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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.

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