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Structuring Your Business for Investment and Growth. Presented by Teri G. Rasmussen Capital Crash Course 2008 December 2007. Teri G. Rasmussen Partner and Vice Chair, Business Law Practice Group Lane, Alton & Horst, LLC trasmussen@lanealton.com (614) 233-4753. Lane, Alton & Horst, LLC

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structuring your business for investment and growth

Structuring Your Business for Investment and Growth

Presented by Teri G. Rasmussen

Capital Crash Course 2008

December 2007

slide2
Teri G. RasmussenPartner and Vice Chair, Business Law Practice GroupLane, Alton & Horst, LLCtrasmussen@lanealton.com(614) 233-4753

Lane, Alton & Horst, LLC

Two Miranova Place, Suite 500

Columbus, Ohio 43215

www.lanealton.com

Lane, Alton & Horst, LLC

teri g rasmussen

Teri G. Rasmussen

B.A., with honors, 1981, University of Iowa J.D., cum laude, 1984, University of Michigan

Bar Admissions:Supreme Court of Ohio, 1984

U.S. District Court, Southern District of Ohio, 1984

U.S. District Court, Northern District of Ohio, 1993

U. S. Sixth Circuit Court of Appeals, 1997Professional Associations:Columbus Bar association (Former Chair, Financial Institutions Committee),

Ohio State Bar Association (Former Chair, Banking, Commercial and Bankruptcy Committee)

American Bar Association

American Bankruptcy Institute

National Association of Women Business Owners (NAWBO)

Lane, Alton & Horst, LLC

teri g rasmussen4

Teri G. Rasmussen

Business Acquisitions and Sales

General Corporate and Business Law

Joint Ventures and Strategic Alliances

Corporate Governance and Shareholder Disputes

Contracts and Loan/Lease Documentation

Business Formation and Financing

Business Planning

Creditors’ Rights and Debt Collection

Business Bankruptcy and Insolvency

UCC and Secured Transactions

Commercial Finance

Litigation

Real Estate

Lane, Alton & Horst, LLC

slide5
Visit my legal blog:

OHIO PRACTICAL BUSINESS LAW COUNSEL

http://ohiopracticalbuslaw.wordpress.com

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i structuring your business
I. Structuring Your Business

THE BASIC SETUP

Lane, Alton & Horst, LLC

every business has a legal form
EVERY Business Has a Legal Form
  • If you don’t make a Decision, the Law will make one for you.
  • A one-person business will automatically be a sole proprietorship.
  • A businesswith two or more Owners will automatically be treated as a general partnership

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the type of legal entity matters
The TYPE of LEGAL ENTITY Matters
  • Level of Formality Required for Recordkeeping
  • Level of Formality Required in Decisionmaking
  • Effect of Death or Disability of Anyone Actively “Involved” in the “Management” of the Business
  • Taxes – Who Pays and How Much
  • Ability of Business Creditors, Disgruntled Employees, and Others to Reach Personal Assets of Owner(s)
  • Who Has “Say” in, or Control of Business and its Operations

Lane, Alton & Horst, LLC

factors to consider in choosing a legal structure
Factors to Consider in Choosing a Legal Structure
  • How much record-keeping are you able and willing to do on a continuing periodic basis?
  • What is YOUR tolerance for risk?
    • What sort of risks are you most comfortable having?
    • What sort of risks do you MOST need/want to avoid?
  • How will the business be financed?
    • Outside Investors and Creditors
    • Personal and Family Funds

Lane, Alton & Horst, LLC

factors to consider in choosing a legal structure10
Factors to Consider in Choosing a Legal Structure
  • What sort of business risks are there in your industry or type of business?
  • How much government regulation is your business generally subject to?
  • Where will your business sell or provide good and/or services?
    • Locally or within one state?
    • Regionally?
    • Nationally?
    • Worldwide?

Lane, Alton & Horst, LLC

factors to consider when you are not the only owner
Factors to Consider When You Are Not the Only Owner
  • How well do you know your fellow owner(s) and can you really trust them?
  • Compatibility of Owners in Temperament, Work Habits, Spending, Risk Tolerance, Etc.
  • Strengths and Weaknesses of Fellow Owner(s)
    • Could a Weakness Cause a Problem for the Business?
    • How Can That be Guarded Against?

Lane, Alton & Horst, LLC

factors to consider when you are not the only owner12
Factors to Consider When You Are Not the Only Owner
  • How Many Owners Will There Be?
  • Owners individuals or business entities?
  • What Role, Responsibilities and/or Duties Will Each Owner Have? How will these be Shared or Allocated?
  • Will any owner(s) or group of owners have veto power with respect to certain specific issues?

Lane, Alton & Horst, LLC

factors to consider when you are not the only owner13
Factors to Consider When You Are Not the Only Owner
  • Are you the “money” person or the “sweat equity” person?
  • What happens if an owner wants out of the business?
    • Getting Investment Out of the Business
    • Transfer, and Restrictions on Transfer, of Ownership
  • What happens to ownership interest upon death or disability of owner?
  • Will some owners get their “investment” back sooner than other owners?

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slide14
THE CHOICES

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choices in basic legal structure
Choices in Basic Legal Structure
  • Sole Proprietorship
  • Partnership
    • Limited
    • General
  • Corporation
    • C-Corp
    • S-Corp
  • Limited Liability Company (LLC)

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basic types of ownership interests
Basic Types of Ownership Interests

Partnership Partnership Interest

Corporation Shares of Capital Stock

LLC Membership Interest

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sole proprietorship basic characteristics
Sole Proprietorship Basic Characteristics
  • No separate existence from owner.
    • Business assets in owner’s personal name
    • Owner signs contract in personal capacity
    • If owner dies or becomes disabled, so does the business
    • Profits and losses from, as well as expenses of, business included on individual income tax return
    • Difficult to transfer

Lane, Alton & Horst, LLC

weighing the sole proprietorship alternative
Advantages

Maximum authority and control

Simplest and least expensive to start – just find a location and open the doors

Appropriate for very small service business not likely to borrow much money and not likely to be sued

Business losses can offset income from other sources

Disadvantages

Death or Illness endangers business

Growth limited by personal energies

Obtaining financing and investment may be difficult

Personal and business affairs easily mixed

Weighing the Sole Proprietorship Alternative

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general partnership definition
General Partnership Definition
  • Ohio law defines a general partnership as “an association of two or more persons to carry on as co-owners, a business for profit”

Ohio Rev. Code 1775.05(A)

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purpose of forming partnership
Purpose of Forming Partnership

Nothing more than

a common law contract between owners

  • To operate broad-based business
  • To share in the responsibilities of management
  • To divide the profits realized from the enterprise

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partnership characteristics
Partnership Characteristics
  • Almost any management and profit-sharing arrangement can be agreed upon among the partners.
  • Must have at least two partners at all times.
  • Joint Venture or Strategic Alliance differ from true partnership because they are generally limited to an isolated and particular transaction.

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creation of general partnership
Creation of General Partnership
  • Can be “accidentally” created – formation occurs whenever parties expressly or implicitly start sharing profits and losses and the management of the business
  • Can be created orally – no written agreement required, though recommended

Lane, Alton & Horst, LLC

limited partnership
Limited Partnership

Only valid if written and formed in compliance with statutory requirements

  • One General Partner – same responsibilities as in general partnership.
  • Other Limited Partners – Have limited rights in exchange for limited liability for partnership debts.

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general and limited partnerships comparison
General Partnership

All Partners Participate in Management

Dissolves upon death or withdrawal of any partner

Limited Partnership

Limited Partners Must Not Be Involved in Day-to-Day Operations

Dissolves only upon death or withdrawal of General Partner

More Complex than General Partnership

General and Limited Partnerships Comparison

Lane, Alton & Horst, LLC

weighing the partnership alternative
Advantages

Two (or more) heads are better than one

Income passes through to Partners

Management Structure Flexibility

No qualification requirements for doing business in other states

Disadvantages

Difficult to get rid of bad partners

More Expensive to form than sole proprietorship, especially in case of limited partnerships

Difficult to transfer ownership interest

Hazy line of authority in general partnership

Cannot have both management responsibilities and limited liability

Weighing the Partnership Alternative

Lane, Alton & Horst, LLC

usefulness of partnership alternative
Usefulness of Partnership Alternative
  • General Partnership is obsolete except in very special circumstances
    • Owner is particularly concerned about deductibility and capital gains treatment of continuing payments to retiring partners(IRC 736(a))
    • Important that business not be treated as entity for tax purposes(e.g. oil and gas investments)
  • Limited Partnership duplicated and supplemented by LLC alternative

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distinguishing characteristics of corporations
Distinguishing Characteristics of Corporations
  • Ownership interests are known as “shares” or “stock” and are freely transferable to anyone else unless shareholders otherwise agree
  • Shareholders are not liable for company obligations except under highly unusual circumstances, but the company itself will be held liable
  • Existence continues even after departure of original owners or key individuals

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corporate governance
Corporate Governance
  • Shareholders have no authority to control day-to-day management or business operations
  • Shareholders elect Directors
    • Board of Directors set general policy
  • Board of Directors appoint Officers such as President, Vice President, Treasurer, and Secretary
    • Officers manage day-to-day operations of company
    • Officers are answerable to Board for their actions

Lane, Alton & Horst, LLC

formation of corporation
Formation of Corporation
  • Corporation has NO owners until stock shares have actually been issued to owners by the Incorporator.
  • Corporation IS NOT validly formed until
    • Shareholders elect Directors

AND

    • Directors appoint Officers.

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corporation formation procedure
Corporation Formation Procedure
  • Articles of Incorporation are signed by “Incorporator”, who may or may not become a Shareholder, and filed with the Secretary of State.
  • Incorporator receives subscriptions and payment for shares and issues them to owners.
  • Incorporator calls first meeting of Shareholders to elect Directors, adopt Code of Regulations, and transact any other business.

4.After Shareholders elect Directors, Directors pass resolution appointing Officers.

Lane, Alton & Horst, LLC

weighing the incorporation alternative e ffect upon personal liability
Incorporating

Helps separate your personal identity from that of your business. Once incorporated, the shareholders of a corporation have only the money they put into the company to lose, and usually no more as a result of being a shareholder.

Remaining Unincorporated

Sole proprietors and general partners are subject to unlimited personal liability for business debt or law suits against their company. Creditors of the sole proprietorship or partnership, including ordinary suppliers, vendors, and other trade creditors can bring suit against the owners of the business and can move to seize the owners’ homes, cars, savings or other personal assets.

Weighing the Incorporation Alternative:Effect Upon Personal Liability

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weighing the incorporation alternative credibility of business
Weighing the Incorporation Alternative:Credibility of Business
  • Adds Credibility.
    • A corporate structure communicates permanence, credibility and stature.
    • Even if you are the only stockholder or employee, your incorporated business may be perceived as a much larger and more credible company.

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weighing the incorporation alternative attracting capital and financing
Incorporated

Capital can be more easily raised with a corporation through the sale of stock.

Investors are more likely to purchase shares in a corporation where there usually is a separation between personal and business assets.

Some banks prefer to lend money to corporations.

Unincorporated

With sole proprietorships and partnerships, investors are much harder to attract because of the inability to have control without personal liability.

Weighing the Incorporation Alternative:Attracting Capital and Financing

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weighing the incorporation alternative transferring ownership
Incorporated

Ownership of a corporation may be transferred, without substantially disrupting operations or the need for complex legal documentation, through the sale of stock.

Unincorporated

Cannot sell sole proprietorship as a going concern, i.e. can only sell individual assets

Partnership may dissolve; generally not easily transferable

Weighing the Incorporation Alternative:Transferring Ownership

Lane, Alton & Horst, LLC

types of corporations
Types of Corporations
  • C-Corp -for larger more mature businesses, especially those publicly held, and for those anticipating making initial public offerings (IPO) of capital stock in the VERY near future
    • Cannot later be converted to S-Corp or LLC without tax consequences
  • S-Corp -for smaller privately held businesses with less than 100 owners, all of whom are individuals; must specifically affirmatively select this status
    • Can later be easily converted to C-corp

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s corporation restrictions on shareholders
S-Corporation Restrictions on Shareholders
  • Maximum of 100 shareholders
  • Must be individuals (or their estate planning trust) – no corporations, LLCs, or partnerships
  • Shareholders must be U.S. citizen or permanent resident – no foreign nationals
  • Only one class of shares/stock permitted – no preferred permitted
  • Taxes on corporation income are “passed through” to shareholder’s income

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close corporations
Close Corporations
  • A close corporation is a special sort of corporation (either S or C) designed for businesses with only a few owners.
    • Allows owners by agreement to bypass many of the usual formalities required of corporations, thereby simplifying management of company affairs
    • Requires a WRITTEN agreement complying with specific statutory requirements(Ohio Rev. Code 1701.591)
    • Often has restrictions on ability of shareholders to transfer ownership

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close corporation agreement
Close Corporation Agreement
  • Allows shareholders to vary and discard many of the legal formalities otherwise imposed on corporations.
  • Allows shareholders to be more specific about how they will treat one another. This can be helpful if a question later arises as to whether a shareholder’s “fiduciary duty” to the company and other shareholders has been met.

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contents of close corporation agreement
Contents ofClose Corporation Agreement
  • Respective voting rights of owners
  • Circumstances giving rise to the right of one or more shareholders to dissolve company
  • Conditions of employment of owners
  • Management authority
  • Payment and timing of dividends
  • Permissibility of transactions with shareholders (e.g. leases)
  • Can includeBuy-sell provisions, including redemption provisions

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close corporation agreement formalities
Close Corporation Agreement Formalities
  • All shareholders must sign the Close Corporation Agreement.
  • Adoption of Close Corporation Agreement must also be recorded in the Company’s official minutes.
  • Agreement must specifically reference the statute authorizing close corporation agreements. Ohio Rev. Code §1701.591
  • Very important that the Company’s stock certificates carry a legend indicating the existence of the Close Corporation Agreement.

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impetus for emergence of limited liability company llc
Impetus for Emergence of Limited Liability Company (LLC)
  • AROSE FROM DESIRE OF BUSINESS OWNERS AND INVESTORS
    • To combine the limited liability protection provided by corporation law with
    • Advantageous income treatment available to Partnerships
  • BUT WITHOUT
    • Management issues of Limited Partnerships
    • S-Corp Restrictions on Type and Number of Shareholders Permitted

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brief history of limited liability company llc
Brief History of Limited Liability Company (LLC)

Relatively recent legal form of business allowing owners

to take advantage of the benefits of

both the corporation and partnership forms of business

  • First statute enacted in Wyoming in 1977
  • Gained popularity after IRS ruled LLC could be treated as a partnership for federal income tax purposes (IRS Rev. Rul. 88-76)
  • Ohio has allowed since 1994
    • Single member LLC permitted since 1997
    • Written Agreement Not Required; Default Provisions of Ohio Rev. Code 1705.13 would govern
  • Now available in all 50 States

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limited liability company characteristics
Limited Liability Company Characteristics
  • Unlimited number of Members with any mix of individuals and business entities
  • Management Participation without loss of Limited Liability Protection
  • Flexible allocations and distributions of profits and losses
  • Flexible Control and Governance
  • Minimal Statutory Formalities Required
  • Taxation Options – Can choose to be taxed either as corporation or as a partnership

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types of limited liability company
Types of Limited Liability Company
  • Manager Managed
    • Similar to Corporationwith only a single Member or small group of selected Members in control of management of business and affairs of company
  • Member Managed
    • More like a Partnership with all Members actively participating in management of company and it business affairs

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manager managed llc
Manager Managed LLC
  • Manager(s) selected and replaced in whatever manner agreed upon by Members
  • In general, Manager(s) make all decisions concerning the company’s business, operational, and financial affairs without input or prior approval of Members
  • Some major substantive decisions still reserved to Members
  • Manager does not have to be a Member
  • Any number of Managers permitted

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member managed llc
Member Managed LLC
  • Ohio statutory provisions govern unless displaced by provisions of a written Operating Agreement
  • Can vote by headcount, pro rata Membership Interest, or any other system agreed upon by the Members
  • A Member’s management voting rights do not have have any relationship to that Member’s ownership interest

Lane, Alton & Horst, LLC

slide47
MAKING THE DECISION

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self sufficient lifestyle company
Self–Sufficient “Lifestyle” Company
  • Businesses with
    • a local focus
    • Non-technology product or service
    • Not requiring or seeking large amounts of outside capital
  • SHOULD PROBABLY CHOOSE BETWEEN
    • LLC
    • S-Corporation

Lane, Alton & Horst, LLC

special advantages of llc
Special Advantages of LLC
  • If you're planning to start a business that will hold real property that will appreciate
      • “C” corporations and their shareholders are subject to tax on the appreciation when assets are sold or liquidated
      • An LLC and its members are not subject to this double taxation

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special advantages of llc50
Special Advantages of LLC
  • If you're thinking about forming an "S" corporation:
    • An "S" corporation is taxed in the same way as an LLC, but it has some restrictions on
        • the number and types of shareholders,
        • how profits and losses can be allocated among the owners, and
        • The kinds of stock they can issue to investors.
    • The LLC has none of these restrictions

Lane, Alton & Horst, LLC

weighing the llc alternative similarities to s corp
Weighing the LLC Alternative –Similarities to S-Corp
  • Both LLCs and S-Corps offer their owners limited liability protection and are both pass-through tax entities.
    • Pass-through taxation allows the income or loss generated by the business to be reflected on the personal income tax return of the owners.
    • This means that if you have business losses you want to use to offset other income you might have from another job or from your spouse's employment, for example, you can claim those losses on your personal income tax.
    • This special tax status eliminates any possibility of double taxation for S corporations and LLCs

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weighing the llc alternative differences from s corp
Weighing the LLC Alternative –Differences From S-Corp
  • LLCs are more flexible in the way profitscan be distributed
    • An S-corporation can only have one class of stock and your percentage of ownership determines the percentage of pass-through income.
    • LLC can have many different classes of interest, and the percentage of pass-through income is not tied to ownership percentage. The pass-through percentage can be set by agreement of the members in the LLC's operating agreement.

Lane, Alton & Horst, LLC

growth oriented businesses
Growth–Oriented Businesses
  • Businesses with
    • Technology or biomedical product
    • Large capital requirements
    • Seeking a wide market
  • SHOULD PROBABLY CHOOSE BETWEEN
    • LLC
    • S-Corporation
    • C-Corporation

Lane, Alton & Horst, LLC

what do investors want
What Do Investors Want?
  • Conventional wisdom suggests that the “market” and at least “institutional investors” greatly prefer C-corporations
    • Restrictions on who can be S-Corp shareholder preclude venture capitalists as shareholders
    • Appreciate tax loss carry-forwards
    • May be restricted from investment in “flow-through” entities due to concerns about unrelated business income tax(UBIT)
    • General comfort level

Lane, Alton & Horst, LLC

alternative to immediate c corp
Alternative to Immediate C-Corp
  • Form LLC (or S-Corp) now
  • Convert from LLC or S-Corp if prospect of investment becomes realistic
    • Conversion from S-Corp to C-Corp very easy – just notify IRS
    • Conversion from LLC to C-Corp may require merger and some tax planning, but is manageable

Lane, Alton & Horst, LLC

conversion of llc into c corp
Conversion of LLC Into C-Corp
  • Process of converting from LLC to a corporation has recently become much easier
    • Ohio Rev. Code 1705.371 and 1701.782 allow LLCs to convert into corporations by notifying certain governmental agencies and filing a Certificate of Conversion with the Ohio Secretary of State
  • Conversions to and from other entities now also easier

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ii structuring your business for investment
II. Structuring Your Business for Investment

INVESTMENT AND FINANCING STRATEGIES AND CONSIDERATIONS

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general concepts risk v return
General Concepts: RISK v. RETURN
  • “Free” $$$
  • “Smart” money v. “dumb” money
  • Equity v. Debt
  • Dilution
    • Timing
    • Effect

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dilution
Dilution
  • Early infusion of substantial outside investment can cause loss of control
  • Same amount of $$$ investment at later stage in company’s existence and growth less effect
  • Smaller piece of the pie may be worth more than 100% ownership of more marginal company

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business plan
Business Plan
  • Generally necessary whatever the investment or financing source being accessed
  • Useful to have even if initially tapping into the “friends and family’ network
    • Helpful in establishing direction and goals
    • Contains information needed to approach others later

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business plan overview
Business Plan Overview
  • EXECUTIVE SUMMARY- ONE PAGE
  • Description of Business
    • Management Team Experience
    • Product or Service
    • Business Premises and Location
  • Financials
  • Marketing
    • Promotion of products/services
    • Addressing competition

Lane, Alton & Horst, LLC

funding sources
Funding Sources
  • Personal savings and assets
  • Friends and Family
  • Bootstrap (profits from business)
  • Banks, equipment lessors, factors, and other financial institutions
  • Grant programs
  • Outside Equity Investors
    • Institutional Venture Capital
    • Angel Investors
    • Initial Public Offering aka IPO

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pecking order if things go wrong
Pecking Order If Things Go Wrong….
  • Secured Lenders
  • Taxing Authorities
  • Unsecured lenders and trade creditors
  • Other investors in the company
  • YOU

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slide64
PLANA: KEEP THE EQUITY

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funding sources without loss of equity
Funding Sources Without Loss of Equity
  • Grants
  • Personal Funds
  • Bootstrapping from operations
  • Friends and Family
  • Banks, Factoring, Equipment Lessors

Lane, Alton & Horst, LLC

assisted bootstrapping
Assisted Bootstrapping
  • Cooperative Ventures with Other Businesses
    • Joint Development Agreement
    • Joint Venture
    • Strategic Alliance

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economic development grants
Economic Development Grants
  • Available only under limited circumstances; eligibility requirements
  • Can be local, state, regional, or federal
    • Municipalities
    • State of Ohio
    • E.g. SBA Small Business Innovation Research/Small Business Technology Transfer (SBIR/SBTT) www.sbir.gov
  • Can sometimes convert to debt upon happening of certain events

Lane, Alton & Horst, LLC

bootstrapping personal funds
Bootstrapping/Personal Funds
  • Revenues from company operations or personal funds
  • Other funding sources are more likely to be interested in becoming involved with your business if you are also putting some of your own money into the company
  • Advantage – no personal loans to be repaid or angry investors to have to confront
  • Disadvantage – may result in
    • insufficient capital to bring a product or service to market successfully
    • depletion of funds previously set aside for retirement or children’s college education

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joint development agreement
Joint Development Agreement
  • Larger established company provides money and resources to small company to refine a product useful to the larger company in some way, e.g. makes a production process less expensive.
  • Spell out how ownership of IP generated under the JDA will be handled
  • Confidentiality and Nondisclosure provisions
  • Be aware of superior resources available to larger company in the event of a dispute

Lane, Alton & Horst, LLC

joint venture strategic alliance
Joint Venture – Strategic Alliance
  • Join together with another company to complete a particular project
  • Can be done contractually
  • Can also be done in form of a LLC with each of the companies involved being a Member

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friends and family option
ADVANTAGES

May be easy to access

May have less FINANCIAL consequences if business fails

DISADVANTAGES

Risk of losing a friend or straining family relationships if business is not successful

Can cause problems even if business is successful

Friends and Family Option

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easy money
Easy Money?
  • Your company needs money, but really isn't bankable at the moment.
  • Your brother-in-law agrees to put money into the business in exchange for shares of stock.
  • At first you appreciate his generosity and the business tips he now hands out freely.
    • However, when you discover he’s cheating on your sister and divorce ensues, you start wondering how you can get rid of the arrogant painin the neck.

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guidelines for family and friends option
Guidelines forFamily and Friends Option
  • Best reserved for situation where friend or family member can afford to lose the money
  • Decide and explain BEFORE you take the money
    • what role, if any, the relative or friend will have in the business
    • What the upside will be if the business is fabulously successful

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guidelines for family and friends option74
Guidelines forFamily and Friends Option
  • Take time to make a COMPLETE and FULL disclosure of the nature of the business and risks and rewards associated with it, just as you would with an outside investor.
  • Provide regular periodic formal financial statements both before the business gets started and once it is operating.
  • Put “understandings” about the money being given to you IN WRITING.

Lane, Alton & Horst, LLC

loans and leases from outsiders
Loans and Leases from Outsiders
  • Factoring receivables
  • Banks
    • Asset-based lending
    • SBA Loans
    • Commercial Loans
  • Equipment Lessors
  • Ohio Department of Development

Lane, Alton & Horst, LLC

commercial loan categories
Commercial Loan Categories
  • Short Term (5 years or less)
    • Typically made for equipment purchases and to meet cyclical inventory, accounts payable, and general “working capital” needs
  • Long Term
    • Commonly used to purchase, improve, or expand fixed assets such as borrower’s plant, facilities, major equipment, and real estate

Lane, Alton & Horst, LLC

commercial loan categories77
Commercial Loan Categories
  • Secured
    • Promise to repay debt is supported by pledge, aka security interest of some or all of the borrower’s assets
    • If default occurs, lender is able to take possession of assets pledged, sell them in a “commercially reasonable” manner, and apply net sale proceeds to debt owed
  • Unsecured
    • No collateral supports promise to repay debt
    • Lender relying upon the creditworthiness and reputation of the borrower

Lane, Alton & Horst, LLC

types of commercial loans
Types of Commercial Loans
  • Asset-Based - Revolving Credit facility
    • Formula based upon “Eligible Accounts Receivable” and “Eligible Inventory”
    • Often used for general working capital purposes
  • All Business Assets – Short Term Loan
  • Line of Credit
    • Can be Secured or Unsecured Loan
  • Real Estate – Long Term Loan

Lane, Alton & Horst, LLC

loan applications and proposals content
Loan Applications and Proposals - Content
  • In addition to purpose and amount of loan sought, loan applications and/or proposals will require the following General Information:
    • Names of business, principals in business, and any other guarantors or co-debtors
    • Legal Ownership and Governance Structure
    • Business Description and History
    • Thumbnail Management Profile, including background, education, experience, skills, and accomplishments of principals and key employees

Lane, Alton & Horst, LLC

loan applications and proposals financial informational content
Loan Applications and Proposals – Financial Informational Content
  • Personal Financial Statements and Tax Returns (generally for preceding 3 years) of principals or majority ownership and any other guarantors or co-debtors
  • Company’s Financial Statements (including balance sheet and income statement) for YTD and preceding 3 years – may require accountant’s audit or review
  • Appraisal or other Valuation of Collateral

Lane, Alton & Horst, LLC

loan applications and proposals market informational content
Loan Applications and Proposals – Market Informational Content
  • Products or Services Produced
  • Industry, Market, and Customers/Clients for Products and Services, i.e, Company’s “niche”
  • Production Capabilities and Procedures
  • Outlook and Demand for Products and Services
  • Procedures and Processes for Addressing Competition

Lane, Alton & Horst, LLC

loan applications and proposals other documentation to be reviewed
Loan Applications and Proposals – Other Documentation to be Reviewed
  • Leases for Business Premises
  • Corporate Governance Documents (e.g. Code of Regulations, Close Corporation Agreement, Operating Agreement, Buy-Sell Agreement)
  • Transaction Documentation if Loan Proceeds Constitute Financing for Deal
  • Environmental Reports, Surveys, if applicable
  • Key Contracts with Vendors or Customers?

Lane, Alton & Horst, LLC

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PLAN B:SWAP OWNERSHIP FOR $$$

Lane, Alton & Horst, LLC

legal considerations in raising capital
Legal Considerations in Raising Capital
  • Compliance with FEDERAL and STATE Securities laws
    • Regulation of MANNER in which done, i.e. registration and issuance
    • Regulation of INFORMATION DISCLOSED, i.e. accuracy and adequate disclosure of risks and rewards
  • Proper documentation of business arrangements made
  • Effect on Founder(s): Risk/Reward Calc

Lane, Alton & Horst, LLC

sources of equity funding
Sources of EQUITY Funding
  • Initial Public Offering
  • Venture Capitalists
  • Angel Investors

Lane, Alton & Horst, LLC

i nitial p ublic o ffering option
Initial Public Offering Option?
  • Extremely expensive
  • Very time-consuming
  • Most entreprenuers exit through
    • sale of the business to someone else
    • operating until eventually winding down

Lane, Alton & Horst, LLC

going public the facts
“Going Public” – The Facts
  • Substantially less than 1% of all businesses in U.S. are publicly traded
  • May take as long as a year or more to accomplish
  • Need at history of accelerating growth
  • Experienced management team crucial
  • Establishment of formal corporate policies in areas such as human resources important
  • Need to have strong business plan

Lane, Alton & Horst, LLC

weighing the ipo option
Advantages

Stronger and larger capital base

Owner diversification

Increased credibility/prestige

Access to financing

Transferability of ownership

Cash out for founders

Disadvantages

Ongoing reporting and disclosure requirements

Trading Restrictions

Less Control over company business and financial affairs

Greater regulation

Confidentiality loss

Very expensive

Weighing the IPO Option

Lane, Alton & Horst, LLC

ipo mechanics
IPO Mechanics
  • Registration Statement filed with SEC
    • Prospectus – provides information about company’s financial history and forecasts, together with uses intended for offering proceeds
  • “Cooling Off” Period/“Road show” with prospective investors, including distribution of preliminary prospectus aka “red herring”
  • Valuation of company to determine offering price and size of offering
  • SEC approval for distribution of Prospectus

Lane, Alton & Horst, LLC

venture capital investment
Venture Capital Investment
  • Difficult to obtain, even for technology based business
  • Expensive, both economically and otherwise
  • Require extremely high rates of return on investment
  • Finite time horizon to show economic results
  • Typically not interested in investments of less than $1 million

Lane, Alton & Horst, LLC

venture capital investment involvement in your business
Venture Capital Investment =Involvement in Your Business
  • WILL result in dilution of ownership
  • WILL require seat(s) on board of directors
  • WILL affect business operations and timelines

Lane, Alton & Horst, LLC

types of venture capital funding early stage
Types of Venture Capital Funding – Early Stage
  • Seed - relatively small amount of capital provided to inventor or entrepreneur to “prove” a concept and ready it for a “start-up” operation
  • Start-up – provided to companies not long in existence who may not yet have widely sold their product or service commercially
  • First-Stage – provided to assist companies that have exhausted initial capital and require additional funds to initiate full scale manufacturing or servicing

Lane, Alton & Horst, LLC

other types of venture capital funding
Other Types ofVenture Capital Funding
  • Mezzanine – generally for companies showing promise to be used for further expansion or additional product development
  • Bridge – shorter term interim financing to assist company making transition to more permanent financing
  • Acquisition – funds to finance acquisition of all or a portion of another company

Lane, Alton & Horst, LLC

vc analysis of target companies
VC Analysis of Target Companies
  • Management Team – talent, experience, maturity, betting on “jockey”, not the “horse”
  • Business Model – How realistic, scalable, and novel
  • Technology – Ownership rights; ability to protect from competitors’ infringement or design around; novelty of concept
  • Market – size, growth, type
  • Competition – who’s already there and how well funded and/or established

Lane, Alton & Horst, LLC

factors determining value of company
Factors Determining Value of Company
  • Nature of Company’s Business and Operating History, Especially as Compared to Similar Companies
  • Industry and Economic Outlook
  • Book Value and Financial Condition
  • Earnings and Dividend Paying Capacity
  • Value of Goodwill and Other Intangible Assets
  • Purchase Prices of Other Companies Engaged in Similar Line of Business

Lane, Alton & Horst, LLC

special factors affecting value
Special Factors Affecting Value
  • Unique or Proprietary Products, Data, Processes or Services
  • Desirable Contracts or Customers and/or advantageous Vendor/Supplier Relationships
  • Synergistic with or Complementary to Other Portfolio Investments
  • Barriers to entry for Would-be Competitors
  • Favorable Leaseholds
  • Existence/Use of Prior Capital Rounds

Lane, Alton & Horst, LLC

angel investors
Angel Investors
  • Typically high net worth individuals or an entity owned by them
  • Three Flavors
    • Passive – only interested in economic “return on investment”
    • Hands-On – add value to company through expertise or contacts
    • Officious Intermeddlers – those who think they add value, but really don’t
  • Beware of complying with Securities Laws!

Lane, Alton & Horst, LLC

angel investors98
Angel Investors
  • As “high net worth” individuals, the considerations driving selection of the C-corp form may not be as important as for institutional venture capitalists
  • May appreciate “pass-through” losses

Lane, Alton & Horst, LLC

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INVESTMENT VEHICLES

Lane, Alton & Horst, LLC

outside investor bait
Outside Investor “Bait”
  • Promissory Notes
  • Membership Interests
  • Shares of stock
    • Preferred
    • Common
  • Options and Warrants
  • Convertible Debentures

Lane, Alton & Horst, LLC

preferred stock
Preferred Stock
  • Many varieties
    • May or may not have voting rights
    • May be convertible to common stock
  • Core characteristic is priority and preference in, i.e. paid first
    • Payment of dividends
    • Liquidation of Company
  • Not permitted in S-Corporation

Lane, Alton & Horst, LLC

convertible debt financing instruments trigger
Convertible Debt Financing Instruments - Trigger
  • Business owner doesn’t want to give up ownership unless absolutely necessary, but needs to attract investors
  • Investors want
    • Possibility of larger return than typically resulting from ordinary loan to business
    • Greater protection of ability to be repaid

Lane, Alton & Horst, LLC

part debt part equity hybrid
Part Debt - Part Equity Hybrid
  • Solution is to give investors promissory note which allows conversion to equity under certain circumstances
  • Will be regarded as a “securities” transaction

Lane, Alton & Horst, LLC

how convertible debt financing works
How Convertible Debt Financing Works

Convertible debt holders expect

  • A fixed rate of return based on interest payments

AND

  • Option to participate in any increase in the overall value of the business by exercising conversion privilege
  • Greater ability than typical lender to take charge of company’s affairs if not repaid

Lane, Alton & Horst, LLC

convertible debenture aka promissory note
Convertible Debenture aka Promissory Note
  • Looks like a promissory note, including a fixed rate of interest, with some extra provisions included
  • Generally has a “conversion period” or a “triggering event” which determines when OR whether lender can exercise its option to take stock in lieu of payment
  • Conversion to equity may be at a discount or a premium to the face amount of the note
  • Avoids valuation issues to some extent

Lane, Alton & Horst, LLC

when offering a security
When offering a security
  • Must be part of public offering

OR

  • Exempt form registration

Lane, Alton & Horst, LLC

what is a security
What is a “security”?
  • Very broadly defined under both federal and state law(Ohio Rev. Code 1707.01(B))
  • Basically includes anything where the party providing funds is led to expect profits and return on the investment from the efforts of others.SEC v. W.J. Howery , 328 U.S. 293 (1946)

Lane, Alton & Horst, LLC

slide109
Includes more than traditional shares of stock in a company
    • Membership Interests
    • Warrants and Options
    • Can include Promissory Notes

Lane, Alton & Horst, LLC

promissory notes can be securities
Promissory Notes CAN BE Securities
  • Reves v. Ernst & Young, 494 U.S. 56 (1990)
    • “family resemblance” test
    • designed to ascertain ECONOMIC REALITIES of transaction
    • Explicitly adopted as also governing Ohio securities law in Perrysburg Twp v. City of Rossford, 103 Ohio St.3d (2004)
    • See alsoMacRitchie, “Is a Note a ‘Security’? Current Tests under State Law”, 46 S.D.L. Rev. 369 (2001)

Lane, Alton & Horst, LLC

reves family resemblance
Reves “Family Resemblance”
  • Motivations – if for investment, then security; if commercial, then nonsecurity
  • Plan of Distribution – common trading for investment v. one-on-one negotiated transaction
  • Reasonable Expectations –would reasonable member of public consider it an “investment”
  • Presence of Risk-Reducing Factors –suggest that note is a security

Lane, Alton & Horst, LLC

securities act of 1933 aka securities act
Securities Act of 1933 aka Securities Act
  • Initial federal response to 1929 Stock Market Crash
  • Federal version of “blue sky” laws which regulate what must be disclosed
  • Intended to protect investing public against fraudulent schemes and unscrupulous promoters by requiring full disclosure of all material risks

Lane, Alton & Horst, LLC

securities exchange act of 1934 aka exchange act
Securities Exchange Act of 1934 aka Exchange Act
  • Enabling act to implement provisions of Securities Act
  • Established and empowered Securities and Exchange Commission (SEC) to regulate virtually all facets of securities transactions
  • Addresses registration and issuance procedures for securities
  • Focused on the sale and trading of securities

Lane, Alton & Horst, LLC

state blue sky regulations
State “Blue Sky” Regulations
  • Origin of name uncertain, but references perception that unscrupulous promoters would sell “blue sky” to investors if not properly restrained
  • If selling in more than one state, must comply with requirements of EVERY state in which investors reside
  • In Ohio, the Division of Securities in the Department of Commerce is responsible for enforcement of Ohio Rev. Code Chapter 1707

Lane, Alton & Horst, LLC

ohio securities laws overview
Ohio Securities Laws Overview
  • Ohio Revised Code Chapter 1707
  • Division of Securities enforces its licensing, registration and anti-fraud standards through administrative actions, civil injunctive proceedings and criminal prosecutions
  • Ohio Rev. Code 1707.03(O) provides exemption for sale to ten or fewer investors in Ohio who are reasonably believed to be purchasing for their own investment
  • Federal exemptions from registration also recognized

Lane, Alton & Horst, LLC

registration requirements
Registration Requirements
  • Must satisfy both federal SEC and state statutory and regulatory requirements
  • Very expensive and complicated – definitely need to consult attorney experienced in this area
  • Several exemptions available which allow sale of securities without registration

Lane, Alton & Horst, LLC

warning warning
Warning, Warning….
  • Neither this debenture nor the securities into which this debenture is convertible have been registered with the securities and exchange commission or the securities commission of any state in reliance upon an exemption from registration under the securities act of 1933, as amended (the "securities act"), and, accordingly, may not be offered or sold except pursuant to an effective registration statement under the securities act or pursuant to an available exemption from, or in a transaction not subject to, the registration requirements of the securities act and in accordance with applicable state securities laws.

Lane, Alton & Horst, LLC

bypassing registration of securities sec 3 a 11 intrastate offering
Bypassing Registration of Securities – Sec (3)(a)(11) Intrastate Offering
  • Refers to section of ’33 Securities Act which contains exemption from registration
  • Issuing company must be incorporated in the state in which securities will be offered (e.g. company incorporated in Ohio offers shares to Ohio residents)
  • Issuing company must carry out a significant portion of its business in the selected state
  • No limit on size of offering or number of purchasers

Lane, Alton & Horst, LLC

bypassing registration of securities sec 4 2 private offering
Bypassing Registration of Securities - Sec.4(2) Private Offering
  • Refers to section of ’33 Securities Act which contains exemption from registration
  • SEC 1982 promulgation of Regulation D
      • Rule 501 – “accredited investor” defined
      • Rule 502 – terms and conditions for Reg D to apply
      • Rule 503 – Reg D notice requirements
      • Rule 504 – Exemption for offering of securities of $1 million or less
      • Rule 505 - Exemption for offering of securities of $5 million or less

Lane, Alton & Horst, LLC

rule 506 safe harbor
Rule 506 “Safe Harbor”
  • Can raise unlimited amount of capital
  • No general solicitation or advertising to market securities
  • Can have unlimited number of “accredited investors” and up to 35 others
  • ALL investors must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment

Lane, Alton & Horst, LLC

key aspects of federal private offering registration exemption
Key Aspects of Federal Private Offering Registration Exemption
  • Anti-fraud provisions still applicable
  • Burden still on issuer to demonstrate offering qualifies for exemption from registration
  • May not use public solicitation or general advertising – keep careful records
  • Allows for sale to unlimited number of accredited investors and up to 35 others
  • If one investor doesn’t meet requirements, entire offering can be in violation
  • Securities are “restricted” - Purchasers can’t resell without exemption or registration

Lane, Alton & Horst, LLC

advertising and solicitation
Advertising and Solicitation
  • Can be difficult to apply – what if media does story on product of new company?
  • Prohibition may not be applicable to targets with whom there is a “substantial preexisting relationship”
  • Important to keep careful records of who is provided information about the offering
  • DON’T put blanket information on company website with “click here” option to invest

Lane, Alton & Horst, LLC

accredited investors
Accredited Investors
  • Qualify as sophisticated investor able to bear investment’s economic risk
  • Have access to type of information normally contained in a prospectus
  • Agree to hold securities for investment and not to resell or distribute to the public
  • Not required to receive PPM, but must receive adequate financial information

Lane, Alton & Horst, LLC

types of accredited investors
Types of Accredited Investors
  • Wealthy individuals
    • Net worth (including spouse) of more than $1 million
    • Income for each of last 2 years in excess of $200,000 (or $300,000 when considering jointly with spouse)
  • Directors and executive officers of company issuing security
  • Institutional investors

Lane, Alton & Horst, LLC

qualifying accredited investors
Qualifying Accredited Investors
  • Typically required to complete Subscription Agreements and Investor Questionnaires
  • Remember to provide full and fair disclosure of all relevant information about the company to prevent misunderstandings

Lane, Alton & Horst, LLC

private placement memorandum aka ppm
Private Placement Memorandum aka PPM
  • Required when offering securities to prospective purchasers who are not “accredited investors”
  • Lengthy stand-alone document disclosing everything prospective purchaser needs to know about the company, as well as its plans and prospects, to make an informed decision to invest in the company
  • Includes Subscription Agreement which acts as the “sale contract” for shares

Lane, Alton & Horst, LLC

why a ppm
Why a PPM?
  • Required by law with respect to investments by those who are not accredited investors
  • Provides information to prospective investors
  • Protection against securities fraud claims by establishing a record of what information was provided potential investors
  • Enhances credibility

Lane, Alton & Horst, LLC

contents of ppm
Contents of PPM
  • Cautionary Language regarding investment risks
  • Summary of Offering terms – often in a table format
  • Description of issuing company, its organizational structure, management team, capitalization, and history
  • Business Plan and selected financial data
  • Specific risk factors
  • Disclosure of potential conflicts of interest
  • Subscription procedures

Lane, Alton & Horst, LLC

ppm timeline
PPM Timeline
  • Prepare written business plan
  • Corporate “clean up” and “due diligence”
  • Select advisors
  • Identify prospective investors
  • Determine offering terms
  • Make necessary filings
  • Circulate PPM to qualified recipients

Lane, Alton & Horst, LLC

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If PPM has stated maximum or minimum, issuer cannot change unilaterally – all investors must sign off

Lane, Alton & Horst, LLC

iii structuring your business for growth
III. Structuring Your Business for Growth
  • STRATEGIES AND CONSIDERATIONS

Lane, Alton & Horst, LLC

follow corporate formalities avoid piercing the corporate veil
Follow Corporate Formalities – Avoid Piercing the Corporate Veil
  • Belvedere Condominium Unit Owners’ Association v. R.E. Roark Companies, Inc., 67 Ohio St.3d 274 (1993):
    • Individual shareholder can be held liable for debts of corporation when business and financial affairs of the shareholder and corporation are so intertwined that corporation has no separate existence.

Lane, Alton & Horst, LLC

belvedere test for piercing corporate veil
Belvedere Test for Piercing Corporate Veil
  • Control over the corporation is so complete that it has no separate mind, will or existence of its own
  • Shareholders exercises control over corporation in such a way as to commit fraud or an illegal act
  • Injury or unjust loss resulted from the control

Lane, Alton & Horst, LLC

practical warning signs
Practical Warning Signs
  • Grossly inadequate capitalization
  • Failure to observe corporate formalities or have regular meetings among owners
  • Diversion of company funds or property for personal use
  • Business used as mere façade for other operations of owner

Lane, Alton & Horst, LLC

bizpointers for avoiding inadvertent personal liability for company debts
BizPointers for Avoiding Inadvertent Personal Liability for Company Debts
  • KEEP GOOD CORPORATE RECORDS. If there is more than one shareholder or owner, have regular periodic meetings (monthly or quarterly) and keep MINUTES of what is discussed at those meetings
  • KEEP ACCURATE RECORDS OF REVENUE COMING IN AND EXPENSES PAID. If you bill clients or customers, make sure they make the check payable to the company rather than you personally.

Lane, Alton & Horst, LLC

bizpointers for avoiding inadvertent personal liability for company debts136
BizPointers for Avoiding Inadvertent Personal Liability for Company Debts
  • DON’T PAY COMPANY BILLS FROM PERSONAL FUNDS, even if cash flow is bad!!! If the business is short of funds to cover payroll or some other expense, deposit a personal check in the company bank account instead of just paying it yourself. Keep track of these “loans” to the company.
  • DON’T PAY PERSONAL DEBTS FROM COMPANY FUNDS. Be sensible about what expenses the business pays for you.

Lane, Alton & Horst, LLC

bizpointers for avoiding inadvertent personal liability for company debts137
BizPointers for Avoiding Inadvertent Personal Liability for Company Debts
  • Use signage, business order forms, invoices, and stationery with the company’s proper name and address prominently featured. It may be worthwhile to consider investing in a PO Box if you don’t yet have separate business premises.
  • Remember to treat the Company as if it were a separate person. The Company IS NOT you and you ARE NOT the Company.

Lane, Alton & Horst, LLC

secure rights to intellectual property
Secure Rights to Intellectual Property
  • IP may be the MOST valuable asset for an early stage technology based company
    • Copyrights (includes software)
    • Trademarks (includes company logo)
    • Servicemarks
    • Patents
    • Trade Secrets

Lane, Alton & Horst, LLC

importance of rights to intellectual property
Importance of Rights to Intellectual Property
  • Freedom to Operate
    • Need to be sure someone else’s IP won’t prevent your company from carrying out its business objectives
    • Need to be sure the Company has the right to use IP key to achieving its business objectives
  • Competitive Advantage – Need to preclude other from using or working around key IP

Lane, Alton & Horst, LLC

protecting ip
Protecting IP
  • Register at state and federal levels
    • U.S. Patent and Trademark Office or Library of Congress Copyright Office
    • Ohio Secretary of State (trademarks and service marks only)
  • Specify that it is “Work for Hire” so that the company becomes the owner
  • License others who make use of your IP
  • Confidentiality and Nondisclosure Agreements

Lane, Alton & Horst, LLC

special founder ip issues
Special Founder IP Issues
  • Assignment of ownership of IP developed by founder which is key to company’s financial prospects, with the attendant filings at the appropriate governmental offices
  • Waivers or disclaimers of any conflicting rights to key IP
  • Assignment of subsequent IP developed
  • Noncompete Agreement

Lane, Alton & Horst, LLC

employee ip issues
Employee IP Issues
  • “Employee agrees that he or she shall promptly and fully disclose in writing to the Employer, shall hold in trust for the sole right and benefit of the Employer, and shall make available to the Employer all Employee Developments, including but not limited to any work papers, drawings, designs, schematics, specifications, descriptions, models, diskettes, computer tapes, source codes or other tangible incidents of Employee Developments. Employee agrees that all Employee Developments shall be considered “works made for hire,” as that term is defined in the United States Copyright Act, by Employee for the Employer, and prepared within the scope of his or her employment, and that all right, title and ownership interest in and to the Employee Developments, including, without limitation, copyright, trade secret, patent or other intellectual property rights, shall exclusively vest in, be retained by, and are hereby assigned to the Employer or its designee, both during and following the term of Employee’s employment.”

Lane, Alton & Horst, LLC

employee ip issues143
Employee IP Issues
  • Proprietary Rights Agreement -assigning IP developed by employee
  • Confidentiality and Nondisclosure Agreement
  • Noncompete
  • Centralization of IP information
  • Access limitations
  • Restrictions on article publication

Lane, Alton & Horst, LLC

securing key employees
Securing Key Employees
  • Employment Agreement
  • Noncompete Agreements(can be included in Employment Agreement) -must be reasonable in scope and time
    • Prohibited activities and geographic areas must be related to Company’s actual or reasonably anticipated business operations
    • Longer the time period in effect, the less likely to be enforceable

Lane, Alton & Horst, LLC

equity incentivizing to attract and retain key employees
Equity Incentivizing to Attract and Retain Key Employees
  • Purpose
    • Attract top talent or skill sets
    • Make up for below-market compensation
  • Types
    • Award of restricted stock
    • Stock options
    • Stock Appreciation Rights, also known as phantom or shadow stock
  • Lots of flexibility in structuring

Lane, Alton & Horst, LLC

employee shareholders have rights
Employee Shareholders Have Rights…
  • Once an employee has even a tiny slice of equity ownership, the “at will” nature of the relationship can change

Lane, Alton & Horst, LLC

ohio close corporation shareholder heightened fiduciary duty rule
Ohio Close Corporation Shareholder Heightened Fiduciary Duty Rule

Under Ohio law, owners of small businesses with only a few shareholders, members, or partners have a “heightened fiduciary duty” toward one another.

  • Applies no matter how small the ownership interest of the minority shareholder is
  • Means that controlling shareholders DO NOT have ability to run the company in ANY way they see fit
  • Must have “legitimate business purpose” when taking adverse action toward fellow shareholder

Lane, Alton & Horst, LLC

heightened fiduciary duty
“Heightened Fiduciary Duty”

Crosby v. Beam,

47 Ohio St. 3d 105, 548 N.E.2d 217 (1989)

  • Facts: Minority shareholder alleged that majority shareholders improperly expended Company funds to pay unreasonable salaries to themselves and personal expenses
  • Holding: A "heightened fiduciary duty" exists between shareholders of close corporations. Majority or controlling shareholders breach such fiduciary duty to minority shareholders when control of the close corporation is utilized to prevent the minority from having an equal opportunity in the corporation.

Lane, Alton & Horst, LLC

heightened fiduciary duty equal opportunity principle
“Heightened Fiduciary Duty” = Equal Opportunity Principle

“Where majority or controlling shareholders in a close corporation breach their heightened fiduciary duty to minority shareholders by utilizing their majority control of the corporation to their own advantage, without providing minority shareholders with an equal opportunity to benefit, such breach, absent a legitimate business purpose, is actionable." ”

- Crosby v. Beam, 1989

Lane, Alton & Horst, LLC

heightened fiduciary duty rule
Heightened Fiduciary Duty Rule
  • Fiduciary duty is greater than obligation of fairness implied in arms-length transactions
  • Requires one to promote the collective, long term interest of the Company
  • Forbids promotion of limited personal short term interests

Lane, Alton & Horst, LLC

obvious cant s
Obvious Cant’s
  • Employing family members at unjustified high salaries
  • Giving family members special perks such as company car, golf membership if they wouldn’t receive in similar position elsewhere
  • Siphoning off earnings through exorbitant salaries and bonuses
  • Using Company funds to buy personal items

Lane, Alton & Horst, LLC

obvious cant s152
Obvious Cant’s
  • Cannot compete with company
  • Cannot usurp its commercial opportunities
  • Refusal to declare dividends
  • Refusal to distribute earnings as bonuses or retirement benefits
  • Removal as director or officer

Lane, Alton & Horst, LLC

obvious cant s153
Obvious Cant’s
  • Similar businesses pay President $300,000
  • Company has high profits and can afford to pay as much as $700,000
  • OK?
  • NO, excess profits must be distributed to all shareholders as dividends

Lane, Alton & Horst, LLC

problematic situations
Problematic Situations
  • Employment Termination
  • Involuntary dissolution of corporation
  • Chilling effect on operational freedom
  • Restrictions on sale of company

Lane, Alton & Horst, LLC

effect on exit strategies
Effect on Exit Strategies
  • Should the majority owner wish the company to repurchase some of his ownership interest, it is no longer as simple as writing the check.
    • Now the new co-owner must have the same opportunity to have the company repurchase a similar proportion of his ownership interest.
  • Also difficult to eliminate small ownership stakes at a later date

Lane, Alton & Horst, LLC

can i fire a shareholder employee who doesn t work and play well with others
Can I Fire a Shareholder Employee Who Doesn’t Work and Play Well with Others?

YES

  • Priebe v. O’Malley, 89 Ohio App. 3d 8, 623 N.E. 2d 573 (9th App. Dist – Medina Cty) ([Myron] was not producing sales and … was not working well with other employees. Other evidence existed on the record that [Myron] was converting corporate property to personal use, that he was not working full daily hours, and that he threatened to shut down the company… )
  • Duggan v. Orthopaedic Institute of Ohio, Inc., 365 F. Supp. 2d 853 (N.D. Ohio 2005) – removal of shareholder employee from role as President, but allowing him to continue as shareholder and employee was based on legitimate business reason) (Defendants give several reasons for their decision to terminate the plaintiff; namely, that he was over-extended, refused to delegate work, failed to share information, had poor people management skills, and treated [Company] employees in an abusive manner. “)

Lane, Alton & Horst, LLC

can i fire a shareholder employee who doesn t work and play well with others157
Can I Fire a Shareholder Employee Who Doesn’t Work and Play Well with Others?

NO

  • Gigax v. Repka,83 Ohio App.3d 615, 615 N.E.2d 644 (2d App. Dist Montgomery Cty. 1992)(Termination of fellow shareholder employee requires “legitimate business reason” and specific articulated issues)
  • Thomas v. Fletcher, 2006 Ohio 6685, 2006 Ohio App. LEXIS 6590 (3d App. Dist. – Shelby Cty)(“While the parties had some disagreements regarding the corporation, the Fletchers and Thomas continued to operate the business and the business continued to function.”)

Lane, Alton & Horst, LLC

mirror equity incentivizing
“Mirror” Equity Incentivizing
  • Useful when company unable or unwilling to alter ownership structure
  • Gives employees the benefits of equity ownership by contractually providing them deferred compensation based on
    • longevity of employment and
    • performance of the company over time
  • Vests similarly to 401(k) plans

Lane, Alton & Horst, LLC

mechanics of mirror equity
Mechanics of Mirror Equity
  • Unlike grant of actual equity, no tax consequence for either company or employee until employee receives cash payment
  • Value of mirror equity tied to value of company stock or change in another designated financial benchmark such as net income
  • Can require sophisticated recordkeeping and accounting
  • Customization and flexibility in structure

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paying attention to corporate governance
Paying Attention to Corporate Governance
  • Important to get independent board of directors as early as possible
  • Being a director is a MAJOR responsibility and time commitment
    • Need to be able to obtain D&O insurance
    • Need to compensate fairly
    • Need to have experience and skill sets beyond those of the founder(s)
  • Advisory Boards are NOT the same thing, but can still be useful.

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ensuring an exit strategy
ENSURING AN EXIT STRATEGY

A Buy-Sell Agreement Can Incorporate Several Different Methods

  • “Push-Pull”
  • Right of First Refusal
  • Cross Purchase
  • Puts
  • Calls

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buy sell agreement
Buy-Sell Agreement
  • Perhaps the most important method to protect your financial and business interests while being fair to your owner(s).
  • Proven method of establishing fair and rational solutions to many sorts of disputes that can arise among owners concerning their respective ownership interests and their value.
  • Useful for placing other reasonable restrictions on transferring the ownership interest to anyone else, e.g. rights of first refusal.

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buy sell agreement163
Buy-Sell Agreement
  • A Buy-Sell Agreement deals with different situations in which it becomes necessary or desirable for someone to give up their ownership interest.
    • Typically, it includes a procedure for the departing owner to receive the value of his investment in the company without crippling the company.
    • It also offers a reasonable alternative to requiring expensive resolution through the courts.

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Without a Buy-sell Agreement….

Minority Owners Have Little or No Opportunity to Exit Business Without Substantial Loss

  • Unless the business as a whole is being sold to a third party, owners wishing to leave the business in general have no right to demand that the company or the other owners redeem their ownership interest by buying the departing owner out at any price.
  • Nor does the company or other owner have any responsibility to help find a replacement owner willing to buy the ownership interest. Thus if no purchaser can be found, the owner wishing to sever his ties with the business has no way to obtain the value of his investment.

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buy sell agreement triggering events
Buy-Sell Agreement – Triggering Events
  • Involuntary Termination of Employment
    • Termination for Cause
    • Termination for Good Reason
  • Retirement
  • Resignation from Employment
  • Death or Permanent Disability
  • Removal as Officer or Director
  • Happening of Particular Events
  • Occurrence or Nonoccurrence of Benchmarks

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controlling who the other owners will be
Controlling Who the Other Owners Will Be
  • A “right of first refusal” allows the company or fellow owners to match an offer made by a third party for the ownership interest.
  • Provisions requiring owners to be active in the business or preventing them from having full voting rights unless all or a certain portion of the remaining owners agree can ensure that owners share a similar philosophy or that the business stays in the family.

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push pull exit
“Push-Pull” Exit
  • In two person businesses, a “push-pull” clause sets up a procedure allowing either owner to buy out, or be bought out by, the other owner.
    • If Tom decides he doesn’t want to continue in business with Kate for any reason, or for no reason, Tom has a decision to make. He must determine whether he
      • wants to continue running the business, but without Kate, or
      • would rather move on and leave Kate with the business.

Lane, Alton & Horst, LLC

push pull buy out
“Push-Pull” Buy-Out
  • Suppose Tom elects to buy Kate out and run the business by himself. He must then come up with the purchase price at which he is willing to buy all of Kate’s ownership interest. At that juncture, Kate has two choices.
    • Kate can accept Tom’s offer and sell out to him at the price offered
      • Tom offers Kate $100,000 for her ownership interest. Kate accepts and sells her ownership interest to Tom for $100,000.
    • Kate can decide to buy Tom out at the same price Tom had offered to her.
      • Tom offers Kate $100,000 for her ownership interest. Kate rejects the offer and must then pay Tom $100,000 for his ownership interest.

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push pull sell out
“Push-Pull” Sell-Out
  • If Tom would rather end his ownership of the company, he notifies Kate of the price at which he is willing to sell all of his ownership interest.
          • Tom tells Kate he wants $100,000 for his ownership interest
    • Kate then chooses between accepting Tom’s request to become the sole owner of the business
          • Kate pays Tom $100,000 for his ownership interest
    • and having him buy her out at that same price.
          • Kate rejects Tom’s offer. Tom must then pay her $100,000 for her ownership interest

Lane, Alton & Horst, LLC

exit through puts and calls
Exit Through Puts and Calls
  • In businesses with more owners, a “put” or “call” option requires the purchase or sale of an owner’s ownership interest by the company or other owners upon the occurrence of certain predetermined events or achievement of particular benchmarks.

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cross purchase
Cross Purchase

Your Family Can Receive the Benefit of

Your Investment Upon Your Death or Disability Without Argument

  • Under a “cross purchase” provision, owners agree that on a pro rata basis they will purchase the ownership interest of a disabled or deceased owner at an agreed predetermined price or based upon a specified formula. Sometimes owners agree to purchase life insurance on one another to provide a source of funding for this obligation.

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Visit my legal blog:

OHIO PRACTICAL BUSINESS LAW COUNSEL

http://ohiopracticalbuslaw.wordpress.com

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Teri G. RasmussenPartner and Vice Chair, Business Law Practice GroupLane, Alton & Horst, LLCtrasmussen@lanealton.com(614) 233-4753

Lane, Alton & Horst, LLC

Two Miranova Place, Suite 500

Columbus, Ohio 43215

www.lanealton.com