May 2020 - Linden Law Partners

Dissolution Considerations for Co-Founders of Startups

Posted on May 27, 2020August 1, 2024 by lindenlawpart1

The Importance of Mandatory Dissolution Provisions in Agreements Among Co-Owners

When co-founders of a startup are forming their entity and putting their founder agreements together, one issue that is often overlooked concerns the resolution of deadlocks or dissolving the business if the co-founders are unable to co-exist. By the time many founders figure out the importance of this issue, the honeymoon phase of their relationship with their co-founder(s) has worn off and the ability to extract themselves from the business (or their co-founder(s)) has become significantly more difficult and expensive.

While buy-sell provisions are standard in written agreements among co-founders to address deadlocks or separation, in practice they are often of limited value and rarely utilized. The valuation methodologies in buy-sell provisions are frequently dated and they sometimes lack the mechanical detail necessary for a founder to trigger without simply instigating interpretive disputes with other co-founders.

For example, we recently saw a buy-sell provision in a contentious situation where it was not clear whether events triggering the buy-sell had occurred, and therefore subject to competing interpretations between the co-founders.

Nor should founders rely on judicial dissolution statutes under state corporate, partnership or limited liability company acts as a practical avenue to dissolve their business relationship. Many of these judicial dissolution statutes require costly litigation to be utilized and even then, there is often no section of the statute requiring a judge to formally dissolve the business.

However, unlike an impractical buy-sell provision or an arcane judicial dissolution statute, a mandatory dissolution agreement among co-founders is intended to provide the principal co-founders with a right to dissolve the business in a relatively cost-effective and pre-agreed upon manner from the outset (and likely when the co-founders are thinking more objectively than is often the case when their relationship may have soured).

Think of this like a pre-nuptial agreement among business partners. This dissolution arrangement should be negotiated and written at the beginning of the relationship (not the end) and should be included in the body of the operating or partnership agreement (for LLCs and partnerships) or the shareholders agreement (for corporations). We sometimes advise that a separate “Dissolution Agreement” be attached as an exhibit to the shareholders or operating/partnership agreement.

Key Provisions for Dissolution Considerations Agreements

Appointment of a Liquidating Trustee* and Authority to Wind Up. The liquidating trustee is responsible for carrying out the winding up of the business. Typically, one co-founder is appointed the liquidating trustee, but there can be more than one and the co-founders can agree to take on shared responsibilities.

Regardless, the principal co-founders should all agree on the specific wind-down procedures, and when and how they are to occur. *As a quick note, reference here to a “liquidating trustee” is a term of art – I am simply referring to the person or persons authorized to take wind-up actions required for a dissolution (in practice that person might be a general partner, manager, CEO, etc.).

Accounting; Financial Statements; Taxes. The co-founders should agree on who the accountant will be to prepare the final books and taxes for the business, and it is advisable to agree that they will be prepared and filed in accordance with the historical custom of the business. This helps eliminate the ability for co-founders to argue over accounting and tax items where prior custom has existed.

There should be a deadline date by which the accountant for the business is required to make final tax filings in order to prohibit any one co-founder from unnecessary procrastination or otherwise attempting to prevent or delay the final completion of financial and tax matters.

Capital Contributions. The co-owners should include a provision that requires the payment of certain additional capital contributions in connection with various creditor obligations and expenses and other payments during the winding up process, and the process for calling and making those contributions.

Division of Company Assets. The dissolution agreement should establish how distributions of cash and other business property will be handled during the winding up period and upon final liquidation. Typically, distributions of cash would be handled in accordance with the applicable distribution provisions contained in the operative agreements among co-founders (such as an operating agreement).

Consideration should be given to whether distributions should be limited (or prohibited) during the dissolution period while vendors or creditors are owed money. Depending on the situation, the division of other business property may be in a manner that differs from percentage ownership or historical distributions. If so, this should be spelled out.

Non-Disparagement and Restrictive Covenants. A mutual non-disparagement clause is advisable, but non-compete and non-solicit agreements are generally not included to allow each co-founder to continue in the business for his, her or its own account following (but not before) the termination of the company or partnership.

Costs and Expenses of Winding Up. The agreement should specify how all costs and expenses arising out of the wind-up process will be split among the co-founders, and deadlines for their payment should be established. These costs would typically be split based on the ownership percentages of the co-founders and/or however historically split among them pre-dissolution.

Indemnification. Each co-founder should be obligated to indemnify and hold harmless the other co-founders for all losses incurred because of the indemnifying co-founder’s breach or failure to perform any of its duties and obligations under the dissolution agreement.

Dispute Resolution. As is prudent with any other contract, the parties should specify a forum for dispute resolution, whether a court venue, arbitration, or the assignment of disputes to a third party, such as an independent accounting arbitrator for any disputes over the final preparation of the financial statements or tax returns. We also normally advise on the inclusion of an attorneys’ fees recovery provision by a prevailing party which is helpful to hold each co-founder’s feet to the fire in ensuring that it does what it is obligated to do under the dissolution agreement.

Conclusion

A mandatory dissolution agreement can provide co-founders of a closely held business with a relatively streamlined, cost-effective and balanced manner of exiting when the business is not working out or the co-founders are not getting along. While the parties are always free to agree to a different deal outside of the dissolution agreement, when no such deal can be struck, the dissolution agreement will provide a baseline from which the founders can separate equitably and efficiently.

Linden Law Partners has extensive experience advising companies and business owners on all aspects of dissolution considerations and the agreements around them. Contact us here for help.

Overview of Equity Incentive Compensation for Startups and Early Stage Companies

Posted on May 12, 2020August 1, 2024 by lindenlawpart1

Hiring and keeping talented employees is a challenge for many businesses, but in particular for startups and early-stage companies that are more limited in the amount of cash flow they can commit to competitive salaries. One way to bridge this gap is with equity incentive compensation. Broadly speaking, equity incentive compensation refers to the grant by a company to its key employees and service providers of an ownership stake.

For startups positioned to realize significant potential growth in the value of their companies, this type of compensation can be especially appealing to employees and service providers who see the potential of “getting in on the ground floor”. But more than just luring top talent, equity incentive compensation can help any company achieve the following:

1. More strongly align the interests of, and incentivize high-level performance from, key employees or service providers;

2. Build employee loyalty and develop a more authentic sense of purpose; and

3. Save and redeploy early stage cash that would otherwise have to be spent on salaries or contract labor.

Types of Employee Equity Incentive Plans for Private Companies

Equity incentive compensation can take many forms for private companies, with each presenting a unique set of advantages and disadvantages. While the optimal types and structures for any given company will depend on its particular business circumstances, below is a summary highlighting some of the most popular kinds of equity incentives used by many private companies today.

Stock Options. Stock options are a well-known form of equity incentive compensation that can be utilized by corporations. The holder of a stock option has the right to buy stock of the company at a set price, called the “exercise price”, for a certain period of time (typically ten years) beginning when the stock option vests.

The exercise price usually is equal to the fair market value of the stock at the time the stock option is granted. Stock options almost always vest over time (typically 3-4 years) to help motivate the recipient to continue to be employed with the company longer term. The holder becomes an actual shareholder of the company only when the stock option is exercised and the stock underlying the option is purchased for the exercise price.

Stock options can be attractive to holders if the company expects substantial growth and/or a liquidity event (sale) down the road at an increased value. However, if there is no appreciation in the company’s stock over time, then the option provides the holder with no financial benefit. The holder of a stock option must also have the cash necessary to pay the exercise price to convert the options to actual shares of stock.

As a practical matter, stock options of a private company are almost always converted only at the time of some liquidity event, such as a sale of the company or an IPO, and then the exercise is “cashless” (meaning the exercise price is taken off the top of the proceeds the option holder would otherwise realize had he or she actually paid the cash exercise price, converted the options to shares, and then concurrently sold them at a profit as part of the liquidity event).

Restricted Stock. Restricted stock is an actual grant of shares of stock, but for a period of time (a “restricted period”) the shares (1) can typically be repurchased by the company for a set price, (2) are subject to forfeiture by the holder without payment upon the occurrence of certain events, such as when the holder’s services to the company terminate prior to vesting in full, and (3) are subject to restrictions on transfer or resale.

Because the holder will become a shareholder on the grant date, he or she will normally have the right to vote and receive dividends. Restricted stock can incentivize holders since they should theoretically become similarly aligned with the company’s other shareholders immediately upon the initial grant.

The holder isn’t required to pay anything (or only a minimal amount) at the time the stock is granted, and depending on the value of the stock at the time of grant, he or she may realize a substantial long-term tax benefit by making an IRS Section 83(b) tax election.

Profits Interests. Profits interests are the most common form of equity compensation used today by partnerships and limited liability companies. Profits interests are awarded to key employees and service providers in exchange for his or her contribution of services to the company (in lieu of being required to make a cash or other tangible capital investment as would be the case for a traditional equity investor).

A profits interest is technically an ownership interest that gives the holder the right to a share of future profits and appreciation of the company, but the holder is not entitled to participate in the capital and accumulated profits or value of the company as of the initial grant date.

For example, if the “hurdle” or “threshold” value of the profits interest holder’s participation was $3 million, it means the holder’s profits interest only begins to share in the company’s distributions or sale proceeds after the initial $3 million of value has been paid to its founders and/or cash equity investors. Please see our profits interest blog for additional information and key considerations around granting profits interests specifically.

Other. Other equity-based forms of incentive compensation include restricted stock units, stock appreciation rights, phantom stock, and long-term cash incentive plans.

Conclusion

A properly structured equity incentive compensation plan can help innovative companies stand out from their competitors when it comes to hiring and retaining key talent. However, various legal and business considerations, including important tax considerations, are critical when determining the best plan and structure for a particular company. Linden Law Partners has many years of experience counseling entrepreneurs and businesses on the intricacies of equity incentive compensation. Contact us here for help.

Timeless and Timely M&A Due Diligence Considerations

Posted on May 7, 2020October 9, 2024 by lindenlawpart1

Due diligence is an important and expected part of any merger or acquisition (M&A) transaction. The due diligence process gives the buyer the opportunity to identify any operational or legal risks that may exist with the seller or its business prior to entering into a purchase agreement and closing the transaction.

Further, any specific issues (that do not arise to the level of terminating the transaction) identified during due diligence will typically be accounted for in the purchase agreement through the negotiation of terms such as the purchase price, representations and warranties, closing conditions, and post-closing indemnification obligations of the seller.

Typical Scope of M&A Due Diligence Considerations

The scope of M&A due diligence and a buyer’s exact requests will vary based on the specific transaction. While not exhaustive, summarized below are some of the general areas almost always covered by a buyer’s due diligence requests:

1. Business Organization. A seller will need to provide its corporate records concerning its formation and good standing, governing documents (e.g., articles or certificate of incorporation or organization, bylaws, operating agreement), share ownership, and capitalization.

Other items can include records pertaining to jurisdictions where the seller conducts business or owns or leases real property, and documentation in connection with any equity or debt financings, securities issuances, stock repurchases, or material acquisition or disposition transactions.

2. Accounting/Financial. Requests under this general category will include copies of tax returns for certain periods (typically the prior 2-5 years), financial statements, and documentation pertaining to loan or other debt arrangements. Sellers will also be asked to include any information pertaining to any past or pending tax proceedings or controversies.

Other types of reports or statements requested may include budgets, accounts receivable aging reports, an accounts payable list, and other documentation detailing the income, expenses, and liabilities of the business.

3. Operations, Customers, Business Insurance, Etc. A buyer will want to review a seller’s customer, vendor, and supplier agreements, marketing and sales plans and arrangements, other contracts material to the business, as well as commercial liability and property insurance policies and claims.

Information regarding real and personal property, including inventory (if applicable), of the seller will be required. Information technology and systems and disaster recovery information is also typical. Other requests will vary depending on the seller’s line of business.

4. Human Resources. Buyers will ask for employee, salary, and bonus information, employment agreements, independent contractor information and agreements, collective bargaining and other labor contracts, health, welfare, and safety practices and policies, and OSHA, EEOC, and other employee-related complaints and proceedings.

Also included under this category will be summaries and copies of the Company’s employee benefit plans, including 401(k), medical, dental, disability, and life insurance plans and benefits.

5. Legal and Compliance. This area of due diligence covers all litigation matters, required permits, licenses, and other government and regulatory approvals, intellectual property disclosures and related USPTO filings, environmental compliance, and any other specific legal or regulatory matters applicable to the business.

How COVID-19 May Affect the Due Diligence Process

Due to the uncertainties created by the global pandemic, buyers are likely to approach M&A deals with greater scrutiny than before. As such, buyers may seek detailed information in areas that implicate potential disruptions to the seller’s business, the seller’s financial capability to weather the economic fall-out from COVID-19, and other risks to the target business arising from COVID-19.

Specific due diligence areas that a buyer may want to examine more closely include material contracts with customers, vendors, and suppliers (including the seller’s ability to perform under such contracts as well as termination and force majeure provisions), the seller’s debt obligations and ability to repay, business insurance policy coverages and exclusions, compliance with state and local public health orders,

Compliance with privacy laws that may be implicated (such as if sensitive employee or customer information has been or will be disclosed due to COVID-19), and employee health, safety, and welfare policies and related measures being taken by the seller.

Conclusion

Linden Law Partners has represented sellers and buyers in hundreds of M&A transactions across a variety of industries. We have extensive experience guiding our clients through the ins and outs of the M&A due diligence process. Contact us today for help.