. One way to approach this decision is to ask yourself how much the corporation should be forced to consider its public purpose. In the “benefit corporation”, the board of directors MUST consider the impacts of any action on the company in the short term and long term, and its shareholders, employees, customer, community, and environment, and its ability to accomplish its public purpose. This will force the board to deliberate very carefully, and will require your counsel to prepare corporate documentation carefully to record the board’s deliberations. By contrast, the “flexible purpose corporation” merely allows the board to consider its public purpose when making decisions, but does not require that furthering the purpose be a component of its decision.

In making your decision to conduct your business using a B corporation, you can avoid some common misconceptions. One common myth is that a B corporation needs to be certified. There is nothing in any of California’s B corporation laws that require any type of third party certification. There is, in the “benefit corporation”, a need to compare the efforts toward meeting public purpose to a third party standard, but this falls short of requiring actual certification. Another common question that often arises is whether B corporations are taxed differently. At this time, they are not. Of course, a B corporation does not need to be a nonprofit corporation for tax purposes.

In a future blog, I will cover one of the most critical considerations you face when adopting a B corporation – the disclosure of your company’s activities.

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As a corporate and business lawyer in San Jose, I have been busy speaking with Silicon Valley business owners about a recent California law affecting companies that have misclassified employees as independent contractors. When the 2008 economic crisis hit, large high tech companies and small start-ups in San Jose, Santa Clara and Sunnyvale, among other cities, adapted by hiring workers as independent contractors to avoid paying payroll taxes and offering benefits to the new hires. Unfortunately, some companies may have inadvertently misclassified employees as independent contractors.

There has been a lot of publicity around the new IRS program allowing businesses to voluntarily correct the misclassification and pay only a low penalty. However, there has not been quite as much news about the recent California law (Senate Bill 459 signed into law by Governor Brown in October, 2011) which makes the willful misclassification of employees and independent contractors illegal and subject to severe penalties. Under the California law, the Labor Commissioner can impose penalties not just on the employer, but also on the employer’s accountant or other paid advisor (other than employees or attorneys). These penalties range from $5,000 to $15,000 for each misclassified person, or $10,000 to $25,000 per violation if there is a “pattern and practice” of violations. There are still more penalties for employers that charge their misclassified employees a deduction against wages for any purpose (including space rent, goods, materials, services, equipment maintenance, etc.), which is considered as another attempt to wrongfully treat them as independent contractors.

What does “Willful Misclassification” Mean?

The definition of willful misclassification in the law is: “avoiding employee status for an individual by voluntarily and knowingly misclassifying that individual as an independent contractor.” (California Labor Code Section 226.8 (i)(4).)

Contractors Beware

The labor agency is required to notify the Contractors State License Board if a contractor is determined to have willfully misclassified workers, and the new law requires the Contractors State License Board to initiate discipline against the contractor.

Everyone Beware

The new law also provides for public embarrassment by requiring employers who have willfully misclassified employees and independent contractors to prominently display a notice on their website (or if they do not have a website, then in an area accessible to all employees and the general public) saying that they have committed a serious violation of the law by willfully misclassifying employees, that they have changed their business practices so as not to do it again, that any employee who thinks they may be misclassified may contact the Labor and Workforce Development Agency (with contact information), and that the notice is being posted by state order.

It is not just the employer that needs to worry about misclassification. If you provide paid advice to an employer, knowingly advising the company to treat a worker as an independent contractor to avoid employee status, you can be held jointly and severally liable for the misclassification. This rule does not apply to business lawyers like myself, because attorneys providing legal advice are exempt from this liability, as are people who work for the company and provide advice to the employer.

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As a Silicon Valley business attorney, I often help small businesses and start-up companies in San Jose and Santa Clara with their financing transactions. Whether my client is a newly formed software corporation getting capitalization from its founders or an existing company trying to raise money by making a preferred stock offering, as my client’s business lawyer, I need to counsel them in their fundraising efforts to ensure that the company complies with securities laws.

However, a bill recently introduced in the California State Senate will make it harder for small businesses and start-up companies to raise money in California. The bill, SB 978, could eliminate a securities exemption commonly used in fundraising transactions and expose a company to fines, and its controlling persons to individual liability, if a certain filing is not completed in time.

A little background is helpful to understand why this bill is such a disaster. Fundraising to start or grow a company requires compliance with both state and federal securities laws. If an offering violates the securities law, anyone who purchased the securities in that offering can rescind their purchase and get their money back. The aggrieved investor can look to the company for return of funds, or can look to any of its controlling persons individually. If you are considered to be a controlling person of a company that misses a securities filing deadline for an offering, your house may be on the line.

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In fiercely competitive Silicon Valley, businesses of all sizes must be on guard to prevent unfair competition. Unfair competition consists of business piracy, theft of trade secrets, and other dishonest or fraudulent acts in the course of business. As a business litigation lawyer in San Jose, I have seen companies initiate lawsuits against offending parties when unfair competition occurs. This blog focuses on unfair competition by competitors.

While corporate espionage and spying are known to occur, most businesses encounter unfair competition through less clandestine means, and from more familiar sources, such as prior business owners and trusted partners. For example, unfair competition can occur if the owner of a Thai restaurant sells his or her business with a non-compete clause, but then sets up a new competing restaurant across the street.

The key to successfully winning a lawsuit in each of these examples begins with a well-drafted non-compete agreement (or a “covenant not to compete”). So businesses should consult with a business lawyer to help them draft such an agreement. California generally disfavors agreements not to compete, and views restraints on engaging in a lawful profession, trade, or business as harmful to the state’s economy and the personal freedoms of its citizens. However, some agreements not to compete are recognized as valid under California law, including those relating to the sale of a business and the withdrawal of a partner.

In these instances, the key factors used to determine the validity of the non-compete agreement are its geography and duration. A business purchase agreement may include a clause stating that the seller agrees to refrain from operating a similar business within the specific geographic area that the purchased business operates. The duration of this agreement is usually limited to a number of years. The non-compete agreement protects the value of the purchased business – and serves to prevent the seller from selling his or her business today and then setting up shop next door tomorrow!

Similar rules apply to agreements not to compete as they relate to partnerships, and the courts have enforced agreements among partners in various professions, including physicians, accountants, and attorneys. In the case of professionals, non-compete agreements are typically enforced by requiring the competing partner to compensate his or her former partners to some extent at least for the business taken from them.

One of the benefits of a well-drafted non-compete agreement is that, if it is abided by the parties, it can prevent potentially costly litigation. If, however, litigation becomes necessary to enforce a non-compete agreement, the results of winning the subsequent unfair competition lawsuit can be twofold. First, the plaintiff may receive restitution for the money lost due to the defendant’s unfair competition activities, and may also be awarded any of the defendant’s ill-gotten gains. Second, if the plaintiff provides evidence showing a probability that the defendant will commit future violations of the unfair competition laws, an injunction may be issued ordering the defendant to curtail its unfair activities.

The injunction remedy stands in recognition of the fact that sometimes a defendant’s unlawful conduct will continually harm the plaintiff unless the defendant is stopped. Rather than require the plaintiff to file lawsuit after lawsuit in an exhausting effort to seek money damages, the injunction empowers the plaintiff to put a stop to the defendant’s unlawful activities once and for all.

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As a merger and acquisition lawyer in Silicon Valley, I have been involved in numerous business transactions, from small startups transferring their technologies after getting acquired by other companies, to medium-sized and larger technology and pharmaceutical companies going public. With Facebook’s impending IPO, many companies in San Jose, Sunnyvale, Santa Clara and Mountain View are expecting another technology boom. A company hoping to take advantage of the imminent dot-com boom and sell its business should make sure its books are in order and hire a good M&A attorney to prepare an acquisition agreement.

As discussed in my last blog, a seller will often make a number of commitments to a buyer concerning the seller’s business. These commitments, known as representations and warranties, allocate between the buyer and seller many of the risks existing in the seller’s business.

One of the most important documents accompanying the representations and warranties is a schedule that describes certain items requested to be disclosed, and any exceptions to the content of the representations and warranties. This document, which goes by “Schedule of Exceptions” or “Disclosure Schedule,” is really a description of the main documents and key agreements of the seller, and disclosures of material facts concerning the buyer and its operations. It can often take as much time to prepare and negotiate as the acquisition agreement itself. There are a number of things the seller can do to help expedite the preparation of this document.

First, keep good corporate records. As I discussed in my blog on due diligence, organizing the seller’s major documents, and making sure they are readily available, will considerably reduce the time to close the transaction.

Second, appoint someone who has intimate knowledge of the seller and its operations to assist in gathering requested documentation and answer the inevitable questions. Typically, the company’s chief financial officer or controller will fill this role.

Third, get all of the documents to the company’s attorney as soon as possible. The lawyers will need to review the documents and decide what types of schedules and disclosures will be required. This is a very time consuming process.

Fourth, discuss early on any areas where the company thinks a buyer might be concerned. This is not a time to sweep difficult issues under the rug, but a time to get them out in the open. There is nothing worse than being blind-sided at the last minute with the proverbial skeleton in the closet. Worse, failing to disclose difficult issues known to management can lead to a fraud claim, a claim for which the seller’s liability is never limited. Areas that raise concerns include any transactions between the seller and any of its insiders, litigation and threats of litigation, and accounting irregularities.

Fifth, start preparing the Disclosure Schedule as soon as possible. Attorneys that are experienced in acquisition transactions are aware of the likely representations that will be requested, and can start organizing and preparing the substance of the Disclosure Schedule even before the acquisition agreement is distributed. Delivering a completed Disclosure Schedule to buyer’s counsel sooner rather than later will surface any issues so they can be resolved in a timely manner.

Sixth, review the Disclosure Schedule with your attorney to determine if any issues exist that will delay closing. There are two major areas that need to be reviewed. The first is the approval that is required for the transaction to proceed. Almost always, this will involve approval by the board of directors and the shareholders of the Company. It may require preparation and delivery of a separate disclosure document to the shareholders to assist them in determining whether to approve the transaction. The second is the existence of any material agreements, desired by the buyer to operate the business, that require approval of the other party in order to close the transaction.

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Has your business been misclassifying workers as independent contractors? If so, you should pay special attention to a recent IRS announcement of its new program giving a break to employers who voluntarily correct such misclassifications. With Silicon Valley being a technology hub, there are thousands of computer programmers and engineers working as independent contractors in San Jose, Sunnyvale, and Mountain View. High-tech companies and start-ups that employ these individuals should carefully review their HR files to see if they have misclassified any employee. If a company discovers that it has wrongly classified an employee, it should then evaluate the IRS program to determine if the company should participate in the program.

In an earlier blog, I wrote about the importance of companies classifying their workers correctly in order to avoid substantial penalties and taxes. If your company may have misclassified workers, the new IRS program will let you voluntarily correct your errors and just pay a low penalty equal to 1.068% of compensation paid to those workers last year. IRS Announcement 2011-64 provides the details. To qualify for the IRS program, your company must not be under audit, and must have consistently treated the workers as contractors for the past three years. No reasonable basis for the previous misclassification is necessary. Going forward, you must treat the workers correctly as employees. The minimal penalty may be a good idea if you consider that the Labor Department and the IRS are beginning to share leads on misclassified workers. [Kiplinger Tax Letter September 30, 2011, Vol. 86, No. 20.]

However, there are some potential downsides in addition to having to pay the penalty. So, think twice before you come clean with the IRS. First, you will lose IRS Safe Harbor protection on those workers and they will always be treated as employees going forward. Second, as part of the deal, the IRS requires you to agree to extend the statute of limitations for an extra three years, meaning you can be audited for employment taxes and misclassifications for six years. Third, the California Employment Development Department (“EDD”) is not participating in the program, so it is not bound by the rules and will likely assess your identified workers for the full three year statutory period. And the EDD is likely to find out about your deal with the IRS because of their agreement with the IRS to share information, and because they will see your employer credit for paying unemployment taxes and it will not reconcile with your quarterly wage reporting, triggering an audit. [Spidell California Taxletter, vol. 33.11, November 1, 2011, pages 124-125.] California has some new misclassification penalties which are significant.

If you still feel that participating in the IRS program is a good idea and will help you sleep better at night because you have been misclassifying workers, think carefully about which workers do and do not need to be reported and re-classified. It may be that only some of your workers are misclassified, but once you claim them as employees under the new IRS program, you are stuck with that classification.

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Those endless representations and warranties in your acquisition agreement aren’t just for your merger and acquisition lawyer. Ignore them at your own risk.

Mergers and acquisitions in San Jose and elsewhere are a lot more complex than those of the past when deals were closed with a handshake. As acquisition documentation becomes more extensive, companies frequently turn to mergers and acquisitions attorneys to assist them with their transactions. One issue on which an attorney will focus deals with the representations and warranties of a seller.

A seller’s representations and warranties, which are the commitments that a seller will make to a buyer concerning the state of the seller’s business, make up one of the more extensive sections of an acquisition agreement and serve a number of functions. This is because they allocate between the buyer and seller many of the risks existing in the buyer’s business.

Representations allocate risk in a fairly straightforward manner. The seller will make a statement of fact regarding its business. If the seller’s statement is wrong, and the buyer is damaged as a result, the seller will compensate the buyer for any damages the buyer incurs.

An example helps illustrate the point. Let’s say that the seller states that it has paid all of its taxes, a very common representation. After the closing, the business that was sold gets hit with a sales tax audit, and is found to have underpaid its sales taxes. Because the seller’s representation was wrong (i.e., it hadn’t paid all of its taxes), the buyer, all other things being equal, can look to the seller for reimbursement for the amount of the additional sales tax liability.

The situation above describes the simplest form of risk allocation in an acquisition agreement. In this form, the seller bears the risk whether the seller knew there was a problem or not.

Some types of risk allocation shift risk only if the seller knew there was a problem. These representations, sometimes referred to as knowledge-qualified representations, allow a seller to escape liability in a representation if the seller did not know a problem existed.

In our sales tax example above, let’s say that the representation stated that the seller did not know of any nonpayment of taxes. Let’s also say that the seller’s officers were completely unaware that they had failed to pay any sales taxes. In that situation, the seller would not be liable for the sales tax liability.

Because acquisition agreements are prepared by lawyers, the concept of knowledge can mean different things. For example, does knowledge mean the subjective knowledge of the seller’s CEO, or the subjective knowledge of all of the seller’s employees? Does knowledge mean just what is in employees’ memories, or should employees be required to look through their files? If employees are required to look through files, should they also be required to look through other documentation, such as public records and other resources? For these reasons, it is critical that the concept of knowledge be defined so that the seller knows what they have to do to satisfy the representation, and both parties know how the risk is to be allocated.

What if the seller wants to allocate the risk of an item back to the buyer? When a seller makes a representation that he or she knows may not be entirely correct, the seller will disclose an “exception.” The seller provides this disclosure in a schedule commonly attached to acquisition agreements, known as a “disclosure schedule,” or a “schedule of exceptions.” Unless the agreement specifies otherwise, a buyer cannot recover for damages for an item that has been disclosed.

Going back to our sales tax example, if the seller knew there was a problem, the seller would describe the problem in a disclosure schedule. The seller would say something like “Seller underpaid its sales tax liability for the periods 2008 through 2010, which liability seller believes to be between $50,000 and $75,000.” The buyer could not thereafter bring a claim for reimbursement for the later assessed tax liability as a result of the seller’s disclosed exception.

As I mentioned above, representations and warranties, and their accompanying disclosures, are heavily negotiated. One point of contention is whether the risk of an item, even when disclosed, should be allocated to the buyer. Buyers with sufficient leverage will force the seller to remove the disclosed item, or affirmatively accept the risk associated with the item. Another point of contention is what the concept of knowledge means, and whether knowledge can qualify a particular representation. For these reasons, it is critical to spend a lot of time understanding the representations and warranties of any acquisition agreement so that you can understand the risks that may exist for you in a deal.

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

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

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With the new year comes new laws, and businesses in the San Jose area should be aware of the new California employment laws that are on the books in 2012. Ensuring compliance with these new laws is good for the bottom-line, as it will make for happy employees, who will in turn make for satisfied customers. Making sure that your business complies with the new laws put on the books each January 1st may help your company avoid employment-related litigation.
Hiring Practices
Starting in 2012, employers may no longer obtain consumer credit reports about employees and job applicants. There are exceptions to this law, particularly for positions requiring access to bank or credit card information and other personal information, positions that include access to $10,000 or more during the daily course of business, positions involving signatory authority, and management positions.
Also, at the time of hire, employers must now provide notice to new nonexempt employees of the following information: pay rate; overtime rate; form of pay (hourly, salary, commission, other); a list of allowances that are included as part of the minimum wage; name, principal address, and telephone number of the employer; and the regular pay day designated by the employer. The employer must provide written notice to employees within seven days of any changes to this information.
Finally, the penalty for willfully misclassifying employees as independent contractors is now between $5,000 and $25,000. This five-fold penalty increase underscores the importance of properly classifying new hires.
Employee Leave
All employers with five or more employees must maintain and pay for a group health plan for any eligible female employee who takes Pregnancy Disability Leave for up to a maximum of four months during a 12 month time period. These benefits must remain at the same level as though the employee had been working during the leave. These requirements extend beyond those of the federal Family and Medical Leave Act.
The law regarding organ and bone marrow donor leave has also been clarified for 2012. During a one year period, employees are allowed 30 days of leave for organ donation and 5 days of leave for bone marrow donation, with the law now stating that the leave days are to be calculated as business days.
Discrimination Law
The California Fair Employment and Housing Act (FEHA) has been amended to prohibit employers from discriminating against employees based on genetic information, including genetic tests of an employee or his or her family members, and the existence of a disease or disorder in family members of the employee. FEHA differs from a similar federal law in that FEHA applies to employers with five or more employees, while the federal law covers employers with 15 or more employees.
FEHA has also been updated to clarify that discrimination on the basis of gender identity or gender expression is prohibited. Previously, only the term gender identity was used. Gender expression is defined as, “a person’s gender-related appearance and behavior whether or not stereotypically associated with the person’s assigned sex at birth.” Employee dress codes must allow employees to dress in a manner consistent with both the employee’s gender identity and gender expression.
Additionally, health care service plans and health insurance policies issued to California residents must provide equal coverage to domestic partners as that provided to spouses. While this has been the standing policy in California, the new law ensures that employers located outside California and with a majority of employees located outside of California must comply with California law as it pertains to California residents.
Wage and Hour Laws
Employees alleging violations of the minimum wage may now recover liquidated damages as a result of a complaint heard before the Labor Commissioner. Liquidated damages, which serve to punish the employer, are permitted in an amount equal to the unpaid wages owed to the employee. Put simply, for every dollar an employee is awarded in unpaid wages, the Labor Commissioner is authorized to award an additional dollar in penalties. Previously, employees could receive liquidated damages only after filing a complaint in civil court.
In the prevailing wage arena, which applies to specified state or federal public works contracts, the minimum penalty for wage violations has been raised from $10 to $40 per day for each worker paid less than the prevailing wage, and the maximum has been raised from $50 to $200.

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

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