Mind Your Business: Part Three – Agreements Among Founders and the Entity

There is a nearly infinite number of agreements founders can make amongst themselves and with the business. A few of the most common types are discussed below. Keep in mind that some agreements will not be valid if they contradict a statute that governs the operation of your particular entity type. This article does not take consideration of such statutes. As always, before drafting any agreements that will impact your business, you should consult with a knowledgeable attorney to discuss your goals and the best way to reach them.

Founders’ Agreement

A Founders’ Agreement is a great starting point when you first meet with your fellow founders to get in writing the things you expect from your business. It can also help to solidify your common goals and see the path of least resistance to get there.

The Founder’s Agreement will often include the roles and responsibilities of each founder, the method for decision-making and operation of the business, ownership interest, how contributions will be valued, vesting of interest, and how to handle the voluntary (or involuntary) departure of a founder.

It is important to keep in mind that the Founders’ Agreement is just a roadmap for the business and to be sure all appropriate topics are included in the operating documents of the entity.

Stock Control Arrangements

In some situations it is necessary to give a member or shareholder more voting power than their membership or share ownership percentage would otherwise allow. There are a number of mechanisms by which to accomplish this.

            Supermajority Voting Requirement

In a privately or closely held company, a minority shareholder may require a veto over certain major corporate decisions or actions as a condition of that minority shareholder’s investment. Such a requirement can be included in the articles of incorporation and bylaws.

            Irrevocable Proxies

A proxy gives the holder the right to vote the shares covered by the proxy on matters specified in the proxy. A proxy can be made irrevocable under specified circumstances.

            Voting Trusts

In a voting trust, shares are placed under the control of a trustee who votes the shares as provided in the voting trust agreement. In many states, including California, the length of the term of a voting trust is limited, subject to certain rights to extend the term.

            Dual Classes of Stock

One class of stock can be given substantially greater voting power than any other.

            Cumulative Voting

An agreement can be made in connection with representation on the board of directors through cumulative voting, which allocates each shareholder a number of votes equal to the number of shares times the number of directors to be elected. In California, unlike in Delaware and most other states, cumulative voting is mandated in the case of certain publicly traded, exchange-listed companies.

Buy-Sell Agreements

Buy-Sell Agreements protect the rights of the remaining founders when one founder dies or leaves the company.

This is best illustrated by example. Chris, David, and Matt found DW, Inc. Sadly, Chris passes away, leaving his shares in DW, Inc. to his wife, Rose. Rose then has one-third ownership of DW, Inc. and (in this scenario) the right to elect herself to the board of directors. However, Rose has a different idea of how she wants DW, Inc. to be run and David and Matt don’t want her to have control. If DW, Inc. has a Buy-Sell Agreement, his estate (here, Rose) is obligated to sell Chris’ shares to DW, Inc.

What happens if DW, Inc. anticipates it will not have enough money to purchase the shares from a deceased founder or doesn’t want to spend its money to do so? DW, Inc. should have an Insured Buy-Sell Agreement where either DW, Inc. or each shareholder, buys insurance on the founders to cover the obligation on the company to buy those shares.

Buy-Sell Agreements often include a right of first refusal. A right of first refusal says that if a shareholder wants to sell his shares to a third party, he has to offer them back to the company and if the company passes, they are offered to the shareholders. The Buy-Sell Agreement will often include a provision that says the price offered to the company and then the shareholders is the lower of either the offer price to the third party or the formula basis set forth in the Buy-Sell Agreement. So, if Peter offers Matt $1MM for his shares in DW, Inc. and the formula in the Buy-Sell Agreement values Matt’s shares at $1.5MM, Matt must offer the shares to the company, and then the shareholders, at a price of $1MM.

Purchase can also be triggered on a “triggering event” such as upon a founder leaving the company or on being fired. Sometimes Buy-Sell Agreements will also provide that if one of the founders becomes divorced, the shares, instead of being divided as community property by a court, must be reoffered to the company.

Transfer of Founders’ Technology to the Entity

There are two basic types of agreement that will transfer the technology of a founder to the entity – an Inventor’s Licensing Agreement and an Inventor’s Assignment Agreement.

            Inventor’s Licensing Agreement

In a licensing agreement, the founder/inventor retains ownership of her intellectual property, patents, and trade secrets, but licenses them to the entity in exchange for shares and possible a royalty fee.

For example, if Kaylee licenses the engine she designed to Serenity, Inc. in exchange for shares and a royalty fee, the engine and the associated intellectual property remain hers even after she leaves the company. Serenity, Inc. is merely “borrowing” the information.

            Inventor’s Assignment Agreement

In an assignment agreement, the founder/inventor makes a full transfer of all right, title, and interest in the technology or intellectual property to the company in exchange for shares.

Here, if Kaylee were to assign the engine she designed and all associated intellectual property to Serenity, Inc., she would receive shares in the company, but would not be entitled to royalties or any future interest in that technology.

            Employment Agreements

Employment agreements are used by companies to protect the rights of the employees as well as protect the trade secrets of the business. Employment agreements often include specifics as to the term of employment, benefits, rights to technology of the employee (as discussed above), termination events and compensation payable on termination, and how to resolve disputes. Many employers want to include a covenant not to compete, but in California these will generally not be enforceable, except in connection with the sale of a business.

Conclusion

There are endless variations of agreements among founders and with the company, which is why it is important to consult an attorney regarding what you are seeking to do to find the most efficient means to accomplish your goals.

By Jessica Coffield

Mind Your Business: Part 2 – Initial Financing and Capital Structure

Once you have selected and formed your business entity by filing the necessary documents with the Secretary of State, the next most obvious questions are: how does the company get money and how do I secure my piece of it?

There are a myriad of options for financing your business depending on your particular needs. It is crucial to work with your accountant and attorney to fully understand the implications of the various options. If you have additional concerns, it is prudent to hire an attorney who specializes in taxation to advise.

Interest in the company is referred to as a “security.” There are two basic ways to acquire a security in the company – equity and debt. Equity is basically an ownership interest in the company. In a corporation, equity can be common stock, preferred stock, or a hybrid of both. Preferred stock has a senior position to common stock and has a liquidation preference, meaning the holders of preferred stock get their money out first in the event of dissolution.

Equity

In an LLC, the equity is referred to as “membership interests.” These can have similar characteristics to common and preferred stock with the creation of classes of membership interest (e.g. Class A and Class B).

Partnership equity is the percentage ownership interest a partner has in the partnership.

Anytime you are issuing security to a founder or future investor, you must be sure to comply with the federal and state securities laws. For small businesses and start-ups, there will often be an exemption to registration, but, at least in California, you still have to file a notice of issuance.

The Cheap Stock Problem

Every new company faces the cheap stock problem. To illustrate by example, imagine Carter and Preacher form a fishing company, each investing $500 for 50% each of the company. The value of the fishing company at that point is $1,000. Carter and Preacher then bring in Russell, an outside investor, who will invest $500,000 for 10% of the company. This values the company at $5 million. The problem arises where Carter and Preacher issue their initial stock (the “cheap stock”) at about the same time as they issue the expensive stock to Russell. The IRS has a habit of treating the discount in valuation (the difference between a $1,000 valuation and a $5MM valuation) as services rendered to build up the value and tax it at ordinary income rates.

There are two mechanisms for avoiding this problem. One, have a period of time between the issuance to the founders (here, Carter and Preacher) and the issuance to outside investors (here, Russell) (the longer the better) so the difference in value is not deemed to be taxable. Two, issue a senior security (e.g. preferred stock) to outside investors and common stock to the founders, thereby creating a difference in value.

Debt Securities

In addition to raising additional capital from outside investors to finance the company, it is wise to explore the use of debt to finance. The benefits of using debt are obvious: there is no dilution of the percentage ownership of founders or other existing investors; the debt holder has no ownership interest in the company; the lender has no claim for future profits of the business, only repayment of principal and interest; and the debt is a known equation, meaning the company can budget for it. Additionally, interest on debt can be deductible for tax purposes. Furthermore, raising debt can sometimes be simpler than equity because you don’t have to be concerned with state and federal securities laws.

The disadvantages of using debt to finance the company are equally obvious: debt has to be repaid while common stock does not; debt requires cash flow, so you have to know the company will create enough cash flow to repay debts.

Furthermore, covenants and restrictions built in by lenders can impair the flexibility and ability to conduct business.

Conclusion

The choice of capital structure and how you initially finance your business is of critical importance. Be sure to work closely with a CPA or other financial professional and your attorney to make the choices that will allow your business to thrive.

By Jessica B. Coffield

Mind Your Business: Part 1 – Entity Selection

Starting a new business is one of the most exciting and fulfilling professional experiences a person can have. It is also nerve-wracking, emotional, and sometimes downright scary. The purpose of this three-part series is to provide a basic understanding of the process so you and your attorney can focus on how to best meet your specific business goals. Part one discusses selection of a business entity; part two provides an overview of initial financing and capital structure; and part three discusses agreements founders may want to have among themselves.

There are a number of options that may be available to you when forming your new business. It is helpful to have a basic understanding of the different entities as you begin planning your future business. A qualified attorney can explain in detail how each entity structure would affect your particular business.

The Sole Proprietorship

A sole proprietorship is not actually an entity at all, but is often referred to when discussing business structures. A sole proprietorship means that the owner of the business has full liability of the company. Sole proprietorships are easy and cost effective, but there is no protection for the sole proprietor for any debts or liabilities of the business. Thus, this structure is only advisable where the company has little liabilities, operations or obligations.

The Corporation

A corporation is a fairly rigid entity structure. For instance, it requires articles of incorporation, a board of directors that appoints officers, and officers that generally employ employees. The board of directors is elected yearly by the shareholders (there is a variation on the corporation known as a “close corporation” that can vary this, but that is not discussed in this article). The failure to adhere to formalities (e.g. comingling funds, not conducting meetings, etc.) can lead to personal liability of shareholders for the obligations and liabilities of the corporation.

You may have heard of “C corporations” or “S corporations.” These designations refer to the way the corporation is taxed (named for subchapters C and S of the Internal Revenue Code). In a C corporation, the company itself is taxed on the business profits. The shareholders then pay income tax on the money they received from the corporation (e.g. salary, bonuses, or dividends.) An S corporation, on the other hand, allows the shareholders to enjoy the limited liability of a corporation while being taxed as a partnership. This is referred to as pass-through taxation, meaning the business profits “pass through” to the shareholders in their proportionate share, who are taxed individually. Once the income tax is paid, any amount left that has not been distributed to the shareholders is previously taxed income or PTI, which can be distributed without taxation. The S corporation itself does not pay any income tax. In order to enjoy the status of an S corporation, however, you have to follow certain restrictions, including a limitation on the classes of stock, number of shareholders, and persons who can be shareholders.

If you intend to operate your business primarily as a source of income for the shareholders and plan to pull out all earnings other than necessary for the next year’s working capital, you will likely want a pass-through entity such as an S corporation, a Limited Liability Company (an “LLC”), or a partnership. If you are intending on building up earnings in the corporation to, for example, prepare for a public offering in the future, you may be better suited by selecting a C corporation.

The Partnership

A partnership can be general or limited. A general partnership is formed by two or more persons engaging in business activity. Like the sole proprietorship, nothing is filed with any government entity. Further, no partnership agreement is necessary (although it is prudent to have one). Anything not covered by an agreement is covered under the Uniform Partnership Act. The major distinction from corporations and LLCs is that limited liability is not available – the partners are liable for all debts, taxes, or tortious liability and the partners’ personal assets can be reached to pay such liabilities.

Like a corporation or an LLC, a limited partnership is formed with a filing. Those partners actively managing the business are referred to as “general partners” while those passively investing are referred to as “limited partners” (so they have limited liability for the debts, taxes, etc. of the business). Limited partners cannot actively participate in the management of the business, otherwise they risk losing their limited liability status.

All partnerships are taxed as pass-through entities – income and expenses of the entity are treated as income and expenses of the investors or owners and the entity is not separately taxed, avoiding the double taxation issue of a C corporation.

The Limited Liability Company

An LLC is basically a corporation that is taxed like a partnership. A shareholder in a corporation is generally not liable for debts of the corporation, except for his investment. This is the same for an LLC. Income and expenses of an LLC pass through to owners, like in a partnership and S corporation. However, an LLC has the option to be taxed as corporation or partnership. Perhaps the most attractive feature of an LLC is its flexibility. For instance, in general the failure to comply with statutory formalities does not jeopardize the limited liability status. If you are considering forming an LLC, it is important to discuss this with an attorney as recent changes to the laws governing LLCs have created new default provisions to the operations of LLCs.

Conclusion

A qualified attorney can work with you to choose the appropriate entity and help you file the appropriate documents with the state and draft the operative documents you will need to run a successful business.

By Jessica B. Coffield

Calculating Past Medical Special Damages in Personal Injury Cases

The primary objective of an award of damages in a personal injury case is to compensate an injured party for that party’s loss.  A fundamental concept in tort law is that a plaintiff is entitled to be placed in the same position, at least from a monetary standpoint, that he or she would have been if the injury in question had not occurred.

In theory, calculating damages related to a plaintiff’s past medical treatment should be a relatively straightforward task.  Let’s examine a hypothetical scenario where a plaintiff (we’ll call him “Bob”) was involved in a car accident and had to get back surgery which cost $100,000.  In this scenario, Bob is entitled to recover $100,000 in damages, right?  It turns out that the answer is not quite so simple and requires looking into the complex relationship between healthcare providers, insurance companies and medical finance companies.

Scenario 1: Bob has no health insurance.

The first factor to consider is whether Bob had health insurance that covered the cost of his back surgery.  If Bob didn’t have insurance and ended up paying a medical provider $100,000 in cash for his surgery, then he would be able to recover the full $100,000 assuming that this amount represented the “reasonable value” of the medical services he received.  What constitutes “reasonable value” is arguable and is generally proven by expert witnesses who are familiar with how much certain procedures typically cost.

Scenario 2: Bob has health insurance.

Things get a little more complicated once we begin to take insurance into account.

Generally, California’s “collateral source rule” provides that an injured party cannot recover less in damages merely because that injured party was already compensated by his or her insurance company.  An underlying reason behind the rule is that a “[d]efendant should not be able to avoid payment of full compensation for the injury inflicted merely because the victim has had the foresight to provide himself with insurance.”  (Helfend v. Southern Cal. Rapid Transit Dist. (1970) 2 Cal. 3d 1, 10.)

However, in Howell v. Hamilton Meats & Provisions, Inc. (2011) 52 Cal.4th 541, the California Supreme Court found that the collateral source rule did not apply in situations where medical providers contracted with insurance companies to accept as full payment, an amount less than what they might normally charge.  For example, a physical therapist might normally charge $200 for a therapy session but will contract with an insurance company to provide that same session to one of their insured patients for only $80.  Medical providers may agree to accept this reduced price in order to gain other commercial benefits such as the guarantee of prompt payment or the potential increase in the volume of business in the form of patients from the insurance carrier.

In this type of situation, a medical provider’s bills will typically state both the full “undiscounted” price of a particular procedure as well as the lesser amount that has been accepted by the provider as payment in full.  The Court in Howell reasoned that because the full undiscounted price was never actually incurred, a plaintiff’s recovery was limited to only the lesser amount that was actually accepted by the medical provider.  (Id. at 548.)  This would be true even if the full undiscounted sum represented the reasonable value of the medical service provided.  The Court in Howell stated that “a plaintiff may recover as economic damages no more than the reasonable value of the medical services received and is not entitled to recover the reasonable value if his or her actual loss was less. [Citations.]” (Id. at 555, emphasis in original.)  In essence, in order to be recoverable, a medical expense has to be both incurred and reasonable. (Id. at 555.)

With respect to our hypothetical scenario, if Bob did have health insurance and if his medical provider had agreed to accept only $75,000 as full payment for a procedure that would typically cost $100,000, then at most, Bob could only recover $75,000 pursuant to Howell.  This would be true even if the $100,000 price represented the reasonable value of the medical service provided.

Scenario 3: Bob and the medical finance company.

Things become even more complicated when we deal with entities known as “medical finance companies.”  These companies have emerged to fill a very niche role in personal injury cases involving uninsured plaintiffs.  Let’s revisit our scenario with Bob to get a better understanding at how these companies operate.

Let’s assume that Bob does not have any health insurance and that he doesn’t have the $100,000 in cash to pay his medical provider for back surgery.  Even if Bob doesn’t have this money, he may still be able to get this procedure done on a lien basis.  A medical provider, knowing that Bob has a pending personal injury lawsuit, may agree to provide medical services in exchange for a $100,000 lien against any recovery Bob might obtain in his lawsuit.  If Bob wins his case, the medical provider gets paid directly out of the recovery.  If Bob loses, the medical provider doesn’t get paid at all.  This arrangement, while pretty good for Bob, represents a significant financial risk to the medical provider.  This is where medical finance companies come in.

Medical finance companies typically get involved in situations where a plaintiff sustains an injury and needs medical treatment, but has no health insurance.  In our scenario, a medical finance company would work with both Bob’s attorney and Bob’s medical provider.  Prior to treatment, Bob’s medical provider would ask the medical finance company to evaluate Bob’s case to determine whether it would be willing to purchase the medical provider’s lien in Bob’s lawsuit.  Next, the medical finance company would contact Bob’s attorney to gather information about the case to determine whether Bob’s claim against the tortfeasor would be worth the investment.  If Bob’s claim meets with the medical finance company’s approval, it would notify Bob’s medical provider to let them know that it would be willing to purchase the lien rights.  After the surgery, Bob’s medical provider could turn around and sell his lien to the medical finance company for a reduced price in exchange for immediate payment.

In our scenario, Bob’s medical provider might agree to sell the $100,000 lien to the medical finance company in exchange for an immediate $50,000 payment.  If Bob wins the case, the medical finance company stands to collect the full $100,000 from the lien which will essentially net the company $50,000 in profit after taking into account the initial cost of purchasing the lien.  If Bob loses his case, the medical finance company will lose the $50,000 that it paid Bob’s medical provider for the lien.

After all of this, what is Bob entitled to recover in his lawsuit?  Is he entitled to recover $100,000 in damages based on the full “undiscounted” price of the surgery similar to that of an uninsured person paying out of pocket?  Or, pursuant to Howell, is Bob only entitled to recover the $50,000 that the medical finance company actually paid the medical provider for the lien?

The court recently dealt with this issue In Moore v. Mercer (2016) 4 Cal.App.5th 424.  In Moore an uninsured plaintiff was involved in a motor vehicle accident and subsequently underwent back surgery.  Plaintiff’s medical provider agreed to do the surgery in exchange for a lien on plaintiff’s recovery in the lawsuit.  After the surgery, plaintiff’s medical provider sold its lien to a medical finance company.

The defendant in Moore argued that there was no distinction between a typical insurer and a medical finance company and as such, pursuant to Howell, plaintiff’s medical damages were capped to the amount the medical finance company paid plaintiff’s health care provider for the lien.  The Court of Appeal flatly disagreed and was unwilling to extend Howell to include medical finance companies.  The Court stated that “evidence of what a third party was willing to pay for an account receivable or lien depends on a wide variety of factors bearing no relevant to the reasonable value of the services when rendered such as the probability of achieving a sizable jury verdict, the skill of the lawyers, and the strength of the evidence.”  (Moore, supra, 4 Cal.App.5th at 442.)  The Court went on to state that “evidence of the amount the provider was willing to accept is equally divorced from the reasonable value of the services delivered and may be related to financial pressures on the provider or managing the cash flow of the operation.”  (Id. at 442-443.)

With respect to our hypothetical scenario, it’s clear that Bob’s recovery is not automatically capped at the $50,000 that the medical finance company paid for the lien and Bob may be entitled to recover up to full $100,000 from the back surgery if it represents the reasonable value of this medical service.

Introducing Evidence of the Sale of a Lien

It is important to note that while the Court of Appeal in Moore was clearly worried about the possibility of litigating collateral issues associated with the sale of liens, the Court did concede that this evidence was discoverable because it had some probative value in determining the reasonable value of the medical services provided.  (See Moore, supra, 4 Cal.App.5th at 447-448.)  As such a defense attorney should not necessarily be dissuaded from seeking such evidence but should look to the Court’s decision for guidance as to what facts might possibly overcome an Evidence Code § 352 objection.

One fact that is easy to establish and appears to relate strongly to probative value is the date on which the medical finance company actually purchased the lien.  In Moore, the Court was unconvinced by arguments that the market value of a lien months or years after a service was rendered determined the reasonable value of the medical service as the time the injured patient was treated.  (Moore, supra, 4 Cal.App.5th at 444.)  Accordingly, evidence that a lien was purchased immediately after medical services were rendered is more likely to overcome a section 352 objection as one that was bought years later.

By Raymond Tuason