Entrepreneurs are often portrayed as rule-breaking rebels who have a great new idea to introduce to the world. They may be singularly focused on how best to create and sell their product or service – regardless of what the law or even their customers, may think at first. While this kind of behavior is a great way to focus energy into a product that customers or clients want to buy, it might not be the best way to create a company that investors want to buy. If you ultimately want to build a company to sell, keep in mind that investors are looking for a company with great enterprise value – the sum of the parts of your brand and customer relationships, intellectual property, and other assets. Critically, if you cannot document what these parts are – or, some of these parts have negative value – then your company will be worth less than what you have actually created.
While some companies may be so appealing to investors or acquirers that they may be willing to overlook some omissions or errors, most transactions include some haircut or loss of value for sellers as a result of poor documentation, compliance, or risk management. The best way to prevent this from happening is by taking time early in your lifecycle to set things up the right way. After all, it’s much easier to do things right the first time, than to spend time and money to go back and correct the problem.
One of the first legal decisions you make when starting a company is what type of entity to organize under, and in what jurisdiction. This will not only impact you when you sell the business, but also as you operate it up to that point. Some questions to ask yourself:
- Do I want anyone else involved in the business with me? (We’ll discuss labor strategies and the impact of those choices in our HR post.)
- Which do I care more about: the ease and expense of setting up and maintaining the entity, or the ease and expense of selling the entity?
- Do I want to pick an entity type that works for me now, and potentially reorganize as I’m nearing the point where I want to sell?
- What’s the likelihood that I want to sell only a portion of my business? If I want to sell IP but keep client contracts, for example, how easily could I do that under my planned structure?
What options do you have for entity types? In the United States, the main entity types are:
- Sole proprietorship: this is a business owned by a single individual. There is no distinction between the owner and the business.
- Partnership (general, LP, LLP, LLLP): this is a business owned by two or more partners (individuals or entities). Depending upon the specific type of partnership, liability for the partnership’s debt may fall to one or more of the partners.
- Limited liability company (LLC, LC, PLLC): this is a business which provides limited liability to the owners. Tax treatment of limited liability companies depends upon the number of owners it has.
- Corporation (including PC): this is a business that is treated as a single, separate legal entity. Corporations provide limited liability to owners. For tax purposes, corporations are either classified as C-corporations or S-corporations.
We’ll address the pros and cons of each type of entity in a later post, as well as factors to consider when selecting one, such as in which state to organize.
If you’ve already organized your company, but you’re worried that it’s not the ideal structure for selling, don’t worry! You’re not locked into whatever choice you make now as you organize (or, the choice that you made when you first started your company). Yes, there may be additional costs and effort to reorganize in the future, but if your company’s trajectory changes, reorganization is always technically an option.
When you do organize your company, keep electronic copies of the original documents that were filed with the jurisdiction. Some states will charge you if you request these at a later date, so save yourself some money by maintaining your records. Additionally, acquirers, investors, and even banks and clients may ask for these documents. Since even those states that do not charge can take weeks to produce and deliver copies, it’s a good idea to keep them on-hand to save time.
Imagine that as you’re going through due diligence with an acquirer, they ask for paperwork that shows that you’re registered to do business in state X, but you never registered! This is an issue that can be easily avoided by making sure that you keep track of where your company or its representatives are engaging in activities. Jurisdictions often have different thresholds for requirements to register to do business, so keep an eye on any changes in your activities and make sure you aren’t now required to register.
This post covers HR-specific tasks to keep in mind when you’re building your company to sell, but oftentimes HR matters relate to legal compliance, so keep that in mind as you bring on employees or other outside labor.
Given that much of the value when you sell is likely based on a product or process that your company has developed, you need to be absolutely sure that the related IP is protected. If you’ve built your entire business on IP that you don’t actually own, you’re never going to be able to sell your company for top-dollar. So how do you make sure you’re protected? Again, we’re going to sing the praises of doing things correctly from the start.
Let’s start with the people: make sure that anything created for your company is product that you actually have a right to own. Employment law in most states generally agrees that any work performed by employees for your company, using company-provided assets, or during working times, is owned by the company. Depending on your risk tolerance level and the importance of any IP development, you may want to include specific language in the employment agreement that covers ownership of intellectual property developed by employees to carve certain areas explicitly in. With respect to contractors, the stakes are much higher. Contractors generally use their own equipment and may be working on similar projects for multiple companies, so you need to be sure to have either an IP-assignment clause in the contractor agreement or an IP-assignment agreement that all contractors must sign. Be sure to set this expectation and get these signed before work is performed! You don’t want to end up having to negotiate with the contractor to get this signed, especially if the contractor relied on the re-use of IP in their pricing.
While some degree of IP-assignment coverage can be gained by stating that the deliverables from a contractor or freelancer are “work for hire,” this type of language can get you into hot water with certain states (*cough* California *cough*). Under California’s Unemployment Insurance laws, they classify anyone who is performing “work for hire” as a statutory employee. Consequently, companies who hire contractors in California under a “work for hire” agreement have to pay for unemployment insurance and workers’ compensation for those contractors. Even worse, there’s debate as to whether companies also have to pay payroll taxes in these cases. The California code isn’t explicit on this, but it’s best to just avoid the entire situation by ensuring that your contractor agreement does not include “work for hire” language. As mentioned previously, the IP-assignment benefit can be gained from addition of a specific clause or form (which then doesn’t introduce the California issue).
Next question: are you using IP that someone else owns? This could be something as simple as stock photography, or as complex as satellite imagery data or field-of-use patent licenses. This can be particularly problematic for software companies, whether their software is delivered or provided through the cloud. If you have employees, contractors, or vendors developing source code, data, or processes for you, it’s of utmost importance to understand your contracts, understand their process, and implement regular monitoring. Few issues can kill a deal faster than unclear ownership or right to IP.
We all know that you learn from your mistakes (well, hopefully you learn!). If you’ve run into issues related to an agreement or contract, you probably want to make sure that doesn’t happen again. Maybe you forgot to include information about a notice provision in your employment agreements, or you updated your master service agreement template. If you were to sell your company, do you know which agreements contain those updates and which ones are based on the old version?
One simple solution is to develop a single master form for each type of agreement (employment, contractor, IP assignment, master service agreement, etc.). If any changes are made to this master form, you might consider amending all existing documents to match the changes made to the master form. Alternatively, you might decide that you don’t want to open yourself up to negotiation with the involved party; in this case you should make sure that you have some way to track this information. While contract management systems are typically overkill for small businesses, consider using spreadsheets to help document and manage contract complexity as it occurs.
For many businesses, hiring legal counsel is a painfully expensive undertaking, but there’s no reason to set yourself up to incur extra costs. With proper planning early on in your company’s lifecycle and simple steps that any business owner can take, you can head off issues that might otherwise arise at the time of a sale. An ounce of prevention is worth a pound of cure: consulting expert counsel on how to properly establish your company and its policies and forms can have significant financial savings down the road, as you avoid having to solve problems.