Articles Posted in Business Formation & Development

Because of the inherent risk of fraudulent activity, the sale of stock is a highly regulated transaction by both state and federal authorities. Unfortunately, many corporate shareholders erroneously believe that privately held corporations do not have to worry about securities regulations because of the limited number of people involved and the relatively limited share worth. They often sell shares of stock either via oral contracts or hastily thrown together written agreements without consulting a corporate attorney. While it is true that smaller privately held corporations benefit from a number of exemptions to securities registrations, the directors, officers and shareholders of these corporations must still comply with numerous state and federal regulations when it comes to selling shares of stock. In fact, it can be argued that in the smaller more intimate setting of a closely held private corporation, the risk of fraudulent activity is particularly troubling. For more on exemptions to registration requirements, see “Exemptions to Registering Federal Securities with the SEC“. Given the inherent risk and associated governmental requirements, it is important that corporate officers consult with an experienced corporate attorney before issuing shares of stock.

the-other-one-1241639.jpgA well drafted stock purchase agreement not only protects both the seller and purchaser of stock, it ensures that the corporation is in compliance with securities regulations. It should evidence a transparent transaction. Full disclosure (offering complete access to corporate transactional and financial records) is the key to complying with securities regulations. The idea of course is to ensure that the purchaser is fully informed as to the risk associated with the investment. The stock purchase agreement will also set forth the price per share, the number of shares, whose shares are being sold, the class of shares being sold, the effective date of the transfer and other terms and conditions governing the sale. The stock purchase agreement should clearly define each party’s rights and obligations going forward.

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Starting a new company with business partners requires a careful understanding of each partner’s expectations and goals.  Lengthy and detailed discussions amongst the prospective partners are common.  Unfortunately, these expectations and goals aren’t always adequately memorialized in writing.  Too often, partners rely on oral agreements – sometimes with respect to the entire partnership.  See “Why Oral Partnerships Are a Bad Idea.”  Seasoned business men and women understand that oral agreements are problematic.  They understand the importance of a formal written agreement and in today’s climate usually opt to form a business entity such as a corporation or limited liability company (“LLC”).  However, even with well drafted corporate by-laws or LLC operating agreements, the partners are sometimes still surprised by the result when one of the partners dies, goes bankrupt or merely decides that he or she wants out (perhaps because the sale price for the exiting partner’s share in the business was based on a set value which is now too low given a change in the fair market value of the business). For whatever reason, the owners neglected to ensure that a buy-sell agreement was included, or, if one was included, that it embodied the expectations they had originally discussed.  A well drafted buy-sell agreement addressing every contingency will govern precisely how shares of the business will be transferred upon the occurrence of triggering events and how the price of the shares will be determined.  This article briefly discusses important issues with respect to buy-sell agreements.  It is not a comprehensive analysis however.  Given the complexities of buy-sell agreements, it is best to work with an experienced corporate attorney.  

business-man-407618-m.jpgTriggering events include the death, incapacitation, bankruptcy, divorce or retirement of a partner or the desire of a partner to sell his ownership interest.  A good buy-sell agreement will clearly define precisely what happens upon the occurrence of any of these triggering events.  It may call for the immediate purchase of a deceased, incapacitated or bankrupt partner’s ownership interest by the company itself (Redemption Agreements), or it may grant the remaining partners a right of first refusal before the company itself is required to purchase the interest.  It might also call for the remaining owners to purchase the ownership interest (Cross Purchase Agreements).  In cases of divorce, the buy-sell agreement might require that any claimed interest of the non-partner spouse automatically transfer to the partner (the non-partner spouse will have signed a spousal consent when the buy-sell agreement was originally executed).  When one partner wishes to sell his interest in the company, the buy-sell language will usually require that the remaining partners approve of the sale or at least maintain a first right of refusal in which case the buy-sell agreement will detail the mechanism by which this right will be exercised.

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Whether or not to sell shares in a privately held corporation is often hotly debated among shareholders. In most cases, the shareholders are seeking a necessary cash infusion either because initial funding has run out before the company could reach its full potential or because the shareholders desire expansion. The shareholders, however, are simultaneously reluctant to share equity, profit and control. After investing significant personal time and resources in development, they feel as though they have poured their heart and soul into the company. With so much invested and so much at stake, it’s not surprising that shareholders have disagreements about funding and expansion. Funding and expansion aren’t the only reasons shareholders may want to issue new stock. In smaller closely held corporations, it may be that the shareholders (typically fewer in number) desire to issue new stock to someone with a particular expertise even if that person has no money to invest. In other cases, issuing new stock is a way to ease into a full transfer of ownership over time so that tax liabilities are spread out.

the-deal-104217-m.jpgIn addition, there are important practical considerations not the least of which is whether or not those wishing to sell corporate stock have the authority to do so under the corporate by-laws. If the by-laws require a unanimous decision of the shareholders for the issuance of new stock, then even a one-percent owner with little involvement in the company’s operations can veto the sale. If the total authorized shares under the Articles of Incorporation are already outstanding, then either the Articles need amending or the shareholders will have to relinquish some of their existing shares.

Finding Investors: Once the corporation’s directors decide to issue new corporate stock, the first step becomes the difficult task of finding an investor. In some cases, the call for issuing new stock in the corporation arises because the board of directors has already found (or been approached by) a prospective investor. In such cases, the investor has already been vetted and the directors go straight to a vote. In other cases, the directors consult with the shareholders about the need for investment and after satisfying themselves that the shareholders are on board, seek out investors.

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One of the first decisions new partners face in pursuing a new business venture is what type of business entity to form.  Options include forming formal business entities such as a corporation or limited liability company (LLC) which are registered with the State of California or forming a partnership.  While formal business entities offer many advantages (most notably protection of personal assets from liability), many new business owners prefer partnerships because of the ease of formation and the maximum flexibility in operations.  This article focuses on the partnership.  However, it is prudent to consult with an experienced San Diego partnership lawyer and accountant regarding the benefits of a more formal business entity before moving forward.  

1184018_business_team_-_vector_1.jpgAlthough California law does not require a written partnership agreement, there are significant risks associated with informal oral agreements to form partnerships.  If after careful consideration, the prospective partners opt to go with the partnership, there is little doubt that a written partnership agreement should be entered into. A written agreement of some sort is an essential part of any good business venture.  A well drafted written partnership agreement helps insure that there will be no future misunderstandings regarding each partner’s intent.  Often, partners rely on the default provisions governing partnerships under California law without realizing that many of these default provisions are inapposite to the partners’ expectations.  Or in some cases, the partners will merely rely on oral agreements to deal with key provisions.  However, enforcing oral agreements comes with a host of problems that can result in significant future conflict.  See “Why Oral Partnerships Are a Bad Idea“.  California’s Revised Uniform Partnership Act (RUPA) sets forth the default rules that govern oral partnerships.   

Important Provisions in Partnership Agreements

A complete analysis of every possible provision in a partnership agreement is beyond the scope of this article.  However, there are key issues that prospective partners should pay particular attention to:

  • Limitations on Outside Pursuits:   It is common for partners to commit varying amounts of time towards the operation of the business.  Some maintain full time employment while committing resources and after hour time towards operation of the partnership.  Others maintain partnership interests in other business ventures.  A well-written partnership agreement will address whether these options are permissible.   Whatever the case, the partnership agreement needs to clearly delineate each partners obligations and limitations with respect to time and resources towards business operations. 

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When forming a California limited liability company (LLC) or corporation, it is important that the owners determine whether any of the ownership interests in the company will be treated as a security.  Under federal and state law, if one or more co-owners of a corporation (shareholders) or an LLC (members) seek to invest in the company for profit only, and do not wish to actually work for the company or take an active role in its management, the ownership interest will be treated as a security.  Essentially, a security interest is an ownership interest that is passive in nature (like investing in the stock market).  An ownership interest is not a security if all shareholders or LLC members actively participate in the company’s operations.  In such cases, there is no need for the owners to worry about qualifying for an exemption.  

courtroom-1-1207444-m.jpgRegistering with the SEC vs. Qualifying for an Exemption

LLCs and corporations with security interests are subject to securities laws governed by the Securities Act of 1923 and regulated by the Securities Exchange Commission (SEC). Registering securities can be a complex process requiring that the company provide investors various documents such as financial statements, documentation and other information designed to ensure that potential investors are able to make informed decisions prior to investing.  However, the SEC and state regulators have promulgated a number of exemptions allowing LLCs and corporations to avoid the complex process of registering securities. Once the owners of a company determine that the interest being sold is indeed a security, it must next determine whether the sale qualifies for an exemption.  State and federal exemptions are not identical but typically sales of securities that qualify for a federal exemption also qualify for state exemptions.  If the sale qualifies for an exemption, the next step is to apply for the exemption with the appropriate federal and state securities agencies.  This process is far less complicated than registering securities with the SEC.  

Summary of Commonly Used Federal Exemptions

The following is a brief summary of the most common exemptions to the federal registration requirement found in the Securities Act:

  • Government Securities: Any government treasuries or municipal bonds.
  • Non-Public Offering Exemption: Where the sale of the security is to “sophisticated investors” who have the financial means and have sufficient knowledge in business and investments.  The investor must have full access to information and agree not to redistribute the securities to the public.
  • Single State Offerings: Intrastate companies qualify for a federal exemption to the registration requirement.   An intrastate company is a company that does all of its business in a single state.  To qualify as an intrastate company, an LLC or corporation must:
    • Be incorporated or organized in the state the security is being offered or sold in; 
    • Have its principal place of business in such state; 
    • Be owned entirely by investors who are bona fide residents of such state; 
    • Maintain at least 80 percent of the company’s assets in such state;
    • Derive at least 80 percent of its gross revenues from such state; and
    • Use at least 80 percent of its net proceeds within such state.

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    Continued from “Starting a New Business In California – Hiring Employees”.

    To conclude our series on starting your own California business, we turn to examining the legal health of your company as it moves forward. In essence, a legal check-up is a business risk assessment. New and growing businesses may be reluctant to seek legal advice for broad issues fearing excessive fees. They worry that attorneys will exaggerate their legal needs or at least nitpick to such a degree that the business will feel compelled to comply with all recommendations. However, burying ones head in the sand is not the answer. In fact, many San Diego business attorneys will provide a legal check up for a reasonable fee. Of course, the size of the business matters. A legal check up for an international corporation for instance would require much greater analysis than the typical San Diego business. For most new and growing businesses, a basic legal check can cost less than $1,000.00.

    businessman-walking-592542-m.jpgMost importantly, the fact that a business is made aware of additional legal risk doesn’t necessarily mean that it must immediately remove all risk. Rather, the legal check up will assist entrepreneurs in prioritizing risk. For instance, if a business learns that its workers’ compensation insurance has lapsed (for whatever reason), that the term of its commercial lease expires in one year, that several of its hand-shake agreements should probably be memorialized in a written contract and that its name and goodwill are vulnerable because it doesn’t own a trademark, the business can react accordingly. Clearly, the workers’ compensation issue would need to be resolved immediately at whatever cost. The remaining issues can be dealt with one at a time. There is a year to think about a new commercial lease, the handshake agreements are at least in the short term working out and the trademark issue can be carefully considered over the coming months.

    The following is a summary of the issues your attorney will examine.

    Existing Concerns: Often owners will have immediate concerns they need advice on. These concerns are typically addressed first and may include plans for expanding the business.

    The Type of Business Entity: If the business is operating as a formal business entity such as a corporation or limited liability company (LLC), it is important that the corporate books are in order. Are annual meetings being held pursuant to California law and/or the company’s bylaws or organizational minutes? Are corporate minutes maintained? Are the company’s officers and managers complying with other corporate requirements under California law and the company’s bylaws or organizational minutes? Are statements of information being filed with the California Secretary of State when required? Is the company complying with securities regulations? Corporate entities that fail to comply with corporate formalities (including LLCs) put themselves at risk. The owners of the business may find themselves personally liable for the debts of the corporation. Litigants may be able to pierce the corporate veil.

    Operating as a formal business entity is advisable for most businesses. If your company has not yet done so, the attorney will analyze your business structure and desired goals and discuss the various options available. See “California Limited Liability Company versus the S-Corporation” and “Choosing the Right Business Entity – Sole Proprietorship May Still Be the Right Choice” for some insight.

    The attorney will also analyze agreements between partners, including shareholders’ agreements, buy/sell agreements and written partnership agreements regarding transferability of ownership interests. A written partnership agreement is always advisable. See “Why Oral Partnerships Are a Bad Idea“.

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    A limited liability company is a type of legal entity that possesses many of the same characteristics as a standard corporation. A limited liability company, or LLC, is attractive to many business owners because it combines the limited liability feature of a corporation with the flexibility of a partnership. A key component of the flexibility offered by an LLC is related to how it is taxed. The members of an LLC may elect to have it taxed like a partnership, thereby allowing for pass-through taxation. Although these unique characteristics offer a clear benefit, they can also make compensating LLC members for their equity in the company more complicated.

    90376_accounting_calculator_tax_return.jpgOne common way that LLCs motivate their employees or service providers to grow and improve the business is to give them an equitable interest in the company. There are two basic forms of equity compensation in an LLC: the profit interest and the capital interest. A profit interest allows the holder to share in the profits and residual value of the LLC, while a capital interest is an ownership in both the LLC’s future profits and its current and future assets upon liquidation.

    The recipient of a profit interest receives distributions of future profits of the LLC and an equity interest based on the increased value of the company after the grant of the profit interest. For example, ABC, LLC grants a 5% profit interest to an employee on January 1, 2014 at which time the value of ABC, LLC is $10,000,000. At the time ABC, LLC is sold, it is valued at $15,000,000. The employee’s interest at the time of sale is equal to 5% of $5,000,000 (the increase in the value of the company since the grant date) or $250,000.

    Issuing profit interests to employees or service providers of an LLC is similar to a corporation issuing stock options. Like a stock option, a profit interest has little worth unless the LLC increases in value after the date the interest is granted. Usually, a profit interest will be conferred through a written agreement establishing the specific terms of the interest including in most cases a vesting schedule. Further, a profit interest will generally be subject to a repurchase right or right of first refusal by the LLC should the holder cut ties with the LLC or attempt to transfer or sell the interest.

    Tax Implications Of Profit Interests

    As mentioned above, the grant of a profit interest can create some complex tax issues. Because each member of an LLC is treated as a direct owner of the company’s assets, liabilities and operations, each member is subject to tax on the LLC’s operations. Accordingly, each member must individually report their respective shares of the LLC’s profits and losses. A holder of a profit interest will be a member of the LLC to the extent of their interest and will therefore receive a share of any pass-through items of income, loss and deductions from the company. This also means that the profit interest holder may, for tax purposes, be considered self-employed and subject to the self-employment tax.

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    Generally, corporate officers and directors have a fiduciary obligation to the corporation and its shareholders that requires them to act in good faith, use their best judgment, and do their best to promote the corporation’s interests. Collectively, this set of obligations is known as an officer or director’s fiduciary duty and arises from the legal relationship between the individual and the corporation or shareholder.

    a-business-mans-path-313281-m.jpgAn officer or director’s fiduciary obligations under California law can generally be distilled into two duties: the duty of loyalty and the duty of care. With regard to corporate directors, both of these duties have been codified in California Corporations Code section 309(a) which provides:

    “A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.”

    Generally, officers have the same fiduciary duties as directors.

    The Duty of Loyalty

    The duty of loyalty requires a corporate officer or director to always act in the corporation’s best interest, and forbids the officer or director from engaging in “self-dealing.” Self-dealing is conduct by a corporate officer or director that involves taking advantage of his or her position in the corporation to benefit his or her own interests rather than those of the corporation or shareholders.

    For example, assume John is the CEO of a major computer corporation, ABC, Inc. ABC needs to buy a considerable amount of computer chips to install in its computers, so it begins shopping for a manufacturer. John happens to own a large amount of stock in XYZ, Corp., a manufacturer of computer chips.

    John, without notifying anyone of his personal interest in XYZ, uses his authority as CEO to ensure that ABC hires XYZ to produce the necessary computer chips, giving XYZ’s share price a significant bump and, in the process, earning John a nice return on his investment in XYZ.

    The type of transaction will not always necessarily amount to self-dealing. Had John disclosed to the board of directors that he held an interest in XYZ, and the board elected to contract with XYZ anyway, John would not have violated any fiduciary duty to ABC or its shareholders. However, because John failed to disclose his personal interest in XYZ, his conduct constituted a breach of his duty of loyalty.

    The Duty of Care

    The duty of care requires a corporate officer or director to carry out his duties as would any ordinarily prudent person in similar circumstances. For example, a corporate officer or director might violate his duty of care by contracting to buy a company without first conducting due diligence to find out if it is an economically sound decision.

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    The professional corporation or the professional limited liability company are similar to their traditional counterparts, but are organized for the purpose of providing professional services, such as medical, legal, or accounting services. Unlike other states however, California does not provide for the formation of a “professional limited liability company”. California only provides for the formation of a “professional corporation”. A “professional corporation” is a service corporation that is licensed by the State of California. With an ever increasing prevalence of professionals in California, the professional corporation is becoming more and more prevalent. This article is specifically directed at the California Professional Corporation.

    1270499_beach_playa_6.jpgA professional corporation is formed, just as a traditional corporation, by the filing of articles of incorporation with the California Secretary of State. However, unlike traditional corporations, a professional corporation generally has to comply with the rules and regulations of the appropriate licensing body. For instance, a professional corporation for medical doctors must register with the Medical Board of California. Moreover, there are specific requirements regarding who may own shares and who may hold title as an officer and/or director of a professional corporation. Typically, only licensed professionals of like professions may share in the ownership and serve as officers and/or directors.

    Shareholder Limitations On Professional Corporations

    In California, shares of stock in a professional corporation can only be issued to individuals that hold a license in the professional service which the business provides. Further, a shareholder of a professional corporation is prohibited from entering into a voting trust, proxy, or any other arrangement that would permit a non-shareholder to vote his or her shares of stock. In the event a shareholder is disqualified from rendering professional services or dies, the professional corporation must acquire all of his shares.

    Choosing A Name For The Professional Corporation

    In California, the name of a professional corporation must end with specific designations such as “a Professional Corporation” or the abbreviation “PC.” The name requirements vary from profession to profession. In addition, the name cannot be the same as, or “deceptively similar” to, that of any other professional corporation licensed in California. The California Secretary of State maintains a database of current business names that may be checked to see if the name chosen is available. If a name is available, it can be reserved for up to sixty days by filing a reservation request with the office of the California Secretary of State. It’s important to review the particular state licensing board for the requirements of any given profession to ensure compliance.

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    One of the most important decisions entrepreneurs face when starting a new business is how to organize the new venture.  Although the flexibility provided by a limited liability company (LLC) is enticing, California’s gross receipts tax is distasteful to many business owners.  Moreover, the rigidity and formality of the standard corporate structure can prove cumbersome for young businesses.  California’s statutory Close Corporate (meaning that the form of business entity was created and governed by statute) provides entrepreneurs a third option offering much of the same flexibility LLC’s provide while simultaneously avoiding California’s gross receipts tax.  Because the ultimate choice will vary from business to business, it’s important to consult with a San Diego business attorney and a tax professional such as a C.P.A. before moving forward.  

    corporate-955464-m.jpgA close corporation is one in which the shares of the corporation are not freely traded and are held by a limited number of individuals.  Significantly, the shareholders of a close corporation can authorize the elimination of the board of directors and run the corporation themselves, actively managing and operating the company’s day-to-day affairs. Most states have statutes specifically limiting the number of shareholders (generally between 30 and 50),and requiring that certain transfer restrictions appear on the stock certificates.  California’s Corporation Code Sec. 158(a) requires that a close corporation’s Articles of Incorporation state, “This Corporation is a close corporation and that the number of shareholders shall not exceed 35.”  In order to properly establish the corporation as closely held, the shareholders must prepare a written agreement (shareholder’s agreement) outlining the method by which management decisions are to be made and determining what, if any, restrictions are applicable to the sale of the ownership shares.

    Because the shareholders manage a close corporation, they owe greater fiduciary duties to each other, and the controlling shareholders owe minority owners the highest duty not to oppress them.  In the normal corporate structure, if a minority shareholder disagrees with the manner in which the company is conducting its business, typically his only recourse is to sell the stock (assuming the company’s officers or directors are not violating the law or the corporation’s bylaws).  In a close corporation, however, sale of the stock is generally not an option.  As such, the law allows minority shareholders to sue the majority shareholder(s) and seek court intervention in the management of the company

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