FAQ Small Business

Some common questions asked by entrepreneurs setting up or operating a small business (though of interest to startup business entrepreneurs as well):

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What is the difference between a startup business and a small business?
What has been said generally under faq # 2 (why use a business lawyer) about the need to use a good business lawyer goes double for the use of a startup business lawyer.

With business startup companies, the legal issues faced by the business are normally several times the complexity in relation to those faced by a traditional small business.

With respect to raising funds, for example, it is very easy for a startup without proper guidance to get into trouble with the securities laws.

Similarly, because a startup business will typically deal with technology, the intellectual property issues are often very important for such companies, even at inception. If these issues are not handled properly at the start, serious problems can emerge later at the due diligence phase of a funding or an acquisition. This is especially true of casual dealings that founders will often have with technical friends who help them develop intellectual property (IP) in undocumented or poorly documented arrangements. If nothing else, a good business attorney will spot such problems, alert the founder group to them, and cause them to do what is needed to avoid problems.

This type of example could be multiplied many times over in different areas of law affecting a startup business company. What happens when founders as a group issue stock to themselves only to have one of them leave the company within a short while after the issuance? Unless they have made provision to be able to buy back the shares at little or no cost from the departing founder, the remaining founders wind up working exceptionally hard to build value for a founder who contributes little or nothing to the startup. Over the years, we have had many founding groups come to us having done their own “quickie” online incorporation only to find themselves in situations such as this. Very often this was because, lacking sound guidance on legal issues, they filled in the blanks in the kits they received without knowing what they were doing. Once the legal rights were fixed, and disagreements set it, there was no longer any easy fix for the problems. These are costly errors indeed.

It serves no purpose to belabor this point. If you are a founder about to establish a startup business, do so only with skilled assistance from a good startup business attorney.

Why use a business lawyer?
The short answer is for the lawyer’s expertise.

As an entrepreneur, you can use legal self-help resources and many excellent resources of this type exist. This involves a significant investment of time, which many entrepreneurs are willing to invest in order to educate themselves about legal procedures and thereby reduce their dependency on lawyers. There is, however, a point of diminishing returns that is reached fairly quickly. It is one thing to acquaint yourself with how corporations are formed and with how they work in general. But a typical corporate law treatise will run many volumes. What entrepreneur desires to make a time investment at a level needed to master such an intricate body of law? And the corporate aspect is only one of many that can apply to the law affecting your business. There is contract law, intellectual property law, securities law, UCC law, commercial law in general, employment law, agency law, tax law, and a bewildering array of other fields, not to mention the vast and intricate areas of law that arise both substantively and procedurally when litigation is involved. Who wants to master all of that and still try to run a business with any measure of success?

As long-time Silicon Valley business lawyers who have worked closely with entrepreneurs for nearly three decades, we by no means discourage our clients from seeking to educate themselves – a smart and well-informed entrepreneur is a lawyer’s best ally. Our style therefore as a law firm is to educate clients, not to keep them in the dark. Self-help resources assist in this process to the extent the client is motivated to use them.

Does this mean that a well-educated entrepreneur can dispense with the services of a good business lawyer? Not at all. Indeed, the serial entrepreneur is the very person who will be the first tell you that the services of a good business lawyer are indispensable to the healthy functioning of your business. This is the very type of entrepreneur who has had great business success. Because of this experience, the serial entrepreneur – who is by then knowledgeable about legal issues at a pretty sophisticated level – knows full well that the business world is simply too complex to make smart decisions without a good business lawyer.

This much is often readily acknowledged by you who would start up new ventures.

The question remains, is it worth it to cut corners, for example, by using online incorporation services to set up your company with the intent of hiring a lawyer only later? Of course, there is nothing wrong with trying to save early-stage costs. And sometimes this makes sense for an early-stage company for this reason. The problem, though, is that an entrepreneur often lacks the knowledge to make informed judgments on the key issues that arise in this context. Which state do I file in? Which type of entity do I choose? Do I make special tax elections or not? And so on. When the issues concern a startup, the online services come up woefully short in the assistance they provide and this for good reason: such services are prohibited from practicing law and can only act as facilitators. They cannot guide you in how to make your legal decisions; they can only drop a kit into your lap and say, in effect, “here is some generic guidance, good luck.” You can fill out the blanks using very generalized instructions, but you will have no basis for making sound legal judgments on any of the issues involved, whether corporate, tax, securities law, intellectual property or otherwise.

All too often we have seen the failed results (legally speaking) of new ventures trying to go it alone without the help of a good business lawyer. The mistakes are legal, not business, and were easily avoidable at the start. By the time such mistakes are subsequently discovered, the cost of fixing them often well exceeds what the business would have paid to do it right in the first place.

Of course, good business and corporate lawyers are not cheap, and this forces every new venture to weigh whether the costs are worth the benefits for any potential use of the business or corporate lawyer’s services.

Our recommendation is that every new venture, at a minimum, should at least consult with a good business and corporate attorney at the beginning to understand the costs and benefits in light of the facts of their situation. An initial consultation of this type is not expensive, and it carries with it no obligation. You can then see what potential legal expertise is available and determine whether you need it or whether you can do without it in setting up and operating your business.

What we as a Silicon Valley business law firm seek to achieve is to give the startup business or small business venture significant value in relation to what is being paid for the services – that is, the services will be worthwhile because they are equivalent in value to those provided by larger firms who would charge significantly more for comparable services and will further be worthwhile because money spent on them will save the business from the large expense of having to correct costly mistakes when it fails to do things right. Ask any entrepreneur who has become entangled in a lawsuit, for example, because a contract was poorly drafted – the couple of thousand dollars saved at inception might have cost tens of thousands of dollars or more to clean up.

Your goal as an entrepreneur is not to become a lawyer but to develop a strong working knowledge of all legal aspects of your business, akin to that of a serial entrepreneur – this lets you partner with a good business lawyer to enable you to set the strategic direction in your legal affairs with valuable tactical and technical help from your business attorney. The way to best gain that knowledge is not through self-help tools (though these can also help) but by working under the knowledgeable guidance of a skilled business attorney at the different steps in the development of your business.

When it comes to something as vital as your startup business or small business venture, this is not an area to be penny-wise and pound-foolish.

What type of clients does a business or corporate lawyer represent?

Having worked with small business owners, business startup companies, and entrepreneurs for over 25 years, our attorneys often have been asked what exactly it is that we do when we act as “business lawyers” or as “corporate attorneys.”

A business lawyer or business attorney refers to a lawyer who represents business entities or who represents individuals who act in a business capacity. Thus, a business lawyer or business attorney will represent corporations, limited liability companies (LLCs), general partnerships, limited partnerships, sole proprietorships, joint ventures, and the like, as well as founder groups, owners, proprietors, partners, directors, officers, managers shareholders, and entrepreneurs.

In addition to the above, as business lawyers, our attorneys also represent other individuals in their dealings with business entities. This includes individual founders, executives, and investors who are negotiating with their companies, minority shareholders seeking to protect their shareholder rights, contractors, consultants, advisory directors, employees, and the like.

When we act as corporate lawyers or corporate attorneys, we represent many types of corporate entities – California and Delaware, C-corps, S-corps, statutory close corporations, and the like. In such a role, a corporate attorney is simply a business lawyer serving the needs of a particular type of business entity. Because corporate transactions often involve federal and state securities laws more so than do those of other business entities, a business lawyer handling corporate matters may be practicing in a more specialized area than is an attorney handling transactions relating to other business entities. Our attorneys act both as business lawyers and corporate attorneys in the various business transactions we handle.

Though not commonly used this way, we also regard a business lawyer or corporate attorney as a lawyer who represents business and corporate entities in commercial litigation. For the owner or entrepreneur needing business litigation assistance, it is a great advantage to be able to get assistance and strategic advice from an informed and experienced California attorney who is well-versed in both transactional and litigation matters.

Why can’t I just use a form contract?
Our era is one in which legal forms proliferate and many entrepreneurs are tempted to use them without much thought given to customizing them for the facts of their deal.

This is a huge mistake.

Contract and commercial law is highly complicated and does not lend itself to thoughtless application. If it were only a matter of filling in the names, for example, on a partnership agreement, then anyone starting a business could go to a stationery store (the old way) or go to a forms download site (the new), buy a canned partnership agreement, fill in the names, and be done with it. This is normally an unwise way to form a company. Such a boilerplate form may have nothing to do with the nature of the business being set up by the parties. It may have language in it that has no bearing on their deal and that will only confuse them and everyone else concerning what was intended by their deal. Worse, it will not expressly set forth the nature of their deal to make clear what they intend in their contract. Such a contract is an open invitation to litigation should anything go wrong in the deal between such parties. Perhaps tens or even hundreds of thousands of dollars will be spent hashing and re-hashing ad nauseam what they intended when they “agreed” to badly-worded boilerplate. If you have ever had the misfortune to suffer this fate, you will never again resort to such corner-cutting in documenting the affairs of your startup business or small business.

Can entrepreneurs get away with this in some cases? Of course, to some degree they often can. They need a simple promissory note, and the generic one fits their needs without too many risks of getting legally blind-sided in a simple transaction. They need a canned nda for their employees and they have a form they had used in a prior company – the type of form that has remained pretty constant over many years of use. This can work for the entrepreneur and, even when there are potential technical problems with the documents they are using, the problems may never arise in their particular situations.

For every case where entrepreneurs either can or do get away with it, though, there are all too many situations in which their attempts to do so proves ill-advised.

Bad business lawyers are lawyers that simply take forms and switch the names without giving thought to the nature of the deal before them. Bad as this may be, at least such lawyers have a modicum of legal education and experience to be able to spot some of the legal issues and some of the potential traps.

The same cannot be said for an entrepreneur trying to do the same thing but without the benefit of a legal education or legal training. This then is the worst of all cases. Don’t put yourself in this situation.

The issue gets confused when the entrepreneur will have had significant exposure to certain types of legal documentation, as for example in the case of one who managed the contracts of a large company in an executive capacity while working under the guidance of skilled lawyers. In such cases, someone who has had a lot of practical experience with a particular class of contracts is often far more aware of their ins and outs than are non-specialist lawyers who have not dealt much with such contracts.

This is true as well of the seasoned entrepreneur who has developed such a strong working knowledge of business deals as to be able to run rings around certainly any green business lawyer who attempts to work on such deals.

While all this is true, it simply means that law has a practical side as well as a theoretical one, and any smart person who has worked through complex legal deals often enough will come away from that experience with some excellent skills applicable to such deals. Serial entrepreneurs, contract managers, and others with like experience fit this mold.

This only confirms, however, why it is ill-advised for an entrepreneur to try to do business by using legal forms unthinkingly. The seasoned entrepreneur, the skilled contract manager, etc. may not be business lawyers but do have the vast experience to be able to think their way carefully through a complex contract. Even then, such persons will attest that they ultimately need their deals reviewed by a skilled business attorney. Though they may be able to drive a deal more efficiently owing to their experience, they themselves know this is no substitute for using the services of a lawyer who is an expert in their field.

The operative word is “think.” A good business lawyer will think carefully about any given deal and will customize any contract for the commercial situation at hand. A seasoned entrepreneur will do the same within the limits of a layman’s knowledge in a technical field.

Use of boilerplate forms without the requisite training, experience, and education does not give an entrepreneur any basis for thinking through a deal to spot the issues and potential trouble spots. Don’t use boilerplate forms mindlessly. In the end, it may cost you dearly.

Why use a startup business lawyer?
What has been said generally under faq # 2 (why use a business lawyer) about the need to use a good business lawyer goes double for the use of a startup business lawyer.

With business startup companies, the legal issues faced by the business are normally several times the complexity in relation to those faced by a traditional small business.

With respect to raising funds, for example, it is very easy for a startup without proper guidance to get into trouble with the securities laws.

Similarly, because a startup business will typically deal with technology, the intellectual property issues are often very important for such companies, even at inception. If these issues are not handled properly at the start, serious problems can emerge later at the due diligence phase of a funding or an acquisition. This is especially true of casual dealings that founders will often have with technical friends who help them develop intellectual property (IP) in undocumented or poorly documented arrangements. If nothing else, a good business attorney will spot such problems, alert the founder group to them, and cause them to do what is needed to avoid problems.

This type of example could be multiplied many times over in different areas of law affecting a startup business company. What happens when founders as a group issue stock to themselves only to have one of them leave the company within a short while after the issuance? Unless they have made provision to be able to buy back the shares at little or no cost from the departing founder, the remaining founders wind up working exceptionally hard to build value for a founder who contributes little or nothing to the startup. Over the years, we have had many founding groups come to us having done their own “quickie” online incorporation only to find themselves in situations such as this. Very often this was because, lacking sound guidance on legal issues, they filled in the blanks in the kits they received without knowing what they were doing. Once the legal rights were fixed, and disagreements set it, there was no longer any easy fix for the problems. These are costly errors indeed.

It serves no purpose to belabor this point. If you are a founder about to establish a startup business, do so only with skilled assistance from a good startup business attorney.

Can your law firm represent my business even though we are located far from your offices?
Almost always, yes but sometimes, it depends.

In today’s virtual world, over 90% of our business, corporate, and intellectual property law practice is conducted in some manner other than face-to-face. Thus, it is no problem for us to represent not only clients physically located in Cupertino, Sunnyvale, Mountain View, Los Altos, Palo Alto, Campbell, Los Gatos, Milpitas, Fremont, San Jose, or elsewhere in Santa Clara County or Silicon Valley but also those located anywhere in the San Francisco Bay Area, including on the San Francisco Peninsula or in the North Bay or East Bay or, for that matter, anywhere in California or even worldwide. We have routinely represented clients located in Japan, Singapore, India, Germany, UK, Taiwan, and many parts of the world far removed from Silicon Valley. In modern business transactions, this is normal and presents no impediment to our being able to represent the legal interests of such clients.

Of course, if you are located in Texas and want us to represent you on matters concerning Texas law, then we cannot help you. We are California lawyers and not Texas lawyers. And similarly for other local jurisdictions. If your matter concerns Silicon Valley or California law matters, then the above applies and we can potentially help you even though you are located remotely from our offices.

If you are part of a founding team involved in a business startup whose members are located in far-flung locations, we can normally assist you without any problems as long as there is at least one founder or other key person who can serve as a local liaison – while the latter is not strictly necessary, it is a practical reality that most founding teams feel much more comfortable with their business startup attorney if someone whom they know relates well to that attorney based on direct personal interactions. Lawyers who do business startup law must be able to gain the confidence of the founding team or look elsewhere for their legal work – in our experience, having at least one key local link with the founding team is very important for this purpose.

In addition, for many small business clients, it is often important for the owners to have initial face-to-face contact with their business lawyer to determine their comfort level with that lawyer. This is not always needed, especially if the small business owner can gain a good comfort level based on the reputation of the attorney and based on telephonic conference calls. A lawyer’s expertise and command of issues will definitely convey itself across phone lines if the person asking the questions is a knowledgeable entrepreneur. Of course, for any client located within California, and certainly within the San Francisco Bay Area, it is normally easy to gather even a group of owners for an initial face-to-face meeting or two and then do the rest of the interaction by virtual means.

Commercial litigation also poses many situations where local presence is necessary but this is not invariably so. Our attorneys are often retained to help business clients located remotely from our offices with lawsuits in Silicon Valley and the like. If you have questions about this issue, feel free to call our office to discuss them with our attorneys.

Will you meet with me on a Saturday, etc. or at my office or business?
Within reason, yes.

Notwithstanding the stereotype of a business lawyer as one just sits back in his desk chair counting his money, a good business lawyer is of necessity a very hard worker. The technical aspects of business law are very demanding and it takes habits of hard work and diligence to master them.

It is no different for founders, entrepreneurs, and other business owners.

Sometimes it is not possible for you to break away from your business easily during normal working hours. This is especially true for a founder who is currently employed while contemplating a break from an existing business or of a founding team that may have one or more members in such a position. Our attorneys understand this and are prepared to meet with you during off-hours, on weekends, or at your business as the situation may reasonably require.

Besides being hard-working, a business lawyer (or a corporate lawyer or intellectual property lawyer for that matter) cannot serve business clients well without being responsive – that is, making himself available and accessible in reasonable ways so that the client can get answers to questions, etc. in a timely way and also getting the client’s projects done on time.

For this reason too, our attorneys seek to make themselves reasonably available in ways that make it convenient for you to interact with them and that enable you to get project work on time, whether this means off-hours meetings or late-night projects as needed to meet client deadlines.

What are some of the basic legal factors to consider in selling or buying a small business?
Three Types of Small Business Sale

A small business can be sold by asset sale, stock sale, or merger, with asset sale being the normal vehicle of choice for many small businesses.

Business Sale – Canned versus Customized

Sometimes the sale of a small business is done via a basically canned process through a broker. In that case, a buyer and seller get a homogenized process that may or may not suit their legal needs. The documentation will be “standard” but contract terms will not be customized for the parties. Such documentation will cover minimum terms but little else.

Better by far in all but very small sales is to use customized deal documents prepared and reviewed by qualified business lawyers. Typically, a seller will get legal and accounting advice on how to structure the sale and will then work with a prospective buyer to get the basics of the deal documented in a term sheet or letter of intent. A term sheet, though not legally binding, provides a useful framework for moving forward. The parties may of course skip right to a formal contract instead.

Business Sale – The Purchase Agreement

The formal contract is a purchase agreement. It normally contains covenants or promises (“I will sell to you and you will buy from me x assets or x stock shares,” etc.), warranties and representations (“as seller, I warrant and represent that I have good title to what I am selling you and that there are no liens on it and no lawsuits against it,” etc.), and conditions to closing (“our deal with close only at such time as x, y, and z conditions are met,” as for example getting a landlord’s consent to a lease assignment).

The Escrow Process, Due Diligence, and Confidentiality Agreements

The contract is signed and an escrow normally established as a mechanism by which to get to a closing where the sale will consummate. Procedurally, such an escrow works much like that set up when a home is sold, except that (for example) instead of waiting for the results for a title search the parties may be waiting for a liquor license approval or some other condition pertaining to a business sale.

Due diligence is a critical part of this process, mostly on the part of the buyer. This is the process by which a buyer inspects the books and records of the business being sold and takes other steps to ensure that what is being sold is authentic and worth the value being paid. Lawyers and accountants typically assist with this process.

Detailed due diligence can be done before or after a formal contract signing or it can be done in stages – limited due diligence prior to signing a term sheet with detailed due diligence during the escrow period. Buyer satisfaction with due diligence is often a condition to closing.

Due diligence is not normally allowed until a buyer has signed a confidentiality agreement.

Common Traps and Pitfalls in the Sale of a Small Business

Many traps and pitfalls can arise during a sale. Sometimes a buyer will claim to want to buy a business while in fact scheming to gain access to key information that will be used competitively against the seller. A confidentiality agreement helps here but this may prove cold comfort to a seller stuck with a lawsuit. Be discerning in this area.

A serious seller risk is to take a carry-back loan with inadequate protections. Proper collateral (UCC and otherwise) is usually key to dealing with this in case of default.

Buyers normally face the greater risks. Unscrupulous sellers can play all sorts of tricks to make a deceptive sale. The nature and range of tricks used, or even mistakes inadvertently made, is vast and varied. This is often the major area of focus by attorneys and CPAs in shaping a seller’s representations and warranties and in handling due diligence.

From a buyer standpoint, the structure of the deal can affect liability risks: in a stock sale, a buyer will inherit the entire corporate history, good and bad, along with the purchase; in an asset sale, a buyer can normally limit the inherited liability risk considerably if not altogether.

Most businesses are sold with a premium placed on good will, consisting generally of the going concern value of having a particular customer base, a recognizable name, and so on. Most buyers then will want a non-compete agreement from the seller or, if the seller won’t give it, at least a non-solicitation agreement relating to existing customers.

Watch out especially for distress sales. Unless a distress sale proceeds by UCC foreclosure, or out of bankruptcy, any buyer of a business overwhelmed with debt can potentially inherit all or part of that debt even if the contract specifies that the buyer is not assuming any liabilities. Given the risks, distress sales are typically radioactive for a buyer.

Common Business Tax Issues

Another major issue is tax. A stock sale will have very different tax consequences from an asset sale, some favoring the seller and others the buyer.

For example, if a seller is a C-corp with low basis assets, any sale of its assets for a substantial sum would likely lead to a serious risk of a double-tax. Let us say corporate seller ABC Corp. sells its business for $10 million via asset sale and has a near-zero basis in its assets. This can happen, for example, where a manufacturing business with fully-depreciated assets is sold. Normally, that sale would constitute a taxable capital gain to the corporation. Given that this is a C-corp, however, the cash in the company would normally be taxed again as a dividend when distributed to shareholders.

In the same scenario, if the ABC Corp. shareholders sold 100% of the stock of the corporation to a buyer, then those shareholders would pay tax on a one-time capital gain and nothing more.

Such tax issues can get complex and should be handled with skilled professional help. A good business lawyer can suggest approaches that can mitigate double-tax problems. The point of this is not to attempt to address any given situation but rather to illustrate how tax can seriously affect the outcome depending on how a sale is structured.

By the same token, in an asset sale, the purchase price should be allocated among the assets being sold, and this will result in differing income and sales tax treatment, depending on the nature of the assets being sold and on the nature of the allocation. Such allocations should be done with the help of a qualified lawyer or CPA.

Don’t ignore these tax aspects of a business sale – they can sometimes be the most important part of a deal, and they are almost always important to some significant degree. In more sophisticated deals, tax-free deals are also done via reorganizations.

Estimated Transaction Costs

How about transactional costs? These can literally go all over the board. In a typical small business sale, a buyer should use as a rough estimate of total transaction costs a rule of 2% to 5% of the purchase price. This would be money spent on attorneys, accountants, and other professionals, as well as for escrow fees. Seller costs normally are lower, though they can be significant if broker fees are involved or if the deal is complex. In any case, don’t rely solely on any rule-of-thumb approach – use that for initial planning and then consult with your professionals to refine the estimates.

Work with a Qualified Business Attorney

This highlights some key issues connected with a small business sale but does not address their legal implications or strategies for implementing them (see your lawyer for this). It also does not touch upon important issues such as the need to get consents and approvals (landlord, agency, vendor, and spousal, among others), the use of fairness opinions, opinions of counsel, no-shop agreements, hold-back provisions, earn-out provisions, or issues such as UCC bulk sales compliance, indemnification, joint and several liability, and the like. These deals can have many nuances that only a knowledgeable lawyer will pick up.

For your particular deal, get a good business lawyer. It is not wise to scrimp on expense in complex areas where stakes can be high. Whatever is saved today will be spent many times over trying to dig out of a mess if problems occur. Therefore, budget what is needed and do it right.

Entrepreneur’s Guide to Corporations and How They Work
Three Types of Small Business Sale
Introduction

Every entrepreneur should have a basic understanding of how corporations work. If you do, you should normally have little or no difficulty deciding whether you should adopt the corporate format or in maintaining your existing corporation simply and inexpensively.

Here are some explanations and guidelines that will help you.

How Corporations Work: Shareholders, Directors, and Officers

Think of a corporation as being akin to a centuries-old algorithm that is so thoroughly debugged that it can adapt itself as easily to the simple needs of a one-person corporation as it can to the complex needs of multi-national enterprises.

The goal is to facilitate capital formation by offering limited-liability protection to investors who put up risk capital.

This can be a founder who puts up his own money to fund a small business. It can be VCs who invest in a startup in hopes of getting a 10x return within a few years. It can be public investors who buy stock through a publicly-traded exchange.

In any case, while the corporate law affords limited-liability protection to shareholders generally, it has special rules that facilitate comparatively simple maintenance for closely held corporations.

Before we can understand how those rules work, we need to understand how shareholders, directors, and officers relate to one another within the corporate context.

In a closely held corporation, as in others, shareholders own the entity. But they do not manage it directly, other than by electing the board of directors. The broad idea behind limited liability is that there needs to be a sharp distinction between those who own and those who manage the affairs of the corporation.

Shareholders elect the directors and thereby ultimately control the company. Besides electing the directors, shareholders need to approve important actions generally affecting their ownership interests or otherwise deemed fundamental — for example, increasing the number of authorized shares, amending the corporation’s charter document, approving a merger or acquisition, or authorizing a dissolution. Apart from a few such fundamental areas, shareholders do not normally vote on corporate matters. They leave the most important management decisions to the board.

Under law, the board is responsible for all major decisions of a corporation that are material or “out of the ordinary course of business.” Let us call these “high-level” management decisions and let us distinguish them from the day-to-day management conducted by corporate officers. Where a high-level decision is involved, the action requires the approval of the board if it is to be properly authorized.

Of course, one can easily imagine issues about exactly where the line between high-level and day-to-day management decisions should be drawn. Corporations are creatures of state law, and your state law may differ from that of other states. Check with a good business lawyer in your area if you need to understand which types of actions require board approval.

Here are some obvious cases. If your corporation decides to issue stock in exchange for a capital contribution, this needs board approval. Grant of options? Needs board approval. Material building lease? Needs board approval. Bank line? Needs board approval. Appointing a corporate officer? Needs board approval. Acquiring a company? Needs board approval. Dissolving your company? Needs board approval.

In contrast, corporate officers deal with day-to-day management of the corporation’s business. These too can be very important decisions, as one can derive even from the titles of corporate officers. Company president’s, after all, do important things. The point, though, is that such actions are operational in nature and need no special documentation as would an action of the board of directors.

To recap, then: (1) shareholders own but don’t manage; (2) directors do high-level management; and (3) officers run day-to-day operations.

It is imperative that entrepreneurs in a closely held corporation keep the above distinctions in mind. If you do, there will be no confusion of roles. You will know, for example, that shareholders do not vote to appoint officers, that the company president cannot just go sign for a building lease without board approval, that an individual board member cannot act to sign a contract for the company, that the company cannot sell substantially all of its assets without both shareholder and board approval, and so on. Always check with a lawyer when there is any doubt. But there are clear lines of division, and it is critical to observe these in administering the affairs of a corporation.

Given this division of functions, here are some general guidelines on how to administer the affairs of a corporation.

Treat the Corporation as a Legal Person

A corporation is a legal “person,” albeit an artificial one. What does this mean?

A person has rights. So too does a corporation. You can enter into a contract as an individual. So too can a corporation. You can buy and sell property. So too can a corporation. You can sue and be sued, as can a corporation. If a law says that you must file a fictitious business name statement (dba) as a prerequisite to doing business under any name other than your exact name, then such a law applies to a corporation as well.

Let us use this last example to illustrate the point of a corporation being a person.

If John Smith as an individual seeks to do business as “Smith Enterprises,” he will need to apply individually for a dba to use that name. If John Smith’s corporation, J. Smith, Inc., seeks to do business as “Smith Enterprises,” then the entity will need to apply for the dba. What does this mean logistically for John Smith? It means that, when he goes down to make the application, he will list the corporation as the applicant and will sign it at the end, not as an individual, but as an agent for the corporation. Thus, for example, he will sign it as “J. Smith, Inc., by John Smith, President.” The “person” applying is not John Smith the individual but rather J. Smith, Inc. the corporation. In making the application, J. Smith, Inc., a legal person, acts through its agent, the president of the corporation, John Smith.

Use Consents to Document the Actions of Shareholders and Directors

How exactly do you document the fact that a corporation is acting through its agents?

In a public company context, there is great formality associated with board and shareholder meetings. Formal notices are sent out. Meetings are handled with strict protocol. Motions are made and seconded, discussion is had, formal votes are taken and recorded by a corporate secretary. Minutes are taken and formally approved.

In a closely held context, corporate actions are normally documented in much simpler fashion.

Indeed, now that we understand the general division of functions, we can see some remarkable things about how corporations work: specifically, that many apparently complex steps can be dramatically simplified.

Here is how this works. In most states, such as California, a corporation can legally exist and function even if it has only one shareholder. That same shareholder can appoint himself as the sole member of the corporation’s board of directors. And that one-man board can similarly appoint that same individual to each of the officer positions. The result: one individual fills all the roles and does everything, just as in the case of a sole proprietor.

Does this single-person corporation still have to honor the rules relating to the corporate division of functions as outlined above? Absolutely. The sole individual in that corporation functions in three different capacities: as a shareholder, as a director, and as an officer. In acting for the corporation, that individual must always bear in mind the role in which he is acting. If the corporation needs to enter into a building lease, then he must approve it in his role as sole director and must also give himself authority to physically sign it in his role as president. If his company is being acquired, he must approve the deal as a shareholder and as a director for the acquisition to be valid. And so on. Legally, what do have here? We have two legal “persons,” one an artificial person that can act only through agents and another an individual who acts on its behalf as an agent. As an agent, that individual wears at least three hats, one as shareholder, another as director, and another as officer. Though he practically can function much as a sole proprietor would, he must be careful to honor the division of functions that corporate law requires.

But how can this individual “meet” with himself to approve those items requiring shareholder or director approval. There is no mystery to this. No one can possibly “meet” with himself, unless he wears a straight jacket. But there is no need to go into convulsions over this because the corporate law makes simple provision for how approvals are done at the shareholder and director level. And this brings us to yet another radically simplifying feature that is woven into the genius of corporate law.

If you consider the division of functions set out above, you will see a hierarchy, with the shareholders on top dealing with the most fundamental actions, the directors immediately below dealing with the high-level management functions, and the officers just below them dealing with the day-to-day management. At each level, how do we know that the “person” known as the corporation has been authorized to act. We know this when any action besides day-to-day activity has been “approved” at the level required – shareholder or board or both. How do we know that such approvals have been properly given? There are two ways: first, by a vote at a meeting; second, by what is called a corporate “consent.”

The meeting is the part most of us are familiar with. The shareholders of ABC Corp. are required to approve an impending merger already negotiated by its officers under the direction of its board. A notice goes out as required by law giving at least a set number of minimum days advance warning that a meeting will occur. The shareholders show up and conduct a formal meeting. The meeting is chaired, motions are made and seconded, votes are taken, and minutes are recorded. In those minutes will be recorded various actions that were thus authorized, which appear in the form of corporate resolutions. For example, “The shareholders of ABC Corp., by unanimous vote, approved the following: RESOLVED, that ABC Corp. is hereby authorized to merge with Voracious, Inc. on the terms and conditions set forth in that certain Merger Agreement attached as Exhibit A.” These minutes are duly recorded by the corporate secretary and we thus know that the corporation’s shareholders have “acted” to authorize the action. The action of the shareholders has been properly documented.

In this example, there would also be an accompanying meeting of the board of directors, which also could be held by the notice-meeting-minute format. The resolutions adopted at the board meeting would also add something like the following: “RESOLVED FURTHER that the President of ABC Corp. is hereby authorized to sign the Merger Agreement on behalf of the company.” Again, in this way, we know that the board – acting as agents for the artificial person known as ABC Corp. – has authorized the corporation to act, and we thus know that the merger (in this instance) is a proper and lawful act of the corporation. The action of the board has been properly documented.

These are the sort of corporate formalities of which we always hear. And, indeed, if every corporate action required them always to be done with that level of formality, then the corporation would become administratively burdensome as a vehicle by which a typical small, closely held corporation could do business. It could function, and many small corporations do function in this way, but this aspect of it would often be regarded by its principals as a serious negative.

This is where the corporate “consent,” when combined with the normal division of corporate functions, saves the day for the closely held corporation. Recall that day-to-day operations are done by the corporate officers – these require no form of special corporate approval beyond what is routinely set out in a corporation’s bylaws defining the roles and duties of the corporate officers. That is, all such actions by the officers have a standing approval as set out once for all, so to speak, in the bylaws. Thus, the officers can go about with their conduct of normal company business without needing to get special documentation for any of their actions. These are all proper corporate actions that occur without special documentation.

Now let us consider our hierarchy again. If the day-to-day actions of officers do not need special documentation, and if that constitutes 99% of what the corporation typically does, there is no administrative burden whatever associated with such activity. About the only thing that differs, practically, between what such officers do in this way and what a sole proprietor does is that the officers must always remember to use the block-signature format to ensure that it is the corporation and not an officer individually that enters into contracts or makes applications or otherwise acts by signing.

That takes care of the overwhelming bulk of the corporation’s activities, whether it is 99% or some other ratio to the whole – no special documentation required. The corporate consent takes care of the rest for most situations in any closely held corporation where the principals are not feuding. Consents are simple documents (often “one-pagers”) that simply set forth each of the resolutions to be adopted and bracket them with simple language saying who is adopting them, plus signatures for the adopters. If it is a shareholder consent, it will say something like, “The undersigned, holding the number of shares set forth opposite their names below, hereby approve by this consent the following resolutions . . .,” with the resolutions then set out similar to the format described above for meetings (“RESOLVED that . . .”). The shareholders then sign the consent. No meeting required.

Board consents work in a similar way as far as the mechanics go. The consent describes the action being approved by setting forth the appropriate resolutions. The directors then sign. No meeting required.

There are a few important caveats to note here. First, the consent procedures may vary from state to state and local law always needs to be consulted concerning their requirements and validity for varying situations. Next, the rules for approval will sometimes be slightly different for what it takes to approve an action using a consent versus what it takes to approve it at a meeting. For example, under the law of most states, such as California and Delaware, a board consent is not valid unless it is approved unanimously by the directors. If unanimity is not possible, then the board will need to hold a formal meeting, where a majority of the directors can approve the action. This is just another way of saying that, when matters are in conflict, something so important as board approval needs to be obtained in a more formal way that, among other things, lets the dissenting directors know that an action has been approved. Otherwise, there might be great confusion among even the directors themselves concerning whether some action had or had not been approved. The same principle applies to shareholder consents but in a slightly different way: in the case of shareholder consents, a consent may legitimately be adopted approving the action by whatever percentage of the voting shares would otherwise be required to approve it at a meeting but the signing of such a consent by the requisite number needs to be followed in fairly short order by a notice sent to the other shareholders telling them of its adoption. All of this is another way of saying that the corporate consent is a highly useful administrative tool for closely held corporations but cannot be used without regard to the rights of dissenters in the company.

There is also another important caveat that explains why corporate lawyers promote the idea of having regular meetings of the directors and of the shareholders. This serves a very good purpose. Since small companies tend to be lax in paying attention to their legal affairs, periodic meetings with the lawyer promote discipline. The very process forces the entrepreneur to pay attention to important legal issues that might otherwise be neglected.

In other words, in answer to the question, “should our corporate management meet periodically with our business lawyer to make sure we do things right,” the answer is yes. It is “yes,” however, not for legal reasons as such but rather for prudential reasons. Regular meetings promote legal discipline and accountability and should be held for that purpose. In a closely held context, however, they are not necessarily required to comply with corporate formalities (as long as consents are properly used).

Now let us summarize. We have set out the theory and the hedges and qualifications for how corporate administration works. But look again at our hierarchy: if 99% of corporate activity needs no special documentation and if we are a closely held corporation whose management is acting in unison, then even the small remaining percentage of authorizations needing special documentation can be done by consent. In this situation, no formal meetings are required.

Returning to the one-person case, we also see why it is unnecessary for that person to “meet” with himself. Nor is it necessary for that person to go about documenting all manner of corporate activity when only a relatively few fundamental or “high-level” items even require such documentation. Thus, standing back from our common impression of corporate formalities in a public company context, we can see that such formalities can be managed without any undue burden at all by you if you just understand how it all works. Again, legally, we have two persons, one real and one artificial, with the real person wearing three hats. As long as he understands the roles in the corporate division of function, the practical result is his having the ability to function perfectly legitimately as a corporation with not much more practical burden than would apply if he were functioning as a sole proprietor.

The handling of annual meetings is really no different for a typical closely held corporation. During the annual meeting of shareholders, the shareholders must act to elect the following year’s board and to approve the prior year’s financials. If there is no dissent, this can normally readily be done by consent. During the annual meeting of directors, the newly appointed board will act to appoint the next year’s officers. Again, absent dissent, a consent can accomplish this. All in all, the annual meetings can be done with little or no hassle in most cases involving closely held corporations.

The above discussion readily suggests why the door to the corporate world is easily accessible to a huge universe of small companies without any great difficulty.

Keep Things Separate

This brings us to the most important step in corporate administration: keep your personal things separate from your corporate business.

You are dealing with two separate persons, legally speaking — you and the corporation.

Don’t commingle personal assets with corporate assets. The assets belong to two different persons. If you fail to keep the assets separate, the law may well see your corporation as being your mere alter ego – hence, you may be liable for its actions.

Don’t raid corporate funds as if they were there to pay your personal bills. If you work for the corporation, document your salary and bonuses. If you pay yourself a dividend, document it as a dividend.

If your corporation uses space in a building that you own, have it sign a lease agreement for that space.

If you loan money to your corporation, or borrow from it, document the transaction with a loan.

Remember, the corporation is a legal person. If you transact business with it in any way, you should treat it as a separate person.

When it comes tax time, the corporation, just like any other person, needs to file all appropriate returns. Make sure you arrange for this.

Keeping your corporation separate is not complex. It does require that you as an entrepreneur always bear in mind the separate legal existence of the corporation and that you treat and document things accordingly.

Pay Attention to Routine Aspects of Maintenance

Every state has its routine requirements for corporate maintenance. California requires that every corporation periodically file a so-called Statement of Information to let the state (and the world) know who its management is.

If the corporation issues stock, applicable securities law exemptions must be complied with. Sometimes this involves filing some form or other with the state.

None of these items tends to be complex in a closely-held corporation.

Conclusion

Corporate administration is straight-forward and easy for most small corporations. Don’t be intimidated by the corporate format. It has a logic to it. It has clear procedures for complying with corporate formalities that are neither complex nor expensive. As an entrepreneur, you need to understand these things. This will enable you to make smarter decisions as well as to limit your legal expense in being able better to manage your lawyer’s activities in this area.

Entrepreneur’s Guide to Lawsuits and How to Minimize Lawsuit Risks
Introduction

Many entrepreneurs do not understand the basics of how a lawsuit works. Below, I sum this up in a nutshell. I do so from a perspective that should give you a basis for making strategic decisions about the process. Though I write for entrepreneurs, I explain the legal processes. If you don’t understand those, you can’t think strategically about your options in dealing with this area.

After explaining the lawsuit process, I add some helpful and practical tips for how entrepreneurs can prevent or minimize lawsuit risks.

How Lawsuits Work

1. Lawsuits are done through a public court system, either federal or state. Other dispute-resolution mechanisms, such as arbitration, use private resources but can have the force of law behind them. For example, legal authorities say that arbitration can be binding and, if parties agree to it by contract, the courts will enforce such provisions. If someone gets an arbitration award, laws exist by which it can be enforced through court systems.

2. Lawsuits are initiated by the filing of a complaint. A complaint sets forth allegations and asks for remedies. Remedies may be money damages or some form of non-monetary remedy, such as an injunction.

3. Once a complaint is filed, the party sued ultimately files an answer. An answer sets forth responses to the allegations in the complaint, typically denials.

4. When allegations have been formally denied in the answer, issues have been framed. These may be factual or legal issues. That is, disputes over what happened or about its legal significance.

5. The point of a trial is for a so-called trier of fact to consider all admissible evidence and to decide each material factual issue. In other words, to determine the facts of the case after sifting through what each side claims are the facts. A trier of fact decides who to believe where there is conflicting testimony. And so on.

6. A trier of fact can be a judge or jury. If the case is one triable to a jury (as most damage cases are), and if one of the parties has demanded a jury trial and preserved its right to it, the case will be tried to a jury. In such a case, the jury decides all material facts. If there is no jury trial, a judge will decide the facts and will be deemed the trier of fact.

7. Once the facts are determined, the law is applied to them to come to a legal verdict or decision about the case. If there is a jury, the jury will be instructed by the judge on the applicable legal standards but it will be up to the jury to apply such standards to determine a verdict. If there is no jury, the judge applies the law to the facts to come to a decision.

8. The whole point of a trial is to resolve both the legal and factual issues to come to a verdict.

9. In between the initial framing of the issues and the trial, a pretrial process occurs. During the pretrial process, parties can conduct discovery. Discovery involves formal legal mechanisms by which one party can compel another party or a non-party to the case to answer written questions under oath, make admissions, produce documents, or answer questions in a deposition format under oath.

10. Parties can also file what are called motions for varying purposes. A motion is a formal application to the court asking the court to rule in a certain way on a specific issue. The subject of a motion can vary from ones concerning housekeeping details all the way to others asking the court to throw out the whole case.

11. Pleadings are not limited to the complaint and the answer made by the primary parties. They can include any number of cross-complaints and answers to cross-complaints as well. In other words, “you sue me, I’ll sue you back.” Or, “I’ll sue the other guy too.”

12. Owing to the complexities that can arise, and to keep the case moving toward an ultimate trial, all courts have pre-trial procedures for supervising a case. In federal courts, there is a single-judge assignment system. Your case gets assigned to and stays with one judge (or possibly a magistrate assigned by that judge) from start to finish. In state courts, a master-calendar system is often used. This means that judges are assigned to perform specialized functions and will stick with one basic function until periodically reassigned. So, one or more judges may hear pretrial motion matters only. Others may conduct trials only. Still others will preside over the court’s calendar and deal with scheduling matters as they arise in all cases before the court. In such a system, your case may be handled by several judges on its path between filing and trial.

13. Under either a single-judge or master calendar system, your case will come up periodically for status review and for assignment to the next step in the court’s system for moving the case toward trial. Once the case is what they call “fully at issue” (meaning that all parties have been named and served and have formally appeared in the case or have had defaults taken against them), and discovery is complete, the case will be assigned to trial.

14. At the end of a trial, any party or both can appeal and ask a reviewing court to reverse or modify any judgment entered at the trial.

Why Lawsuits Are Frustrating for Entrepreneurs

This system of jurisprudence is one of the most refined and effective in the world. Why then are lawsuits so frustrating for entrepreneurs.

Here are a few reasons:

1. So-called “notice pleading” resolves all allegations made by a party in favor of that party. This means that the law has made a policy judgment that all cases and issues except those that are frivolous or plainly lacking in merit will have their “day in court,” i.e., will proceed to a full trial on the merits. Because of this policy judgment, parties get multiple opportunities to fix their allegations in order to attempt to state viable claims. In addition, for most purposes, if a party alleges something, the courts must abide by rules stating that such allegations must be assumed to be true (for the most part) until the case gets to trial. This means that a party can conduct often extensive discovery based on the thinnest of allegations, sometimes even preposterous ones. It also means that the mechanisms enabling judges to toss unmeritorious cases are very limited, and all but the most obviously baseless of cases tend to get through them.

2. The net result: if somebody sues you, and is determined to push the case toward a trial, you normally must endure a process by which you cannot simply and easily get rid of the claim.

3. Liabilities as defined by judges and legislators have been continually expanding over recent decades. This means that something that was perfectly legal in the past can now be made the subject of a lawsuit. There are policy reasons for this, ones that (much like the idea behind notice pleading) assume it is good that every person aggrieved by something should have a day in court. For example, it once was the case that a realtor had little or no liability exposure over a residential sale unless the realtor committed some sort of fraud or did something equally egregious. No more. Today, there are all sorts of technical reasons for which a realtor can be sued (or dragged into an arbitration). Like it or not, such legal developments are a fact of life.

4. The net result: courts are clogged. This means delays and longs ones too. From the time a case is filed, it is not uncommon in most court systems for that case to take a year or more to get to trial. Even when it is set for trial, it is not uncommon for a case to have to be reset to a later date because no courtroom is available. If a case is appealed after a trial, it can take years to resolve.

5. “Justice delayed is justice denied” might be an appropriate motto for some situations that arise in our court systems. Unfortunately, when you find yourself in such a situation, where a convoluted court process causes you to be under tremendous pressure to settle, your meritorious claim or defense gets snuffed out before it ever sees the light of day at trial.

6. More than that, each step in the long and drawn-out process costs money, and it is not uncommon for a case to run up tens of thousands of dollars in legal bills on both sides (millions for the really big cases).

7. Bottom line: litigation is a slow, cumbersome, and expensive process.

Tips for Minimizing Lawsuit Risks

How do you deal with all this as an entrepreneur?

1. Obviously, try to avoid situations that might give rise to lawsuits. In business, this often involves people issues.

First, avoid doing inflammatory things. Even if you are generally in the right, if something that you do really reeks, you have just set yourself up to have a case against you shopped to a contingency-fee lawyer who knows very well how such things appear to a jury.

Second, if you are about to enter into a contract with someone who displays lousy character, watch out. Whatever is done to others can and will be done to you as well. Formal contract provisions might mean that you are technically right in the long run, but if you have to litigate the meaning of a contract or some complicated pattern of performance under a contract with someone who is what the lawyers call a “snake in the grass,” you will pay dearly for the privilege of proving that you are in the right. It is unfashionable to say it, but don’t do opportunistic deals with shady or disreputable people. This likely will only lead to trouble. And, believe me, the very persons who are the most disreputable are also those who know the ins and outs of litigation all too well and who will abuse the litigation process at your expense.

Third, don’t cut corners with your contracts. Make sure you work with a good business lawyer to ensure that contracts are well-drafted and tight. Be extra careful with using form contracts that have not be customized for your deal. This is a high-risk way to approach any deal. In all but extremely routine situations, always make sure to customize your contracts.

Fourth, in appropriate cases, work with your business lawyer to do compliance reviews in regular and recurring areas such as employment policies. In general, be preventive in your approach in those areas where problems are likely to arise, even if only because of the law of averages.

2. If you need to bring a lawsuit, make sure you are very sure of the merits of your case before launching. Count the cost as well. Cost is not a one-sided thing, after all. If you are in the right and have a strong case with a lot at stake, it will be worth funding a needed fight if there are no other good alternatives. The party on the other side will incur costs as well. And that party will need to assess whether those costs are worth it if, in the end, there may be a fat judgment awaiting him. In certain cases, you might even find a good business lawyer willing to take your case under a contingency-fee arrangement, though this is far less common with business cases than it is in other areas such as personal injury.

3. If you get sued, have the case evaluated by a skilled attorney and settle upon a manageable strategy for dealing with it. Sometimes this will mean fighting it out to the end, especially if it is frivolous and if you need to make an example of the case so that others are discouraged from bringing such cases. Sometimes it will mean attempting to settle it. A word of caution, though: human nature being what it is, you will not often be able to settle cases in the early phases. Lawsuits often are very basic. If an adversary senses blood, the settlement demands will escalate. Thus, it is often crucial that a case be vigorously defended until a party has some sense pounded into him before attempting to settle. Some parties never do. And some cases therefore will go to trial. This will cost you but it is sometimes necessary.

Non-binding mediation processes can and do facilitate settlement but mostly once the parties have reached a settling frame of mind. Thus, later-stage mediations will tend to be more effective than early-stage ones.

4. It can help in commercial situations to add attorneys’ fee clauses to your contracts if you believe these will discourage frivolous suits. Without an attorneys’ fee clause, under the U.S. system, each party normally bears his own attorneys’ fees for a case even if he wins it. With such a clause, the prevailing party in the lawsuit will normally be able to have fees awarded to him. This can be a double-edged sword, though, because you will have to pay the other side’s fees if you lose. But it does make sense for many commercial situations to have such clauses in your contracts to increase your leverage with potential adverse parties.

5. Consider using binding arbitration clauses in the right situations. Arbitrations are no panaceas. They can be long and complex proceedings in their own right. But they do tend to be somewhat simpler and less expensive. They are less public as well.

Be careful with arbitrations, though. For example, you should be cautious about stipulating in your contracts that issues affecting intellectual property ownership rights and the like will be subject to binding arbitration. Arbitration has no effective appeal process. If you get a bum decision, you are normally stuck with it unless the arbitrator was bribed or something equally egregious happened. For example, if an arbitrator merely bungled the meaning of the law applying to your IP ownership, you very likely would have no remedy from a bad decision.

Arbitration is ideally suited for regular and recurring situations in your business where you would derive significant advantage from taking away a claimant’s right to a jury trial. For such cases, do try to weave binding arbitration clauses into your contracts. Remember, though, that social policy can override such clauses in some situations and, if that happens, such clauses will not stick and you will wind up in court.

The overriding rule in all cases, then, comes down to something pretty basic: treat others as you yourself would want to be treated. Even if you have to do something that is difficult, such as fire an employee, always use caution in how you take such steps and always be professional and businesslike.

6. If liability risks are of particular concern in your business, and especially if they cannot be dealt with through insurance, set your business up as a corporation, LLC, or other limited-liability vehicle. This is no panacea either. But it does give you leverage if your adversary knows that there is only so much blood to be squeezed out of the turnip in the event of a legal victory.

Along this same vein, be cautious about signing personal guarantees. Whatever shield you get from a limited-liability entity is gone as soon as you personally obligate yourself to something. Sometimes you will have no choice, but don’t make such commitments without careful thought.

Conclusion

Lawsuits are a continuing concern for entrepreneurs. They are unpleasant. But they do come up. And they must be dealt with. Work closely with a good business lawyer and treat them with the seriousness they deserve. They are generally manageable but need to be handled with care.