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Business Arrangements

Confidentiality Agreement Traps & Trade Secret Destruction – Part 2

In the first part of this series on confidentiality agreement traps, we discussed how a “time duration” trap in a confidentiality agreement (CA) strips statutory protections from trade secrets. Failing to obtain signed confidentiality agreements from the recipient’s personnel sets up the second trap.

Personnel as Parties to the CA

Requiring the entity receiving confidential information (Receiving Entity) to sign a confidentiality agreement is beyond dispute. However, a Receiving Entity can act only through its officers, employees and other personnel. Accordingly, confidential information must be disclosed to these individuals for use on behalf of the Receiving Entity. Requesting signed confidentiality agreement from officers, employees and other personnel of the Receiving Entity can lead to contentious negotiations. Receiving Entities frequently claim that:

(1)     obtaining and tracking CAs with personnel is too burdensome; and

(2)     CAs with personnel are unnecessary since (if the CA is properly drafted) the Receiving Entity will be responsible for violations by its personnel.

In contrast, the disclosing party will claim that it needs the right to obtain injunctive relief and damages from personnel violating the confidentiality requirements. As a practical matter, most of the Receiving Entity’s personnel will have no knowledge of their company’s obligations under the CA without co-signing it.

The Second Trap

The “Second Trap” is highlighted in a recent judicial decision holding that the information’s confidentiality was lost and and the CA was unenforceable. In nClosures Inc. v. Block and Company, Inc., 770 F.3d 598 (7th Cir. 2014), after signing a confidentiality agreement the device designer provided confidential designs to a contract manufacturer. Six months after the first device was produced, the contract manufacturer developed its own competing device.

The federal district court ruled for the contract manufacturer when the designer sued for breach of the confidentiality agreement. On appeal, the Seventh Circuit Court of Appeals held that obtaining a confidentiality agreement only at the outset of the relationship was insufficient. Failing to obtain signed confidentiality agreements from each individual accessing confidential information was cited as a factor in the court’s ruling that:

(1)     the designer failed to keep its proprietary information confidential, and

(2)     the confidentiality agreement was unenforceable.

In reaching this decision, the Seventh Circuit referenced its previous holding that:

a federal court applying Illinois law “will enforce [confidentiality] agreements only when the information sought to be protected is actually confidential and reasonable efforts were made to keep it confidential.” Id. at 602.

Loss of Trade Secrets

As noted in the first part of this series, the Texas Uniform Trade Secrets Act (TUTSA) requires “efforts that are reasonable under the circumstances to maintain its secrecy.” Reasonable efforts to maintain secrecy generally include enforceable confidentiality agreements. Since an unenforceable confidentiality agreement is legally equivalent to no confidentiality agreement, nClosures would mean the “trade secret” owner failed to take reasonable efforts to maintain secrecy with a corresponding loss of the trade secret protections under TUTSA.

Effect on Business Value

Trade secrets add value to virtually all businesses. If trade secret protection is lost, the sale of the business may become impossible or possibly only at a drastically reduced valuation.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts.  Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.

Business Arrangements

A. Scope of Business Arrangements

The term “business arrangements” generally describes various business activities of our clients. More specifically, these activities include entity formation, owner buy-sell agreements, admission and withdrawal of owners, purchase and sale of business assets or franchises, obtaining or providing security interests to secure payment or performance obligations, and releases of obligations to settle disputes.

B. Entity Formation

Texas offers several types of entities for liability protection, including corporations, limited liability companies (LLCs), limited partnerships, various professional entities and combinations of the foregoing. Regardless of entity type, the formation process consists generally of the following:

  • confirming name availability by calling or emailing the Texas Secretary of State at 512.463.5555 or corpinfo@sos.state.tx.us. Name approval only determines name availability in the Secretary of State’s records; without a separate trademark search to confirm availability, the name may infringe another’s trademark.
  • engaging a registered agent
  • filing a certificate of formation with the Texas Secretary of State
  • preparing governing documents – bylaws (corporation or association), company agreement (LLC) or partnership agreement (limited partnership)
  • organizing the newly formed entity by issuing ownership interests, adopting the governing documents, and electing governing persons (directors, managers and officers)
  • obtaining an employer identification number from the IRS – https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
  • providing a bank with the entity’s EIN and copies of the filed certificate of formation and governing documents to open a business account.

Series LLCs, popularized by real estate investors and owners of multiple assets desiring lower profiles, require additional formation. A series of an LLC is not a separate entity from the Master LLC and may be best conceptualized as a “cell” of the Master LLC. The certificate of formation and governing documents of Series LLCs establish one or more series of members, managers, membership interests, or assets that have separate rights, obligations and liabilities and business purposes from the Master LLC. Each individual series has the ability to sue and be sued, enter into contracts, hold title to assets, and grant liens or security interests in its assets.

Joint ventures and strategic alliances combine or share joint operating and ownership activities for a specific business objective through contractual arrangements or through partnerships, LLCs or corporate entities.

Entity formation services abound on the internet. Unfortunately, these services require the individual to determine the best type of entity for the particular business and ownership structure. These services also fail to advise the owners of best practices for avoiding personal liability for the entity’s debts and obligations.

C. Owner Buy-Sell Agreements; Admission and Withdrawal of Owners

Ownership changes are inevitable. A buy-sell agreement among owners anticipates these changes at a fraction of the cost of ensuing litigation from disputes regarding these foreseeable changes. Buy-sell agreements should address:

  • business “divorce” & impasse resolution
  • transfer restrictions and rights of first refusal
  • initial capital contributions & ownership vesting
  • withdrawing owner’s equity & purchase rights
  • additional capital contributions – obligations and penalties
  • treatment of deceased owner’s equity
  • representation on the board of directors
  • drag-along right whereby majority owners can require minority owners to join in a sale
  • co-sale right whereby minority owners can elect to join in sales by majority owners
  • permitted transfers for estate planning
  • confidentiality and noncompetition obligations

D. Purchasing or Selling Business Assets

Business assets may be bought and sold in discrete transactions or as part of ongoing supply or distribution arrangements. Confidentiality of these business terms should be considered. Sales involving significant seller-financed amounts should contain protective provisions restricting purchaser’s activities, addressing defaults and acceleration rights for certain events, and requiring collateral (see Security Interests discussed below). In lieu of specified quantities, purchase and sale arrangements may consist of purchaser’s agreement to purchase all of its goods from seller (a “requirements contract”) or of seller’s agreement to sell its entire production to purchaser (an “output contract”). The Uniform Commercial Code (UCC) provides a “default” set of commercial laws which may be modified, for the most part, by written agreement. Unfortunately the UCC default rules regarding these types of contracts are generalized, vague and difficult to apply to particular situations. Contractual terms addressing obligations (while disclaiming others) and contingencies such as unanticipated production problems and demand or price spikes provide greater certainty and minimize disputes with valued trading partners.

Warranties of merchantability, noninfringement and, if applicable, fitness for a particular purpose are implied as a matter of law under the UCC to all goods sold. To avoid the ambiguity and scope of these implied warranties, knowledgeable suppliers adopt express written warranties detailing the scope and limits of their obligations to replace these UCC warranties. If the strict UCC requirements are not satisfied, attempts to limit the damages and remedies for violations of the UCC warranties are unenforceable.

Purchase orders and invoices frequently contain conflicting terms. Deciding which terms are effective involves the dreaded “battle of the forms” triggering the various UCC “knockout” rules. While a favorite of law school professors for law school exams, few businesses want to become the subject of these exam questions. Rather than “after the fact” litigation of this battle, addressing this issue at the outset enhances certainty while saving money.

E. Purchasing (and inadvertently selling) a Franchise

Many of the issues outlined in Business Acquisitions – Part 1 and subsequent articles on this website apply to franchise purchases. Importantly, franchise purchases raise additional issues relating to the nature of a franchise. A franchise is essentially a license to operate a branded and systemized business for a limited time period (typically 10 years). Because the franchisor must protect its brand (trademarks and service marks), franchise agreements impose many financial, operating and quality obligations on the purchaser/franchisee. Just as commercial leases are landlord-biased, franchise agreements are franchisor-biased. When negotiating these agreements, prioritizing issues is critical as it counterproductive to request numerous changes of lesser importance.

Businesses licensing others to use their trademarks in connection with distribution or supply arrangements may be selling an “inadvertent franchise” or “accidental franchise.” Under trademark law, licensing a trademark without retaining adequate quality control results in abandonment or loss of the trademark. However, retaining these quality control rights resemble the operating and quality controls of a franchise. Unlike trademark licenses which are private contractual matters, franchises are heavily regulated by the Federal Trade Commission (FTC) and by many states. Although state definitions vary, the FTC defines a “franchise” as any continuing commercial relationship or arrangement in which:

“(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.

After analyzing the licensing arrangement under FTC regulations and applicable state franchising laws, modifying the proposed operations may be necessary to avoid elements of the “franchise” definition or to qualify for an exemption or exception from the definition.

F. Security Interests to Collateralize Payment or Performance Obligations

A promise to pay or perform obligations may become an empty promise without collateral and/or personal guaranties. The UCC sets forth the requirements for security interests on most tangible and intangible assets. Requirements include a written agreement granting the security interest and identifying the collateral followed by “perfecting” the security interest to maintain collection priority over subsequent creditors. Security interests may also be granted on ownership interests in corporations, LLCs and limited partnerships as “general intangibles” under Article 9 of the UCC. However, these types of security interests are inadequately protected unless the issuer corporation, LLC or limited partnership “opts in” to UCC Article 8 (Investment Securities) as part of the collateralization process. The opt-in procedure is simple and prevents unscrupulous debtors from circumventing the perfection (priority protection) of the security interest.

G. Settling Obligations

Not all business arrangements are successful. At times, breached obligations and liabilities must be settled with payments and releases. Releases should extend to affiliates of the parties and waive and release all business obligations (outside of the release agreement) and all known and unknown claims existing as of the release date. Texas courts require releases to have conspicuous language expressly stating any release of negligence claims. Other states have statutes require special language for releases. To be effective, releases of claims arising out of employment relationships must strictly comply with requirements under federal and state anti-discrimination laws.

Letters of Intent – Key Aspects and Dangers

Parties frequently sign an “agreement in principle,” “term sheet,” “memorandum of understanding” or “letter of intent” (LOI) which are synonymous terms for a summary of points forming a basis for continued negotiation of a business acquisition, merger or other business transfer or a commercial transaction, joint venture or other business arrangement.

I. Letter of Intent Benefits

A. Start regulatory review periods (e.g., Hart Scott Rodino pre-merger antitrust notification filings).

B. Cost-Effective “Go – No Go” Decision. LOIs are relatively inexpensive means for confirming major deal terms before incurring the substantial expenses of due diligence and purchase and financing documentation.

II. Letter of Intent Risks

The LOI may be construed as a binding purchase and sale agreement if it is improperly drafted or if it is improperly characterized in subsequent announcements or other actions of the parties.

A. Vague Tests for Binding LOI. The legal standard in determining if the parties intended to reach an agreement is an objective test – would a “reasonable person” believe that an agreement had been reached based on all of the evidence? The subjective intent of the parties (their actual understandings) is not determinative and, in any event, their understandings would be conflicting in a dispute. Since reasonable persons may reach different conclusions, this imprecise standard leads to unpredictable outcomes and litigation.

  1. An enforceable agreement requires agreement on essential terms. T.O. Stanley Boot Co. v. Bank of El Paso, 847 S.W.2d 218, 221 (Tex. 1992).
  2. Parties may agree on some of the contractual terms, understanding them to be an agreement, and leave other contract terms to be made later. It is only when an essential term is left open for future negotiation that there is nothing more than an unenforceable agreement to agree. A party cannot accept an offer to form a contract unless its terms are reasonably certain. Oakrock Exploration Co. v. Killam, 87 S.W.3d 685, 690 (Tex. App.–San Antonio 2002, pet. denied) (citing T.O. Stanley Boot Co., Id at 221).
  3. Texas courts will construe several separate instruments relating to the same matter together, even if executed at different times, to determine if their cumulative effect constitutes a binding agreement. Board of Ins. Comm’rs v. Great Southern Life Ins. Co., 239 S.W.2d 803 (Tex. 1951).

TIP – Rather than forcing a court to determine the “intent” of the parties who are now making contradictory claims, the LOI should clearly and plainly state its nonbinding or binding effect. Simply stating that a document is a “letter of intent” or “agreement in principle” is insufficient. While most parties subjectively intend an LOI to be a preliminary road map for further negotiations, occasionally a seller wants the LOI to be a binding purchase agreement to fix the purchase price, avoid seller representations and warranties, and eliminate the buyer’s opportunity for due diligence. Sometimes the buyer, as in the Texaco v. Pennzoil case discussed below, wants the LOI construed as a binding agreement. In that case, the buyer (Pennzoil) wanted its LOI to acquire Getty Oil characterized as a binding agreement in order to sue Texaco for tortious interference with contract. Some commentators believe that Pennzoil fared better from the litigation than if it had successfully purchased Getty Oil.

B. Binding LOI without Subsequent Purchase Agreement.

In Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768 (Tex. App. 1987), writ of error refused 748 S.W.2d 631 (Tex. 1988), cert. dismissed, 485 U.S. 994, Pennzoil won a $10.5 billion judgment against Texaco for tortious interference with Pennzoil’s “handshake” agreement to acquire a controlling interest in Getty Oil for $5.3 billion. Although the judgment was later settled for $3 billion cash, Texaco was forced to file for bankruptcy. A definitive merger agreement for this multi-billion dollar transaction was never signed or even negotiated. However, the court found that a merger agreement had been reached based on a 5-page Memorandum of Agreement and a Getty Oil press release that it had reached an “agreement in principle” with Pennzoil. Other evidence of an agreement included a provision in the subsequent agreement between Texaco and Getty Oil where Getty affirmatively disclaimed making representations regarding the “Pennzoil Agreement” and Texaco indemnified the Getty Oil trustees for any claims arising out of the Pennzoil Agreement. In addition, the Getty-Pennzoil press release announcing the “agreement in principle” included multiple statements worded as covenants or agreements such as: (i) Getty shareholders will receive; (ii) Pennzoil will contribute; (iii) the parties will…. These statements were used to determine that Getty and Pennzoil had reached a “binding agreement” notwithstanding the reference in the press release that the agreement in principle was subject to execution of a definitive merger agreement and stockholder approval.

TIP – References to an “agreement” and obligatory statements should be avoided in subsequent emails, press releases, announcements or other descriptions of the LOI.

C. Binding LOI in Addition to Binding Purchase Agreement.

In Kelly v. Rio Grande Computerland Group, 128 S.W.3d 759 (Tex. Civ. App. – El Paso 2004, no writ) the selling shareholders entered into a “Letter of Intent” providing favorable employment terms for the largest shareholder to serve as President after the closing. However, the purchase agreement omitted these and several other provisions. When the largest shareholder was not retained as the President or even as an employee, he sued the purchaser for breaching the “agreement” contained in the LOI. The purchase agreement contained the following general merger clause:

“Entire Agreement. This Agreement merges all previous negotiations between the parties hereto and constitutes the entire agreement and understanding between the parties with respect to the subject matter of this Agreement. No alterations, modifications or change of this Agreement shall be valid except by a like instrument in writing and signed by each party to this Agreement.”

TIP – A subsequent purchase agreement should specifically list superseded LOIs, agreements and writings in addition to containing a general merger clause.

III. Binding and Nonbinding Provisions. Most LOIs contain binding and nonbinding provisions. Typically, the “transaction” terms are expressly stated to be nonbinding and the “deal protection” provisions are expressly stated to be binding. As a partially binding agreement, these types of LOIs present challenges in clearly stating the intent of the parties.

A. Structuring for Clear Intent.

  • Include an introductory paragraph stating that (1) the provisions listed in “Part A” are not binding agreements unless and until the parties sign definitive agreements regarding and that (2) the provisions in “Part B” are binding on execution of the LOI.
  • List Binding and Nonbinding Provisions under Separate Headings in the LOI such as: “Part A – Nonbinding Provisions” and “Part B – Binding Provisions”
  • Under each heading, restate the intention (the following provisions of this Part [A/B] [are/are not] binding on the parties)
  • List the types of closing conditions typical for the type of transaction in the nonbinding provisions of Part A. Invariably, the buyer will want a “due diligence” closing condition (although the standard of satisfaction with the due diligence results may vary).
  • Reiterate at the end of the LOI which provisions (e.g., those in Part A) are not intended by the parties to be binding and which provisions (e.g., only the provisions in Part B) are intended to be binding.

B. Nonbinding Provisions. Although nonbinding, these provisions are the most important from business and cost control perspectives. These provisions vary based on the type of transaction but typically state:

  • The nature of the transaction – stock or asset purchase, merger, etc.
  • Price and type of consideration
  • Seller financing – terms of promissory notes and/or earn-out
  • Purchase price adjustments based on working capital, cash equivalent, or inventory levels at closing.
  • Buyer’s pricing formula subject to due diligence confirmation of seller statements
  • Post-closing employment and consulting arrangements
  • Post-closing noncompetition and nonsolicitation terms
  • Post-closing purchase price holdback/escrow
  • Closing conditions
  • Due diligence and applicable standard for buyer’s satisfaction
  • Approval requirements
  • Interim conduct of business (may be binding or nonbinding)
  • Interim compensation of employees
  • Applicable financing condition(s)

C. Binding Provisions. Binding provisions may include:

  • A “reasonable or best efforts” obligation to negotiate
  • No-shop/exclusive dealing clauses
  • Interim conduct of business (may be binding or nonbinding)
  • Confidentiality agreement of buyer
  • Governing law
  • Dispute resolution
  • Responsibility for expenses
  • Expiration/deadline for returning fully executed counterpart

IV. Sample Provisions

A. EBITDA Definition for Earn-out (Nonbinding). Transaction provisions defining critical terms may reduce future disputes when drafting the definitive agreement. For example:

“EBITDA” shall mean the earnings of Newco before deductions for interest, taxes, depreciation and amortization determined on a consistent basis with [GAAP consistently applied of/the federal income tax filings made by] the [Seller] prior to the purchase and sale (i) increased by the sum of (i) any [bonus] amounts paid or accrued to be paid to [Selling Owner/Key Employee of Newco] or other members of Newco’s senior management and (ii) any amounts paid or accrued to be paid to [Acquirer], any member of Newco’s board, any direct or indirect portfolio company of [Acquirer], or any direct or indirect affiliate of a Newco board member (each an “Acquirer Affiliate” and collectively “Acquirer Affiliates”), and (ii) after adjustment of the purchase and sales prices of any goods or services Newco sells to or purchases from any Acquirer Affiliate to reflect the amounts that Newco would have realized or paid if dealing with an independent party in an arm’s-length commercial transaction. EBITDA will be determined by [Seller/Acquirer] promptly after the close of each full year after the closing. If [Acquirer/Seller] objects within 30 days of receipt to the calculations, an independent CPA will make a final determination of the amount.

B. Post-Closing Operations (Nonbinding). These transaction provisions relating to Earn-outs must be carefully tailored to each transaction to address financial, accounting and operational issues (to be discussed in a future post relating to Earn-outs).

C.  Equity Protective Provisions (Nonbinding). If the purchase consists of only a controlling interest in the Seller or the Seller retains any equity ownership in the post-closing business, the LOI should summarize the equity protective provisions to be included in the definitive purchase agreement.

D. Confidentiality (Binding). Incorporating a separate Confidentiality Agreement by reference maintains the brevity of the LOI while permitting sufficient length in a separate document to address the issues described in posts on this website discussing “Confidentiality Agreement Traps.”

E. Due Diligence Procedures (Binding). “Subject to executing a confidentiality agreement satisfactory to Seller, the Seller shall permit Acquirer and its employees, consultants and representatives who require such information in order to analyze, investigate and possibly facilitate the proposed transaction (collectively “Personnel”) to have reasonable access to information regarding the Seller and its business; provided, however, until the Seller decides that the closing is assured, Seller may elect to withhold competitively sensitive information (including without limitation customer names, quantity of work and other business matters) and may elect to provide disclosures using symbols, code names and descriptive information in lieu of actual information. Acquirer shall use best efforts to not interfere in any material respect with the operations of the Seller’s business. Acquirer and all of its Personnel must observe the following procedures regarding access to the physical premises of the Seller unless otherwise approved in writing by the Seller:

  • The timing and duration of visits to any premises of the Seller shall be mutually agreed in advance.
  • Representatives of the Acquirer agree to converse only with such employees of the Seller as Seller approves in writing.
  • Acquirer shall send no more than three people at a time to visit any premises of the Seller.
  • Due diligence shall be conducted at the premises of the Seller only in [Seller/Owner’s] presence.”

F. Expiration Clause (Binding). An expiration clause should be included in each LOI since (i) an offer [consisting of the Binding Terms] remains open until it is either accepted or notice of withdrawal of the offer is given, (ii) a tight deadline may inhibit the ability of the other party to “shop the deal,” and (iii) in contrast to a written notice of withdrawal of the offer, an automatic expiration provides a non-confrontational means of terminating the offer without jeopardizing future negotiations.

G. Exclusive Dealing/No Shop Clause (Binding). This clause prevents Seller from seeking, negotiating or agreeing to other offers for a time period sufficient to provide Acquirer a reasonable amount of time to negotiate a definitive agreement.

H. Option Consideration (Binding). Under Texas law, generally a purchaser cannot enforce a “contract” in which it has no obligations. Adding a clause containing purchaser’s promise to pay Seller $100 on demand provides “legal consideration” to make the binding portions of the LOI enforceable when signed by Seller.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts.  Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.

Family Business Succession Planning

Family Business Succession Planning

As Baby Boomers approach retirement, family business succession planning becomes critical. Family businesses generate almost half of the U.S. GDP and employ the bulk of the U.S. workforce. Despite these impressive statistics, studies estimate that only 30% of family businesses survive the second generation and only 10% survive the third generation. Reasons for this high failure rate include the lack of adequate succession planning by most family businesses and insufficient planning to minimize transfer taxes across generations. This article does not address tax aspects of business succession planning.

Broadly speaking, business succession planning consists of transferring ownership and control of the business while minimizing income, gift and estate taxes. Within these broad conceptual categories are a virtually infinite array of combinations that should be customized for each business and family. For a family business, succession planning must also address the emotional issues and dynamics of the family. After the requirements to protect and continue the business are established, the business succession plan must be coordinated with estate planning to minimize taxes.

Business succession planning issues may be grouped into three broad categories of management, ownership, and tax issues. Adequate planning requires a multi-disciplinary team of professionals including an accountant, attorney, financial/insurance advisor, business appraiser and, for more complex cases, family business consultant.

This overview focuses on non-tax legal issues frequently encountered. It is not intended to be and cannot substitute for legal advice applied to the facts of a particular family business.

I. Succession Planning Overview

A. Basic Outcomes

  • sale to third parties, employees or active family members – see Part III below
  • gifts to family members – see Part IV below
  • liquidation

B. Basic Components of a Succession Plan

  • Identify primary objective
    • Legacy – preserve the legacy family business to (i) infuse future generations with business ambition, family values, relationships and long-term wealth-building goals, and (ii) provide security for valued employees
    • Wealth Management – the business is sold (to family members desiring to own/operate the business or to non-family) and the sales proceeds are distributed to family members for investment in other businesses or passive investments
  • Business Analysis
    • Valuation/Appraisal
    • Mission and strategic plan
    • SWOT (strengths, weaknesses, opportunities and threats) Analysis
    • Cash flow and capital needs of business
    • Liquidity demands arising on owner’s death
    • Effect of owner’s death on customer, creditor and employee relationships
    • Recommended reading – “The E Myth” by Michael E. Gerber
  • Management Issues
    • “Family-first” vs “business first” focus – how should business decisions by the next generation be prioritized between needs of the business and needs of the family?
    • Is a leader available in the next generation who possesses the passion and competence to implement a shared vision for the business?
    • Should non-family run the company?
    • What kinds of incentives are necessary to attract and retain top employees?
  • Ownership Models
    • Owner-Employee – first generation owners frequently work in the business and derive “ownership benefits” from compensation and other deductible perks.
    • Hybrid Ownership – sibling- or cousin-owned companies (typically second- and third-generation) use a hybrid ownership model with some owners active in daily operations and other owners having varying governance/oversight roles
    • Owner-Investor – ownership held in family entities such as limited liability companies (LLCs), limited partnerships, corporations or trusts with governance/oversight policies established by an active board
  • Personal Family Issues
    • Fairness/equalization issues between active and inactive children
    • Financial needs of the senior generation
    • Emotional and family dynamics (including spouses)
    • When does senior generation step-down?
  • Implementation Schedule
    • Begin now to avoid “damage control” succession from disability or unexpected death
    • Planning takes time to properly analyze issues, obtain consensus and commitment of stakeholders (family, employees and business associates), groom successors and implement planning team recommendations
    • Establish schedule with milestones for review and accountability
    • Conduct periodic reviews to adjust succession plan as changes occur

II. Buy-Sell Agreement

A. Critical for Multi-Owner Businesses. The purpose of a Buy-Sell Agreement is to provide business and ownership continuity while minimizing disputes.

B. Definition. Sometimes referred to as a business “pre-nuptial” agreement, a Buy-Sell Agreement is an agreement among the owners of the business to establish:

  • restrictions against undesired ownership transfers
  • procedures for permitted ownership transfers
  • representation on the board or other governing body of the business
  • rights and obligations of owners with respect to a future sale of the business
  • vesting and repurchase rights of a withdrawing employee’s ownership interest
  • confidentiality and noncompetition obligations
  • approval requirements for major transactions
  • dispute resolution procedures

C. Sample Issues Addressed

  • The following events typically trigger a redistribution of ownership:
    • death
    • disability
    • termination of employment (voluntary or involuntary)
    • retirement
    • proposed transfers to third parties
    • involuntary transfers (i.e., bankruptcy or divorce)
    • management impasse or disputes
    • supermajority vote to sell the company (drag-along rights)
    • permitted joinder by other owners in an owner’s sale (tag-along or participation rights)
  • The method(s) for determining the price of ownership interests purchased under the Buy-Sell Agreement should be specified, together with the payment terms (cash or installment payments) and any collateral requirements for deferred payments
  • Insurance funding of purchases by the company and/or the other owners is frequently specified.
  • Mandatory minimum distributions of income to owners to pay income taxes on undistributed S corporation, LLC or limited partnership income taxable to them

D. Integration with Succession Plan. The Buy-Sell Agreement should be consistent with the succession plan.

III. Sale of Business

A. Preparatory Actions. As with selling a house, the business should be in good order before being put on the market. Preparatory actions include:

  • Valuation
    • To facilitate the valuation process, the owner or his/her accountant should submit to the business appraiser:
      • an “adjusted balance sheet” listing the company’s assets at estimated fair market value and eliminating assets and liabilities that will not be transferred (such as cash, any personal vehicles and associated obligations, etc.)
      • a three-year “discretionary income” spreadsheet adding back to the business’ taxable income: compensation paid to the owner(s); depreciation; interest income and expense; expenditures motivated by “tax avoidance” and any other items that are not integral to the business
  • Control expenses – if the most heavily weighted valuation component is capitalization of the business’ cash flow, each dollar of savings will have a multiplier effect on valuation
  • Records
    • Conform financial records to generally accepted accounting principles (GAAP)
    • Obtain a review or audit of the financial statements of the business
    • Bring contracts and other records up-to-date
    • Update SWOT analysis and business plan to reflect focus on current opportunities, competitive advantages and improvement of weaknesses (sometimes identifying additional resources for growth attracts buyers who can provide the resources for an immediate ROI increase)
    • Create reports showing historical and projected business growth
    • Prepare detailed asset schedule and detailed records of completed and pending jobs/sales/transactions
  • Enhance business image
    • Update web site and printed marketing materials
    • Clean up facilities – dust inventory storage to reduce appearance of obsolescence, upgrade exterior landscaping, etc.
    • Obtain customer and business partner testimonials
  • Information systems (including accounting software) should be “standard” to facilitate buyer utilization
  • Reduce excessive concentrations of suppliers and customers
  • Groom strong employees and qualified managers to reduce dependence of business on current owner(s)
  • Negotiate key personnel employment/retention agreements
  • Execute noncompetition and confidentiality agreements with all personnel/consultants
  • Intellectual property
    • protect trademarks, patents and copyright by registration
    • protect trade secrets by confidentiality agreements and other actions reasonably necessary to preserve secrecy
    • confirm adequacy of licenses for intellectual property used in the business
  • Conduct a “sell-side” due diligence review to anticipate buyer issues and avoid “surprises”
    • maintaining seller integrity/buyer trust is critical
    • review material contracts, leases and loan documents for imminent expiration and for clauses prohibiting assignment, change of control or ownership transfers
  • Identify obligations personally guaranteed by selling owner(s) for refinancing or release
  • Engage legal counsel and accountant experienced in selling businesses
    • Obtain legal review of business structure to minimize owner’s exposure to post-sale liabilities
    • Analyze and, if feasible, settle pending litigation by or against the business
    • Analyze potential environmental liabilities
    • Due to conflicts of interest, the same legal counsel should not represent the buyer and the seller.
  • Determine optimum tax-advantaged sale method
  • Analyze sale alternatives
    • sale of ownership interests or assets
    • full or partial sale, with or without an auction
    • minority equity investment/recapitalization
    • Should any assets or lines of business be retained for post-sale income to selling owner(s)?
  • Identify and contact potential purchasers through existing contacts or, after your attorney’s review of the contract, engage a business broker or investment banker to market business by auction or negotiated sale
  • Analyze potential buyer’s financial and operational capabilities to complete the transaction and to meet required licensing standards
  • Discuss potential sale with key employees and obtain agreement to maintain confidentiality
  • Divide due diligence into phases
    • Phase 1 – summary business information is delivered after the potential buyer has been qualified and a confidentiality agreement has been signed
    • Phase 2 – business information provided after a letter of intent is executed
    • Phase 3 – highly sensitive business information should be made available only after all other buyer closing conditions in the purchase agreement have been satisfied.

Caveat: No confidential business information should be disclosed prior to buyer’s execution of a confidentiality agreement. Even after the confidentiality agreement is signed, extremely sensitive business information should not be disclosed until all other buyer closing conditions are satisfied or waived.

B. Sales Documentation

  • Letter of intent
    • expressly nonbinding major transactional terms for preparation of definitive sales agreements
    • expressly binding provisions for confidentiality of disclosed information, non-solicitation of employees, nondisclosure of negotiations, allocation of costs and dispute resolution.
  • Purchase and Sale Agreement (including obligations to refinance or obtain release of seller guaranties; expect the buyer to require a noncompetition agreement with each selling owner)
  • Consulting and employment agreements with selling owner(s) for continuity and income
  • Security Agreement for deferred payments (including earn-outs)
  • Buyer’s promissory note, personal guaranty and security agreement for Seller financing

C. Sale to Employees

  • Preparatory actions are generally same as described in Part III.A except due diligence may be reduced for key employees who have been involved in the business. Depending on degree of owner involvement in the business, the purchasing employees may have superior knowledge about the business requiring the reversal of business information disclosures
  • Sales Documentation is generally the same as described in Part III.B except representation and warranties of selling owner(s) may be reduced
  • Leveraged buy-out or seller financing may be necessary for purchasing employee(s) to pay the purchase price
  • Sale to an employee stock ownership plan (ESOP) – a defined contribution retirement plan designed to provide employees with an opportunity to invest in employer securities.
  • If less than all of the ownership interests are sold, new owners should be required to execute the Buy-Sell Agreement.

D.Sale to Family Members

  • Preparatory actions are generally same as described in Part III.A except due diligence may be reduced for active family members.
  • Sales Documentation is generally the same as described in Part III.B except representation and warranties of selling owner(s) may be reduced
  • Leveraged buy-out or seller financing may be necessary for purchasing family member(s) to pay the purchase price
  • If less than all of the ownership interests are sold, new owners should be required to execute the Buy-Sell Agreement.

IV. Transfer to Family Members other than by Sale

A. Transfer Methods

  • Direct and Indirect Gifts
  • Redemption of transferring owner’s interest (leaving other owner’s interest outstanding)

B. Non-Tax Issues

  • New owners should be required to execute the Buy-Sell Agreement
  • Fairness/equalization issues between active and inactive owners
    • Equal transfers to children are not required by law.
    • Sale of business to active children at fair market value can provide the most equal treatment (but may not be the most tax efficient)
    • Distribution to inactive children of non-business assets in an amount having equal value to the business
    • What is the value of the business – “fair market value” of the business as a whole or the discounted value of the ownership interests?
    • Insurance proceeds are frequently used to supplement the value of non-business assets as necessary
    • Real estate used by the business may be transferred to inactive children for leasing to the business. Caveat: The property should be transferred subject to a long-term lease with purchase option to prevent “unreasonable” landlord actions
  • Award equity to active children as reimbursement for previously inadequate compensation
  • Protections for selling and inactive owners
    • Retention of Control
    • Limited liability companies and limited partnerships may be used to transfer ownership to children while senior generation retains control
    • Senior generation owns voting shares of a corporation and transfers ownership to children by nonvoting shares
    • Ownership interests may be placed in a trust with voting exercised by a board or committee of trustees
    • Income protection for senior generation and/or inactive owners
    • Issuance of preferred stock with cumulative dividends and/or right to require repurchase by the business on pre-determined terms
    • Installment sale promissory notes
    • Salary continuation, consulting and employment agreements
    • Approval requirements for “major” actions
  • Contractual protections and incentives for key employees
  • Contractual assurance (via Buy-Sell Agreement) of transfer of control to active children on death/disability of currently controlling owner

V. Tax Minimization Techniques.

Although beyond the scope of this paper, various methods exist to reduce federal estate and transfer taxes. Listed below are brief, incomplete summaries of a few techniques for discussion with your attorney and tax adviser.

A. Gifting Ownership Interests

  • Annual gifts valued up to the annual gift tax exclusion amount per donor to each of multiple recipients
  • Gifts valued up to the lifetime gift tax exclusion
  • Gifts of family LLC or family limited partnership interests (the value of the gifted interests are discounted for lack of control and minority ownership, thus permitting gifts of greater percentages of the business within the foregoing gift tax exclusions)
  • Gifts of ownership interests in trust to children and grandchildren
  • Gifts to children and charity with subsequent corporate repurchase from charity

B. Sales of Ownership Interests

  • Installment sale to intentionally defective grantor trust
  • Private Annuity
    • Objective – avoid gift and estate tax
    • Structure – ownership interests are sold to active children in exchange for unsecured promise to make payments to seller for the remainder of seller’s life or for the remainder of seller and his/her spouse’s lives
  • Self-Canceling Installment Note (SCIN)
    • Objective – avoid gift and estate tax
    • Structure – an installment note in which the remaining payments are canceled on seller’s death
  • Charitable Remainder Trust – seller donates ownership interests to a charitable remainder trust for the benefit of seller (and his/her spouse) followed by a cash sale to the business of the ownership interests; the cash funding of the trust provides retirement income to seller (and his/her spouse) while contemporaneously reducing seller’s ownership interest in the business.
  • Grantor Retained Annuity Trust (GRAT) – seller retains the right to receive fixed annuity payments for a term of years or until his death. At the end of the term, the seller receives no additional benefits from the trust, and remaining property (remainder interest) in the trust is either distributed to beneficiaries or held for their benefit. Only the value of the remainder interest is subject to gift tax.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts.  Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.

Confidentiality Agreement Traps & Trade Secret Destruction

A nondisclosure or confidentiality agreement (CA) is frequently viewed as an unnecessary formality to be satisfied with an off-the-shelf “form” so the parties can move on to a business purchase and sale, joint venture, supply relationship, employment arrangement, service arrangement or other business. If properly drafted, a CA offers legal protection of confidential information. If not, catastrophic outcomes include forfeiture of trade secret protection, possible destruction of business value, and incentivizing competitors to pirate employees.

As a four part series, we will highlight unintended consequences of improperly prepared CAs and discuss possible solutions in the last part.

Trade Secrets Require Secrecy

Although every business develops trade secrets, few recognize that their information, processes and methods are protectible. Under the Texas Uniform Trade Secret Act (TUTSA), customer lists, supplier lists and even “negative information” (unproductive methods and techniques that a business wants its competitors to waste resources exploring) may be trade secrets if their secrecy is properly maintained. TUTSA defines a “trade secret” as “information, including a formula, pattern, compilation, program, device, method, technique, process, financial data, or list of actual or potential customers or suppliers, that:

(A) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use; and

(B) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.”

Trade secret owners may use TUTSA  to obtain injunctions, royalties and damages (including double those amounts for willful and malicious misappropriation), and recover attorneys’ fees.

The Duration Trap Trade Secret Destruction

Business brokers, private equity groups and venture capitalists commonly insist on a “duration clause” which terminates their confidentiality obligations after a stated time period (frequently two to four years). Proponents of pro-duration clauses argue the need to avoid: (1) claims of wrongful use/disclosure of confidential information when similar information is rightfully sourced elsewhere; and (2) being required to track the source of each item of confidential information across the multitude of  deals reviewed.

While these arguments are frequently persuasive, the more compelling argument is the irreparable “collateral damage” to the disclosing business. Trade secret protection exists only if reasonable efforts are exercised to maintain secrecy. An agreement allowing disclosure of trade secret information at a future time establishes abandonment by the business of reasonable efforts to maintain secrecy. Courts considering this issue agree that a duration clause terminates trade secret status and protection. A few cases on this point include:

  • Because of a two-year duration clause in a third party CA, a trade secret owner lost an injunction proceeding against its primary competitor for trade secret misappropriation. Silicon Image, Inc. v. Analogk Semiconductor, Inc., 642 F. Supp. 2d 957 (N.D. Cal. 2008).
  • A 10-year time duration clause in a business relationship CA blocked the trade secret owner’s effort to obtain a preliminary injunction. DB Riley, Inc. v. AB Engineering Corp., 977 F. Supp. 84 (D. Mass. 1997).
  • A former employer lost trade secret protection and could not prevent a former employee from taking the information after a 12-month CA expired. ECT International Inc. v. Zwerlein, 597 N.W.2d 479 (WI 1999).

A business owner whose trade secret protection may find that the business is no longer an attractive purchase or business partner. Acquirers might conclude that “green fielding” the business is less expensive than paying a premium for a business with compromised trade secrets/intellectual property. Potential joint venturers may bypass the business by absorbing the critical information directly into their services and products. Employees might learn that their personal marketability has dramatically increased by bringing proprietary knowledge to a competitor.

Different approaches  to resolving this issue will be explored in the last part of this series.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts.  Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.