Understanding the basics

Before you can understand the pros and cons, you need to make sure that you understand the basic features of convertible debt and equity.

Equity
Investors get preferred stock. The preferred stock has all sorts of contractual rights including a liquidation preference and terms for conversion to common stock. To calculate the price of the purchased stock, the company is given a pre-money valuation. “Pre-money” means the valuation of the company immediately prior to receiving funds from investors. For example, if there’s an $8mm pre-money valuation and investors contribute $2mm the investors will have a 20% interest in a $10mm (post-money) company.

Convertible Debt
There’s two different varieties of convertible debt–traditional convertible debt, and something called convertible equity.

With convertible debt, the price of the stock is not calculated at the time of investment. Investors have rights to interest, and the conversion price is not determined until the company receives a “follow on,” or subsequent, round of financing. If the company does not receive a follow on round of financing before the debt matures, the investors can call in the debt, which may result in a bankruptcy for the corporation.

The convertible debt usually has a price cap. A price cap works like this: if there’s a $20mm price cap and the follow on investors value the company at $50mm, the convertible debt holders’ interest will convert at a $20mm valuation–meaning they will get a greater interest in the company than they would have if their investment was converted at the $50mm price.

Convertible debt holders also get a discount, meaning that they’ll pay a certain percentage less than the new investors no matter what. For example, if the follow-on round values the company at $5mm and there’s a 20% discount, the debt holders’ interest will convert at a valuation of $4mm.

With convertible equity (also sometimes called convertible securities) the investors don’t have the right to call in the debt. Rather, if time passes and there’s no follow-on round, the investors’ interests convert to common rather than preferred stock.

Pros & Cons of Convertible Debt

Dispelling the myths. It is often said (less often now, however) that convertible debt is cheaper, faster, and enables the company to easily price different investors at different prices. But, if this was ever true, it is no longer true. The terms of equity deals have largely become standardized, which means they can be done quickly and more cost effectively. Also, pricing different investors at different prices can lead to a complex, unwieldy, and burdensome capitalization structure.

The Benefits of Convertible Debt
Pro: you can delay the initial valuation. While this leads to other issues, delaying the valuation has its benefits: initial investors don’t have to spend the time and effort trying to precisely value the company; and if there’s no hard price on the seed round, the company will not have a down-round in the “Series A” round.

Pro: lack of control provisions–for whatever reason investors don’t usually get veto rights on a sale or future financing in convertible debt deals.

Pro: lack of board seat–again, for whatever reason, it is customary for equity investors to get board rights, but convertible debt holders typically do not have any right to a board seat.

The Problems with Convertible Debt
Con: with traditional convertible debt, investors can call in the debt upon maturity and may have the power to bankrupt your company or force your start-up to move forward with a Series A round before it’s ready.

Con: many of the worst, most anti-entrepreneur terms that have been phased out of equity deals are implicit in convertible debt deals.

• Convertible debt with a cap acts like a full ratchet. “Full ratchet” is a term from equity deals that allows investors’ interests to multiply automatically if stock is later sold at a lower price. If an investors buys a 20% interest at a $10mm valuation and the company later sells stock at a $5mm valuation, the amount of stock the original investor has automatically doubles. Enterprenuers didn’t think this was fair, and many investors agreed. Thus, you won’t find full ratchets in many equity deals anymore. But the “full ratchet” effect happens in convertible debt when the follow-on investor values the company at a lower price. If the company’s value drops in half between the seed round and the Series A, the convertible debt holder automatically gets twice as many shares.
• Convertible debt holders get a discount on top of the full ratchet. If the company’s value drops in half between the rounds, the convertible debt holders actually get more than twice what they would have received at the initial valuation because of the 10-30% discount they usually receive.
• Convertible debt holders can get a multiple liquidation preference. Most seed stage VC’s doing equity deals don’t even ask for multiple liquidation preferences, but convertible debt holders often get these preferences implicitly. For example: I give you a $1mm convertible note at a $9mm pre-money cap. Worst case scenario for me, I get a 10% interest in your company. You raise $6mm at a $24mm pre-money valuation, my stock converts into that security. Since I only paid $10mm post-money, I’m going to get three times as many shares to make up for the price difference. While my $1mm is only 10% of the company, it has nearly $3mm in liquidation preferences. That’s effectively a 3x liquidation preference.

Con: uncertainty—delaying the pricing adds uncertainty to the deal. You have to know the valuation to know whether or not it’s a good deal for either party. If there’s a cap, the investors knows the floor on how much stock he or she will receive. But there’s usually no ceiling–unless it’s structured as a convertible equity deal, there’s no lower-end cap, and the entrepreneur doesn’t know how much stock he or she might be giving up to the convertible debt holder.

Con: complexity—there are more moving parts to a convertible debt deal. You have to describe (1) when the price will be calculated, (2) how the price will be calculated, and (3) terms for interest and repayment of interest. You don’t have corresponding terms in an equity deal.

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You don’t just have to take our word for it. Many respected VC’s and attorneys have shared their thoughts on this issue. For more reading on this topic, see:

Mark Suster, “The Truth About Convertible Debt at Startups and the Hidden Terms You Didn’t Understand” Both Sides of the Table, September 5th, 2012 http://www.bothsidesofthetable.com/2012/09/05/the-truth-about-convertible-debt-at-startups-and-the-hidden-terms-you-didnt-understand/

Yokum Taku, “What is Convertible Equity (or a Convertible Security)” Startup Company Lawyer, August 21st, 2012 http://www.startupcompanylawyer.com/2012/08/31/what-is-convertible-equity-or-a-convertible-security/

Yokum Taku, “Is Convertible Debt with a Price Cap Really the Best Financing Structure?” Startup Company Lawyer, January 9th, 2011
http://www.startupcompanylawyer.com/2011/01/09/is-convertible-debt-with-a-price-cap-really-the-best-financing-structure/

David Rose, “How Does Convertible Debt Work?” Gust Blog, September 6th, 2012
http://gust.com/angel-investing/startup-blogs/2012/09/06/how-does-convertible-debt-work/

William Carleton, “Convertible Notes Without the Notes” Counselor @ Law, September 4th, 2012
http://www.wac6.com/wac6/convertible-notes/

Ted Wang, “Version 2.0 and Why Series Seed Documents Are Better than Capped Convertible Notes” SeriesSeed.com September 2nd, 2010
http://www.seriesseed.com/posts/2010/09/version-20-and-why-series-seed-documents-are-better-than-capped-convertible-notes.html

Dan Shapiro, “A Cap is not a Valuation” DanShapiro.com Septemeber 12th, 2012
http://www.danshapiro.com/blog/2012/09/a-cap-is-not-a-valuation/

Fred Wilson, “Convertible Debt” AVC September 8th, 2012
http://www.avc.com/a_vc/2012/09/convertible-debt.html

A Brief Background
Manchester United, the English soccer club, raised $232 million in its IPO last year. During the IPO process, there were serious concerns about the club’s financial projections once Ferguson retired. Many believed that the club’s success over the prior two decades was attributable in large part to Ferguson. Manchester United cautioned in its IPO that “we are highly dependent on members of our management…Any successor to our current manager may not be as successful as our current manager.”

Investors Weary of Risks
Any time an executive of a successful company decides to exit, investors fear that the successor executive will fail to maintain the company’s success under the prior executive. This fear often results in stock prices falling because the demand to sell is higher than the demand to buy the company’s shares.  This is why investors prefer a solid employee pool of shares to use as incentives for key persons. When Manchester United’s manager announced he would retire at the end of this season, shares fell substantially. The sharp decline in stock prices indicates Ferguson’s relative value to the team and investors’ lack of trust in the future success of Manchester United without Ferguson. Ferguson is considered what is known as a key person.

What is a key person?
The IRS defines a key person as “an individual whose contribution to a business is so significant that there is certainty that future earnings levels will be adversely affected by the loss of the individual.” The IRS goes on to explain that, in determining whether to apply a key person discount, the following factors are to be considered: (i) whether the claimed individual is actually responsible for the company’s profit levels; and (ii) if there is a key person, whether the individual can be adequately replaced.

How to Account for Key Persons
Generally small closely-held businesses are hit harder by the exit of a key employee because larger (especially publicly held) companies have an easier time finding replacement employees and executives. Further, companies that sell products are generally better able to withstand the loss of a key employee than service-based companies, which depend largely on the experience, knowledge and reputation of the key employee.

When it comes to valuing a company, key employees and executives are often taken into account by applying a key person discount. The idea of the key person discount is simple: when a business is highly reliant on one or more key employees, a valuation discount may be appropriate to account for the risk of reduced future earnings if these individuals exit. Typically, valuators will use one of three methods to take into account the key person discount when valuing the company: (i) adjust future earnings to reflect the risk of losing a key employee; (ii) adjust the discount or cap rate; or discount calculated value by a certain percentage (similar to a marketability or monthly interest discount calculation). Typically the range for these key person discounts is 4 to 6 percent, but there is little empirical support to substantiate these percentages.

The goal is to rebrand Seattle as a startup hub, similar to San Francisco and New York, two of the more well-known startup communities in the U.S.

The city plans to replace Russak with a startup business liasion, whose job will be to connect students and entrepreneurs with local tech companies to develop innovate buds across the city.

One of the major hurdles to Seattle becoming a startup bug is the lack of resources for entrepreneurs, or more specifically, the lack of public awareness and support of Seattle’s growing startup community. To get on the startup map, Seattle needs to be proactive in telling the world about the unique, exciting startup landscape that is growing in the Emerald City.

There’s a battle going on for startup community supremacy and Seattle is slowing gaining momentum. The city’s takeover of Startup Seattle is a positive move and one that entrepreneurs and investors in the Seattle community should be excited about.

What products or services does the company offer?
It may seem like a no-brainer to most, but it is important to acquire an in-depth knowledge of the products or services of the company you’re purchasing. In many cases, the purchaser is well aware of the products or services because it is the products or services of the company that attracted the purchaser to the deal. The better you know the products and services, the easier it will be to assess the market you are entering, forecast future revenues, anticipate shifts in consumer demand, and the costs it will take to operate the company.

Who operates the company’s day to day activities?
Some companies have one general manager or CEO that operates the business. That person may be an integral part of making sure the business continues to operate without a hitch. Does he or she have an employment agreement? What are the terms of the agreement? Is he or she obligated to stay with the company despite a change in ownership? Unless you plan to take over managing the day to day activities of the business, it’s important that you hold onto those employees that manage the company.

Are there other key employees that drive the company’s operations?
For many businesses, there are certain employees that are necessary to the company’s success. It’s important to identify those key employees and review any employment agreements or compensation packages tied to those employees during due diligence. There may be an executive that is due a large bonus or whose stock option plan will vest next year. Or there may be a key engineer or designer that could leave the company. A purchaser that fails to recognize these issues surrounding key employees may end up owning a company with diminished value. A seller, on the other hand, can maximize its value by ensuring that key employees are retained and obligated to continue performing for the purchaser.

Are there key customers and suppliers that are necessary to maintain the company’s business?
Another important consideration is the key customers and suppliers. Many companies rely heavily on the income generated from just a few customers. Other companies rely heavily on a small number of suppliers in order to produce and sell their products or services. It’s important to recognize these key customers and suppliers. Further, it’s important to review the terms of any contracts with those key parties in order to understand the rights and obligations of the business and its customers. In some cases, it is worth requiring the business owner to introduce you to the key customers and suppliers in order to begin building a relationship with those individuals. Purchasers often require business owners to sign a non-compete agreement that restricts the business owner’s ability to “poach” key customers and suppliers after he or she sells the business.

The moral of today’s post is the more you know about the business, its operations, its employees, and its key customers, the less likely you’ll encounter unanticipated obstacles when you take ownership of the business.

If you’re interested in learning more about due diligence, selling a business, or  purchasing a business, please check out our blog series and contact us to schedule your free consultation today.

Avoid a Headache; Know the Financials In and Out
The last thing you want to do is purchase a company with disorganized books and a lack of financial records. Not only will you spend time and money sorting out the books and reconciling the financial records, you’ll also likely inherit “surprise debt” or other financial liabilities. By taking the time to review the company’s books and learn more about its financial condition, you’ll avoid a headache or two down the road.

If you’re the seller, there are some things you can do in advance to be a more attractive investment opportunity and to make things easier during the due diligence process. A prepared seller will have cleaned up the company’s books, organized its financial reports, and put together a comprehensive folder that details the company’s financial condition. The best practice is to complete your own set of due diligence prior to finding a buyer.

Hiring Help
I’ll be the first person to admit that reviewing financial statements and accounting reports is not exciting. Often, these number-laced documents send readers into a sudden coma after just minutes. Luckily, there are experts out there that actually enjoy reviewing financial statements, balance sheets, and accountants’ reports. They’re called (fittingly) accountants. It’s worth the money finding the right CPA to work with during the due diligence phase of purchasing a business.

Tax Liabilities
When you look into the financial condition of the company, you’ll want to make sure that the company does not have any significant tax liabilities. Has the company filed regular tax returns? Has the company paid payroll taxes to the government? Are there any outstanding tax payments that are owed? These are some of the questions you should find answers to during due diligence. It’s surprising how many businesses choose to neglect mandatory tax requirements; the penalties for ignoring these tax requirements can be significant.

Promissory Notes
It is also important to determine whether the target company has provided loans to its employees. Sometimes, the promissory notes are extended to officers to enable the officers to purchase company stock and start their capital gain holding period with respect to such stock. The promissory notes should be reviewed to determine the recourse nature of the notes and the interest rate that applies. Also, under the Sarbanes-Oxley Act of 2002, loans are prohibited to public company officers. Therefore, the buyer will need to make sure to review carefully any outstanding loans to individuals that may or will become officers of the target company post-acquisition.

If you’re interested in learning more about financial issues you should be aware of when purchasing a business, please feel free to contact us today to schedule your free consultation.

Reviewing the Owner’s Governing Documents
Prior to any acquisition, the purchaser will need to know the basic organizational structure of the business, i.e. how it was formed, its governing documents, and its key personnel. Knowing how the business is organized will dictate how the transaction will be structured.

Securities Matters
Is the purchase going to be structured as a stock purchase? How many shareholders currently own stock in the company? Is there a shareholder agreement? Are there restrictions on acquisitions or transfers of stock? Will the transaction need to be registered with the SEC? These questions are just a glimpse at some of the securities matters the purchaser will need to consider during due diligence. Generally outside legal counsel will conduct an audit of the owner’s business to identify the key securities issues that the owner and purchaser need to be aware of.

Regulatory Matters
Is the owner’s business subject to special government regulations? Are there environmental considerations that the purchaser should be aware of, e.g. permits, hazardous waste handling, and EPA regulations? These are important considerations as they will affect the purchaser’s ability to continue the business. Certain regulations can be costly and time consuming to comply with, and even more costly if the purchaser is unaware of them and fails to comply. This portion of due diligence requires reviewing any licenses or permits that business currently holds, reviewing the facilities and location of the facilities to be aware of the environmental risks and regulations, and researching any additional licenses or permits the purchaser may be required to obtain. An environmental audit typically requires hiring an environmental engineering firm to complete the environmental review.

Pending or Threatened Litigation
The purchaser will need to be aware of any pending or threatened litigation the owner is involved in. Litigation is expensive and time-consuming and will subject the purchaser to significant hassles if left undisclosed or undiscovered. While a public company is required to disclose any pending litigation matters in its SEC filings, discovering pending litigation for a private company can be more difficult. For any pending or threatened litigation, it’s important to determine the relevant information, including the parties involved, the nature of the proceedings, the timing of future hearing/trials, the status, relief sought, and settlements offered, estimated future costs, relevant insurance coverage, and any legal opinions on the cases.

It is also important to establish a materiality threshold regarding each claim, i.e. a threshold for walking away because of a pending claim. By evaluating each claim and quantifying the potential liability or recovery, the purchaser can assess whether the pending litigation is a deal breaker or whether the deal can be restructured to minimize the purchaser’s risks associated with the on-going litigation. In some cases the acquisition may compromise the current strategy for the on-going litigation.

Stay tuned for our next post in this series that will cover the financial issues surrounding due diligence.

If you have any questions regarding the legal issues surrounding due diligence, please feel free to contact us or comment below.

The SEC’s report confirms that Regulation FD applies to social media and other emerging means of communication used by public companies the same way it applies to company websites. In 2008, the SEC issued guidance that clarified that websites can serve as effective means of communication to announce information to investors so long as the investors are aware of where to find the information.

Regulation FD requires companies to distribute material information in a manner that is reasonably designed to have the information reach the general public broadly. The regulation is intended to ensure that all investors have the ability to gain access to material information as the same time, eliminating any unfair advantages to one shareholder over another.

Today’s report stems from an inquiry the Division of Enforcement investigated into a post by Netflix CEO Reed Hastings on his personal Facebook page. Hastings commented that Netflix’s monthly online viewing had exceeded one billion hours for the first time. This information was not reported by Netflix through a press release of Form 8-K. Following the post, Netflix’s stock price rose from $70.45 to $81.72 the following day. The SEC did not initiate an enforcement action or allege any wrongdoing by Netflix or its CEO, but recognized that it needed to clarify any market confusion.

The report explains that although each case will be evaluated on its own facts, disclosure of material, non-public information through the personal social media site of an individual executive officer is unlikely to quality as an acceptable method of disclosure under the securities laws.

What does this all mean? It means that companies are permitted to disclose certain material information through their company Facebook, Twitter, or other social media site and such disclosure (so long as investors are pointed to the announcement and it contains the necessary information) will likely satisfy Regulation FD.
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If you’d like to learn more about securities regulation and how we can assist your company with compliance, please feel free to contact us today.

Businesses often are faced with the choice of whether to register a trademark or service mark with a state or the United States Patent and Trademark Office (USPTO). It is well known that state registrations tend to be less expensive and often take less time to apply for and receive confirmation that the mark has been registered. However, there are key benefits to registering your trademark with the USPTO. Today’s post highlights those key benefits of federally registered trademarks and service marks, and provides helpful resources for registering your trademark at the state and federal level.

The Lanham Act
First, let’s start with the basics. Under the Lanham Act, a person who obtains a federal registration that predates another person’s use of the same (or confusingly similar) mark has superior rights to use the mark throughout the U.S. This is true regardless of whether the person has obtained a state registration or was the first person to use the mark in the state. Courtesy of the Supremacy Clause, a federal registration will always trump a state registration if there is any conflict between the two.

Confusingly Similar
If any mark is currently registered or its registration is pending, it is possible that the USPTO may issue a “likelihood of confusion” refusal when you file your trademark application. Likelihood of confusion exists between trademarks when the marks are so similar and the goods or services for which they are used are so related that consumers would mistakenly believe they come from the same source.

Each application is decided on its own facts, and there is no strict mechanical test for determining likelihood of confusion. To determine whether a likelihood of confusion exists, the marks are first examined for their similarities and differences. Keep in mind that in order to find a likelihood of confusion, the marks do not have to be identical. When marks sound alike when spoken, are visually similar, or create the same general commercial impression in the consumer’s mind, the marks may be considered confusingly similar. Similarity in sound, appearance, or meaning may be sufficient to support a finding of likelihood of confusion, depending on the relatedness of the goods or services. It is important to complete a thorough search in order to determine whether there is any confusingly similar mark already in use prior to submitting your trademark application. Generally, the USPTO filing fees (see below) are non-refundable even if your trademark application is rejected.

Right to Use the Mark Across Entire U.S.
A person or business that owns a registered trademark has the right to use that mark in the U.S., including in states where a subsequent (“junior”) state mark is registered. Once the federal registrant enters the junior’s market area, the junior must cease to use the mark. Furthermore, the federal registration itself is constructive notice of the right to use the mark across the entire U.S.

The Exception
As is usually the case in law, there’s an exception. The exception exists when the state mark was registered prior to the federal mark. If the state mark was in use before the date of the first use of the federally registered mark, the prior state mark holder may have some rights to use the mark. Those rights are limited to a certain geographical area, usually the state where the mark is registered and used. State registrations tend to serve as evidence for a prior use in order to establish rights to the mark in the states where it was registered.

Common Law Trademark Rights
Common law rights arise from actual use of a mark and may allow the common law user to successfully challenge a registration or application. But common law trademark rights are not preferred, as they extend only to the places where a trademark has been used in commerce. Furthermore, they do not afford the level of protection that a federally registered trademark receives, such as the ability to recover profits, statutory damages, attorneys fees, treble (triple) damages for willful infringement, national priority, and the right to use the ® to give notice of rights in a mark. Some business owners are deceived by the idea of common law rights, when in actuality there aren’t many “rights” associated with trademarks relying solely on common law principles. Common law rights should be thought of as a right of last resort, and not relied on to enforce an individual’s use of a trademark.

Registering Your Mark at the State Level
To register your mark with the Washington Secretary of State, you will need to fill out and submit the Washington State Trademark Registration/Renewal form. It costs $55.00 to file for a new mark (unless you request the registration to be expedited, in which case it costs an additional $50.00). You are required to renew your trademark at the state level every five years for a fee of $50.00. RCW 19.77 lays out trademark laws in Washington.

Registering Your Mark at the Federal Level
To register your mark with the USPTO, you will need to file an application online through the USPTO website or you can submit a paper application to the USPTO. The USPTO filing fees range from $275 to $375 per registered class. Filing a federal trademark registration is a more complex and time intensive process that includes comprehensive trademark searches, identifying the basis for the mark, including class, design code (if applicable), and description of each good or service. We recommend working with an attorney when preparing to file a federal trademark registration.

Background
FINRA is a private self-regulatory organization that has the authority to exercise comprehensive oversight over all securities firms that do business with the public.

FINRA’s Customer Code governs arbitration between customers of FINRA members and FINRA members. (There is also an Industry Code which governs disputes between FINRA members.)

Rule 12200 provides that parties must arbitrate a dispute under the Customer Code if: (1) Arbitration under the Code is either: (a) required by a written agreement, or (b) requested by the customer; (2) the dispute is between a customer and a member or associated person of a member; and (3) the dispute arises in connection with the business activities of the member or the associated person, except disputes involving the insurance business activities of a member that is also an insurance company. (Emphasis added.)

The Trio of Fourth Circuit Cases
The Fourth Circuit has issued three opinions in 2013 which determine the scope of Rule 12200. In particular, the Court determined the definition of the word customer as used in Rule 12200. The definition is significant to FINRA members and those aggrieved by FINRA members because the Customer Code provides an appealing avenue to remedy for parties seeking compensation from FINRA members.

In all three of the cases, the Court was faced with similar facts: a party alleging to be a customer of a FINRA member had attempted to initiate an arbitration proceeding against the FINRA member pursuant to Rule 12200; the FINRA member filed suit in a federal district court seeking an injunction preventing the arbitration proceedings on the basis that the party initiating the proceeding was not a customer under Rule 12200 and thus had no basis to initiate the arbitration proceeding.

The Rule — “Customer” as Used in Rule 12200 Defined
The Fourth Circuit held that a “customer” for the purposes of Rule 12200 is someone who (1) is not a broker or dealer, (2)  purchases commodities or services, (3) from a FINRA member, (4) in the course of the member’s business activities, which are namely the activities of investment banking and the securities business.

How the Cases Applied the Rule

UBS Financial Services; Citigroup v. Carilion Clinic
UBS and Citi served as underwriters for an auction-rate bond and served as lead broker-dealers for Carilion’s auction-rate bond auctions. Carilion claimed that UBS and Citi misled it on the nature of the auction-rate bond market, failed to disclose material information, and violated fiduciary duties. Citi and UBS argued that Carilion was not a customer under Rule 12200 because Carilion did not receive investment or brokerage services. The Court disagreed and found that Carilion was a customer because Carilion contracted with UBS and Citi to provide investment and securities advice and services.

Morgan Keegan & Company v. Silverman
Morgan Keegan  had bond funds which were traded on the New York Stock Exchange. The Silvermans purchased the bond funds not from Morgan Keegan during the initial offering, but through Legg Mason, a third party, on the secondary market. The Silvermans never had a brokerage account with Morgan Keegan, but claimed a customer relationship on the basis that Morgan Keegan encouraged the Legg Mason broker to purchase the funds. The Court found this to be too tenuous of a relationship for the Silvermans to qualify as Morgan Keegan customers under FINRA’s Rule 12200.

Raymond James v. Cary; Smith; Barkin; and Spolar
The parties alleging to be Raymond James’ customers purchased securities after consulting with an individual that was not affiliated with Raymond James. The parties alleged that they were customers because the advisor who encouraged the purchase of securities split fees with another individual that was an associated person of Raymond James. The Court held that this transaction did not create a customer relationship with Raymond James because the securities purchasers did not have accounts with Raymond James, did not receive investment advice from someone claiming to be a Raymond James representative, and did not meet with a representative of Raymond James.

Key Takeaways from the Three Opinions

1. An individual does not become a customer of a FINRA member by interacting with a third party who interacts with that FINRA member.
2. FINRA members that directly provide any investment banking or securities services and advice to an individual are likely subject to the arbitration provisions of FINRA’s Rule 12200 with respect to that individual.

The due diligence process allows the purchaser to identify the risks with the proposed transaction before completing the transaction. Throughout the due diligence process the purchaser seeks material information the owner has not disclosed in preliminary discussions. Unintentional omissions are frequent, especially where the seller is inexperienced with the due diligence process. Failure to thoroughly investigate the seller during due diligence can lead to otherwise avoidable expensive “surprises” down the road.

The due diligence process can also be important for the seller, particularly when the seller is receiving stock from the purchaser as part of the transaction. In such an instance, the seller will also be making an investment in the purchaser’s company. Even if the seller is receiving cash as part of the transaction, the seller usually wants to make inquiries into the purchaser for the benefit of the seller’s stakeholders including its shareholders, employees, customers, suppliers, and distributors. Often times the transaction will be less appealing to the seller if it is discovered that purchaser has a track record of liquidating assets and winding up acquired businesses.

If issues are uncovered as a result of the due diligence process, the parties have an array of options to mitigate the identified risks. The parties could back out of the deal; sometimes the best deals are the ones you don’t do. The parties could restructure the transaction—for example, the purchaser may insist on purchasing the assets of the company rather than the entity as a whole (purchasing the entity involves greater risk for the purchaser). The parties could renegotiate the purchase price. The parties could also contractually assign particular risks to a certain party.

Due diligence starts after the owner and the purchaser execute a letter of intent. Typically due diligence will include a thorough review of all of the business’ written documents, as well as an on-site review of the business. Some purchasers choose to conduct interviews with employees during the on-site review. During due diligence, the purchaser is concerned with a plethora of issues, including:

• Legal Issues: any legal issues surrounding the business, including governing instruments, securities matters, regulatory matters, and pending or potential litigation or legal expenses;
• Financial Issues: the financial condition of the company, including financial statements, accountants’ reports, bank holdings, debt, and tax matters;
• Operational Issues: how the company is currently operated, including employee and labor-related matters, customer and supplier-related matters, and products or services the company offers;
• Intellectual Property Issues: often the most expensive asset a company holds is its intellectual property, including software, copyrights, trademarks/service marks, patents, trade secrets, and any IP agreements;
• Contracts and Material Information: who the company is contracting with and what obligations are owed, including licensing agreements, R & D agreements, documents related to joint ventures/acquisitions, a schedule of major competitors by product, non-compete agreements, and any other material contracts;
• Miscellaneous: this includes real property, environmental matters, insurance, news releases and marketing materials, reports filed with government agencies, indemnification agreements, and any other significant information.

As part of our blog series on the purchase and sale of a business, over the next few weeks we will review each of these due diligence topics, pointing out the most important aspects you should be aware of when selling or purchasing a business.