How the U.S. Can Avoid Another Recession (assuming there is leadership to do it)

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Even as Washington gridlock becomes the norm, ideas continue to circulate about kickstarting the sputtering U.S. economy.  Everyone seems to agree that startups and other small businesses will lead a renewed hiring boom and increase demand, but not everyone is in agreement about how to get there. There are some ideas, however, that continue to move forward.  Jeff Bussgang of Boston's Flybridge Capital Partners has highlighted some of them recently in an article that is worth reading, and points out this remarkable stat:

The Kauffman Foundation's research on this matter is clear: From 1997 to 2005, job growth in the US was driven entirely by start-ups.

The Startup Visa and government investment in innovation were also topics of this blog in that past in addition some other ideas like the green card visa.  The U.S. needs to make it easier for businesses to start here, and then make sure that we attract as many of the world's leading scientists and entrepreneurs to make it happen.

As Congress dithers over process and campaign year politics, it is hard to understand why there is not more urgency on this vital area of economic development.

This First Thing Every Founder Should Purchase

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What is the first thing a new startup company should purchase? Right, a hat rack. Wait, what?  You need one because each founder is going to be wearing several hats - organizationally speaking - and it is important to keep the various roles separate. Here is why. I was recently working with a client who is splitting off from a business he started with a partner, taking some of the assets from their company, and putting those assets into a new company in which he is the sole stockholder. As an exiting founder of the old company and the sole founder of the new one, he is taking on several different responsibilities, including as a stockholder, director, and even lender. This is legally significant, even if he does (inaccurately) refer to "my company" or "my equipment".

But when talking about roles, first understand that that I am not talking about titles. The titles that companies often hand out early on have less to do with the business than they do for establishing some sort of status hierarchy. Some state laws even necessitate designations like president, treasurer, and secretary - Massachusetts is an example - but don't get bogged down in titles. The law dictates legal distinctions between stockholders and directors, but don't try to pigeonhole your team into arbitrary titles that don't fit your organization.  Let the work dictate what roles and responsibilities to assign to management.

Why does this matter, you ask? There are several reasons:

  1. Title to property. New founders often erroneously treat company property as personal property. This has ramifications both from a practical standpoint (who owns the property that he wants to take to the next venture) and legal significance (can the company collateralize the property for lenders). If the exiting founder wants to take certain property with him, it is already tied up by a security interest under the company's bank debt? Did the company pay for the equipment or was it using property belonging to its stockholders? Those questions become all the more important when a change of ownership takes place.
  2. Organizational confusion. It is critical to sort out the rights and responsibilities of the organization - who has the ultimate control and authority? Often, a pair of founders will split these management roles equally (see my earlier post on why that may not be the best idea), but that effectively means that every decision requires unanimous agreement. Many important decisions have to get made on a daily basis; without proper role assignment, decision-making can get bogged down or actions may be taken without authority or notice. Even worse, an organization may not understand who is responsible for making key decisions.  Not only does this create problems within an organization, but it could also raise red flags to future investors.
  3. Legal risk. there are also significant legal ramifications should the rights and responsibilities of the owners and managers get muddled. While state law protects owners from personal liability for corporate obligations, a court may sometimes "pierce the corporate veil" and assign personal liability where owners of a company did not maintain the "separateness" of the entity.  Blurring the lines between corporate and personal increases that risk, as does lax handling of roles. It may seem odd for a stockholder to elect a director who authorizes the company to take debt from a lender when each of those is the same person.  But maintaining those distinct roles will help protect you from liability and confusion.

So where does all of that leave business owners? From the start of your business, choose a structure that fits with your business and keep straight what actions you take as a stockholder versus the actions you take as a director.  Then clearly allocate management responsibilities between the founders and the rest of the team and make sure that structure is clear to the rest of the organization. Because your decisions not only have ramifications for the company, but also may directly impact your personal bottom line.

Still Time to Take Advantage of Tax-Free Investment in Small Business Stock

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With all of the uncertainty in the markets recently, now is a great time to take another look at one way to create jobs with tax free investment. But you only have a few more months to take advantage of it. Remember the Small Business Jobs Act of 2010?  How about the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011?  Well, if you are a small businesses, a provision of these laws give investors, founders, and other stockholders the right to purchase certain types of small business stock and then sell that stock with tax-free gains of up to $10 million, provided you act quickly and then exercise a little patience.

United States Code Section 1202 was revised to exclude 100% of gains from the sale of "qualified small business stock" and that exclusion counts for both income tax and alternative minimum tax purposes.  But here is some fine print:

  • the company must be a C corporation (if you are taking advantage of the flow-through tax treatment of an S corp, you are out of luck);
  • the stock must be acquired between September 27, 2010 and January 1, 2012, and must be held for five years before being sold;
  • and at least 80% of the assets of the company must be used for one or more qualified businesses.
There are other provisions that may apply to your company as well, so you should review this carefully with your legal and accounting advisors.  But for those companies that meet the conditions, now could be the time to take advantage this temporary opportunity.

M&A Series: How is the purchase of a company structured?

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When a client asked if I would help him sell his business, he told me that he was ready to go and already had a buyer.  I followed that up with "is it a stock deal or an asset deal", and his face went blank. Most acquisitions are done with one of two structures:  either the buyer purchases all of the assets of a business out of the selling company, or the buyer purchases all of the ownership interest (i.e. stock, membership interests, etc.) and takes over the company, which can either continue as a subsidiary or can be merged into the buyer or related entity.  If the selling company is not a corporation or an LLC, then the deal has to be for assets.  Which one is right for your business?  Each has its pros and cons.

In an asset deal, the buyer is paying cash, stock, or other property for all of the assets that the seller uses in the operation of the business - everything from equipment, to Web sites, to trademarks, copyrights, and patents, to contracts.  The benefit to the buyer is that it does not have to buy any of the liabilities of the seller, or any bad assets for that matter.  For example, if someone has a claim to sue the seller for something that occurred prior to the sale, that will remain the seller's responsibility.  Likewise, if the seller has debt or other obligations outstanding at the time of close, none of that passes to the buyer unless expressly agreed (sometimes, the buyer will, as part of the purchase price, assume some outstanding debt or other obligations, like a real estate lease or mortgage).  Plus, the buyer gets a stepped up basis in the assets it is buying which will be advantageous when selling the assets later and for amortizing the assets over a period of years.  The down side to an asset deal is that everything that gets transferred has to be assigned.  For most of the basic assets of the company, that is easily done through a bill of sale.  But for certain contracts, capital equipment, vehicles, Web sites and other registered intellectual property, and leases, some sort of assignment has to be made, which may include getting consent from the current contract holder or entering into an amendment to the original contract.  That can often slow down a deal.  It is frustrating to all of the parties when a $25 million transaction is being held up because we don't have a signature of a landlord on a lease assignment (which does happen).

If, on the other hand, the buyer purchases all of the stock of the seller, in a way, it is simpler conceptually because you eliminate the need to transfer the assets.  The selling company still owns it all after the closing - the only change is that the company has new owners.  But in addition to keeping all of its assets, it also keeps all of its liabilities, even if they are not known at the time of the closing.  This may cause a bit of heartburn for the buyer, and may lengthen the negotiation process because there will be more focus on the representations and warranties and indemnification provisions in the final agreements (which I will cover is a later post).  On the tax side, the seller can enjoy significant tax benefits at capital gains rates, but the buyer loses the benefit of depreciation that it would have had in an asset deal.  The bottom line is that a stock sale benefits the seller more than the buyer.

Putting all of that together, sellers will generally push for a stock sale and buyers will typically want an asset sale.  But at the same time, either can be an acceptable structure depending on the nature of the deal.  That is just where the negotiation begins.