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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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As a business litigation lawyer in Silicon Valley, I have seen quite a few employee-related issues come up for businesses in San Jose and Santa Clara. For the purpose of this blog, I have combined issues of several clients into one hypothetical owner of a small Internet company. The owner discovered that one of her employees had started a competing online business and was attempting to staff the new business with her current employees. The owner was justifiably concerned as to whether her employee’s acts were illegal, and whether she, as employer, had any recourse. This blog summarizes some of the litigation issues businesses face when employees take actions that violate California’s unfair competition laws. Click here to read my previous blog on unfair competition by competitors.

The owner’s biggest problem was the fact that her employees were being solicited to work elsewhere. Like many small business owners, this owner had worked hard to create a business staffed by well-trained employees who provided customers with excellent goods and services. The deliberate effort by the company’s existing employee to pick up her other employees caused the owner undue stress and frustration.

The soliciting employee in this case was clearly in the wrong. Under California law, while working for a company, an employee cannot solicit fellow employees to leave that company and work for a competitor. To do so is a breach of a confidential relationship, a breach of an implied obligation, and possibly even a breach of fiduciary duty, depending on the soliciting employee’s position. Where the employee is a fiduciary, liability for unfair competition may also extend to the hiring competitor if it knows of the employee’s actions and benefits from them.

While the owner provided a top-notch online service with an established and growing customer base, she was also concerned about her employee’s competing web site. California law permits an employee to make some preparations to establish a competing business while employed. However, the employer may have good cause to terminate the employee if the acts by that employee to establish the business are such that the employee cannot give his or her undivided loyalty to the employer. Once an employee ceases work, the employee may go into direct competition with his now-former employer.

It is also important to note that employers may also sue former employees who misappropriate their ex-employer’s proprietary information or trade secrets. For example, businesses expend a great amount of time, effort, and money in developing customer lists. Such lists are often the most valuable asset a company a may have, and can qualify as both proprietary information and a protected trade secret. Under California law, an employee may not take an employer’s protected customer address list and then begin directly soliciting the customers.

However, to qualify as protected information, the customer list should contain specific information not generally known to the public or competitors. This information might include names of contact personnel, history of previous dealings with the customer, price quotes provided to the customer, and other particular information. A company should also maintain its customer list in a confidential manner. The more rigorous a business attempts to maintain the secrecy of its customer list, e.g. informing employees of the confidential nature of the information, protecting the information with passwords, including notices that the information is proprietary, and other steps, the more likely the court will be to find that the customer list qualifies as proprietary information or a trade secret. A non-solicitation clause in an employment contract, restricting the employee from soliciting the employer’s customers for a certain period of time after leaving, may bolster an employer’s argument that the employee cannot lawfully use the customer list.

Trade secrets, of course, are not limited to customer lists, and include a wide variety of formats, such as business plans, bid specifications, software code, and other documents and information. Such documents and information should be proactively protected by businesses, in case an instance occurs where litigation arises due to an employee’s misappropriation of trade secrets, or other acts of unfair competition.

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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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As a Silicon Valley small business attorney, I am regularly helping new clients with choosing their form of entity. Almost as often, I am asked to help new clients complete entity formations that they did themselves on-line. Much too often I have to tell these small business owners that their intent to save money by forming the entity on-line is going to cost them a lot more money because they picked the wrong entity for their business and we need to dissolve it and form a new one. More than once I have had licensed California contractors come to me to complete the California LLCs they formed, only to have to tell them that they are not eligible to be LLCs. There was even more confusion when the LLC law changed as of January 1, 2011 to allow LLCs to be licensed as contractors, but the Contractor State License Board was not licensing LLCs.

Back in January 2011 I wrote about the change to the California Limited Liability Company Act to allow contractors to operate as LLCs. However, until now contractors could not actually form as LLCs because the California Contractor State License Board had not yet changed their rules to allow the issuance of licenses to LLCs. Finally, the Contractor State License Board is now authorized to issue a contractor’s license to an LLC.

Keep in mind that if you are going to operate as a licensed contractor in an LLC, your business will be subject to additional liability and insurance requirements. A contractor-LLC must either have a $1,000,000 insurance policy, or put $1,000,000 in cash into an escrow or deposit account. If the contractor-LLC has more than five employees, it must have an additional $100,000 of insurance or deposits for each employee (not including the first five), up to a maximum of $5,000,000.

It is also crucial to make sure your contractor-LLC stays in good standing with the California Secretary of State. In the event the licensed contractor-LLC is suspended at any time, each member who is a licensed contractor will be personally liable for up to $1,000,000 in damages as a result of the licensed activities of the LLC during a time in which it is suspended. Since one of the main reasons you would operate in an LLC is to insulate the members from personal liability, make sure you have a good LLC lawyer, or a business lawyer that is very experienced with forming and maintaining LLCs, that will remind you to file your statement of information when due, and a good accountant who will make sure your California income tax returns are filed on time and the LLC’s franchise taxes and gross receipts fees are paid when due.

Source: Spidell’s California Taxletter, Feb. 1, 2012, vol 34.2 p 16.

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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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