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

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

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

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

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

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

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

For both corporations and limited liability companies, requirements include:

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

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Because acquisition transactions in Silicon Valley move very quickly, it is a good idea to understand the basics of deal structure. Every approach contains trade-offs among a number of different factors, including ease of closing, tax impact, risk preferences, third party involvement, and regulatory issues. This post examines the asset purchase structure.

Asset purchase agreements are used when the buyer does not want to assume any liabilities of the seller, except for those specifically outlined in the agreement (and those from which applicable law does not permit the buyer to escape). This structure is typically used for small owner-operator businesses, such as restaurants, retail establishments, and small service or manufacturing businesses. It can also be used where actual, or a fear of, residual liabilities exist, such as with businesses performing hazardous operations.

In addition to their liability-limiting feature, asset purchase transactions can provide tax benefits to the buyer. For example, some of the assets purchased in the transaction can be depreciated over time.

The tax impact may of the transaction, however, require attention and negotiation. Assets which are not intended for resale may be subject to sales tax. Although the seller is liable for any sales tax in California, parties often negotiate and apportion this liability in sale documentation. Because different types of assets and obligations create different tax obligations, parties are required to agree to an allocation of the assets purchased to particular classes and report the allocations to the taxing authorities.

Special tasks face buyers purchasing a restaurant or a company which principally sells merchandise from stock. In these cases, a buyer, in cooperation with the seller, will make a “bulk sales” notice. If the buyer fails to do so, the buyer may be liable for claims of the purchased company, even if the buyer merely purchased the company’s assets.

Assets can be purchased with cash or stock. If stock is used, securities laws must be complied with, which can increase expense and time to close a sale. If a mixture of cash and stock is used, tax impacts might arise in corporate transactions depending on the relative proportion of each component.

Asset transactions create administrative burdens. All assets must be listed and accounted for. This often requires taking a physical inventory and making adjustments if the inventory predates the closing. If the business has valuable contracts, the contracts need to be reviewed to determine if they can be assigned to the buyer. If not, the other party to the contract may need to consent to the assignment, a potentially time consuming and frustrating process.

Because only assets are being purchased, employees of the purchased business may have to be terminated. Any employees with accrued vacation will have to be paid that vacation. The buyer will then have the option to hire those employees back, or bring in its own employees. For companies with a large number of employees which expect to close facilities after the acquisition, federal and California law may require advance notification to affected employees.

Asset deals provide the best liability limitation for buyers. However, their complexity may render them unwieldy for larger transactions and their use should be explored prior to committing to any sale.

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

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

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

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

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

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

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Two recent conversations have reminded me of the importance of separating business enterprises for liability protection. I was helping a Sunnyvale real estate investor negotiate a commercial loan extension with a bank, and was thrilled that we had planned well in the past to separate all of his major properties into separate LLCs. It gave the bank a lot less power in negotiating against us – my client’s other properties were safe from this potential liability, but could be used as additional collateral if he chose to do so. At the same time, I was talking to a Mountain View manufacturing client about the risk of a potential employee lawsuit and realized that, due to some bad advice in the past that my client got from another advisor, he was holding real estate in the corporation thereby making the real estate subject to any liabilities of the company.

The example I often use is that each of your business enterprises or major assets is like a domino. Putting all of your dominoes in one entity means that a single domino falling can knock the others down too. Separating your dominoes into multiple entities means that if one entity is subjected to a lawsuit, the assets in the other entities should be insulated. Therefore, if my Mountain View client is faced with a large judgment on his employee problem, thanks to the appreciation in the real estate, the company looks like a really deep pocket.

Deciding how many entities to form, and how to separate your assets, is a complex cost/benefit analysis that depends highly on your level of comfort with risk. A good rule of thumb is to separate unrelated businesses (such as manufacturing and real estate, operating companies and investments). For real estate, consider grouping properties by the level of liability and the equity in each property, as well as the location of the properties. Also check with your professional advisors, such as your attorney and CPA, for liability, tax and insurance issues that could affect your decision.

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In my San Jose law practice, I often meet with clients who tell me they want to form a certain type of entity, and then proceed to tell me some facts that actually disqualify them from that form of entity. Even worse is when the client tells me that some other advisor told them they should be that form of entity. Recently, I met with a Cupertino real estate investor who said his financial advisor told him he should form an LLP for his property (he was not eligible to be an LLP). In Silicon Valley, we have a lot of do-it-yourselfers who form their own company online and then regret their ill-informed choice of entity and have to pay an attorney a lot more to fix the problem than they would have paid to do it right in the first place.

Here are some basic facts about LPs, LLPs and LLCs in California to help you make a more knowledgeable initial decision.

LP: This stands for “Limited Partnership.” In a limited partnership, at least one partner must be a general partner, which means that partner will be personally responsible for any liabilities of the partnership, as well as partnership decisions. The limited partners are not responsible for partnership liabilities, but also do not have any say in the management of the partnership.

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As usual, January is a time when people think about getting their business in order and consider the ‘choice of entity’ question. Already this month I have received calls from two contractors, one from San Jose and one from Sunnyvale, who want to form an entity for their construction business. I was able to give them the news that, as of January 1, 2011, the California Corporations Code finally allows a California limited liability company (“LLC”) to operate as a licensed contractor. However, the Contractors’ State License Board is only required to start processing applications no later than January 1, 2012.

For years, contractors were limited by a provision in the LLC Act that said an LLC may not “render professional services, as defined in Section 13401 and in Section 13401.3, in this state.” Sections 13401 defines professional services as “any type of professional services that may be lawfully rendered only pursuant to a license, certification, or registration authorized by the Business and Professions Code, the Chiropractic Act, or the Osteopathic Act.” In addition, a section of the Contractors’ State License Law provided for the issuance of contractors’ licenses only to individuals, partnerships and corporations.

As of this year, the LLC law was changed to add: “…a limited liability company may render services that may be lawfully rendered only pursuant to a license, certificate, or registration authorized by the Business and Professions Code if the applicable provisions of the Business and Professions Code authorize a limited liability company to hold that license, certificate or registration.” The Contractors’ State License Law was changed to allow for individuals, firms, partnerships, corporations, limited liability companies, associations, organizations, or any combination thereof.

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In Part 1 of this entry, I discussed the importance of a business owner choosing the right professional advisors to assist in the sale of the company, whether in San Jose or Palo Alto, and some of the different types of experts.

Although there is overlap, advisors that assist with businesses having a substantial sales price are investment bankers that specialize in mergers and acquisitions. These professionals often help in cleaning up a company’s operations, provide pre-acquisition strategic guidance, act as chief negotiators in the sales transaction, and provide advice and formal opinions concerning deal valuation.

Compensation is a key issue in any agreement with an advisor. Compensation can involve payment of an initial fee, such as where acquisition solicitation materials are prepared, to a commission, such as where the broker takes an active role in negotiations that are successfully closed. Brokers and investment bankers will typically request a non-refundable engagement fee and a success fee. The latter can take many forms. One form provides for a set amount, plus a percentage commission based on the transaction value. Another form provides for a commission percentage which changes with the transaction value, often providing higher percentage commissions for higher values to encourage the advisor to be more aggressive in its pricing negotiations. Exceptions or adjustments to the fee structure are often made for introductions or transactions then in process which were not sourced with the assistance of the professional. Most advisor contracts contain a “tail”, which allows the advisor to collect a success fee for transactions occurring within a certain period, typically 12 – 18 months after the advisory relationship ends. Sometimes the tail can be limited to transactions for which the introduction was made by the advisor.

Advisors can go a long way toward guiding a company and its stakeholders through a successful transaction. Management, however, can’t expect that the advisor will take care of everything involved, and must be prepared to contribute extensively toward the transaction’s success.

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Every business owner at one time or another wants to sell their Silicon Valley business and move from Los Altos, Mountain View or San Jose to Tahoe or Tahiti. Being bogged down in daily operations doesn’t leave a lot of time for an owner to make the necessary contacts to build interest in their company. Owners wish they could just have someone else sell their business.

There are a number of professional advisors that can assist in the sale of a company. Like fundraising, however, management cannot simply pass to someone else a function this important. One of the key reasons for management involvement is that a business buyer is typically found through the company’s own contacts.

As with any advisor, choosing the right professional to advise on potential acquirers and transaction terms is a combination of validation by your network, expertise, and your own personal comfort with the individual with whom you will be working.

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