If you are like many entrepreneurs, your business plan may focus on growth, marketing or product development – or sometimes just day-to-day survival. In the middle of all the noise, you may not have taken the time to step back and assess whether the legal foundation is in place to protect the long-term health and sustainability of your business. You are certainly in good company! In the same way you look out for your personal health by having an annual check-up, it's important to have a periodic legal check-up of your business. Unfortunately, as with physical check-ups, many of us put off having our legal condition examined. The new year is a great time to do both, but we can only help you with the latter.
Legal checkups are defensive in nature in that they identify risks, which, if not identified early, can lead to serious harm to the business. Business life has become more complicated with ever-expanding regulations. Unfortunately, because many business owners do not understand their legal obligations, they may continue for years violating important regulations. This can result in serious and sometimes fatal legal consequences. As with a medical checkup, a whole lot of grief can be avoided in the future if these legal risks are identified and addressed early.
In addition to minimizing risks, business check-ups can also help you identify and exploit wonderful opportunities. Periodic legal check-ups should be part of any long term exit strategy. Owners are often not aware of legal tools that can create value and sustainability and make the business attractive to a future purchaser. A legal check-up can help you identify and protect valuable assets (such as intellectual property, contracts, non-competes, etc.) and ensure they are transferable to an eventual buyer.
Adding value by ensuring a healthy legal condition does not happen overnight. It is a process which takes time and continuous attention and planning. Ideally, this process should start as early as possible in the company’s history. Approaching business growth as a process toward eventual acquisition can add substantial value, whether or not the company is actually sold. If there is an acquisition, this increased value will lead to a higher sale price and better payment terms. It’s often too late to start this process when a prospective buyer appears at the doorstep with a letter of intent. You should view the legal check-up as a worthwhile and even an enjoyable exercise. You may be surprised at the opportunities and hidden treasures you unearth. To follow are some of the types of issues you could expect to be covered in a legal check-up:
Form of Entity. Do you have the correct form of legal entity to optimize your overall tax-planning and for an acquisition? For example, a C Corporation may not be the best choice of entity if you expect to be acquired. The double taxation associated with an asset sale may limit the options for structuring the acquisition. It may be time to convert to a pass-through entity, such as an S corporation or LLC. The form of entity can also impact strategies for sharing ownership of the company with employees through incentive stock option plans, restricted stock plans, and similar strategies.
Ownership of Stock and LLC Interests. A legal check-up will also reveal whether stock records have been properly prepared and kept up-to-date so that there is a clear “chain of title” for ownership of the company. It is important to verify whether stock or LLC interests have been properly approved, documented and paid for. As part of a legal check-up, you can determine if any necessary disclosures to investors and filings with the SEC and states securities commissioners are required. An eventual buyer must be able to verify with certainty who owns the company so they know they actually end up owning the company. In real estate deals, this assurance is provided by title insurance. Unfortunately, there is no title insurance for company interests. For this, the buyer is relying on your internal corporate records.
Governing Documents. A legal check-up will also reveal whether key governing documents have been adopted and kept up-to-date so that corporate governance is well- defined and that investors, directors and officers understand their rights and responsibilities. Corporate directors and officers and LLC managers owe a fiduciary duty to the company. Governing documents should be reviewed to ensure they contain appropriate exculpation provisions in order to protect managers from frivolous lawsuits and personal liability. A legal check-up should reveal whether required annual meetings are being held, and if so, that all meetings and formal actions are held and properly documented in compliance with the governing documents.
Buy-Sell Agreements. A well-drafted Buy-Sell Agreement (for a corporation) and an Operating Agreement (for an LLC) will address changes of ownership upon the occurrence of certain contingencies, such as the death, disability, termination of employment, or bankruptcy of a stockholder. This document may also restrict an owner from transferring his or her interest to a third party without the consent of the other owners, or require that the other owners be given a right of first refusal. In short, a Buy-Sell Agreement can provide an appropriate legal mechanism for keeping strangers out of the business. Many businesses have not invested the time to enact a Buy-Sell Agreement or their Buy-Sell Agreement is not well-tailored to the current owner dynamics and expectations. A legal check-up should include a review of the company’s Buy-Sell Agreement, or recommendations for adopting a Buy-Sell Agreement if one does not exist.
Identifying Intangible Assets. Many of your most valuable assets are intangible. These include intellectual property, technology, non-competition covenants, contracts, leases, and technology licenses. You cannot see or touch them, and they can also be difficult to identify on a balance sheet. A legal check-up can help you identify how to appropriately document these intangible assets. Various types of intangible assets are discussed in the following paragraphs.
Intellectual Property. As the company acquires inventions, processes, databases and branding, the resulting intellectual property (copyright, trademarks, patents and trade secrets) should be identified and properly documented and protected. Your business name, logo and domain name are part of your brand. It may be time to file a federal trademark registration before someone else starts using these. Simple on-line trademark and Google searches will reveal if anyone else is already using your name. Contracts with vendors and independent contractors should include language whereby copyrights and inventions resulting from the work are transferred to your company. Otherwise, the vendors will own the copyrights and the right to patent the inventions. Most work product created by non-employees is not considered a “work for hire”.
Employment Agreements; Non-Competition Covenants. A legal check-up will reveal whether or not non-competition and non-disclosure covenants are in place with both inside staff and, when appropriate, with outside vendors. In the absence of these covenants, employees and vendors will be free to solicit your customers and hire away your employees.
Contracts and Leases. We encourage clients to view contracts and leases as valuable assets which may eventually be sold in an acquisition. Certain clauses will add value to your contracts and will make the contract more attractive to a buyer in an acquisition. To the extent possible, assignment clauses in office leases and other important contracts should permit transfer of these valuable assets to an eventual buyer. Other terms such as renewal, early termination, expansion clauses and rights of first refusal will add value to your lease. Also, contracts for products and services should address ownership and transferability of copyrightable work product.
Employment Matters. A legal check-up can determine if your company is in compliance with employment and wage and hour laws and regulations, and that effective benefit plans and employee policies are adopted. Employee litigation is one of the greatest liability risks a business faces. It should be company policy to ask discharged employees to sign termination agreements releasing the company from any claims. It is surprising how many companies do not have an effective employment policy handbook. The handbook is an essential document in setting expectations with both the employer and the employee and allows the company to impose employee policies on a consistent basis, which provides an effective defense against claims of discrimination.
Data Security. Most businesses work with IT professionals to make sure robust safeguards are in place against data breaches. But even with the best technological safeguards, breaches still occur. It is important that you understand your obligations with respect to the acquisition, storage, use and destruction of third party information, and how you should respond in the event of a data breach. This is all governed by a complicated web of state and federal laws governing privacy, cybersecurity and trade secrets. Which laws apply to your company depend on various factors, including the industry you are in and the types of information you collect. Appropriate policies should be in place for responding to breaches when they occur. Also, your attorney should encourage you to consult with your insurance advisors as to whether you have the best coverage in place for your type of business, including cyber liability coverage.
Spinning Off New Entities. Depending on where you are in your growth, it may be wise to spin-off company divisions or assets into separate but affiliated legal entities. For example, if a patent, trademark or other intellectual property is a key asset, perhaps this should be held in a separate entity and licensed to the operating company. Also, real estate used in the business could be owned by a separate LLC and leased to the operating company. This may increase total value, diversify risk, cause more accurate financial reporting, and allow you the opportunity to retain part of the business.
Assembling your Professional Team. Although many in our profession find this hard to believe, lawyers do not know everything. As part of the legal check-up, your attorney should help you plan an effective team of outside advisors, including a good CPA, HR professional, and, if appropriate, an M&A advisor and perhaps a valuation professional. Ask your CPA to begin preparing financial statements and to put in place rigorous systems for financial reporting and fraud reduction. Your attorney can also discuss whether it is advisable to convene an informal “Board of Advisors”. This is typically a non-fiduciary, non-governing committee of industry peers and professional advisors.
Every business is unique, and a legal check-up will not be exactly the same for any two companies. This should not, therefore, be viewed as an exhaustive list of the subjects of a legal check-up. Other issues may be identified during the check-up. Or, some of the issues above may be less relevant to your company. Or issues that are not relevant today may become more relevant in the future as your company grows.
For questions about this article, or other business-related matters, please contact an attorney in our Business & Transactional practice group.