Bottom Line Business Insights : Maryland Business Lawyer & Attorney : Wagonheim Law Firm : Mergers & Acquisitions & Contractual Negotiation

To many business owners, the question of “legal structure” begins and ends with the completion of a pre-printed form from Office Depot and the payment of a nominal filing fee to the State Department of Assessments and Taxation. The fact of the matter is that many business owners leave money on the table by failing to select the right business entity when they start out or by forgetting to reexamine their choice at different stages in the company’s development.

There are three primary reasons to select a business entity:

1. Tax considerations;
2. Day-to-day operations; and
3. Exit strategy. 

Sole proprietorships, limited liability entities, S corporations and partnerships are the so-called pass-through entities in which profit and loss are taxed at a personal level for the owners. Other entities, of which there are many, are subject to different tax treatment. The failure to match the type of business to the legal structure can result in significant (and often unnecessary) tax liability.

Depending upon the type of business, limited liability entities and corporations are often vastly preferable to other structures inasmuch as they insulate their owners from personal liability for acts of the entity. An owner’s personal assets (such as a house, cars, bank accounts, and personal property) are often directly at risk when business is being conducted through a sole proprietorship or in a partnership setting. Protection from risk constitutes a fundamental basis for selecting a business structure. 

All good things must come to an end. Whether the business owner is anticipating a 40 year career or a two year cash-out in the business, exit strategy must always be considered in business formation. If one is looking to approach the investment community for a capital infusion, anticipate banks financing or hopes to sell to employees at a later date, it is best to select a business structure most amenable to the particular option envisioned. 

Finally, regardless of their current business entity, business owners can decide to change their structure at any point in the company’s evolution. Although there may be tax ramifications and other challenges involved in such a restructuring, the benefits of the end product often outweigh the convenience of standing pat. 

Bottom line: The business owner must know and understand the pros and cons of the legal structure in which he or she is conducting business.

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Not long ago, I found myself sitting in our conference room across from a very interesting gentleman. He was in his upper fifties, maybe 60, and carried himself as a professional. He explained that he had been in business for upwards of 40 years – that he had made some big mistakes, learned from them, moved on, and built a fairly successful business. 

He told me that the business that he had started had run its course and he wanted to start a new one, having learned from the mistakes of the old. In order to start the company, he decided to bring in 3 additional people. These people were friends of his, experienced in his industry, and possessed of the skill sets necessary to make the new venture run. My visitor had decided to divide 40% of the stock among them, retaining 60% for himself – enough, he felt, to keep control of the company.

He was convinced that giving out shares of the company was the only way to keep the group motivated, absent money to pay each person’s going rate. My visitor was wrong.

Recently, I wrote a piece in our e-mail series discussing the mistake of offering partnership at the outset of a business relationship. And whether the discussion concerns true partnership or co-ownership of a corporation or LLC, the fact of the matter is that co-ownership is a business marriage. And make no mistake, just like the real thing, a business divorce can be expensive and emotionally draining. 

For his part, my prospective client was asking his friends to invest their time and skill in a new business for little or no compensation. What he wanted was a way to show his friends that they would reap the benefits of their investment.   We explored a number of possible solutions, but what we decided upon was offering stock options.

People, you see, are unpredictable. Some may be highly skilled and great friends, but start working together and it’s a train wreck. Different business philosophies, work ethic, or personalities can destroy a team that could not possibly look better on paper. Stock options and a vesting schedule are two ways to put together an arrangement now which takes effect later. 

In this case, we could commit to an option to purchase stock in the company beginning in 3 years, discounted for each year the person had been with the company. Moreover, as incentives, other discounts to the purchase price could also apply, provided we took care not to trigger any unwanted tax consequences.

In other words, my prospective client could date before he got married. And in my experience, that’s a pretty good plan.

This podcast is brought to you by WYPR and Eliot Wagonheim.

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Guest Blogger: Michael J. Lentz, Esquire

Last October, CNN ran a story about a Pennsylvania woman mauled by a pet bear that she kept in her backyard. When I saw this story, my first thought was “well, that was a headline waiting to happen.” CNN also reported that, in addition to the 350-lb. black bear, the woman kept a Bengal tiger and an African lion. Apparently, she had the necessary permits from the Commonwealth, and “the property routinely passed inspection and had no violations.” Even doing everything right, the poor woman was obviously still at risk. After all, the bear, even in a cage in a Pennsylvania neighborhood, was still a bear. 

Of course, almost all small businesses have bears in their backyards, too. Whether it’s a client or customer who persistently fails to pay, or an employee who shows up late, leaves early, and habitually fails to produce, or a vendor that consistently fails to deliver as promised, business owners often accept, and even seem to welcome these rascals. Despite well-honed instincts warning of potential problems, many business owners disregard these instincts, for a variety of reasons, some sound and some not. With proper care and feeding, the delinquent customer, incorrigible employee, or unreliable supplier may, for a while, appear pleasant to have around and a worthwhile addition to the business. 

Eventually, though, damage to the business is inevitable. The customer will abandon the business with an enormous receivable, the employee will disappoint a significant client in a critical situation, or the supplier will fail to deliver vital materials. 

Bottom Line: Trust your instincts, and remember that the things that threaten your business now will threaten it as long as you welcome them, even if they appear to be under control for a while. 

Michael graduated from Georgetown University Law Center in 1998. After spending five years with large Baltimore firms and three years as a solo and small firm practitioner, Michael joined Wagonheim Law in 2006, where he continues to utilize his extensive experience in commercial, bankruptcy, and appellate litigation to work with companies throughout the mid-Atlantic region.

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Guest Blogger: Michael J. Lentz, Esquire

I’ll admit it – I used to be profoundly annoyed by, and more than a little bit uncomfortable with, the notion that Twitter could be a useful tool in the development of my commercial litigation practice. I envisioned Twitter as the latest unwelcome step in the drive-thru-ification of America, where fast and easy often replace, and are often deified at the expense of, thorough and thoughtful. I viewed Twitter as nothing more than one of many ways for the self-absorbed to tell the rest of the world about their lives - it seemed unnecessary at best, and shallow and self-aggrandizing at worst. 

Last week, though, I attended an excellent webinar on the use of Twitter for client development, presented by Kevin O’Keefe, the founder of LexBlog (full disclosure: LexBlog hosts this blog). I’m not going to attempt to reiterate Kevin’s points here – you can follow his blog or follow him on Twitter. At the start of the webinar, I was largely Twitter illiterate – I didn’t know a hashtag from a hash brown. More to the point, I literally could not fathom that Twitter could be useful to me, so I didn’t see any reason to attempt to become literate. 

An hour later, though, I had specific examples of ways in which Twitter might be useful to a busy litigator trying to develop a practice. Certainly, some of the suggestions were inapposite. Others were sensible in theory, but might be difficult for me to put in to practice, given a finite amount of time to devote to the effort. There were other suggestions, though, that made sense immediately, and that I knew I could put into place immediately. Receiving fairly simple, concrete examples of what Twitter can do for me made me change the way I thought about Twitter. I’m still not convinced that it’s the eighth wonder of the world, as some of its advocates seem to believe, and I’ll probably never use it as fully as Kevin and others like him do, but I am convinced that it has its place. 

This epiphany reminded me of an important marketing lesson: when you’re marketing, whether verbally or in writing, and whether your audience is an enormous group or a single individual, make the presentation not merely about you, and your skills and talents, but about what you can do for your audience. Leave your audience with simple, concrete examples of how your business, product or service can help them.  No matter how good your business is at what it does, prospective customers and clients will not become actual clients and customers unless and until you can explain, simply and completely, how your business will benefit them. 

Michael graduated from Georgetown University Law Center in 1998. After spending five years with large Baltimore firms and three years as a solo and small firm practitioner, Michael joined Wagonheim Law in 2006, where he continues to utilize his extensive experience in commercial, bankruptcy, and appellate litigation to work with companies throughout the mid-Atlantic region.

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Yesterday at 5:00, I found myself sitting in our conference room across from a very interesting gentleman. He was in his upper fifties, maybe 60, and carried himself as a professional. He explained that he had been in business for upwards of 40 years – that he had made some big mistakes, learned from them, moved on, and built a fairly successful business. 

He told me that the business that he had started had run its course and he wanted to start a new one, having learned from the mistakes of the old. In order to start the company, he decided to bring in 3 additional people. These people were friends of his, experienced in his industry, and possessed of the skill sets necessary to make the new venture run. My visitor had decided to divide 40% of the stock among them, retaining 60% for himself – enough, he felt, to keep control of the company.

He was convinced that giving out shares of the company was the only way to keep the group motivated, absent money to pay each person’s going rate. My visitor was wrong.

Recently, I wrote a piece in our e-mail series discussing the mistake of offering partnership at the outset of a business relationship. And whether the discussion concerns true partnership or co-ownership of a corporation or LLC, the fact of the matter is that co-ownership is a business marriage. And make no mistake, just like the real thing, a business divorce can be expensive and emotionally draining. 

For his part, my prospective client was asking his friends to invest their time and skill in a new business for little or no compensation. What he wanted was a way to show his friends that they would reap the benefits of their investment.   We explored a number of possible solutions, but what we decided upon was offering stock options.

People, you see, are unpredictable. Some may be highly skilled and great friends, but start working together and it’s a trainwreck. Different business philosophies, work ethic, or personalities can destroy a team that could not possibly look better on paper.   Stock options and a vesting schedule are two ways to put together an arrangement now which takes effect later. 

In this case, we could commit to an option to purchase stock in the company beginning in 3 years, discounted for each year the person had been with the company. Moreover, as incentives, other discounts to the purchase price could also apply, provided we took care not to trigger any unwanted tax consequences.

In other words, my prospective client could date before he got married. And in my experience, that’s a pretty good plan.

Questions? Comments? Concerns? Raise it for discussion on Facebook, Twitter, or LinkedIn.

For more information on our free e-mail series, click here.

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“There is a difference,” I was taught, “between ten years of experience and one year of experience repeated ten times.”   I thought about this the other day as I contemplated the calendar change to 2011 and the fact that next year will mark my 25th year in practice. 

Everyday it seems like I see too many examples of companies celebrating survival, rather than progress. We regularly receive letters adorned with “our 10^th anniversary” ribbon stickers and see businesses using the phrase “since 1956” or some such instead of an actual message.   When I was a young attorney (maybe for ego’s sake I should say “younger” attorney), I was hoping to be made partner when the management committee told me instead “we’ve decided that you have to wait 3 more years before we extend an offer of partnership.” 

Now, granted I was young – younger than any of the partners by a long shot – but I had just as many clients and generated more revenue than most.   “Why,” I asked, “does it matter how many more sunrises I see between now and an offer of partnership?” I urged them to give me something different such as a revenue, performance, or even billable hour target to hit. But no, to them it was time. To me, this made no sense.

One of the real values of seeing another sunrise is the ability to leave behind the mistakes and absurdities that had, no doubt, been a part of your yesterday. But equally as important, with the sunrise comes the opportunity to build on yesterday’s lessons. Sometimes that’s painful in business.

Print out your customer list. Not a list of your most active or largest. Print out a list of all of them. Don’t just read the names, ponder them. As to each, are they enthusiastic about your work or did you make a cringe inducing mistake? Were you late? Were you, perhaps, a bit less responsive than you should have been? Are they loyal to you or are they casting a wandering eye across the business landscape wondering if they can do better? 

I have yet to find a business owner who, in his heart of hearts, can honestly say that he did right by 100% of his customers 100% of the time. 

So here are the questions: What are you going to do about the failures? Are you committed to learning? Have you created a company culture open to improvement? Can you begin a lasting and productive dialogue about your failures? Have you ever conducted a bloodless autopsy – one with a mission of education rather than the identification of a scapegoat?

In other words, in 2011, what will you have learned by the sunrise?

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“I got a phone call this morning from one of our oldest customers. He fired us. After 20 years, he fired us. Said he doesn’t know us anymore. I think I know why.” 

The speaker recounted his phone conversation to his account reps, saying “we used to do business with a handshake, face-to-face. Now it’s a phone call, a fax, ‘get back to you later,’ with another fax, probably.” 

This United Airlines commercial was originally aired before e-mail and the advent of social media. First aired twenty years ago, in 1990, it still resonates. So many businesses are started by an entrepreneur, skilled in the producing the product or service that spawned the company. Customers came because of the skill and stayed because of the attention. As the owner of a small business, the founder could track every project and knew every client. When someone was upset; he knew it.

Growth has a way of making that kind of personal attention obsolete. Time passes and a founder looks around to realize that whole projects are being performed for customers he never met.   And what about the ones he knew – the ones who built his business or who inspired him to go into business in the first place? Chances are, they’ve been delegated. Delegated to talented people, to be sure, but delegated just the same. 

Sooner or later, the thought has to occur to these customers – your old friends -- that if they mean little enough to your company that they can be delegated, your company means little enough to them that they can go elsewhere.  

Looking ahead to 2011, most business owners set targets for growth -- more revenue, more customers, bigger projects, better distribution. But how many set goals reflecting stronger relationships, customer retention, and expressions of gratitude? 

Many years ago, I read a book in which the author urged business owners to “pay attention to the ‘fine’s.’” He meant that people rarely voice their complaints. When asked about service or the particular product they purchased, even when dissatisfied, they’d normally respond that things were “fine.” Not every customer can be counted on for enthusiasm. After all, there isn’t an infinite amount of enthusiasm to go around. But the silence and the “fine’s” speak volumes to those with a keen enough ear and enough focus to notice. 

So what are you doing to focus on client retention, rather than just growth? Studies indicate that a new client is 7 times more expensive in terms of marketing and advertising dollars than existing clients. The point is that it is much cheaper and more efficient to keep the clients you have than spend every ounce of energy trying to bring new prospects in the door. 

If you do not already track trends in returning business, 2011 is an ideal time to start. After all, nothing speaks to customer satisfaction more than repeat business. Even more than tracking it, look for the things that increase the pace of returning business over time. 

Perhaps, like those executives in the United Airlines commercial, you can forgo e-mail, faxes and phone calls, and, just once in a while, put in the time to travel even great distances for a handshake.

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My wife is a product of Oregon.   So is her favorite beer, Bridgeport Coho Pacific Extra Pale Ale. Years ago, when she first made the move to join me in Maryland, I tried to surprise her with a case of Oregon’s finest. Unfortunately, the brewery did not ship product farther east than Colorado. It was not willing to make an exception in my case. 

Maryland law required that I first obtain a distributor’s license to facilitate the transaction. I did not qualify for one. I tried to get a few of our retail stores interested in serving as my proxy, but no one would bite. And as much as I revere Baltimore’s Natty Boh roots and tradition, the two products were hardly interchangeable. 

My memory of this failed gift came flooding back to me yesterday when I read Scott Calvert’s article in the Baltimore Sun reporting on the possible loosening of Maryland’s prohibition against direct shipment of alcoholic beverages. The Sun cited Maryland’s wine industry lobbyists as basing their opposition to direct-shipping on two arguments: (1) that direct shipment to consumers would make it easier for minors to obtain wine; and (2) aggressive out-of-state competition would imperil Maryland’s own wine retailing industry. 

We’ll leave the first argument by the wayside, saying only that on its face it makes no sense, given that how alcohol gets into the dining room liquor cabinet is much less significant an issue than the parentally-imposed controls over how it gets out.

It’s the second argument that attracted my attention.  According to the Sun, the Maryland wine industry lobby favors the existing statutory environment because it limits competition.   Now, I completely understand why an industry lobbying group would want to insulate its members from competition. In fact, I’m certain that there are very few businesses in the country that wouldn’t benefit from a little statutorily-imposed exclusivity.  

But that’s hardly the point.

The point is that a business in our economic system should be constructed to beat the competition, rather than rely on the law to do it for them. If a company is not able to articulate to its prospective customers at least one (and ideally three) clear benefits to doing business with it as opposed to its competition, then it deserves to lose those potential customers. Price, service, selection, trust, relationships, knowledgeable sales staff, value-added services, an expanded product line…something. These are the elements of successful competition – regardless of industry.

Friend of the firm, Mitch Pressman of Chesapeake Wine Company was exactly on point when he was quoted in the Sun article as saying that he welcomed the competition. He welcomed anything that would bring about an increased interest in his product. And it is precisely his confidence in his business, staff, selection, knowledge, etc., rather than a reliance on antiquated statutory protections, that positions him to overcome the competition. 

And that’s the way it should be.

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Guest Blogger: Michael J. Lentz, Esquire

Ordinarily, employment in Maryland is “at will,” meaning that in the absence of a contract that says otherwise, an employer can fire an employee at any time, for any (non-discriminatory) reason, or for no reason at all. Of course, a written employment contract will govern the relationship between the employer and its employee. 

However, in some circumstances, Maryland courts will interpret a shareholders’ agreement to be an employment contract. If a shareholder, who also happens to be an employee, enters into a shareholders’ agreement with the employing corporation, and the agreement includes the employee’s duties, compensation, and other employment related terms, the terms of the shareholders’ agreement will govern the employment of the employee-shareholder. A shareholder’s agreement that doesn’t speak to the issue will not change an employee’s at-will status, or provide post-termination benefits, but courts will enforce all written terms. Also, Maryland law requires all parties to a contract to deal with each other fairly and in good faith, even if no such requirements appear in the parties’ agreement. Since a shareholder’s agreement that addresses terms relating to employment will be construed as a an employment contract, this implied covenant of good faith and fair dealing will be implied in the parties’ employment relationship. 

As a practical matter, this means that if you have employee shareholders, their shareholder agreements should include either nothing relating to their employment or all pertinent terms of their employment.

Perhaps just as significantly, even in the absence of a written employment contract, shareholders in closely-held corporations may be entitled to rights similar to those found in employment contracts. This is because a shareholder who invests in a closely held corporation may, depending on the nature and size of his investment, expect to be involved in the management and day-to-day operations of the corporation. Maryland courts have held that a shareholder in a closely-held corporation is entitled to “reasonably expect that ownership in the corporation would entitle him to a job, a share of the corporate earnings, and a place in corporate management.”  

Corporations, and their majority shareholders, should take care to respect these reasonable expectations of minority shareholders. Maryland law suggests that courts have a wide variety of remedies available to them to ensure that the investment expectations of minority shareholders are protected, including the appointment of a receiver to run the corporation and, if no less drastic measure will protect the minority shareholder, the dissolution of the corporation. 

Bottom Line: In closely-held corporations, minority shareholders present challenges not faced by publicly-traded corporations and other corporations with large numbers of shareholders. The corporation, its majority shareholders, and any minority shareholders are well advised to reach explicit, concrete agreements regarding their expectations for the venture, and to commit those agreements to writing thoroughly and precisely. 

Michael graduated from Georgetown University Law Center in 1998. After spending five years with large Baltimore firms and three years as a solo and small firm practitioner, Michael joined Wagonheim Law in 2006, where he continues to utilize his extensive experience in commercial, bankruptcy, and appellate litigation to work with companies throughout the mid-Atlantic region.

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Newton’s First Law of Motion, though revolutionary in its day, is simple enough: An object in motion will stay in motion and an object at rest will stay at rest, unless acted on by an outside force. 

This Law has helped legions of students understand physics and has shaped the world view of generations of scientists. And it works, too, until one gets down to the subatomic world where quarks, fermions and baryons dwell. There, as Daniel Pink says in his revolutionary book Drive about employee motivation, “things get freaky.” In other words, things don’t work the way logic and history teach us they should.

Surprisingly, the same can be said for employee motivation. 

The quest for employee motivation is about control and the application of external force. Speaking as an employer myself, I am constantly thinking about what I can do to control the outcome I desire. I think: “What can I do to raise our revenue by increasing the rate at which files are opened or the efficiency with which work is performed.“  

My mindset, in other words, tends to reflect conventional wisdom of “pay more, get more.”  If you want more widgets produced, hours billed, or projects completed, create a bonus structure that rewards production.   When I took Introductory Economics at Duke in 1982, our textbook instructed us that in a world of perfect information, the parties will work toward a wealth-maximizing result. In other words, wealth was the determinative factor in human motivation. And if wealth is the determinative factor, business owners like me could manipulate wealth, thereby increasing motivation.

The problem is that it just doesn’t seem to work that way with anything but repetitive piecework. Where creative, problem-solving work is concerned, things tend to get freaky.

Time and time again, people leave lucrative positions to take lower paying jobs doing what they truly like. They’ll forgo a W-2 environment for the much riskier (and more work-intensive) entrepreneurial undertaking. They’ll spend hundreds of hours playing clarinet when they don’t have a hope of getting to the stage. They’ll spend hours on Sudoku or puzzles without any kind of incentive or reward. 

My brother-in-law has spent his career as a long-haul truck driver, now working for UPS. From his observation of several large, nationally known companies, he concluded that most people wanted to do a good job. But when companies began installing incentive programs, long-term productivity plummeted. In the short run, of course, the drivers worked to attain the bonuses. Then, as the company began raising the targets and installing more incentives to hit, people began to tie their motivation to the bonus(es) they hoped to achieve. Once they determined that an incentive was out of reach or unimportant, their productivity dropped off to a point far below pre-incentive levels. 

Pink comes to this same conclusion by traveling a different path. Pink refutes the historical incentive laden bonus structure by pointing out such seeming anomalies as the rise of open source products such as Firefox and Linux, the triumph of all-volunteer Wikipedia over the heavily funded Microsoft Encarta, and the pervasive presence of non-compensated, open resources offering everything from car repair advice to recipes. 

In 1999, thirty years after his groundbreaking work as a psychology graduate student at Carnegie Mellon University, Edward Deci, reviewed 128 separate sociological experiments and came to the conclusion that tangible rewards tend to have a substantially negative effect on intrinsic motivation.    Why? Because the creativity and sense of accomplishment that people once enjoyed had, when presented with productivity bonuses, suddenly become “work.” As Pink stated, “over and over again, they discovered that extrinsic rewards – in particular contingent, expected “if-then” rewards – snuffed out the third drive [of internal motivation].”

The challenge, therefore, is a daunting one. It is easy, after all, to figure out the results we want and provide a monetary reward based upon achievement. The challenge, however, is to create an environment that sparks each producer’s internal drive to succeed. 

As we approach the New Year and contemplate, as business people, what we can do to make our own enterprises better in 2011, nothing merits consideration more than the question of employee motivation. We have to determine:

1. What outcomes do we want to inspire; and
2. What can we do as managers to incentivize the outcome without snuffing out that all-important self-motivation?

I’ll write more on this subject in upcoming blogs. Please feel free to weigh in with your comments.

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I have to admit that I’m a sucker for a good, old fashioned sarcastic remark. I’m the type of guy who’ll actually compliment someone who directs a sarcastic remark my way, as long as the sarcasm is sufficiently artful. I admit that this is a little weird, but I think I can trace its origins back to one of the most sarcastic guys ever to put pen to paper, and someone who intimately understood the absurdities of life: British mathematician and novelist Lewis Carroll. Carroll, you may recall, wrote Alice’s Adventures in Wonderland (but to everyone except English professors, it’s just plain old Alice in Wonderland). One of my favorite passages from the book also happens to involve my favorite character, the Cheshire Cat. It goes something like this:

Alice:   “Would you tell me, please, which way I ought to go from here?”

Cheshire Cat: “That depends a good deal on where you want to get to.”

Alice:   “I don’t much care where . . .”

Cheshire Cat (grinning, no doubt):     “Then it doesn’t much matter which way you go.”

Alice:   “ . . . so long as I get somewhere.”

Cheshire Cat: “Oh, you’re sure to do that, if only you walk long enough.”

I can hear the wagering in the room now: “$50 bucks says there’s no way he connects Alice in Wonderland to anything remotely resembling a legal issue.” Oh, Grasshopper! Watch this:          

Anyway, where was I? Oh, right. The Cheshire Cat. I like this passage as much for the Cat’s lethargic, disdainful sarcasm as much as for what the Cat teaches us about knowing where we’re going – and where we’ll end up if we don’t know: “somewhere.” Well, if “somewhere” isn’t good enough, then planning is required. This applies not only to a trip to the supermarket, but to careers, family life, business plans, and “succession planning” – which, conveniently enough, is what I want to focus on in this week’s blog. 

So, what’s succession planning? Fundamentally, it’s deciding early on in the life of your company what happens to the ownership interests – the equity -- if something happens to you or your fellow partners or stockholders. What could that something be? How about a decision by one of your partners to just stop working, for whatever reason (such as an illness, retirement, a lifelong desire to move to Bangkok, or just plain boredom). Would this leave your company in the lurch? Would the company be obligated to continue to pay distributions or dividends to a partner who just stops working? In the absence of a well-drafted succession plan, the answer is highly likely to be “yes.”

Or, let’s take another example. One that most people would prefer not to think about: the death of one of your partners, or your own passing. It’s not pleasant to contemplate, but the reality is that the deceased partner’s equity in the company lives on. Something has to happen to it. Succession planning will determine what that something is. Unless you would prefer for a probate court or your deceased partner’s last will and testament to determine who succeeds to her equity in the company. In which case it’s as likely to end up in the hands of her husband as her crazy sister who lives in an Ashram in Kathmandu. How would that affect your company’s operations and its cash flow? Better to avoid these possibilities altogether and come up with a written succession plan or agreement.

A well thought-out succession plan will determine what happens to each stockholder’s or partner’s ownership interests and rights in, as well as obligations to, the company in the event something happens. In the case of a corporation, the succession plan is usually made part and parcel of the Shareholders’ Agreement (which would make a good topic for another blog – making mental note to self). In an LLC or partnership, the succession planning language is generally included in the operating agreement or partnership agreement. In any case, it can also be a separate, stand-alone agreement if not included in either of these documents.

Most succession plans give the company itself, or the other partners or shareholders, the right (but usually not the obligation) to buy the departing (or departed) shareholder’s equity. It will also determine whether the company or the other partners have a right to buy out a seriously ill partner, or to oust a non-performing partner. The succession plan will also determine who else has a right to buy or inherit the equity in the event the company or the remaining partners decide not to buy it. And, perhaps most important, the plan will provide for a methodology for valuing the equity. Different types of businesses lend themselves to differing valuation techniques, which your financial advisor, accountant, and attorney (me, remember?) will discuss in order to select the proper valuation method.  Because the absolute worst time to attempt to value equity is when a partner dies or leaves. (By way of example, what do you suppose the odds are of arriving at an amicable agreement with your recently deceased partner’s sister with respect to the value of her equity interest? Which the sister now owns, incidentally.)     

There’s much more to succession plans that I’ve touched on here, of course. But I think I’ve covered the major issues with a broad brush. A good succession plan will let you sleep easier at night. And the sooner you implement the plan, the more comfort it provides.

So, now that we’re all comfortable with succession planning and grinning like Cheshire Cats, let’s get down to business and make a succession plan. Before you end up “somewhere,” rather than where you want to be.

If you enjoy reading our blog, please vote for us for the Baltimore Sun's 2010 Mobbie Awards under the category of "Business & Technology" blogs.  Voting starts at 8:00 a.m. Nov. 2 and ends at 5:00 p.m. Nov. 12.  Thank you to all who nominated us!

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Those of you who’ve been following my blog over the past 10 weeks or so (or at least the 3 of you who are still awake and haven’t yet slit your wrists) know that I’ve been discussing how to finance a new or existing business. I’ve been spending a lot of time on this topic for 3 reasons:

1. it’s one of the most important issues business owners face,
   
2. it’s a topic about which I receive a significant number of questions, and
   
3. it’s worth understanding the legal and business ramifications of the various methods of financing a business.
   

Alas, every journey must eventually come to an end, as must this one. With that in mind, let me briefly discuss 3 additional financing sources that I haven’t yet talked about to tie up our financing miniseries: using credit cards, funds from your IRA, or home equity loans.

• HOME EQUITY LOANS:  The advantage of taking out a Home Equity Loan is that you’ll pay a relatively low rate of interest and get a long term loan. Disadvantages? The obvious one is deciding whether you believe in your business enough to risk your house (have you done a business plan and some basic financial projections?). The less obvious one (but perhaps more problematic one) is that your spouse will have to co-sign the loan (I’m assuming that if you’re married, you hold title to your house jointly with your spouse). Is your spouse willing to be liable for the debts of your business if things don’t work out? More important, what happens if the two of you get divorced? In the absence of an up-front written agreement with your spouse dealing with this issue, it’s not going to be pretty. If you go this route, talk to me first.
  

• CREDIT CARDS: Again, are you confident enough in your business plan to risk your personal credit and the inevitable lawsuits and collection efforts should the business fail? If so, there are a number of advantages to using credit cards, including the lack of a need to put up security, the lack of spousal involvement, and the possibility of very low “teaser” rates (which are worth shopping around for). Once the teaser expires, it’s possible to roll the balance over to another card with another low “teaser” rate. 
  

Disadvantages? The risk, of course. Also, credit card financing is and should be short term due to the inevitable interest rate hikes once the teaser period expires. Plus, you will almost certainly have to personally guarantee the card.

Finally, remember all the ink I spilled a couple of months ago blogging about the limited liability gained via incorporating, and the various transgressions that could give rise to a loss of that limited liability? Funding a business using your personal credit cards implicates some of those issues (specifically, segregation of funds issues). Call me so we can discuss if you’re thinking of going this route.

• IRAs: This is the financing technique that I find to be simultaneously both the most appealing and the most terrifying.   So here’s your question: Should you take money out of your IRA to finance your new business?
  

For me, the 2 most important threshold issues related to IRA financing are these: (1) how much of your IRA you’ll be tapping, and (2) your age. Here’s a long but important sentence: If the remaining funds in your IRA (after you pull out whatever you’re going to pull out to fund your company) would be sufficiently small such that living on those funds would have a significant adverse effect on your quality of life at retirement, AND you’re over the age of, say, 45 or so, I’d have a serious heart to heart with both your spouse and your accountant (not necessarily in that order) before pulling the money out. I also personally believe (and you can take this for whatever you think it’s worth) that it’s best to be ultraconservative and assume that the funds remaining (if any) in your IRA after you tap it to finance your business will be all that you’ll have left for retirement. In other words, assume that the remaining funds will NOT grow significantly between now and your retirement (and could possibly decrease), and that you WON’T be able to contribute any additional funds to your IRA between now and retirement.

However, once you decide to take the plunge, you’ve actually got several advantages over virtually any of the other financing techniques I’ve been discussing in my financing miniseries. Debt financing (banks, SBA, home equity, credit cards, etc.) can put a serious strain on your business’s cash flow – not to mention your personal financial situation, since you’re likely giving personal guarantees or security for the loans. Venture capital financing can result in the loss of control over your own company and your eventual personal obsolescence. And financing using the 3Fs can result in family discord, estrangement, disappointment, and broken relationships. But utilizing IRA financing eliminates all of these pitfalls. And, you can avoid early withdrawal penalties and taxes if you employ an IRS approved financing plan.

So, how does it all work? First, you’ll form your new company (and, of course, you’ll form the right kind of entity because you’ve read my blogs on corporate formation). Second, your new company will set up a “qualified retirement plan” in accordance with IRS regulations. (You’ll need an experienced and reputable benefits firm to do this for you. I can help with recommendations, if necessary). Third, you’ll roll over the desired amount of your personal IRA funds into the company’s new “qualified retirement plan.” Last, your company’s newly-established “qualified retirement plan,” fresh with funds from your personal IRA, will use those funds to buy stock in your new company. Your company is now funded with equity from the stock sale (rather than cash flow -draining debt), and the “qualified retirement plan” owns all (or some) of your new company.

The following goes without saying (but since I’m anal retentive AND a lawyer, I’ll say it anyway):  I strongly recommend that you work with an experienced corporate attorney when setting up the new company and when consummating the stock purchase by the qualified retirement plan. Someone like me, perhaps. These are sophisticated corporate transactions and need to be treated as such.

Next up: ever think about what would happen to your company if your business partner died? What if he decided to sell his interest in the company to a third party?  Or suppose she decides to just stop working (can she do that)? If you haven’t thought through these issues, you should. Succession Planning is on deck.

Questions? Comments? Concerns? Raise it for discussion on Facebook, Twitter, or LinkedIn.

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Last week, I discussed why your chances of getting venture capital (“VC”) financing are probably less than your odds of being struck by lightning twice (click here if you missed it). This week, in the interests of piling on, I’m going to discuss why you probably wouldn’t want VC financing even if you could get it.

Most of my corporate clients who run their own businesses decided to strike out on their own for one of two reasons: either they were tired of the headaches, bureaucracy, and limited prospects of working for others, or they’ve got a dream of successfully building, running, and growing a business. In either case, there’s no better way to send these two goals up in smoke than by accepting VC financing. If you started or are running your own business for either of these reasons, then working with VCs probably isn’t for you.

I think there’s a general misconception about what happens when a VC firm makes an investment in a company. In the interests of dispelling myths, here’s what DOESN’T happen:  the VC firm strokes a check, hands it over, and asks you to send them an email every six months to let them know how things are going. In fact, the reality of a VC investment is quite the opposite.

Once the VC investment is made, the VCs will: (1) take positions on your new and expanded board of directors (after they convert your LLC or S Corporation into a C Corporation and reincorporate it in Delaware), (2) install their own candidates as executive officers in key positions, (3) change the equity structure of your company completely (and I do mean completely), (4) provide for special rights for themselves as preferred shareholders of your company, (5) restrict the ability of other shareholders to sell their shares (that means you and your original co-owners and management team, among others), (6) restrict the ability of the company to raise more equity or bank financing, (7) require monthly financial statements and management reports, (8) require you and other key executives to enter into employment agreements (which will include terms governing your salary, hours, vacation time, benefits, dismissal events, and such), (9) restructure the operations of the company, (10) retain broad governance and voting rights within the company, and (11) grant themselves the ability to gain majority control over the board and convert their preferred shares into a majority of the outstanding common shares in the event certain trigger events occur (such as not meeting anticipated financial goals or exit strategies).

What all of this means to you as an entrepreneur is that “your” company is effectively no longer yours. You’re now working for someone else, in accordance with the employment agreement they’ve required you to sign, even if you do remain a large shareholder and an executive officer after the VC investment. Which is why I said that if the autonomy and excitement of working for yourself and being your own boss are the primary reasons you went into business, then accepting VC financing may not be for you. Once the VCs make that investment, the entire culture of your company is going to change (and not for the better, in the minds of most entrepreneurs). 

Incidentally, you’ll have to deal with the actual negotiations and legal and accounting work leading up to the closing and the investment itself. The legal documentation governing a round of VC financing usually runs hundreds of pages, and in order to get to those final, agreed-upon contracts and filings, your company (and its executives and attorneys) will spend up to two months and hundreds of hours negotiating and meeting with your potential investors. In the process, the company will incur tens of thousands of dollars in legal and accounting fees. Good thing there’s a large investment at the end of the process!

And by the way: if you thought I was kidding when I blogged a few weeks ago about the importance of choosing the right corporate form and corporate domicile, and about the importance of adhering to corporate formalities, just wait ‘til you start working with the VCs. There is little that’s more important to them from an operational and administrative standpoint than adhering to corporate formalities. Why? Because VCs never make an investment in any company without an exit strategy, and that exit strategy is either going to be a sale of your company to another company or an initial public offering (IPO). In either case, keeping meticulous books and records is essential to a successful exit.

And what of that exit strategy? Given the state of the equity capital markets these days, the VCs are more likely to sell your company or merge it into or with another company rather than go the IPO route. In all likelihood, this means you’re probably going to get fired from your own company, or be marginalized at best.  Perhaps you’ll end up significantly richer, if you’re lucky, but the odds are good that you’ll end up forced out. There are always redundancies when companies merge or when they’re acquired by larger players, and layoffs are virtually inevitable. Don’t assume that you’ll be immune simply by virtue of the fact that the company was once yours.   

So that’s basically the anatomy of a VC investment. While the upshot is that your company will have the resources (both capital and intellectual) it needs to give it the best shot of becoming a major player in its market space while potentially making you a significant sum of money, the down side for most entrepreneurs is the effective “loss” of their company to the investors.

And just to be clear: I’m not trying to imply that VCs are insensitive, intellectually-challenged bureaucrats who don’t know what’s best for the company. In fact, quite the opposite is true. The VCs I’ve dealt with (and I imagine this is true of most VCs) have been some of the sharpest, most financially savvy people I’ve ever met. They are undoubtedly a huge asset to any company in which they invest. But from the point of view of the entrepreneur, working in the post-investment company can present genuine challenges.

Questions? Comments? Concerns? Raise it for discussion on Facebook, Twitter, or LinkedIn.

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Last week, in response to popular demand, I discussed one of the two major types of SBA loan: the Section 7(a) Loan (if you missed it, click here. This week, I wanted to finish the discussion of SBA programs by talking about the other popular SBA loan program, the Section 504 Loan. 

The Section 504 Loan is limited to very specific corporate purposes. The loan funds can only be used to acquire major fixed assets for expansion and modernization, such as purchasing land and improvements, construction of new facilities or modernizing obsolete facilities, or purchasing long term machinery or equipment. For these reasons, the 504 Loan is less likely to be the right loan for a startup company.

 A 504 Loan is really two separate loans involving two lenders, but it’s treated as a single transaction and both loans are closed at the same time. One of the lenders is a bank, which takes the 1^st lien position and lends up to 50% of the loan amount. The other lender is a Certified Development Company (or CDC for short), which is usually a nonprofit or local governmental economic development entity. The CDC takes the 2^nd lien position and lends up to 40% of the loan amount. Each lender’s loan will be secured by the assets being acquired.  The SBA’s role, as in the 7(a) Loan, is to act as a guarantor. Here, the SBA guarantees 100% of the 2^nd lienholder’s loan, but doesn’t provide any guarantee to the bank (the 1^st lienholder). The theory behind this guarantee structure is that the bank has greater security for its portion of the loan via its 1^st lien position on the assets being acquired and therefore doesn’t need the SBA’s guarantee. 

Additionally, the principal owners of the business are required to provide personal guarantees to both lenders (are you willing to pledge your house, car, savings, etc. for your business loan?). And since the 504 loan only covers 90% of the financing (50% loaned by the bank and 40% loaned by the CDC), the company must contribute 10% of its own money in order to be eligible for the loan. Thus, the increased likelihood that the 504 Loan is not going to be the right loan for a startup.

So, again, we come full circle to the difficulty of obtaining bank financing and the “theoretical” nature of SBA loans. The 7(a) loan can be difficult enough to qualify for, but in the case of the 504 loan, the company actually has to come up with 10% of its own money, provide personal guarantees, and provide liens on its equipment and real estate to the lenders.  Plus satisfy the underwriting standards of the bank and the CDC.

Now that I’ve touched on the main SBA loan programs, I think it’s important to point out that no bank is required to make an SBA loan. Banks are still free to reject any SBA loan application based on their own lending and underwriting standards, even though the loan would be partially guaranteed by the SBA. In addition to all this, there are also eligibility factors that businesses must meet in order to qualify for any SBA financing. I’ve represented many regional and national banks in lending transactions, so I’ve usually got a pretty good idea which lenders are most likely to make SBA loans. It’s probably worth a discussion if you’re interested in exploring SBA financing.  

Let me add here that I am not trying to discourage any business from applying for an SBA loan. I’m merely trying to illustrate what’s involved in the process, provide some details as to how these loans are structured, and perhaps stimulate some thought by business owners and clients. I think the SBA program can be a wonderful tool where a business can meet the lender’s and the SBA’s credit and eligibility criteria.  I encourage my clients to apply for SBA financing if they meet those criteria, and I am more than happy to help present my clients’ applications in the best possible light.

Finally, let me briefly mention a couple of other SBA initiatives that are geared towards small business: the SBIC program, which is a venture capital program sponsored by the SBA, and the SBG program, which is a surety bond program geared towards construction and contracting firms (SBG stands for Surety Bond Guarantee).

A few words about the SBG program: under this program, the SBA will guarantee a certain percentage of a surety bond where the contractor cannot get the bond issued through ordinary channels (and frequently, new or startup contracting businesses will have trouble obtaining surety bonds). This gives sureties an incentive to issue surety bonds in situations where they might not otherwise have done so. Which in turn gives startup construction businesses greater access to contracting opportunities. Theoretically, of course.

Next week, I’m going to discuss one more possible (and sometimes overlooked) way to finance your startup or business, which will conclude what I have to say about the legal aspects related to financing your company.

Questions? Comments? Concerns? Raise it for discussion on Facebook, Twitter, or LinkedIn.

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Over the past few weeks, I’ve been using this blog to discuss various ways of financing a business, whether a startup or an ongoing enterprise. One question that seems to be on the minds of my clients and readers of this blog is the lowdown on SBA financing (i.e., financing under the auspices of the U.S. Small Business Administration, which is an agency of the Federal government). So here’s my take on it.

First off, let me clarify a widespread misconception: the SBA does NOT make loans to small businesses. Rather, the SBA guarantees a portion of a loan made by a bank to a small business, as long as the bank participates in the SBA program and adheres to SBA guidelines when making and servicing the loan. By guaranteeing a portion (usually 50%) of the bank’s loan, the SBA eliminates some of the risk undertaken by the bank. This risk reduction is intended to make it easier for the bank to decide to lend to a startup or small business.

You may recall that a few weeks ago I wrote that getting a bank loan was virtually impossible for a startup business. So, can the SBA’s guarantee help a startup get a bank loan? The answer is “theoretically, yes.” I hate to wax metaphysical in my weekly blog, but in this instance it’s sort of unavoidable. Allow me to explain.

There are essentially two types of loan programs for which the SBA will provide a loan guarantee:  the Section 7(a) Loan and the Section 504 Loan. Let’s first look at the 7(a) loan.

The 7(a) loan can be used by a business for virtually any purpose (working capital, equipment & machinery, land & buildings, etc.). The 7(a) loan involves a sharing of risk between the bank and the SBA. The SBA will guarantee 50% of the loan, while the remaining 50% carries no SBA guarantee. If the borrower (the small business) defaults on the loan, the SBA will make good on the SBA guaranteed portion of the loan by indemnifying the bank for 50% of the bank’s loss. Which means that the bank is still on the hook for the remaining 50% of the loan, which is the portion not guaranteed by the SBA. 

Hence, the “theoretical” availability of the SBA loan to small businesses. Since the bank is still on the hook for at least 50% of the loan in the event the borrower defaults, the bank will still require the borrower to meet all the same credit and lending criteria it would have had to meet were the loan NOT guaranteed by the SBA. Which brings us full circle back to my admonition that getting bank financing for a startup business is difficult. While in theory the SBA guarantee can make it more palatable for a bank to make a loan to a startup, in reality it’s still tough going, especially in “Great Recession” America.

And by the way: if the business defaults on the loan, it is legally liable to both the SBA and the bank for the defaulted loan. The SBA and the bank can (and you can bet your life they will) sue the company after a default. They can also sue the owners personally, if the owners provided additional guarantees. If being on the business end of a lawsuit by the Federal government and a major bank isn’t palatable to you, don’t default on an SBA loan.

Now, a brief word about the logistics of starting the SBA Loan process. Virtually any major bank, and most of the local and regional banks, participate in the SBA loan program. There’s an excellent chance that if you walked into your local bank branch and inquired about SBA loans, they’d direct you to a loan officer who handles them. There’s not much mystery to it. 

Next week, in Part II of this discussion on SBA funding, I’m going to discuss the 504 loan, which is the more complex of the SBA loans. I’ll also have some additional comments on SBA loans and some thoughts on a couple of other SBA programs that don’t involve loans.

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I’m of the opinion that the best way to finance a new business is via the “3 F’s”: Friends, Family, and, for lack of a better term, Fools. Of course, the risk and headache you undertake when you accept money from relatives and close friends is often more aggravating and gut-wrenching than simply taking money from a faceless third party, like a bank or a venture capital firm. Unfortunately, however, because bank and venture capital financing is usually not viable for startups (and I’ll discuss why next week), new businesses are often left with no other alternative than to hit up the 3 F’s.

So, do you like your friends, family members and relatives? Want to continue to have a warm, fuzzy relationship with them? (I’m perhaps assuming too much here, but stay with me.) If the answer is yes (or even if it’s no), and if they’re considering providing funds for you to get your business off the ground, or to keep it running through a rough patch, then take heed of the advice I’m going to discuss here: come to an agreement with them in writing. BEFORE they give you the money.

Perhaps the best way to explain why you need to arrive at an agreement in writing with your family members or friends before they stroke you a check is by discussing what the agreement should, at minimum, include. Here are just a few of the issues you’ll want to focus on while you’re putting together some sort of document to memorialize the arrangements: 

• Did you discuss whether the money was going to be classified as debt (a loan) or as equity (an investment) in the company?

Debt and equity are treated very differently for tax and legal purposes, and they have very different characteristics with respect to repayment and expected returns. Lenders won’t (or shouldn’t) expect much more than 6% - 12% annual interest, plus return or amortization of principal on some agreed-upon schedule. Equity investors, however, often have visions of buying a Greek island with the triple digit returns they expect to make via an investment in your company. Which would certainly help out the Greek economy, these days.

If the money is a loan, you’ll want to deliver a Note to your lender (yes, even if that lender is a relative or friend) which includes, at minimum, the principal amount, interest rate, maturity date, default provisions, repayment/amortization schedule and terms, possible collateral (in which case you’ll also need a security agreement and a UCC filing or a deed of trust), and dispute resolution terms. If the money is an investment (equity rather than debt), you’ll want to include the family member or relative as a shareholder or member of your corporation or LLC, and the rights and obligations of both the company and the equity investor must be spelled out in detail in the company’s constituent documents.  If you want to avoid problems both legal and personal, that is

• Did you provide anything in writing describing your business and the expected return on an investment in your business (e.g., a business plan or a more sophisticated document, such as a Private Placement Memorandum)?

Bear in mind that even the smallest startup is bound by the antifraud provisions of federal and State securities laws with respect to the raising of equity capital, as opposed to debt financing. There are filings to make (such as a federal Form D and state Blue Sky filings), documents to deliver (such as subscription agreements, accredited investor questionnaires, and shareholder or operating agreements), and regulations to follow. Each investor must receive exactly the same information as each other investor, so if you delivered a business plan or PPM to any investor, you’ll need to deliver the exact same document to ALL potential investors. Running afoul of any of these requirements could result in serious problems for your business if you ever find yourself in the middle of a dispute with your investors.

It would also be very useful to prepare a set of pro forma financial projections demonstrating the expected return on an equity investment. This is not only useful for managing expectations, but it’s also important, from a legal perspective, that you disclose any and all material facts about your company and its prospects to your potential investors.

• If the company goes belly-up (and lots of startups do), what are the rights of your lenders or investors? Remember, we’re talking about your friends and relatives here. Will they expect you to personally make good on their losses? Will they silently seethe and exclude you from all future family functions while badmouthing you within the business community? Are you sure you’ve discussed these issues with them and that your documents accurately reflect both your intentions and your investors’ or lenders’ expectations?
  
• Suppose the company needs additional cash. Do you have a right to subordinate the loans of your family members to subsequent lenders (such as other family members)? Can you subordinate their Notes to a bank? (It would be a very good idea to retain this flexibility in case it’s ever necessary to utilize it.) Or, in the case of equity, do you have the ability to dilute the shares or equity interests you issued to your family members or friends by issuing additional equity to third parties?
  

These are just a few of the many issues you’ll need to consider as you raise money at the startup phase or for ongoing operating expenses. Which is why it bears repeating: if you’re going to be raising money from third parties (even if, or especially if, they’re relatives or friends), be sure you put the terms in writing. A very detailed writing. When all parties understand up front what their rights and obligations are, it’s much less likely that you’ll end up estranged from your family members down the road. Remember that you’re going to be married to your relatives and friends for an extended period of time via your mutual business interests in the company. There are rarely any divorces, and courts are not sympathetic to family issues in corporate disputes.

So, before you take money from the 3 F’s, ask yourself: Are you ready to get married? And is the necessity of financing the business worth the potential family issues that could arise down the road? If the answers are yes and yes, be sure you put the arrangements in writing at the outset, and be sure all parties sign that agreement before any money changes hands.

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The first response I usually get from most businesspeople when I mention “corporate formalities” is a puzzled look. Which is not surprising, since the term is rarely used except by lawyers.  The second response is invariably a request by my clients for another cup of my famous high-octane coffee, since the mere mention of “corporate formalities” usually results in the realization that the meeting isn’t over yet (the end of a meeting with me being the highlight of most of my clients’ days). Fortunately, high-octane coffee is plentiful around my office. In extreme cases, I can even produce a finger or two of single-malt scotch if I notice my client snoring and slumped over in their chair mid-discussion.

But I digress. “Corporate formalities” is a term with which you ought to become familiar if you intend to run, or are already responsible for running, a business.

The reason I even bring this arcane term of art up is because of an admonition I included in my last blog (which you can access by clicking here. In that blog, I suggested that even if you make proper filings with the appropriate State agencies to set up your company, you would still not be adequately protected from company liabilities if you failed to also adhere to “corporate formalities” and maintain proper corporate records. So, what did I mean by that?

Let’s discuss a major misconception about “incorporating” (which is a term I use to mean forming any corporate entity, whether an LLC, corporation, partnership, or something else).  The misconception is that all one need do to obtain the “magic bullet” of limited liability is to file a document with the proper State agency, and voila! -- instant “teflon” for the company’s owners.  But the reality is quite different.

You see, incorporating involves a trade-off between you and the State (you didn’t really think that the State was going to give you a freebie, did you?). In exchange for limited liability for the owners of a company, the State insists that the company adhere to certain laws, keep certain records, and adhere to certain procedures.  Those laws, records, and procedures include the following:

• The company must keep a separate bank account, and cannot commingle its funds with its owners’ funds and bank accounts. (Note that this is more straightforward in theory than in practice. I’ve seen numerous businesses get tangled up in banking and segregation of funds issues that could potentially lead to loss of the owners’ limited liability).
• The company must make certain information public, such as the identity of the owners, the address of its corporate headquarters, and the identity of its agent for service of process.
• The company must carefully authorize and document all actions taken by the company, usually in the form of signed resolutions (this is one of the most frequently overlooked corporate formalities, and potentially one of the most serious if the company is ever sued by a shareholder, employee, or customer).
• The company must not engage in activities that are extraneous to its corporate purpose, or that properly belong to the owner or owners (e.g., don’t have your company pay for your tickets to Tahiti, or take on any tasks related to your spouse’s widget factory).

The bottom line is that the failure of your company to adhere to corporate formalities can result in a “disregard” of the corporate form by a court if your company is ever sued. Legally, this is known as “piercing the corporate veil,” and it’s a disaster by any measure. How? Well, if the court awards damages to the person suing your company, it means that YOU, as an owner of the company, are personally liable for those damages. It could also result in fraud and shareholder actions being upheld against you, and the literal unraveling of your company. 

Finally, let’s take the example of a corporate acquisition: your company has been approached by a competitor with a buyout offer, or you decide that, after 15 years in business, you want out and you want to sell your company. As a mergers and acquisitions attorney, I can tell you that the first thing the lawyers on the other side are going to ask for are your corporate books and records. Because the acquirer wants to know what they’re acquiring, and they want to ensure that they’re not inheriting any potential liabilities that they don’t want to inherit. Inadequate books and records can quickly scuttle a potential deal.

Again, I would urge you to ask yourself the following question: Is the modest cost of keeping adequate corporate books and records worth the potential personal liability, or the risk of scuttling a potentially lucrative sale of the company? Only you, as the business owner, can answer this question.

Has your company properly adhered to corporate formalities? Need help getting your corporate house in order? Give me a call. 

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I have this recurring nightmare. I don’t have it every day, or even every month, and to be truthful it usually doesn’t even happen when I’m sleeping. It’s more of a daytime occurrence, but in substance and fear factor, it’s every bit a nightmare. And I have it often enough that it merits writing about here.

If you read my blog last week, you know that I’ve turned my attention to the legal issues surrounding the startup of a business. My nightmare relates to the scenario that occurs when a new client comes to me for the first time and tells me that he’s been running his business for a few months, things are going well, and he needs some sort of legal help with a new line of credit, or with a contract he’s about to sign with a new vendor or joint venturer, or something similar.

When I ask this hypothetical client what kind of company he’s formed, and whether I can see his formation documents, he gives me a blank stare. That’s when the nightmare begins. Both for me and, often enough, for my client as well.

When you form a new venture, it’s not enough to go to some online company or to OfficeMax, fill out a few forms, and file them with the designated state office. Sure, technically, you can do it that way. But there are too many issues (legal and accounting being only two) that need thoughtful consideration out of the gate, and a do-it-yourself kit isn’t going to adequately prepare you to think through those issues.

Instead, you need legal help.

Here are just a few of the issues that I’d ask a new client to consider and discuss with me before he opens his doors for business:

• What type of business are you going into?

• Did you sign any documents or commence any business operations before coming to me to discuss forming your company?

• Are you raising money from third parties (i.e., investors or lenders), or just from the “three F’s” (i.e., family, friends, and fools)?

• Do you have investors? Are they people or companies? Did they lend you the money, or invest it? Is there anything in writing evidencing their investments or loans to you?

• Are you minority or woman owned? How do you make that determination if you have several owners? Can you take advantage of contracting and funding programs related to your ownership status?

• Did you prepare a business plan? If you raised (or intend to raise) outside money, did you prepare an offering document? Did/does your investment offering comply with Securities and Exchange Commission regulations?

• In what state will you conduct the bulk of your business?

• Did you speak with your accountant about tax issues related to operations and the various corporate forms?

• Have you signed any documents in the name of the company?

• Do you have office space? Did you sign a lease, or do you intend to sign one?

• Did you open a bank account? Who has signatory authority on checks?

• What happens if one of the business partners decides to leave the business, or dies? Or one of your partners just decides to stop working on the business but continues to collect profit distributions? Can he do that?

It only took me about 45 seconds to think of the issues above, and I’m just getting started. My point is that when you start a business, there’s a lot to think about. Startup issues will affect the remainder of your business’s life, and your personal life (and mental health) as well. Your lawyer and your accountant need to be part of the process from the very beginning.

There’s an old saying: “Junk in, junk out” (the saying is actually a bit more, uh, “colorful” than this, but I think we all get the gist of it). In other words, it’s best to put high quality legal and accounting work into the startup phase of your business so as to avoid a lot of “junk” (in the form of liability, headache, tax, and other issues) later on down the road when you’re up and running.

I’m going to explore a number of the bulleted issues above in my next several blogs. In the meantime, feel free to call me if you’ve got any questions about any of these issues, or other legal issues affecting your business.

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