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Legal Landmines

Founders Forever with Multiclass Equity

With multi-class equity, founders can retain control of a business even after its ownership has been broadly dispersed by estate planning, equity incentive and other transfers.

Originating with dynastic enterprises that continue to control major U.S. enterprises, modern tech giants developed a more sophisticated approach that is useful to smaller enterprises. Although applicable to all business entities, corporate terminology will be used for simplicity.

Historically, buy-sell agreements and voting trusts have been used to maintain control of closely held companies. Permitted share transfers to family trusts and their subsequent distributions of shares to beneficiaries create uncertainty as the trust (prepared by the shareholder’s attorney) may not operate as anticipated due to death, incapacity or withdrawal of trustees or unforeseen contingent events. While usually enforceable, the objectives of buy-sell agreements may be frustrated by (i) a shareholder’s bankruptcy, (ii) unsatisfied corporate law proxy requirements, and (iii) arcane legal doctrines (such as the Rule Against Perpetuities) invalidating voting and family trusts based on hypothetical events and timing.

Anticipating contingent events affecting estate plans and third party arrangements is a challenge best avoided. If business control is the objective, narrowing the focus to a founder’s control of shares owned by trusts and other entities simplifies documentation and increases the odds of success.

Founder control can be organically preserved by granting in the corporation’s charter (certificate of formation) super-voting rights only to shares held by founders and, if the founder retains exclusive voting control and dispositive power over the shares, their estate planning entities (“Permitted Transferees”). Examples of Permitted Transferees include family trusts of which the founder is the sole trustee or an entity exclusively controlled by the founder through ownership, contract or other means. A founder’s loss of exclusive voting control or dispositive power becomes a “Conversion Event” with an automatic “step-down” in the voting rights of the affected shares.

Illustration

Three classes of common stock (identical in all respects except voting) are designed for the following shareholder classes:

Holders

Class

Votes Per Share

Founders & Permitted Transferees

C

10

Senior Managers & non-Permitted Transferees of Founders

B

1

Key Employees & non-Permitted Transferees of Senior Managers

A

None

Share Ownership

Holders

Class

#Shs

%Vote*

% Equity

Founders & Permitted Transferees

C

1,000

91.0

33.3

Sr. Managers & non-Permitted Transferees of Founders

B

1,000

9.0

33.3

Key Emps & non-Permitted Transferees of Sr. Mgrs

A

1,000

0.0

33.3

Totals

3,000

100.0

100.0

* Class C (10 votes per share) = 10,000 of 11,000 votes; Class B (1 vote per share) = 1,000 of 11,000 votes.

Conversion Event. A founder transfers 500 Class C shares to a non-Permitted Transferee (which automatically convert to 500 Class B common shares in the hands of the non-Permitted Transferee):

 

Holders

Class

#Shs

%Vote

% Equity

Founders & Permitted Transferees

C

  500

77.0

16.7

Sr. Managers & non-Permitted Transferees of Founders

B

1,500

23.0

50.0

Key Emps & non-Permitted Transferees of Sr. Mgrs

A

1,000

0.0

33.3

Totals

3,000

100.0

100.0

Finale. At the time when none of the founders have exclusive voting and dispositive rights, all Class C shares (including those owned by their family trusts and other entities) automatically convert into Class B shares for a traditional single vote per voting share.

Holders

Class

#Shares

%Vote

% Equity

Founders & Permitted Transferees

C

0

  

   —

Sr. Managers & non-Permitted Transferees of Founders

B

2,000

100.0

66.7

Key Emps & non-Permitted Transferees of Sr. Mgrs

A

1,000

0.0

33.3

Totals

3,000

100.0

100.0

Flexibility

Founder control structures may be calibrated to specific targets by class voting arrangements and different definitions of Conversion Events (IPO, minimum ownership, disability, etc.). Publicly traded companies frequently exempt additional situations from voting step-downs to spread control among broader groups of family members and senior management.

Relationship to Buy-Sell Agreement

Dual class equity structures focus on control to enable founders to pursue their vision for the business. Buy-sell agreements (see part II of Family Business Succession Planning) for privately held companies remain important for preserving the economic benefits of ownership through share transfer restrictions (shareholder bankruptcy, death, default, disability, divorce, etc.), rights of first refusal (by class), push-pulls, drag-alongs, tag-alongs, shareholder contributions and insurance funded buyouts.

Neither this post nor any other content on this website creates an attorney-client relationship or constitutes legal advice for any particular situation.

Legal Landmines – Feeling Trapped in your Business?

Early Exit Planning is the Key

Preparing for Departure. It’s inevitable – you will leave your business. To avoid being trapped in your business, early exit planning allows you to leave by attracting buyers and improving valuations. While there are various exit scenarios, statistically speaking selling your business is the most viable voluntary exit. Proper planning can maximize business value for sale or for your family.

Protect Assets and Retain Key Employees. Protecting the business assets (with employee intellectual property assignments, confidentiality and noncompetition agreements) and incentivizing key employees to transfer increases the value of a business. “Golden handcuff” bonus arrangements can boost business valuations by:

  • tying employee bonuses to performance benchmarks impacting value (such as EBITDA in most cases); and
  • vesting employee bonus awards over time (economically incentivizing employees to continue with a purchaser).

Time Improves Outcomes. There is a reason that most professionals recommend exit planning start at least three years in advance. In the chart below, the left axis and golden columns depict annual growth in business value (assuming a 6X multiple of EBITDA growing at 5% per year from $100,000). The right axis and blue line reflect the unvested employee bonuses forfeitable on quitting (assuming employee bonuses equal 15% of EBITDA with awards paid over five years). These results improve with the length of time that the bonus arrangements have been in place.

May 6, 2019


 

Legal Landmines – Partnerships and Sinking Ships

Owner Buy-Sell Agreements Make A Difference

Lifeboats. Owner Buy-Sell Agreements are the lifeboats keeping your business partnership afloat by addressing avoidable internal risks.

Sinking Ships. I woke up this morning to rising water when I found out:

  • I am in business with:
    • my partner’s ex-wife, widow and/or children
    • my competitor
    • someone I don’t know
  • I am running the entire business while sharing the upside with:
    • a departed or incapacitated owner
    • a departing employee/owner who walked away from his employment “commitment”
  • I can’t make estate planning transfers for my family
  • my co-owner sold his interest on lucrative terms leaving me behind
  • my business is dying from an owners’ impasse
  • my co-owners are “free-riding” on my capital without contributing their share
  • my business sale is being held up by a small co-owner’s “ransom” demand
  • my S corporation tax election was terminated by a co-owner’s sale

Plug, Bail or Abandon? Plugging holes requires less pain, cost and effort than bailing against rising water. If neither of these work, abandoning ship may be the final alternative. All business relationships end. Even the record-setting 104-year-old relationship between Ford and Firestone ended acrimoniously in 2001. If you don’t want to go down with the ship, have lifeboats ready for the inevitable and unavoidable! Additional information regarding buy-sell agreements is available in Part II (Buy-Sell Agreement) of this post.

June 13, 2019


 

Legal Landmines – It’s the Little Things

Signatures…           and…          You Can’t Sell What You Don’t Own

 

I Signed Up for Personal Liability. The different signature blocks in a recent Canadian transaction reminded me of a frequent and costly mistake. An agent signing on behalf of a principal is not liable for the principal’s obligations under U.S. law. When signing as an officer (agent) on behalf of a company (the principal), the company, and not the officer, would be liable on the $1.5 million contract… assuming the officer properly signed as an agent. Otherwise, with the stroke of a pen, the officer exchanges zero liability for $1.5 million personal liability on the contract. A proper signature format is:

COMPANY NAME

 

By: ______________________

John Doe, President

What Do You Mean My Tech Company Doesn’t Own Software? The buyer’s attorney tells his client that your company does not own its principal asset and that your company can only sell a copyright infringement lawsuit. Herein lies the faulty assumption that you own the software you hired a consultant to write. Although there is never a good time to make this discovery, some times are worse than others:

  • during due diligence for the sale of the company;
  • after the software becomes enormously valuable (leading the consultant to realize he was grossly underpaid when he wrote the software); or
  • after the consultant has died.

One week ago, the Second Circuit Court of Appeals joined the 7th and 9th Circuits by ruling that a “work made for hire” agreement must be signed with a contractor/consultant before the “work” is created. Because a “work made for hire” written agreement did not predate the magazine columnist’s writings, his estate was allowed to sue the magazine for copyright infringement when it republished the columnist’s articles.

August 8, 2019

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