Business Divorce Planning For The Exit Of A Private Company Owner
Presenting a live 90-minute webinar with interactive Q&A Business Divorce: Planning for the Exit of a Private Company Owner Anticipating and Addressing Issues of Asset Division, Compensation, Competition and More WEDNESDAY, JULY 25, 2012 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today’s faculty features: Kenneth R. Appleby, Partner, Foley & Lardner, Boston Donna Berkelhammer, Counsel, Sands Anderson, Raleigh, N.C. Gregory F. Monday, Partner, Foley & Lardner, Madison, Wis. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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BUSINESS DIVORCE: PLANNING FOR THE EXIT OF A PRIVATE COMPANY OWNER PART I – LEGAL REPRESENTATION Attorney Gregory Monday Foley & Lardner LLP Madison, WI
WHO DOES THE LAWYER REPRESENT . . . A. B. C. When planning owner exit strategies during BUSINESS FORMATION? When planning owner exit strategies for an ESTABLISHED BUSINESS? When implementing an OWNER EXIT? We will look at ABA Model Rules of Professional Conduct, but the applicable rules will be state specific. Please see the full text of ABA Rules and Comments at: http://www.americanbar.org/groups/professional responsibility/publications/mo del rules of professional conduct.html 6
ABA Rule 1.7 Conflict of Interest: Current Clients (a) Except as in (b), lawyer shall not rep a client if the rep involves a concurrent conflict of interest. Concurrent conflict of interest 1. Directly adverse to other client; or 2. Significant risk that rep will be materially limited. (b) Rep may proceed despite concurrent conflict, if 1. Competent and diligent; 2. Not prohibited by law; 3. Not asserting a claim; AND 4. Informed consent in writing. 7
ABA Rule 1.13 Organization As Client (a) Lawyer retained by an organization represents the organization thru its authorized constituents. . (f) In dealing w/ org’s owners, lawyer shall explain identity of client if its interests are adverse to owners. (g) Lawyer representing org may also represent any of its owners etc. subject to Rule 1.7. 8
ABA Rule 1.9 Duties to Former Clients (a) Lawyer who formerly represented a client in a matter cannot rep another person in same or substantially related matter if interests are adverse, unless former client gives informed consent in writing. . (c) Lawyer cannot use/reveal confidential information about the former client. 9
A. BUSINESS FORMATION Lawyer can rep multiple owners in formation of business, including planning rules for exits, if owners give informed written consent. ABA Rule 1.7(b). Conflict usually exists . . . See Formation of Joint Venture example in cmt 8 to ABA Rule 1.7: Lawyer’s ability to advocate all possible positions of each owner is limited by loyalty to other owners. However, owners usually can waive. See cmt 28 to ABA Rule 1.7: Conflict can be waived if clients’ interests generally aligned. 10
B. ESTABLISHED BUSINESS After business is established, lawyer can represent business and owners subject to ABA Rule 1.7. See ABA Rule1.13(g). Planning owner exits generally (e.g., advising re buy-sell agreements and funding of same) usually ok if interests of owners aligned . . . However, owner should be separately represented if effect of planning is disproportionate or exit is imminent. 11
C. OWNER EXIT During Owner Exit, it is more likely that a conflict exists that cannot be waived – i.e., lawyer cannot represent exiting owner and company/other owners. See ABA Rule 1.7(b)(1). If specific Owner Exit being considered, lawyer for company shall inform owner of adverse interests of company. See ABA Rule 1.13(f). To ensure that lawyer can rep company/remaining owners in Owner Exit, lawyer should have specific advance, written waiver if lawyer represented exiting owner during formation or otherwise. See cmt 22 to ABA Rule 1.7 for enforceability of advance waivers. 12
RECOMMENDATIONS: Do exit planning as counsel for the company. Obtain informed, written consent if also representing owners. Include specific advance waivers that allow continuing representation of company/remaining owners if owner exit arises. Be vigilant; it is lawyer’s responsibility to identify and advise owners of conflicts in representation when they arise. 13
FORMATION Business Divorce: Planning for the Exit of a Private Company Owner
Type of business Level of risk Family business Taxation issues Number of people involved Growth potential Financing/Capitalization Expense and formalities Exit strategy/Succession planning Formation Issues 2012 Sands Anderson PC 15
Death Disability/Incompetency Divorce “Retirement” or Voluntary Withdrawal Bankruptcy/Insolvency Termination of Employment Expulsion/Deadlock Family Dispute Reasons for Exit 2012 Sands Anderson PC 16
Buy-Sell Agreement: Shareholders Agreement Operating Agreement Partnership Agreement Employment Agreement Noncompete Agreement Confidentiality Agreement Impacted Formation Documents 17 2012 Sands Anderson PC
Redemption Cross Purchase Right of First Refusal Other Forms of Exit 2012 Sands Anderson PC 18
Buy-back provisions Mandatory/Voluntary Company/Remaining owners Triggering events Deadlock provisions: Is there a majority? Even numbers of board members? Tie break provision? Independent board members? Pricing/Valuation Timing Issues to Consider 2012 Sands Anderson PC 19
Security Confidentiality Release of Claims Indemnification Resignation of employment, management Continuing obligations Issues to Consider 2012 Sands Anderson PC 20
R ussian Roulette - One deadlocked party serves notice to the other party of the all-cash price at which it values a half interest in the business. The party receiving the notice then has the option to either buy or sell at that price. Texas Shootout - Each deadlocked party submits a sealed all-cash bid stating the price at which they are willing to buyout the other party. The sealed bids are opened together, and the highest sealed bid "wins," and that bidder must then buy (and the "loser" must sell) its share at that price. Dutch Auction - A variation of the Texas Shootout where the parties send in sealed bids with the minimum price that they would be prepared to sell their share of the business. The sealed bid that is the highest "wins," and that bidder must then buy the "loser's" share for the price indicated on the loser's sealed bid. Deadlock Exit Strategies 2012 Sands Anderson PC 21
Selecting the Entity Type - Tax Basics Kenneth R. Appleby, Esq. Foley & Lardner, LLP 22 2012 Foley & Lardner LLP Attorney Advertising Prior results do not guarantee a similar outcome Models used are not cli ents but may be representative of clients 321 N. Clark Street, Suite 2800, Chicago, IL 60654 312.832.4500
What Tax Flavors Does it Come In? Corporate taxation – The pure entity. Partnership taxation – The pure passthrough. S Corporations – The “not so pure” pass-through. Sole Proprietorships – The tax nothing. 2012 Foley & Lardner LLP 23
The S Corporation Fallacy It is a quasi pass-through entity It is not taxed the same as a partnership – No basis for debt – Distributions of property create problems – Qualification criteria – Pro rata allocations required 2012 Foley & Lardner LLP 24
Tax Aspects of Formation 2012 Foley & Lardner LLP 25
Limitation on Owners of Different Types of Entities C Corporation and partnerships – No limitations. S Corporations – No entities (restricted availability for certain types of trusts and estates) – No nonresident aliens – No more than 100 shareholders – No more than one class of stock Nonvoting common OK What about debt that converts at a discount? – Inadvertent Termination 2012 Foley & Lardner LLP 26
Formation of Corporation Section 351 tax-deferred contributions. Concern with service partner. Taxability of contributions of encumbered property where liabilities exceed basis under Section 357(c). Only property goes in tax-free – Watch the definition of property. – Certain types of IP can create uncertainty. 2012 Foley & Lardner LLP 27
Formation of Partnership Typically no gain on contribution under Section 721. Not subject to 80% control requirement. No section 357(c) although similar rules may apply. Special rules in the case of noncompensatory options. 2012 Foley & Lardner LLP 28
Major Exceptions to Tax-Free Formation Compensatory Transfers Disguised sales – Issue for partnerships Encumbered Property 2012 Foley & Lardner LLP 29
Operational Aspects 2012 Foley & Lardner LLP 30
Taxability C Corporations – Taxable as a separate entity S Corporations – Generally not taxable as a separate entity but exceptions – Built-in gain tax – Existence of subchapter C E&P can trigger certain corporate level taxes Partnerships – Not taxable as a separate entity 2012 Foley & Lardner LLP 31
Use of Losses C Corporation – Losses are “trapped” at the corporate level (although can be used within a consolidated group). S Corporation – Losses are generally passed through to shareholders. Partnerships – Losses are passed through to partners. Just because losses are passed through to S shareholders/partners, it does not mean they are immediately usable. A number of limitations on use of losses (e.g., passive loss and at-risk rules, need for basis, etc.). 2012 Foley & Lardner LLP 32
Outside Basis Creation as a Result of Entity Borrowing Basic concept is that basis is good because it shields future taxation. C Corporation – Concept not applicable. S Corporation – Shareholder loans create shareholder basis but corporate borrowings do not. – Shareholder guarantees do not change the result Partnerships – Partnership level borrowings can create outside basis for partners. – Allocation of the basis can sometimes be a bit complex 2012 Foley & Lardner LLP 33
Distributions C corporation – dividend vs. other (bonus, rent, etc.) – The double tax problem. – Re-characterization risk. – On 1/1/13, dividends are back to being taxed as ordinary income rather than capital gain. S corporation – basis rules – Cash generally comes out tax-free to extent of shareholder basis. – Distribution of property triggers gain at corporate level. – Distribution of loss property can result in loss of the loss. Partnership – basis rules – Cash generally comes out tax-free to extent of partner basis. – Distribution of property defers gain. 2012 Foley & Lardner LLP 34
Tax Allocations S Corporation – Little flexibility. Taxes allocated pro rata in accordance with ownership percentages. Partnerships – – – – Flexibility Substantial economic effect rules Partners’ interest in the partnership Other limitations 704(c) Family partnership rules Retroactive allocations 2012 Foley & Lardner LLP 35
Self-Employment Tax Tax on net earnings from selfemployment Combined rate of 15.3% S Corporations – Distributions exempt but IRS cracking down. Partnerships – General partners only and applies to entire distributive share plus guaranteed payments. 2012 Foley & Lardner LLP 36
Self Employment Tax - LLCs LLCs – Applies only to guaranteed payments (as opposed to distributive shares) unless: – A manager or authority to contract. – Personally liable for debts. – More than 500 hours participation. Exempt members are known as limited members Applies to all members of service LLCs – Health, law, engineering, accounting, actuarial science, etc. 2012 Foley & Lardner LLP 37
Disposition 2012 Foley & Lardner LLP 38
C Corporations Have the double tax issue in case of an asset sale Avoid a second level of tax with stock sale but buyer less excited due to loss of ability to “step up” basis of acquired assets Reorganization rules available that defer taxes on receipt of buyer stock so long as certain requirements are met 2012 Foley & Lardner LLP 39
S Corporations So long as no entity level taxes are due (as a result of built-in gains tax, for example), only one level of tax in case of both asset and stock sale Can make use of 338(h)(10) election which allows a stock sale to ne treated as an asset sale by buyer Reorganization rules apply here as well 2012 Foley & Lardner LLP 40
Partnerships No double tax concern The reorganization rules are not available so it is more difficult to structure a deferral where the consideration includes buyer stock 2012 Foley & Lardner LLP 41
BUSINESS DIVORCE: PLANNING FOR THE EXIT OF A PRIVATE COMPANY OWNER PART III – KEY PLANNING ISSUES Attorney Gregory Monday Foley & Lardner LLP Madison, WI Attorney Kenneth Appleby Foley & Lardner LLP Boston, MA 42
A. GIVE ALL OWNERS AN EXIT STRATEGY. Majority: Drag along; expulsion/call. Equal owners: Drag along; put/call; tie-breaker; division of assets or spinoff. (See spin-off slide.) Minority: Tag along; put. Employee-owners: Retirement; disability; death. 43
TAX CONSEQUENCES OF SPLITTING AN ENTITY LLCs and Partnerships Generally appreciated assets can be distributed in-kind without adverse tax consequences. Easier to split these types of entities up S Corporations Appreciated assets distributed in-kind do trigger taxable gain. The rules for tax –deferred spin-offs in S corporations is identical to the C corporation rules below. 44
TAX CONSEQUENCES OF SPLITTING AN ENTITY C Corporations Distributions of appreciated assets trigger taxable gain at corporate and shareholder levels. There are rules allowing for tax deferred spinoffs but are tough to comply with - 5 year active trade or business requirement - Continuity of interest requirements - Continuity of business requirements - Post spin-off restrictions on disposition - Number of fact-based requirements makes it difficult to obtain certainty without a ruling from IRS 45
A. GIVE ALL OWNERS AN EXIT STRATEGY (cont’d). Majority: Drag along; expulsion/call. Equal owners: Drag along; put/call; tie-breaker; division of assets or spinoff. Minority: Tag along; put. Employee-owners: Termination; retirement; disability; redemption at death. 46
B. BE CONSISTENT ACROSS DOCUMENTS. Make sure that all documents affecting owners have identical or consistent provisions about exits. Example 1: Buy-Sell Agreement and Employment Agreement should be consistent about ownership effect of termination of owner-manager. Example 2: Definition of disability should be the same for Buy-Sell Agreement, Employment Agreement, and Disability Insurance Policy. Example 3: Dispute resolution mechanisms should be the same in all documents. 47
C. PLAN TO KEEP OWNERS OUT OF COURT. Use mediation and arbitration provisions that are well thought out, thorough, and the same in all owner agreements. Consider incorporating rules of American Arbitration Association http://adr.org/aaa/faces/home or JAMS http://www.jamsadr.com/ Include fee-shifting provisions to discourage litigation. Expect disputes about value. (See next slide.) 48
D. TAILOR THE VALUATION METHODOLOGY. Value is usually the primary issue in an exit, so get it “right” in the buy-sell provisions. Obtain an opinion of value during drafting: – – – Get parties’ expectations in line; Get advice from valuation professional on valuation language in documents; and Get funding mechanisms right. (For a valuation professional’s perspective, see: 519000/relatedresour ces/MERCER BUY-SELL AGREEMENTS.pdf ) Refer value disputes to ADR. 49
E. FUND BUY-SELL OBLIGATIONS. Usually best to minimize seller financing of “business divorce”; maximize down payment. Funding mechanisms may include: – – – – – Sinking fund; Unused LOCs or other 3rd party debt; Cash call or owner loans (for redemption); In kind assets (discussed above); Insurance (for death or disability). Funding mechanisms are tax sensitive. 50
Funding mechanisms are tax sensitive. Use of sinking funds and 3rd party debt require the use of post-tax dollars. Partnerships and LLCs have the advantage of allowing parties to agree on deductibility of payments - Section 736(a) allows partnership to deduct payments but requires ordinary income recognition to recipient. - Section 736(b) provides that payments are capital gain but non-deductible. - Consider whether agt should specify treatment in advance. - Corps (including S corps) don’t offer this flexibility. 51
Funding mechanisms are tax sensitive. Cash infusions from other owners to fund redemption will allow for basis generation (if not deduction). - In case of S corporation, need to be careful with non-pro rata shareholder loans as the may create risk to S status in certain circumstances. Need to think about whether a redemption or a cross-purchase makes more sense from tax standpoint. - Who gets the basis for purchased interest? - AMT issue in case of insurance funding. 52
F. INCLUDE ALL DEAL TERMS IN PLANNING DOCS. If deal terms are not included in the buy-sell provisions, they will be difficult to negotiate upon exit. Example 1: If a redemption or cross-purchase includes seller financing element: – What are terms of the note (i.e., payments, amortization, interest)? – Is the note secured or guaranteed; subordinated? – What loan covenants apply? (Tax issues?) Example 2: Is seller bound by non-competition or confidentiality obligations? Example 3: How are pass-through tax issues handled? 53
Pass-Through Tax Issues In case of pass-through entities, need to cover whether tax year closes or not and how income or loss is allocated. How are tax distributions handled in the year of the redemption or purchase? Could someone end up with the short straw? What is a Section 754 election and why is it so important in the buy-out scenario for not only third party buyers but also for the remaining partners/members? - And if the Section 754 election is made, could it ever come back to haunt the remaining partners/members (hint, yes). 54
G. PLAN FOR EFFECT OF PERSONAL GUARANTEES OF 3rd PARTY DEBT UPON EXIT. Buy-sell agreements and 3rd party loan documents should anticipate and address possible owner exits. Prevent owner exits (including death) from causing technical default or impairing use of lines of credit. Plan for exiting owner to be protected against liability on personal guarantees: removed, replaced, or indemnified. (How is indemnification secured?) 55
H. ANTICIPATE EFFECT OF OWNER EXIT ON GOVERNANCE AND CONTROL. Fact and form of owner exit may affect balance of voting control and management for remaining owners. Example: 3 owners with 40%, 30% & 30% – each owner has swing vote; but if one of the 30% owners is redeemed, majority owner gets control and remaining minority owner has effectively no vote. Consider classified voting; voting and nonvoting interests; super-majority voting; deadlock provisions. 56
Unplanned Exits Business Divorce: Planning for the Exit of a Private Company Owner
Your lack of planning does not constitute an emergency for me! 58 2012 Sands Anderson PC
“The perpetual existence of the corporate structure at common law is ill suited to the functional realities of the closely held corporation.” Comment, Deadlock and Dissolution in the Close Corporation: Has the Sacred Cow Been Butchered?, 58 Neb.L.Rev. 791, 796 (1979) 59 2012 Sands Anderson PC
Deadlock Someone wants out Someone is pushed out (oppressed minority shareholder) Someone wants to close the business entirely Outside investors want out Triggering Events 2012 Sands Anderson PC 60
Organizational documents Statutes: Corporations Act, LLC Act, Partnership Act Dissolution Rights of Shareholders/Members/Partners Dissenters Rights Judicial Dissolution or equitable remedies Fiduciary obligations Negotiation/appeal to respected third party Mediation Arbitration Where to Start 2012 Sands Anderson PC 61
“Incorporated Partnerships” Close cooperation, good faith and mutual respect Based on personal or family relationships Disparate bargaining power Reasonable Expectations Management participation Employment/Salary Dividends/distributions Perks Notice of meetings/ability to review corporate records Oppressed Shareholders 62 2012 Sands Anderson PC
Oppression is not necessarily: Fraud Mismanagement Misapplication of assets Self dealing Oppression is the frustration of: Reasonable expectations Of the minority, complaining shareholder Known to other/majority shareholders Without the fault/control of the minority shareholder Oppressed Shareholders 63 2012 Sands Anderson PC
Judicial dissolution Judicial order of stock sale/purchase at fair price Equitable remedies for breach of fiduciary duty Remedies 2012 Sands Anderson PC 64
C. OWNER EXIT During Owner Exit, it is more likely that a conflict exists that cannot be waived - i.e., lawyer cannot represent exiting owner and company/other owners. See ABA Rule 1.7(b)(1). If specific Owner Exit being considered, lawyer for company shall inform owner of adverse interests of company. See ABA Rule 1.13(f).
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