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As a business lawyer representing many closely held corporations, I often see shareholders elect board members without much thought, either because they are family members or employees of the business. The board of directors serves a very important management role for a corporation and the decision of who you put on the board should not be taken lightly. If an elected board member is no longer a good fit for your company, do not wait too long to replace him/her or you could be missing an opportunity to find a board member who will add value to your company.

Electing a Director

In most corporations, the bylaws provide that directors will be elected at each annual shareholders’ meeting and will hold office until the next annual shareholder meeting and until their successors are elected and qualified, unless they are removed from the board before that time. Each year when it is time to renew your board, make sure you stop to consider whether the same directors should continue serving the company, or if it is time for some new blood. It is much easier to not re-elect a director, than it is to remove one during his/her term.

Removing a Director

Directors can be removed for cause, which means the director being removed did something wrong. The board can declare a director’s seat to be vacant if that director is convicted of a felony or declared incompetent. A director can also be removed for cause by a court order, but the court will require at least 10% of the outstanding shares to petition for removal, and a showing of fraudulent or dishonest acts or gross abuse of authority by the director to be removed.

Shareholders may remove directors without cause if the removal is approved by a majority of the outstanding shares entitled to vote for the election of directors. However, no individual director can be removed over an objection by one or more shareholders who, collectively, have enough votes to elect that director under cumulative voting.

Filling a Vacancy on the Board

Generally, the shareholders are supposed to elect the board of directors. However, depending on how the seat was vacated, either the board itself, or the shareholders, can fill a vacant board seat. If a director dies, is incapacitated, or resigns, the remaining directors can usually appoint a replacement director (unless the corporate documents say otherwise). If a director is removed, the vacancy must be filled by the shareholders unless the corporate documents authorize the board to fill such a vacancy. In the event that a majority of the directors have been appointed by the board, there is a safeguard to make sure the shareholders have the ultimate authority. Holders of 5% or more of the outstanding shares may call a special meeting of the shareholders and elect an entirely new board.

Whether or not your entire board is in place, in order to maintain your corporate liability shield, the corporation must follow the statutory rules regarding regular and special board meetings for the board to make decisions on behalf of the company. The rules for board meetings will be covered in another blog.

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In my last blog concerning market entry into Silicon Valley by foreign companies, I discussed some of the basic issues and tasks surrounding the effort. As an attorney practicing corporate law and representing technology startup companies, I am often asked to assist in designing and implementing the legal structures that enable a foreign-owned company to access the US market.

There are a number of factors that guide a company’s decision to enter the US market. First, what is it trying to sell? Second, does the company hope to generate its return on investment through a cash-flow from sales, or by building value and ultimately selling the company or taking it public? Third, does it need funding from US private investors? Let’s look at how each of these factors guide entity form.

The first factor focuses on the best method for product distribution. If the company is trying to sell simple, commodity type products using an established distribution network, it may be able to get by with no entity at all. In other words, it can sell its products directly into the US through a distributor or independent sales representative. Even if the product is complex, but does not require a sophisticated domestic marketing, sales, or support organization, an independent sales representative could be used.

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Silicon Valley is a magnet for foreign technology companies seeking to expand their offerings into the US market. As a San Jose-based attorney specializing in corporate law, I have seen an uptick in US-based management talent being solicited by foreign companies to help the companies start up their US operations. When faced with the question of what to do, many of the same issues arise in structuring the US market entry of foreign-owned companies.

The first issue is why the company is coming to the United States in the first place. If the company merely wants to sell widgets, it may be able to make do with a simple contractual relationship with a sales professional or distributor. If, on the other hand, the company wants to access US management talent and venture investors, it might look at reorganizing, or flipping-up, its legal headquarters into the US.

The second issue involves taxes. If the company is a mature company and expects to generate significant revenue from its US operations, there are a number of tax planning opportunities that may enable the company to minimize its international tax burden. Understanding the company’s existing structure and its goals, and designing an appropriate corporate and technology ownership and use structure is a necessary task. It can, however, be an expensive undertaking depending on the nature of the company and its products and services.

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As a corporate lawyer representing small businesses here in San Jose and throughout Silicon Valley, I often need to walk my clients through the process of forming a corporation, whether in California, Delaware, or another state, but also the ongoing requirements of maintaining their corporation. It is important to remember that California law provides limited liability to shareholders, so long as the corporation is treated appropriately. When corporate formalities are not followed, creditors and claimants can “pierce the corporate veil” to allow for a judgment against shareholders for a liability that should only have been an obligation of the corporation. One of the most important corporate formalities is the shareholder meeting.

Every California corporation is required to have an annual meeting of the shareholders, and can have additional ‘special’ meetings at any other time when properly called. In order to hold a proper meeting, the meeting must be properly called, noticed, and held. This is a general roadmap on how to do that, but any corporation is subject to the specifics of its corporate documents and should only rely on legal counsel familiar with its documents for requirements specific to its company.

When should the annual shareholder meeting be held?

The annual meeting should be held on a date and time that is stated in the bylaws. Recently I began representing a client that controlled multiple different corporations formed by his previous corporate attorney. Each of the corporations had a different annual meeting date, making it much more difficult for the client to remember to hold his meetings on time. We held a special meeting of the shareholders to amend the bylaws of each corporation to have the meetings on the same date, and then held the meetings back to back in his office. In this case, the shareholders and the board of directors were essentially the same people, so we actually noticed and held a joint annual meeting.

What action is required at the annual shareholder meeting?

The only action required to be taken by the shareholders at an annual meeting is the election of the board of directors. Any other proper business may also be acted upon, so long as it was included in the meeting notice.

Required Notice – What should the notice say?

All shareholders who are entitled to vote are entitled to written notice of the annual meeting (and any special meeting). The bylaws cannot override this requirement. However, most of the time, my small business clients with closely held corporations hold their meetings without formal notice, and we just have the shareholders sign a written waiver of the notice requirement at the meeting. Of course, you should not depend on this if there is any hint of a potential disagreement between the shareholders. Otherwise, a disagreeable shareholder could refuse to waive the notice requirement, and delay or block the shareholders from taking any action at the meeting.

The notice to shareholders must include the date, time and place of the meeting, and whether shareholders can attend by telephone or electronic meeting. For annual meetings, or any other meetings where directors will be elected, the notice must also state the names of the persons nominated for the election. Any other matters the board intends to present to the shareholders for any action at an annual meeting must also be stated in the notice. Although at an annual meeting the shareholders may still be able to act on a matter that was not included in the notice, certain matters may require the unanimous vote of the shareholders, including those not attending the meeting, if the shareholders were not given notice of them in advance.

At a special meeting, the shareholders are not allowed to act on business not included in the notice unless all shareholders provide written waiver of notice for that matter. For this reason, if the corporation has any adverse interests among its shareholder, I recommend that a very specific agenda be provided with the notice of any special meeting. The safest method is to provide the actual language of proposals the board will be presenting to the shareholders at the meeting.

In addition to providing notice before the meeting, in California the corporation must provide an annual financial report to the shareholders at least 15 days before the annual meeting, and no later than 120 days after the end of the corporation’s fiscal year. However, if the corporation has less than 100 shareholders, this requirement can be waived in the bylaws.

Required Notice – How do you give notice?

You should always check to see what the corporation’s bylaws say about notice, but for most corporations, notice can be given by first class mail, in person, or by electronic delivery such as facsimile or e-mail. Notice should go to the address or contact information provided by the shareholder to the corporation. If you do not have an address, or if the electronic notice gets rejected twice, you can mail the notice to the shareholder care of the corporation at its principal executive office, or you can publish it in a local newspaper. In other words, if you cannot find a shareholder you do not have a legal requirement to spend your time looking for them.

The corporation is considered to have provided notice as of the date it mails the notice, or delivers it personally, by fax or electronically. I recommend that the secretary of the corporation sign an affidavit of mailing or electronic transmission for the corporate minute book. I may be able to provide notice and sign the affidavit as the transfer agent for corporations that are my clients.

Required Notice – When should it go out?

Written notice of a shareholder meeting must be given no less than 10 days and no more than 60 days before the scheduled meeting. Corporations will often provide at least 15 days notice so that the annual financial report can be sent to the shareholders at the same time.

Improper Notice

As I mentioned earlier, shareholders can waive the required meeting notice if they did not get notice, or they can waive any problem with the notice they received. If a shareholder does not attend a meeting, they can waive notice in writing either before or after the meeting. If a shareholder shows up at a meeting and does not actually object to the improper notice at the beginning of the meeting, the shareholder is deemed to have waived the notice requirement. However, a shareholder can still object at any time during the meeting if a matter is raised that was not included in the meeting notice. Be very careful about the content of the waiver. Although usually the waiver does not have to include information about what was supposed to be considered at the meeting, certain matters do require a more specific waiver, otherwise unanimous vote of the shareholders may be required on those matters.

Once a company has set a date for its shareholder meeting and either provided proper notice or had the notice requirement waived, the company must now determine who has the right to vote at that meeting, and what votes are required.

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As a business litigation attorney in San Jose, I am always concerned when clients are confronted with murky or unclear regulations. For many years, employers have been awaiting clarity on California’s confusing meal and rest break laws. There has been uncertainty as to whether employers must force their non-exempt employees to take their meal breaks, or whether the employer meets its obligations by simply providing employees the opportunity to take their breaks. The California Supreme Court very recently provided much needed clarification on this important employment law issue in the case of Brinker Restaurant Corporation v. Superior Court of San Diego County.

The Court also addressed the proper method to calculate the timing of both meal and rest breaks, putting an end to the guessing game of how many breaks must be provided, and when the breaks must be given.

Employers Do Not Need To Police Employees During Meal Breaks

The Court decided that employers, while under a legal duty to provide meal breaks at appropriate intervals, are not obligated to ensure that employees do no work while on their breaks. The employer’s obligation is simply to relieve its employees of their work duties, relinquish control over the employee’s activities, and permit the employee a reasonable opportunity to take an uninterrupted 30-minute break. Of course, the employer must not impede or discourage the employee from taking the provided break.

Also of great importance was that the Court stated quite clearly that employers are not required to police meal breaks to ensure that no work is performed during the break. In fact, employees are free to work during their meal break, if they decide to do so.

Timing of Meal Breaks

The Court also provided clear guidance on the timing of meal breaks. The first meal break must be provided no later than the end of an employee’s fifth hour of work. A second meal period must be provided no later than an employee’s 10th hour of work. Meal periods can be scheduled prior to the end of the fifth hour of work, including in the first hour of work, and can occur before the first rest break.

Timing of Rest Breaks

The case also clarified when employees are entitled to rest breaks. Employees must be given one 10-minute rest break for shifts from three and one-half to six hours in length, two 10-minute rest breaks for shifts of more than six and up to 10 hours in length, and three 10-minute rest breaks for shifts more than 10 hours and up to 14 hours in length. Employees who work less than three and one-half hours are not entitled to a rest break. The Court also stated that there is no requirement for an employer to give a rest break before a meal break.

Overall, the business community and employer-side employment attorneys view the Brinker case as a common sense legal opinion that offers clear guidelines for handling employee meal and rest breaks. Furthermore, the case may have the effect of curtailing potential class-action lawsuits against California businesses that, prior to the Court’s ruling, could have been accused of meal and rest break violations.

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I recently taught a program in San Jose to lawyers concerning California B corporations, a subject I covered in prior blogs. As a corporate lawyer, I have been asked by current and prospective business owners whether this new type of entity was the right choice of entity for them. B corporations were created to enable a for-profit company to include as a criteria in its management decisions its pursuit of a public purpose. The B corporation, however, must disclose its public purpose activities.

California recently created two types of B corporations, a “Benefit Corporation” and a “Flexible Purpose Corporation”. Although there are a number of differences between the two, each requires that a company list in its formation documents that it is devoted, among other things, to a public purpose. Each type of B corporation must also discuss its activities directed toward satisfying its public purpose. Each type of B corporation must also post the required disclosure on its website, although financial or proprietary information can be excluded in the website posting, and the company must send the disclosure to its shareholders within 120 days after its fiscal year end. If the disclosure is not posted on its website, a free copy must be made available to anyone, in the case of the Benefit Corporation, or must be made available to anyone through “similar electronic means,” in the case of the Flexible Benefit Corporation.

Benefit Corporation Disclosures

The content of the disclosure differs with the type of B corporation. The Benefit Corporation must provide an Annual Benefit Report. In the report, the company must discuss the process and rationale behind choosing the third party standard which it uses to assess performance toward providing a public benefit. The company must also explain how it pursued the benefit, the extent to which the benefit was achieved, and the circumstances that hindered achievement. Last, the company must list the names of all persons owning 5% or more of the Benefit Corporation’s outstanding stock.

Flexible Purpose Corporation

The disclosure requirements of a Flexible Purpose Corporation roughly parallel those that exist for publicly held companies. The company must provide a Special Purpose Management Discussion and Analysis. The Special Purpose MD&A must identify and discuss short and long term objectives relative to its special purpose, and any changes made during the prior fiscal year. Among other things, the company must also disclose the material operating and capital expenditures required over the next three years to achieve its purpose.

In addition to the annual Special Purpose MD&A, a Special Purpose Current Report must be disclosed no later than 45 days after certain events have occurred. These events include such things as making or withholding a material operating and capital expenditure for achieving the corporation’s purpose, or a determination that the special purpose has been satisfied or should no longer be pursued. Because the law is so new, the extent of the disclosure required is a bit unclear, and best practices are expected to develop that will serve as the basis for a presumption that disclosure is complete.

One “advantage” of the Flexible Purpose Corporation, as opposed to the Benefit Corporation, is that the disclosure can be waived, but it is tricky. The waiver option only exists for corporations with less than 100 holders of record. Holders of 2/3 of the shares of record must waive the disclosure requirements, and the waiver must be provided annually within set time limits. The waiver is also revocable. Disclosure cannot be waived for a Benefit Corporation.

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As a Silicon Valley business lawyer, I have many clients that are limited liability companies, partnerships, and corporations which own real property in California. It is common knowledge that when property changes hands in California, the property will be reassessed (unless an exception applies). However, people often forget that similar rules apply for business entities like corporations, partnerships and LLCs that own real property, when interests in the business entity change hands. As of January 1, 2012 there are some new rules and some higher penalties regarding reporting a change of ownership or control of real property in California. The required period for reporting has been extended from 45 to 90 days. The maximum penalty is now $5,000 for property eligible for the homeowners’ exemption and $20,000 for property not eligible for the homeowners’ exemption.

A change of ownership can happen in one of two ways:

1. Change in Control of a Legal Entity: If real property is owned by an entity and any person or entity gains control of that entity through direct or indirect ownership of more than 50% of the voting stock of a corporation or a majority interest in a partnership or LLC, the real property owned by that entity is considered to have undergone a change in ownership and must be reappraised.

2. Cumulative Transfers by Original Co-Owners: If real property is owned by an entity and over time voting stock or ownership interests representing more than 50% of the total interests are transferred by the original co-owners (in one or more transactions), the real property owned by that entity is considered to have undergone a change in ownership and must be reappraised.

There is no change of ownership when the direct or indirect proportional interests of the transferors and transferees do not change.

For legal entity transfers, the Form BOE-100-B Statement of Change in Control and Ownership of Legal Entities must be filed with the Board of Equalization in three circumstances. The personal or legal entity acquiring control of an entity must file when there is a change in control and the legal entity owned California real property on the date of the change. The entity must file when there is a change in control and it owns California real property. An entity must file upon request by the Board of Equalization. Source: Spidell’s California Taxletter, Volume 34.2, February 1, 2012

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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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Whether you are negotiating an acquisition in Silicon Valley or Small Town, USA, a part of the purchase price is often deferred. I have discussed in prior blogs those portions of the purchase price that are held back to reduce the buyer’s risk of liabilities and issues with post-closing audits. In future blogs, I will discuss a common purchase price deferral that will pay the seller based on the performance of the business AFTER it is sold, often called a contingent purchase price, or an “earnout.”

An earnout serves two purposes. First, it can bridge a valuation gap that may exist between the buyer and the seller. In a sense, the buyer is saying “If your business is worth that much, prove it.” Second, the buyer uses an earnout to protect against risks arising out of everything from insufficient due diligence to difficulty in integrating operations, that the ultimate value will be less than the purchase price.

There are a number of advisors, in addition to a merger and acquisition attorney, that are critical to creating an accurate earnout. First among equals is a CPA. An experienced CPA should be brought in early and often to provide advice concerning the general nature of generally accepted accounting principles (“GAAP”), where interpretations can vary, and how the parties have recognized revenue and expense items and the extent to which they differ. The second is both the buyer’s and seller’s accounting departments. Managing an earnout requires specific knowledge of the accounting functions of the parties involved, and many disputes can be avoided by understanding each party’s processes and how they are to be managed through the earnout period.

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