Even small, simple operations have plenty of moving parts. Use these ten key points to keep your company running smoothly, protect your assets, and avoid litigation. The Must-Have. Don’t go into business with others unless you have an Owners’ Agreement. You can’t see the future, and you can’t be certain that you and your business partners (or their spouses or heirs) will always agree on everything. Why So Formal? Company formalities are important to limiting your personal liability for the company’s obligations. Have separate company bank accounts, separate company financial records, separate company e-mail addresses, and whatever else needed to clearly separate the company’s life from your personal life. If you don’t respect this separation, the courts might not either. This Time, It’s Personal. Lenders and financing companies almost always require the owners of a closely held business to sign personal guarantees. This means they can sue the company, the owners, or both. Do what you can to limit personal guarantees. If you leave the company, understand what happens to your personal guarantees (and try to terminate them). Get Secure. Unless you get paid in full at the time goods or services are delivered, get security for future payments. Security might take the form of an escrow deposit, a personal guarantee, a bank letter of credit, or a pledge of the purchased goods or some other collateral. Whatever the security, have a written agreement that clearly states your rights in case of nonpayment. Business Straight-Jackets. In many cases, restrictive agreements are enforceable (provided they are reasonable in duration and geography). Know what restrictive agreements apply to you and the people you hire. Use restrictive agreements yourself to ensure that the person you hire today isn’t competing against you tomorrow. Protect the Good Stuff. You don’t have to be the latest dot-something tech company to have valuable intellectual property. IP may include your name, slogans, website, plans, and just about anything else you (or someone else) has thought of. If someone else develops your IP (that web designer, for instance), make sure the creator assigns all the rights to you. What’s in a Name? Not much, when it comes to “independent contractors” or “employees.” Whether a person is an employee (which requires tax withholding and other administrative burdens) or an independent contractor (which doesn’t) depends on what he does and how he does it. If you can tell a person how, when, and where to do her job, she’s probably an employee. The Tax Man Cometh. Collecting taxes and delivering them to the taxing authority is a big deal. Employment taxes you withheld and sales taxes you collected are not yours, they belong to the government. The government will get them, with penalties and interest (or worse!) if they’re late. Fresh Stock for Sale! Selling equity (stock, units) in your company may seem like a great way to raise capital. It’s also a great way to have financial investors and security regulators looking over your shoulder. Don’t sell equity if there’s a better way, and there’s probably a better way. Here’s the Catch. Even if you have the right written agreements, it costs money to enforce them. Your agreements might provide that legal fees and costs go to the prevailing party (most of them should), but you won’t get that until the end (and only if you go to court). Litigation is always an expensive last resort.
Buying a business is a great way to hit the ground running as a business owner. These ten issues will help reduce your risk and maximize your profits when you buy a company. The Next Right Step. After agreeing in principle to buy the business (through a Letter of Intent, Term Sheet, or handshake), the buyer and seller must decide on what comes next. The seller might favor negotiating and signing the purchase agreement, followed by a period of due diligence investigation, followed by a closing. The buyer would probably prefer to take care of the due diligence first, and then “sign and close.” What are You Buying? Stock or assets? The seller will probably want to sell the stock (or other company ownership interests) of the target company, but this exposes buyer to greater risk from liabilities arising prior to the sale. The buyer might prefer to buy all the business assets, but valuable contracts and rights belonging to the company might be subject to transfer restrictions, making an asset purchase difficult. Says Who? It is important to know, as early as possible, whose approval is required for the transaction. Certainly, the stock (or other equity) owners of both buyer and target company, but what about option holders? What about the target company’s lenders, landlord, or other contract parties? What about government agencies? Kick the Tires. The most important step in the purchase process is a thorough due diligence investigation of the target company. Insist that the seller answer all of your questions and let you review every contract, record, and detail about the target company. The purchase agreement should make the seller liable for misleading the buyer, but it’s easier to do the due diligence up front than to rely on seller’s contractual obligation. On the Hook. The purchase agreement should include detailed representations and warranties from the seller that the target company is clean, except for “warts” that are specifically identified and acceptably dealt with. The purchase agreement should also explicitly provide that the seller will indemnify the buyer for any losses or costs resulting from an undisclosed “wart.” Get Back. Representations, warranties, and indemnification are a must, but they only give the buyer the opportunity to sue seller over any breach of the purchase agreement or liability not assumed by the buyer. Lawsuits are never much fun, and the results can be surprising. A safer means of protection is to hold back payment of part of the purchase money (or put it in escrow) until the indemnification period is over. Taxes for All. You know that seller will pay capital gains taxes on the sale of the stock or business assets, but the buyer might be liable for taxes as well. Purchase of certain business assets (especially vehicles) might give rise to sales taxes. Purchase of real estate will require documentary stamp taxes, and payment with a promissory note may trigger intangibles taxes. Who pays these taxes should be negotiated. Thanks, Internal Revenue Code. An election under IRC Section 338(h)(10) allows the buyer to purchase corporate stock but the seller to effectively sell the business assets. This takes the tax sting out of a stock purchase by allowing the buyer to allocate the purchase price to the basis of the business assets. Stay or Go. Should the seller be required to continue working in the business after the transaction? Don’t expect sellers to work as hard for the buyer as they did when it was their company. On the other hand, the seller has valuable information about running the business. This Ain’t a House. Beware a purchase contract that is no more than a broker’s form real estate contract with “Business” written at the end. These contracts don’t protect buyers at all. In fact, they mostly just protect the broker. You need a real purchase agreement (and a real attorney).
We don’t like to think about it, but we are all going to die someday. What will happen to your company after your death? The Hardest Decisions. For business owners, the business is often the largest (or only) valuable asset of the estate. Who should inherit the business? How much direct control should they have over the business? What if they are bad business people? What if they don’t want to continue the business? How important is continuing the business legacy? These are just some of the tough questions that must be answered. Trust is a Must. The death of the business owner is turmoil enough; that turmoil shouldn’t be prolonged by uncertainty in the probate administration of business assets. The business owner’s stock or membership interest should be titled in a revocable trust, so the successor trustee can start making business decisions immediately. Business-Minded Trustees. Your mother, father, brother or sister might make a great trustee when it comes to caring for your children, but you need a trustee who will be a savvy business owner like you. You can designate a special trustee or co-trustee specifically to handle the business assets. Now What? What should managers and employees do the day after the business owner dies? Have a written plan of action and make sure someone at the office knows where to find it. Especially important, make sure everyone knows who calls the shots. Insurance for Lost Keys. After the death of a business owner, business-as-usual is nearly impossible. Business performance could suffer for weeks, months, or longer while everyone figures out how to deal with the owner’s loss. In the meantime, bills still need to be paid. Making matters worse, the owner’s death could trigger defaults on credit lines and loans guaranteed by the owner. Company-owned key person life insurance can provide additional capital to help the business get back on stable footing. The Name on the Page. Many businesses rely on the qualification(s) or licensing of the owner in order to stay in business. What happens when the owner—and his or her qualification(s) or license(s)—dies? There may be a grace period to find another licensed person, but this differs from industry to industry. Stock Rich, Cash Poor. A valuable operating business can produce a large estate tax bill, but it might not generate the cash necessary to pay the IRS. The business-owning estate might be allowed to stretch out payment of the tax bill, but it will still be a drain of much-needed cash. Life insurance can provide cash to pay the estate taxes so the business can be left alone. How About a Discount? Generally, a business owned by one person has a greater taxable value than a business owned by several people. Dividing up the ownership of your business can result in discounts of as much as 40% for estate tax purposes. Gifts to family members, long-term grantor retained trusts, and installment sales to intentionally defective grantor trusts can all result in estate tax discounts. No Charity for S Corps. Business owners can use gifts to charitable remainder trusts to generate immediate income tax deductions and partially avoid capital gain taxes on a future sale of the business, but not if the business is an S corporation. The S corp rules prohibit stock ownership by a charitable remainder trust. The Next Generation. Who should inherit the business—a surviving spouse or children from a prior marriage? Often, the business owner wants the children to inherit the business, but the surviving spouse might exercise an elective share and take part of the stock. The business owner should consider having a prenuptial agreement to ensure that the business goes to the children.