PARTNERSHIPS & LLCs OUTLINE I. Introduction a.

Goal: deciding what type of entity you, as a lawyer, would form for a client starting a business i. P-ship 1. also, LLP ii. LLC iii. C-Corp. iv. S-Corp. b. Hypothetical: Designatoy i. Basic story: Software for kids, not yet developed, Roger contributes $20.000 and Rita $15,000 to start comp., need additional $250,000 to start 1. Their exit strategy is either to take the company public, to sell the company to a large toy company or to license the technology and collect royalties ii. What type of entity should they form? 1. P-ship 2. Lim. P-Ship 3. S Corp 4. C Corp 5. LLC iii. What are the issues involved in determining what form of business Designatoy should be? 1. What are they going to have to decide and confront before they start their business? a. Categorization, as below, is key i. They way you handle management issues does not have to be the same as how you handle financial issues b. Management & Control Issues i. Who gets to decide ? 1. Not an issue for one person starting a business ii. Questions of voting 1. The mechanism for deciding a. Majority rules, some issues unanimous, 3rd party if no agreement c. Financial Issues i. Different Contributions 1. Here = $5,000 2. What are some options for dealing with this? a. Dealing w/: i. Time ii. Salaries iii. Profits d. Tax Issues i. Problem of double taxation of corporations 1. Taxes on corporate income, individual income 2. In an LLC, only the owners would pay taxation (individual income tax) ii. Questions 1. How do you plan to run this business? a. Will you take the business public? b. Will you sell the business? c. Sell license? d. Each issue pushes you a different way in regards to taxes e. Liability Issues i. Most entities you form will have limited liability 1. In a partnership, there is no limited liability a. Partners are both liable i. Why, almost always, you dont form a P-ship f. Dissolution Issues i. What happens when we end the business? 1. Who gets what (split things up)? 2. Who gets to decide when we end the business? g. Investor Issues 1

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i.

i. Whos going to put money in and what role are they going to play in the company? 1. Ex: Do we need two different forms of stocks? Exit Strategies i. What do you envision happening from this business? 1. How do envision making money from this business? a. Ex: Going public i. LLCs dont go public, Corps go public ii. Can convert to Corp, but complicated process Other issues i. Marital status ii. Age 1. Such as 27 in this case, points out that things change over time a. Technically not business points i. Day-to-day stuff you know as being a person ii. Lead to iii. Transfer & Buyout Questions iv. Kind of company they are starting employees 1. In this case: software company a. More work, must hire people i. Workers may want piece of compancy 2. Issues raised such as Stock Options a. Incentivize b. Think about type of industry, employees, level of company sophistication v. Governing Law 1. Where do we want to form this company? a. Some states more beneficial? vi. Fiduciary Duties 1. Different duties in one entity v. another

II.

Partnerships a. Rules and Structures of P-ships i. The basic structure of most of the firms that we are going to study (w/ the exception of corporations) 1. Most of the entities evolved out of p-ships 2. Entities are a container that you keep your business stuff in ii. UPA (Uniform Partnership Act) and the RUPA (Revised UPA) 1. In CA, they call the RUPA, the Uniform Partnership Act 2. The old UPA doesnt really apply as much a. But, old companies may be governed by the UPA 3. The rules are helpful b/c they are rules that come into play when you form a partnership and you do not have a written agreement a. The default rules b. They are particularly useful b/c they represent what some bright people think about a situation where people form a partnership and do not go far enough to cover everything i. But, do not rely on the default rules as an attorney 1. However, you can look at these rules for guidance ii. The default are not an all or nothing proposition 1. rather, they are a fill in the blank resource iii. What is a Partnership? 1. A partnership is association of 2 or more persons who acts as co-owners to carry on a business for profit a. This excludes an agent i. Just b/c an agent shares in the profits, doesnt mean p-ship 1. Co-owner part makes b. P-ship is a voluntary relationship i. Voluntary is not the same as knowing 1. People can form a p-ship w/o knowing or intending a. They might not think of themselves as a p-ship, but p-ship rules may apply 2

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ii. When you form a partnership, you fill out a form and announce entity to Secretary of State 1. You do not need that for p-ship thats why p-ships can form unknowingly 2. Whether there is a p-ship, is a question of fact 3. A joint venture is a p-ship iii. As soon as one more person gets involved in a sole proprietorship, you have to put a label on that relationship 1. Such as, employer-employee, p-ship iv. B/c there is an express statement in a contract or written agreement says the people are not partners, it still can be a p-ship 1. At the same time, just b/c you call something a p-ship, doesnt mean it is, but more likely that is b/c of intent a. Just b/c you own property, doesnt mean partners b. Just sharing gross returns, doesnt c. Putting money into an enterprise, doesnt 2. Sharing profits is prima facie evidence of p-ship a. Scales waited in favor of p-ship b. Unless, sharing of profits occurs as a result of wages, debt, annuity, or rent i. Ex: Mall lease, profits go to lease doesnt mean pship ii. Ex: Commission doesnt make you a partner c. Not having joint participation in management and if you dont participate in management and control in business it is more likely than not that the people are not partners i. Sharing in managing doesnt mean p-ship v. Best test: intent of parties to carry on business as co-owners vi. Subjective intent v. Objective intent 1. Subjective intent: meant to be partners 2. Objective intent: acted like partners vii. P-ship by estoppel 1. Really comes up when someone is not partner, but takes or fails to take steps that creates the impression that they are a partner Whats good or bad about p-ships a. Fiduciary relationships i. Must account to the p-ship and hold profits as trustee of p-ship ii. Duty to not compete against p-ship w/ respect to p-ship opportunity 1. That survives withdrawal from the p-ship a. Doesnt apply to competing w/ the p-ship after and unrelated 2. No-compete clauses are not enforceable in CA, expect in the case of co-owners iii. Duty of care 1. Make well-informed decisions iv. Duty of loyalty 1. Dont lie, cheat and steal A lot of the default rules flow out of the structure of a p-ship a. If we are going to make the partners liable, one of them should be able to leave the p-ship i. Thats why one of the default rules is that any partner can dissolve a p-ship b. Structure dictates what the rules governing that entity should be c. Default rules can be drafted around w/ a written agreement d. Default rules say profits are shared equally and each partner has an equal vote i. No matter even they put in unequal share 1. But, each has equal exposure to creditors equal shares 2. You can contract around the equal share of profits, but you cant limit your ability b/c of representations to 3rd parties a. You cant bind someone who is not a party to the contract In re Marriage of Hassiepen a. Basic facts: two people, man and new wife, start electrical business, ex-wife wants sole proprietorship to increase child support 3

b.

What factors matter and dont here? i. What pushes it to being a partnership? 1. They ran the business in an unsophisticated manner a. Joint account ii. One of the things going on here is that you have human beings in the case 1. One thing to note: If sole proprietorship, then Brenda loses a lot ramifications on a totally unrelated person a. Also, although not in the book, the court found a way to give Cynthia, the ex-wife, more child support 5. Martin v. Peyton a. A more sophisticated relationship i. Basic facts: Knauth, Nachod & Kuhne were loaned money by Peyton, et al and in exchange for this money, Peyton and others ask for certain assurances; the creditor of K.N. & K. sues Peyton, claiming p-ship 1. Require Hall, the person they know, to manage business 2. Veto any speculative business share in control a. Enables you to say no, but does not enable you to propose ideas, start transactions you would like 3. Life insurance payoff 4. Compensation from profits for the loan of $2,000,000, etc. share in profits (but not unlimited share) a. At least $100,000 (5%), but more than $500,000 (25%) i. These limitations form the line on how far you can go ii. Elements 2 and 4 form the limits 6. Minute Maid v. United Foods a. United Foods buys frozen foods from Minute Maid i. The price of orange juice fluctuates 1. If you are allowed to hold orange juice, you can decide when to buy orange juice and get favorable prices ii. Why did they get to hold onto the orange juice? 1. B/c of warehouse owned by U.S. Cold Storage a. Subleasing space iii. US makes an agreement w/ United to front them the money to buy oj 1. Special account is set up iv. Minute Maid sues the deep-pocket, US, and claims P-ship 1. US claims lender, bailor-bailee relationship b. What it ultimately comes down to is this special account i. Court says you may be bailor-bailee, but you could also be something else, such as partners ii. Even if losses shared, didnt matter, b/c structure of dealings made losses impossible 7. Problem: When you look at Minute Maid and Martin, they do not look that dissimilar how do you reconcile these cases? a. How do you know what to draft? i. You dont if close to either of the areas in these cases, you are to close to the line b/c they could go either way 1. In Minute Maid, I would not have split profits 50-50 (some other proportion) 2. I might have put a veto right instead of exercising control Issues that come up when forming a p-ship i. Formation ii. Governing law iii. Maintaining costs iv. Liability for p-ship obligations v. Management and control 1. Centralized a. Like a corporation, where a board of directors is elected 2. Decentralized a. In a p-ship, one person doesnt run the show everyone is involved 4

b.

vi. Fiduciary duties vii. Transfer requires the consent of all partners viii. P-ship usually has termination date 1. Airwalker Ventures a. Movie financing by venture cap firm what are the specifics of the arrangement going to be? i. Avoid looking like a p-ship 1. Start w/ financials a. Fixed percentage of profits (not 50-50) b. Or, perhaps revenue sharing i. Implication of profit sharing is that both are allocating money to expenses c. Or, interest on the loan i. Looks less like a p-ship d. Note: In money area, generally safe, until we add all these other things to control other concerns 2. Over-budget problem a. Veto right i. Veto large budget expenses b. Or, a penalty for going over budget i. Less control involved ii. Problem is director may go over budget, but be like we need more money and cant film w/out it c. Or, incentivize for going under budget i. Might not affect ego-artistic director d. Or, look at books and records and look at plan before beginning i. Looking at what was spent and what is being spent ii. Maybe, if you go over budget, I just want an acceptable controller (who could be unrelated to me) who will approve all expenses somebody needs to be responsible 3. Depressing endings a. Veto changes in the ending i. Look to the script before filming ii. But, suppose ending still turns out depressing b. Or, put it in someone elses hands post-production facility c. Or, Test screen the movie, no pass, then revise until criteria met i. Objective criteria 4. Stars w/ limited box officer potential a. Veto power b. Or, certain requirements (objective criteria) for casting actor Choice of Law a. This issue matters b/c state-by-state laws differ i. For example, some states may let you opt out of something while another doesnt 1. But, most of the time you will be drafting an agreement and you will be able to put in the clauses that you so desire a. However, not all businesses are going to operate in just one state Limited Liability Entities a. Where they evolved from i. Originally, just p-ships and corporations 1. Both had benefits and drawbacks a. P-ships i. Good set up for owner/manager ii. Could form w/out papers iii. Preset financial rights 5 2.

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iv. Direct owner participation in management (centralized management) 1. Any partner can bind the p-ship 2. Each partner has equal share in management a. However, they can elect a manager, but not like corporations b/c owners usually hold onto veto rights v. Restricted transferability of ownership rights vi. Could leave/end p-ship at any time very easily vii. Can waive default p-ship rules viii. P-ships are pass-thru entities in regards to tax 1. The partners pay tax even if they dont receive money (the money stays within the partnership) a. Form, K-1, your share of profits pay tax on profits b. You want to distribute at least enough to pay taxes, while distribution forces shareholders in corporations to pay taxes i. However, capital gains taxes can be deferred as opposed to dividend income 2. If the p-ship loses money, then you get to write on taxes that you had a loss and you get to deduct from other money you made a. The IRS has instituted limitations on how much and when the partners could use that loss created distinction b/t active and passive loss w/ active being able to take that loss while passive having a limitation ix. But, no limited liability Corporations i. You do have limited liability, but 1. Double taxation a. Corporate earnings are taxed as well as dividends paid out to shareholders ii. Managed by a board of directors 1. Owned not directly involved in management (decentralized management) iii. Shareholders lack both actual and apparent authority to bind the corporation 1. Vote one vote per share by % (pro rata) iv. Transferability: Shareholder can sell a complete bundle of rights 1. However, limited by securities laws and frequently, by agreement v. Eternal life of corporation 1. Shareholder, by himself, does not have right like partners, to dissolve entity

b.

ii. S-corporations 1. Basic idea: To get rid of double taxation burden a. Not fair to force small company to face both limited liability and double taxation 2. Looks exactly like regular corporation with some exceptions a. Biggest thing: pass-thru taxation i. Still board of directors b. Only one class of stock i. No preferred stock A, B, etc. c. Limitation on how many shareholders you can have i. Limit = 75 1. However, the nature of the shareholders are limited a. No corporate shareholders, non-resident aliens i. Set up for individuals ii. But, the S-corp. can own shares in corps d. Allocations of gain and loss must conform to % of what owners hold in S-corp. i. As opposed to p-ships where you can allocate pretty much any way you can 3. Default: if you screw up, you get turned into a C-corp. (regular corp.) a. Can also convert if so desire LLCs come onto the scene in the 90s i. Limited liability of a corporation 1. Keeping money in the corporation leaves money to have to pay a lawsuit 2. But, in LLCs, the members of the LLC do not have to pay 6

Incentive to take money out of company b/c no taxation and limited liability affords them the ability to avoid paying off lawsuits i. This is what people think is unfair ii. Passive (pass-thru) taxation and flexibility of a p-ship 1. Can look a lot like either a corporation or p-ship a. Easy to form, hard to run b/c very little info available iii. No size limits iv. Why people wouldnt want to form LLCs 1. Cant go public 2. If you dont need to be an LLC, then dont a. Sometimes a corporation does the job i. There are slight variations that can be beneficial to being another entity (such as 401k plans, etc.) v. Kintner Rules 1. To get rid of the Kintner rules, legislature passed the Check the box option a. You get to pick whether you will be taxed like one entity or another 2. What the Kintner rules determined is whether you were a corporation or p-ship a. Used to be that if you had three of the following four factors, you were taxed as a corporation i. Continuity of life 1. More or less saw terms of life for an old LLC or Limited p-ship ii. Centralized management iii. Limited liability iv. Free transferability of interests Limited P-ship i. What is a limited partnership? 1. General partner w/ ownership interest, but also has limited partnerships a. One or more general partners and one or more limited partners i. Rules that apply to general partners are exactly the same as regular p-ships 2. Created before LLCs a. Provided for some limited liability for people who wanted to be limited partners i. Limited partners do not get to participate in management 1. In exchange for that limitation, you have limited liability b. Created a vehicle to participate in profits w/ limited liability i. For most of the time since created until the last 5-10 were the private investment vehicle of choice 3. Even though you have both limited/general partners, you are allowed to have someone play different roles a. Although there is no reason for this, a person could be a general partner and a limited partner i. But, did make sense to be limited partner as individual and form a corporation (w/ limited partner as president) to become a general partner Limited p-ship w/ corporation as general partner 1. Creation of a limited p-ship w/ almost no liability 2. When compared to S-corp, you could have more than one class of stock, more than 75 shareholders, etc. 3. Some limitations: general partner has to control at least 1% of the company 4. Could pierce the corporate veil: shareholders can be held liable, but as long as corporation keeps certain amount of assets and acts fairly, should be fine a. You could never pierce the veil of a limited partner, but limited partner can be liable if: i. he/she acts like a general partner (participating in management) ii. or gets improper distributions from the entity (only to the extent that the distribution was improper) 7

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iii. or for your contribution (capital call provision where

limited partner has to put more money in at the request of the general partner(s)) a creditor has the right to enforce a capital call provision (as well as a trustee of a bankruptcy) so be careful w/ capital call provisions just a forcing of putting money in in installments instead of at one time 4. Re-ULPA: Revised Revised Uniform Limited P-ship Act a. Not yet adopted by the states b. One of the big arguments for allowing LLCs was that they are doing it anyways i. I.e., corporate general partner ii. Make it available to the less sophisticated person iii. Let people participate in management and not be personally liable 1. Irony is that when talking about revising the RULPA, they are talking about changing the rules of limited p-ships a. Rule still is that if limited partner participates in management, can be held liable i. Re-RULPA changes this rule, thus making the limited partner participating in management cannot be held liable b. Important Note: the law changes all the time i. More and more safeharbors have been created for limited partners 5. Kintner Rules as applied to limited p-ships a. W/ corporation running the show, no centralized management b. Also, provisions that if general partner leaves, then limited p-ship ends to avoid continuity of life factor of Kintner rules i. All this avoided w/ check the box option 6. Limited p-ships are a good option a. Good idea: keeping limited partners away from management i. Limited partners dont have many fiduciary duties as opposed to LLCs b. Easily understand and adjudicated c. Ton of flexibility i. Profits can be arranged in any given way for example 7. Interesting way LPs are used: a Family Limited P-ship a. Again, general partner is a corporation and the family members are going to be the limited partner i. Business could be anything, such as a stock portfolio doesnt have to be business activities ii. Distributions could be discretionary iii. No special rules, just a common use of LPs 1. There are tax implications 2. LPs used for estate-type purposes ii. Limited Partner distributions 1. Henkels & McCoy, Inc. v. Adochio a. Red Hawk (w/ G&A as general partners; 19 limited partners) form joint venture with Cedar Ridge to develop Chestnut Woods and separate venture, Timber Knolls, which never took off i. CR hires Henkels to do sewer work, but never pays 1. Sue RH, CW, and G&A ii. Ultimately Henkels sues 19 limited partners of RH to recover monies claiming improper distributions b/c of p-ship agreements specification for company to hold certain monies in reserve 1. Distributions are made in January, April, and July 1989 to RHs limited partners b. Why does it matter what the p-ship agreement says? i. ULPA 608(a): 1. If you take money as a distribution and you owed money to creditors, you have to give the money back, but you only have to give the money back if they catch you w/in a year 8

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a. Incentive to take money out quickly ii. 608(b): 1. If in violation of p-ship agreement, then liable for 6 years iii. Why would the company have a provision to keep a reasonable amount of money in a reserve? 1. It is probably for the protection of the managers/general partners (desire to keep money in the company), not creditors (as dissent points out) a. Debate over whether that created an obligation to keep money in the p-ship Other issue: timing of distributions vs. work performed by subcontractors i. Does entering a contract by the other partner in the joint venture create a liability for the other partner? 1. Does a deal this far away create an obligation to RH? a. The court says yes potential liability/obligation i. Off-balance sheet financing: when you have activities that do not show up on the balance sheet until these transactional obligations become due ii. ULLCA 407 1. Standard for LLCs is that distributions that render a company insolvent are improper a. Whos responsible for the improper distributions? i. People who voted for or knew the distributions in violation of 406 ii. This section gives two years, but limits who you can come after Questions i. What do you do? 1. The penalty for the limited partners was to give the money a. Yes, may be improper contribution, but have nothing to lose i. Invest money for a few years, may have to give it back only liable for what you received ii. A potential option that you cant ignore ii. How could this whole situation be avoided? 1. When setting up the business beforehandavoiding things ex-ante a. Making RH a limited partner in the joint venture b. Could make RH #1, RH #2 where Chestnut Woods and Timber Knolls monies were separate

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LLCs i. In some ways, similar to LLP, but the default rule is management by the members 1. Owners in LLC are members, not shareholders or partners 2. All the members can participate in management 3. It is a pass-thru entity where only the members, not the entity pay the taxes 4. Choice at formation a. Manager-managed i. Looks more like a limited p-ship ii. Can have more than one person or entity iii. Does not have to be a member, but may be if so chosen b. Member-managed i. Looks almost like a p-ship 5. Difficulty: Many different ways to set up an LLC a. Can make any reservations of control/power you want i. Members decide how much control the managers retain b. Big deal: P-ship tax classification 6. Question at beginning: what entity will an LLC be analogized to a. It has been a mixture to form its own distinct law ii. How do form an LLC? 1. File certificate with Secretary of State a. Must include purpose of LLC 9

i. Important b/c defines breadth of LLC and what it can do, as well defining the responsibilities of the members b. Whether member or manager managed c. Duration i. In CA, this could be perpetual 2. Veil piercing a. Can a creditor who has a claim against the LLC get to the members? i. General answer: no ii. Sometimes the veil can be pierced if the member screw up 1. A misrepresentation of capitalization 2. Deliberation under-capitalization 3. Co-mingling of funds 4. Improper distributions can be recovered b. Basically same rules as a Corporation i. But, corps have more rules, formalities 3. Some states give you even more options a. In Delaware, can create some personal liability on a limited basis, such as selecting certain members or assets not so in CA 4. Document that governs LLC: operating agreement a. No requirement that you have a written operating agreement i. If no written agreement, the default rules get filled in 5. Management a. Most LLC statutes provide that LLC managed by members unless selected otherwise 6. Voting a. Split among the states i. Voting is pro-rata (by percentage) v. pro-capita (per person) 1. In p-ships you vote per person a. B/c of unlimited liability 2. In corps pro rata iii. Who can create an obligation for the firm? 1. Actual/Implied/Apparent Authority a. Actual: who according to the operating agreement is granted power b. Apparent: who can bind the company w/out the right to do so i. Dependent on whether member or manager managed 1. Member-managed: each member has authority to bind LLC 2. Manager-managed: members to not have ability to bind LLC iv. Complaints/Misconceptions of the LLC 1. Cant do stock options a. In general, stock options are the right to buy stock in a corp b. No stock options in LLC b/c no stock c. However, you can give a person the right to purchase interest in LLC i. Give person right to purchase units (%) in LLC 1. But, still not like corps b/c in corps you exercise stock options right before a big exit event a. No true w/ LLC b/c pass-thru entity and they regularly distribute income to members incentive for employees to exercise their options i. Different incentive to exercise a little bit early ii. Employees become members and have fiduciary duties to each other that are stronger than shareholders have 2. Can you get around this problem? a. Create a different class of ownership i. Such as can only exercise at exit event b. But, has its own problems i. Public perception: stock options v. paid income how do attract employees when other small companies are providing stock options 2. Squeeze out: corp harder to squeeze out shareholders a. Corp: you can vote on who to manage 10

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i. But, no matter what protections in agreement, can still be forced out Public Offering a. Only valid concern i. True that company forming wants to go public, lean towards corp 1. Corps go public, LLCs dont ii. If start LLC, can convert to corp 1. Usually when you want to go public, want to build up assets, earnings b. Securities laws kick in when you have something known as a security i. A security is an investment in something where you are hoping to make money, but you are not running the show 1. Ex: Interest of limited partner, stock in corporation a. But, not an interest of a general partner 2. Is an interest of an LLC a security? a. Manager-managed: interest is a security b. Member-managed: in CA, not a security 3. When something is a security a. Certain procedures, disclosure and limitations provided by securities law Management a. LLC can elect executives and officers i. Issue of title, ego ii. Manager can be both manager and officer

Tax Issues a. LLC tax in CA gets high at higher levels i. Over $1 million = $6,000 ii. Over $5 million = $11,790 iii. Not an income tax, but rather gross receipts 1. Not profit, but how much comes in the door a. If small profit margin, not good to have LLC in CA i. Ex: Restaurant 6. Other Issues a. Meyer v. Oklahoma i. Can an individual hold a liquor license as an LLC? 1. Court says no ii. There are some businesses that need other licenses and must consider if law provides for LLCs 1. Important on International side a. Not all countries recognize LLCs i. Treat as corporation for tax purposes b. Not good unless country provides rights and privileges of LLC i. People value certainty over possible better results v. Allocation of Financial Rights 1. Allocate three different things: profits, losses and distributions a. Default rules provide that divisions of allocations are made pro rata (by %) i. P-ship by per capita (per person) b. Do not create a more complicated structure than necessary allocation 2. The reason in a p-ship that you have limited liability a. If liable, then all equally liable i. Thats why default rule is per capita 3. In an LLC, whatever contribution is what you are obligated to make a. But, what if more money is needed by LLC? i. Capital Call provision 1. Sometimes unlimited 2. If provide more money to where needed, in what way? a. Pro rata, etc. b. What happens if people put in more down the road v. people who dont put in money 3. The down-the-road contributions need to be provided for in operating agreement 11

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Usually comes down to what the rights of the manager a. Rights may be enforceable by creditor

vi. How can the manager be removed? 1. Majority vote of members? Unanimous? a. Points out voting structure that can be complicated if you let it i. Veto right, majority, super majority, etc. vii. Leaving an LLC 1. Many of the things we are talking about are interrelated a. Ex: Control of business related to how one would cash out of LLC 2. Some of the ways people leave: a. Withdrawal, dissociation i. Can be voluntary or involuntary 1. If we give somebody money when thy leave, how do we value what they take out? b. Transfer i. Do we allow free transferability? ii. Do we provide for distinction b/t financial and management rights? iii. Can prohibit transfer right of refusal viii. Fiduciary Duties 1. Duties of Care/Loyalty a. Question of what that means depending on structure of LLC i. What duties do members have to each other when LLC manager-managed b. Always question of what you can waive? i. Typical rule: waive specific duties, but not general duties BT-I v. Equitable a. Cites to fiduciary duties that cant be waived b. Limited p-ship buys building, takes out loans, general partner purchases the loan, forecloses on building and then buys at foreclosure sale c. Equitable says by foreclosing, acting as role of bank, not as a general partner 3. Even if member/manager has full discretion, there are still going to be fiduciary duties Management and Control a. Two things/categories to keep in mind i. Those that apply among owners/partners ii. What applies vis--vis parties 1. Who has authority to make deals w/ the outside world? a. Who actually has authority? b. Who has apparent authority? iii. In a partnership, there is an equal right to manage the affairs of the p-ship 1. Distinction b/t usual, ordinary course of business and extraordinary acts a. Extraordinary acts: need unanimous consent i. Unanimous consent gives every single person a veto right b. Paciaroni v. Crane i. P-ship races horse, horse gets hurt 1. If horse continues to race, horse could be done forever 2. 2 partners want to race horse, while 1, C, doesnt ii. Who wins? 1. Since risking entire, sole purpose of p-ship, this is an extraordinary act and thus, unanimous consent in required 2. But, every partner has right to dissolve p-ship and C is entitled to 1/3 of p-ship interest a. So, all A and B have to do is post a bond equal to Cs interest prior to the race c. Patel v. Patel i. P.V. and Kirit Patel, the buyers, contract to buy hotel from mother and father of Rajeshkumar Patel, the sellers, who has a 35% interest in the hotel 1. P.V. and Kirit were not aware that Rajeshkumar had an interest in the p-ship 2.

IV.

12

The p-ship agreement required that the son have veto power over the sale of the hotel, but the land title did not have mention of the son ii. What are the two different arguments? 1. Buyers say in unified p-ship agreement that it says who has title, which in this case is mom and dad 2. Son says that the action is not the ordinary business of the p-ship a. Cant sell p-ship w/out unanimous consent iii. You see statements claiming that the parties are the sole owners and have the authority to sell said property 1. Whatever happens w/ the son, the buyers have a claim against the mom and dad 2. The sale was not completed before this claim was filed iv. Points to note 1. Be careful when dealing w/ authority 2. You dont know what a court is going to decide a. Sometimes courts will see things differently i. Make sure contract provisions are clear and there are not conflicts ii. Under RUPA, there is the ability to file a statement of authority w/ the Sec. of State lose ability to argue apparent authority d. Zimmerman v. Hogg & Allen, Professional Association and Heath v. Craighill, Rendleman, Ingle & Blythe, P.A. i. Both involve law firms, partners, a client giving money to a partner to invest 1. In Zimmerman, Greene is give money by Holly Farms to buy KFC stock and he doesnt buy a. Argument is that firm is a law firm, not an investment business and Greene not acting on behalf of firm b. The court says firm is all-encompassing law firm and Greene was managing partner trial as to whether Greene acting on behalf of law firm 2. In Heath, Heath, a client, gives money to Clarkson upon Clarksons investment suggestions a. Heath keeps funneling money to Clarkson i. Clarkson writes checks, checks bounce b. Heath sues law firm and says Clarkson acting on your behalf c. Court says Clarkson not acting on behalf of the firm ii. Distinction: There is a difference b/t the apparent authorization of a partners wrongful act and a partners misapplication of funds received w/in the scope of apparent authority 1. No ones saying Clarkson had he apparent authority to take money and make wild deals did the firm authorize this or make it look like it did 2. Greene was trying to drum up business and create goodwill iii. Be mindful of what apparent authorities you are creating when you draft an agreement 1. What you write down what the purpose of the business is goes to define what the authority of the actors of the business will be iv. Did the act that resulted in this bad thing come w/in the scope of authority iv. All relates to what authority we give individuals to act on behalf of the company 1. You can carve out certain areas to be left to the members rather than to managers a. Big ticket items 2. What do you do w/ dissenters? a. Easy answer: nothing i. Works OK in a big operation, but not in a small operation b. How do measure how important the issue is to the person involved? c. One way of dealing with this is a buyout i. Right to buyout goes both ways ii. How do you determine the buyout? 13

a.

d.

Buy-sell agreement a. One person sets price and other person gets to decide whether to buy or sell at that price i. Incentive to create fair price access to cash affects measure and this reduces business to purely financial number Have a 3rd party to break tie i. Nice to have odd # of people on board 1. Need device for breaking ties

1.

V.

v. Problem 1. Setting up a management structure for a band a. 5 band members and band manager i. Veto right: dont want band involved in day-to-day decisions ii. Concern: what are business decisions and what is where, how and when they play? 1. Must lay out options in a way that makes clients realize ramifications 2. For every additional involvement, there is an additional administrative cost Financial Rights a. Difficult to figure out system of compensation that works in all situations b. Financial structure of p-ship i. Default: equal distribution 1. Most states have pro rate for other biz orgs ii. No statutory right to distributions 1. Should make sure provision in PA that distributions will be made iii. No extra compensation for additional money and services c. What do people put in as capital? i. Money, loan, property (issue of use/ownership) 1. Anything of value a. Gives you p-ship status, membership ii. Services are not compensated, as a default, b/c difficulties arise d. Alternative Compensation Arrangements i. Attempting to minimize costs 1. Shirking 2. Risk bearing 3. Administration costs 4. Opportunism e. Financial Arrangements, not talking about salary i. Talking about sharing in profits and losses f. Starr v. Fordham i. Partner leaves firm, how much should he be paid? 1. Interesting things happen along the way a. Starr says to Fordham that he is not good at generating business and Fordham says no problem b. However, PA says that authority to determine partners share is solely in the hands of the founding partners i. The partner tells Starr: take it or leave it 1. Not an adhesion contract if party actually has the choice to leave it 2. Even if founding partner decides shares at the end of the year, there are still fiduciary duties a. There is a self-interest here and b/c of this, there is a fiduciary duty i. The court says the plaintiffs sophistication doesnt relieve the partner here ii. What do we learn? 1. There is an alternative: we dont need a formula, can leave it to a persons discretion a. But, if left to person to determine, subject to fiduciary duties i. However, fiduciary duties is a very loose term ii. Advice given will depend on the situation at hand, on who you are giving advice to 1. This why people leave firms after they get their bonus 2. Whats the bonus for? 14

a. g.

For rewarding past work (compensation), or incentive to stay with, future work

Capital Accounts i. Heres what it means to have a capital account (always have for p-ships and LLCs) 1. An accounting measure of what your share in the firm is (a measure of the money you contributed) a. Can move up or down i. If profits, increased by share ii. If losses, decreased by share iii. If distributions, decreased by share iv. Capital = contribution + profits losses distributions b. Important b/c of dissolution what the firm owes you or you owe the firm c. Important b/c in a pass-thru entity, you are allowed to deduct losses to the extent of your capital account (deduct losses to the amount of your exposure), except not true in p-ships and some exceptions for loans d. What does it mean to have a negative capital account? i. Assume I put in $50,000, big loss, now capital account is -$25,000 1. In an LLC, it is not going to happen, but in a p-ship you can have a negative capital account ii. Problem is that when you leave p-ship you have an obligation to restore this capital account to zero 1. Why do you have this obligation? a. PA b. IRS i. b/c you have taken tax deductions on money you havent lost ii. Many times when a person leaves a firm, we look to what they are entitled to by looking at their capital account 1. You can draft provisions in the PA to create an incentive for people to stay 2. Darr v. D.R.S. Investments a. Plaintiff leaves p-ship and PA says you get capital back plus/minus any debit/credit in pship account i. Plaintiff sues and Defendants counter-sue for negative balance in capital account 1. When we do accounting books, we dont record the appreciation of capital on the balance sheet Plaintiff argues that he wants his share a. Court says just b/c you made such a bad deal doesnt mean contract was unconscionable 2. Court says we cant rewrite contract b/c it is a bad one or not advantageous 3. What the court does say is that the p-ship switched accounting processes, from cash to accrual, in midstream a. Cash method: when you get it, record it b. Accrual method: includes things in the pipeline such as money you owe and money owed to you i. Firms use accrual method to account for more losses tax purposes 4. Valuing a business a. Liquidation value: how much firm is worth after selling off assets and settling debts b. Going concern value: what is this company worth as an ongoing business 3. Kessler v. Antinora a. Point: people enter into agreements w/o understanding the what ifs b. They enter into arrangement and agreement says nothing about money i. Agreement says Kessler puts up money, Antinora builds house, profits split 6040 ii. Kessler sues, saying we are partners, we should split the losses 60-40 iii. Court says Kessler puts in money, Antinora puts in money Kessler loses money, Antinora losses labor and thus, Antinora doesnt have to put in for losses 1. How much money did Kessler put in? say $400,000 a. How much was Kessler risking? 15

i. How much money did Kessler prepare to lose?

original amount put in or unlimited amount? ii. So, court gets to fair result, but may not be legally sound How about if Antinora, who did perfectly competent work, did better work, the house would have sold more? a. Just a problem that comes up when you have unequal contributions i. You have to think of the ramifications Note: Antinora did not have tax consequences (all work pre-tax) and did not have to restore capital account

2.

3. 4.

VI.

Wall v. Siegel a. Bank loans money to limited partnership i. General partners guarantee loan for approximately $450,000 1. Case is just talking about relationship among three general partners a. What are the general partners responsible for? b. General partners have 30% i. Wall has 15%, Feldstein and Siegel have 15% ii. However, that is not the way they vote one vote each 2. The court says that when there is nothing to the contrary written, we split up losses the way we split up profits 3. Other weird issue: Feldstein and Siegel have already settled with the bank a. How do only some partners settle when all partners are jointly and severally liable? b. But, Feldstein and Siegel could have owed Wall contributions if the court found so, even though they settled 4. Point of trial court decision (which appeals court reversed): Courts dont understand p-ship law a. Even more reason to write it into the PA express provisions that prepare for all possibilities Partners Vicarious Liability a. What individuals are liable for and how to get to these individuals i. Thompson v. Wayne Smith Construction Co., Inc. 1. Vicarious liability not always as easy to do in practice as it is in theory a. Sometimes difficult to chase down partners b. Why would you get a general partner to make a guarantee? i. Short answer: easier to collect on guarantee 2. Mr. Smith sues partners and p-ship (Thompson et al.) in South Carolina and gets a judgment for $107,000 a. Court says cant sue partners not a party to contract, issue of suit b. Cant get money from p-ship and goes to Ohio gets about $2,500 from p-ship and he sues Thompson i. The Supreme Court of Ohio says the partners liability is 1/3 each 1. Dont say joint and several, just limited to 1/3 share c. Meanwhile, in Indiana, he is suing Thompson i. The Supreme Court of Indiana says that we are not looking at Ohio, but rather look back at South Carolina 1. Thompson says good, they dismissed the case 2. SC of IN says not entirely true b/c Smith has exhausted p-ship assets, now he can sue individual partners a. South Carolina says case against individuals wasnt ripe yet 3. If the case is started in Ohio, a totally different result is reached a. Forum shopping can actually have an effect in cases ii. How to reach individuals that this case points out 1. Show separate contract 2. Show p-ship assets exhausted, or 3. P-ship insolvency 16

Three different forms of liability i. Joint and several liability w/ exhaustion requirement ii. Joint and several liability w/out exhaustion requirement iii. Personal liability, but only for your personal share (small minority of states approach) iii. Contract Creditors v. Tort Creditors 1. Contract Creditors have the ability to contract provision regarding liability 2. Tort Creditors dont have the ability to contract for provision, so joint and several liability In California a. Partners are jointly and severally liable unless contracted around i. A judgment against a p-ship is not a judgment against an individual partner 1. Ways to hold partners liable a. Have to show you tried to collect and couldnt b. The p-ship is a debtor in bankruptcy c. P-ship agreed it didnt have to exhaust its assets, or d. A court grants permission b/c it is too hard to collect otherwise and unfair b. If one partner is found liable, can get money from other partners through suits for: i. Contribution 1. Pay part of the judgment held against me ii. Indemnification 1. When youve paid out money and you seek reimbursement c. Why have requirement to exhaust p-ship before letting creditor go after individual partners? i. Case of being able to contract for, knowing what one gets into 1. Tort creditors are different d. If one partner has an individual creditor, that creditor doesnt get choice of proceeding against individual partner or against p-ship assets i. Can only get what that one partner can get 1. If you let creditors go against individual partners from the beginning, then that creditor can jump ahead of the creditor of the individual partner in debt hierarchy a. Way to manage, consider competing interests 4. Agreements dont always cover everything a. You cant always bind creditors i. Outside people who are not a party to the agreement 1. Creditors can contract directly with the partners b. When an individual files for bankruptcy, person is given automatic stay i. Avoidance of claims for a time c. However, if p-ship is bankrupt, can go after individuals i. But, not necessarily true that if individual bankrupt, then you can go after p-ship ii. LLP Limited Liability P-ship 1. A general p-ship where the personal liability of the partners is limited a. Revolves around idea that if not involved in transaction, then not liable i. If there is liability on a partner because of work through p-ship, then partner will seek indemnification from the firm ii. If liability on p-ship and partner caused liability, then p-ship will look to contributions from the partner 1. It is possible that in a firm w/ say, three or four partners, that one partner will seek indemnification and if the p-ship didnt have money, it might seek contributions from other partners iii. Regional Federal Savings Bank v. Margolis & Common West Office Condos, Ltd. v. Resolution Trust Corp. 1. In Margolis, four partners took out a loan w/ personal guarantees on the first 30% of the debt a. Why would the bank want a guarantee on the first-third of the debt? i. It means that well promised you get paid the first 1/3 of the payments, but after that the guarantee is meaningless 17 3.

a.

1. Bank will be able to collect on the assets negotiation to make bank

fell better 2. In Commons, a p-ship is borrowing money, but a single partner, in his individual capacity, personally guarantees 25% of the loan a. What is really guaranteed here is the last 25% i. This loan cant go away like the guarantee above b. Bank sues p-ship, but they cant pay, so then they go after the partners i. Partners say you cant come after us b/c we have already satisfied our guarantee 1. That guarantee modified your right to come after us personally a. Court says the deal was modified i. But, after bank collects, still deficiency ii. Court says guarantee of individual partner, as a person and not in his capacity as partner, is supplemental to the p-ship guarantee 1. When the bank made the deal, what do you think they understood? a. Most people who make these loans dont read the documents c. A guarantee does not provide an exhaustion of p-ship before going after partners 3. What do you do in these situations? a. Do you clarify the guarantee in the document or not? b. Or, do you say that if I bring that up, the bank might disagree with me and clarify it in the other direction? Do you take that risk? i. Chasalow: I like certainty and I like my clients to have certainty 4. Indemnification a. When should indemnification happen? i. Some are easy, some are not 1. Ex: Waiter is angered by customer, is off-duty and trips customer on street 2. Ex: Waiter throws coffee in face of customer who he has a personal vendetta against the customer a. More likely to be liable? 3. Ex: Partner throws the coffee a. P-ship likely liable b/c rep. of p-ship on premises in course of duty i. P-ship can look for contributions by partner 4. Ex: Partner takes out advertisement paying by personal check, but other partner says will not pay you out of p-ship funds b/c of disagreement over decision a. Working in scope of employment, so should be able to get indemnified b. Imagine not actual authority, just apparent authority i. Tough situation no question that I can create a liability, but could be the case that I may have to contribute for a portion of the cost b. Thats why there are indemnification sections in Pas i. But, there is this entire gray area concerning scope of employment, duty ii. General rule: never get indemnified for an intentional wrong, but what about negligence? 1. Depends on authority and duty P-ship Property: Transfer of Rights a. P-ship property owned by p-ship, not be partners i. What you own as a partner is a piece of the total business 1. Defined by agreement and statutory laws that apply to specific entity ii. What rights do you have if you are a partner in a p-ship? 1. Two pieces a. Financial interests/rights: Interest in profits, losses, and distributions b. Management interests/rights: Voting i. In general, financial rights are transferable and management rights are not (at least not w/o the consent of the people involved) 2. How these rights come up a. Creditors due to bankruptcy b. Death 18

VII.

iii. iv.

v.

vi.

vii.

c. Creditors based on p-ship ownership d. Sales/Transfers 3. Person who gets interest is a transferee, not a partner a. None of the management rights or fiduciaries flow to a transferee b. Only have the right to passively receive what the p-ship might choose to distribute i. If in an at-will p-ship, can petition a judge to dissolve a p-ship 4. What about limited p-ships? a. General partner has same rules applied b. A limited partner really only has financial rights, so who cares Top five issue when starting a business 1. Big issues that totally depend upon your client Sunshine Cellular v. Vanguard Cellular Systems, Inc. 1. Sunshine has three partners and one partner wants to sell p-ship rights a. There is a right of first refusal in the PA and it is not exercised b. A right of first refusal is that before you sell, you have to offer it to me first i. This right can be attached to many, many things ii. Ways to do it 1. Match offer 2. Or, no outstanding offer c. What happens if the individuals dont exercise their right of first refusal? i. Vanguard says since you didnt exercise right, you consented to sale of all of partners rights 1. Two other partners say only financial rights, not management rights 2. Court agrees with partners if you dont say anything, then default rule applies a. Requirement of unanimity is implied unless expressly contracted against Mechanics of transfer 1. Partner sells financial interests to transferee a. Transferee can be a foreclosing creditor b. Law says p-ship can pay money to transferee that it could have otherwise paid to the old partner i. In theory, the old partner is owed fiduciary duties and may be able to vote 1. Transferee may force old partners hand ii. More common, p-ship says sale of p-ship interests foregoes right to vote 1. No fiduciary duties, but partners cant commit fraud 2. Clever partners can limit money going to transferee Transfer Provisions 1. Issues become more and more important when only a few people own interests 2. Some agreements require spouse to sign b/c of possible transfer of rights to spouse 3. Transfer provisions dont have to be the same for everyone a. Can be one way for one group, one way for another 4. There are ways to get rid of the money, provided that the selling partner is still being dealt with 5. Can be provision that nobody leaves or transfers Venture Capitalists 1. VC firm decides to raise money a. VC firm usually a limited p-ship i. Has general partner who is management company and limited partners who are investors b. VC takes a management fee (% of assets) & also will take a % of the profits c. Investment is made by way of a capital contribution i. Money put in over time whenever there is a capital call ii. If I buy your interest, I am agreeing to put in a certain amount and I get what you have already put into the company iii. A secondary market developed low ball for money already put in and pay remaining capital call 1. The transferor is going away from investment and losing what was already put in d. Some VCs are LLCs i. Still have management company and investors are members 19

1. b.

Might be more difficult to transfer rights b/c members typically have management rights

VIII.

Non-voluntary transfers i. Not a separate topic the way you treat voluntary transferees is the way you are going to have to treat involuntary transferees ii. Hellman v. Anderson 1. Two partners, Hellman being one, Holstrom the other, & Hellman gets into trouble w/ creditors a. Judgment against Hellman by creditors i. All Hellman has is an interest in the p-ship ii. So, you get a charging order right to get money that would have flowed out of the p-ship that would have gone to Hellman now goes to the creditor iii. Transferee gets financial rights and no management rights 1. Minor differences w/ charging order a. Transferee can go to court to force sale b. Hellman objects to foreclosure on partners interest i. Argument that this messes up the interest that one already has 1. Could dissolve p-ship and reform ii. Even if creditor becomes transferee, they do not have fiduciary duties or rights still a lot of leeway for p-ship to do what it wants c. Key questions: would foreclosure unduly burden the p-ship and dilute partners incentives in a way that hurts the p-ship? i. Burden on defendant but affects plaintiff ii. Transferee cant get more than what it is entitled to iii. Marriage Exception 1. Exception is that there a times when a spouse who becomes a creditor of a partner can collect more than that partner would be entitled to receive a. If two people split up, divorcee gets part of goodwill of business b. If looking to bind spouse, must have him/her sign PA c. Issues i. Who can sell? 1. How easy to sell rights? ii. When can sell? iii. To who can sell? 1. What rights will they have? 2. Limited #? 3. Think about involuntary transfers to creditors iv. Final note: remember that it is ok to say absolutely no transfers Application Real Life Examples a. Fitness Facility Hypo i. Background Facts 1. Client, Frank Fitness, wants to take over gym from acquaintance Bob a. Bob owns corp. & in personal bankruptcy i. Important thing to know about bankruptcy is that sometimes its rules override other rules, so must look into ii. Why dont I just buy the corporation from Bob? 1. Dont want to assume liability of corporation 2. Also, stock purchase has to be approved by bankruptcy court 2. Already negotiated new lease for property terms agreed, not signed a. Lessor has tenant who cant pay rent, so may be willing to make a deal 3. Have obtained equipment from Bobs creditors and agreed to hire Bob as independent contractor a. Creditors may be willing to make a deal too b. Bob willing to sell at good price b/c Bob gets a new job i. Also, the face of the gym will not change being that Bob will be around 4. Have obtained financing from friend Elaine $25,000 for 90% stake a. Once she has been paid $25,000 then 20% stake 5. Also own another gym as general partner and Elaine as limited partner 6. Must be fair-deal, not too one-sided ii. What entity should be formed? 1. List choices 20

2.

3.

a. P-ship b. Limited p-ship c. S-corp. d. C-corp. e. LLC Eliminate things a. Easiest to eliminate is a p-ship i. No limited liability b. How to eliminate others depends on circumstances i. S-corp. 1. Allocation of profits and losses based on ownership 2. Easiest way to eliminate: one class of stock a. In this case, it seems the structure desired is going to two classes of stock ii. C-corp. 1. Double taxation 2. Gym wont go public iii. Does this need to a pass-thru entity? 1. Probably not, but good reason to iv. Keep in mind that there is no exact right answer c. LLP & LLC both good choices i. Look to whats best for client and friends ii. Limited partnership would have Elaine as limited partner and Frank will be general partner individually or as a corporation 1. But, limited p-ship not the choice because Elaine is putting up a lot of money, probably wants more control than limited p-ship could offer and Frank can still have a lot of control in an LLC Structure of LLC a. Two different categories: management and financial rights i. Financial rights 1. 90% dropping down to 20% ii. Management rights 1. What are we going to do here? a. What does Elaine care about? i. Elaine doesnt really care about the day-to-day operations 2. Make Frank the manager, Elaine a member a. Manager-managed LLC b. But, can carve out whatever rights Elaine wants c. Day-to-day would be Frank, but everything else would be Elaine until she gets her money back d. Two classes of stock: A and B i. A: Elaine 90%; Frank 10% ii. B: Frank 80%; Elaine 20% iii. Could have voting rest in class A until paid off or could give A veto rights e. Could have one class of stock and treat Elaines investment as a loan iii. Want to make sure Bobs creditors wont be able to come after the business 1. Could be argument of disguised sale a. But, is it one that passes muster? iv. How is Elaine going to put her money in? 1. At once or over time v. Fiduciary duties 1. Should this opportunity be offered to partners from other gym before they invested first?

b. Berringer Products case study

i. Three players 1. Richard - $600,000 21

2. 3. 4.

a. But, also Richards family - $500,000 Scott - $200,000 Barry - $75,000 Seller wants $1.25 million a. Driving force behind deal was the change in the tax law capital gains tax was going to expire i. Business decisions are based upon tax law all the time b. Purchase price must be $1,437,500 Financial rights a. How do we split up the rights? i. Among the three players? ii. For Richards family? 1. Want liquidation preference and preferential distribution of gains a. Liquidation preference means they get their money out first i. Going to have more than one class of stock So, no S-corp. b. Distribution rights how should they be split up? i. Equal or not? ii. Can use salary as a form of distribution can make argument of wearing two hats (one as investor, one as manager) iii. Part of the allocation of financial rights should be related to management position iv. Could structure as contributions treated as loans to company or could distribute first profits pro rata and thereafter, divide all money equally c. Preferential distribution of gains for Richard family probably means they want to get paid first i. You might pro rate the money like 50 to players, 50 to family ii. If you are giving them faster payback scale, then once paid back, your % might shrink iii. We might be able to allocate a greater % of the loss to Richards family Management/Control a. Issue b/c how much each player is putting in as well as Richards family again i. Family wants certain voting rights 1. Usually management decision is wholly separate from financial rights, but related in this case (interchange) 2. How do we divide the voting rights? a. Could offer a veto right Why did I not talk about forming a p-ship? Answer: Liability a. Especially when some of the tubing is used for nuclear materials b. Also, financial liability c. Employees i. Injury ii. Union Stock Options a. Do I give employees stock options? Financing a. Loans i. Guaranteed ii. Distributed equally or pro rata 1. Will affect profit distribution Transferability, Ending of entity, New players, Exit strategies, etc. a. How do handle someone leaving? i. Do you handle different players differently? b. On flip side, can you force someone out? 22

ii. Issues 1.

2.

3.

4. 5.

6.

c.

d.

e.

i. Can you buy their stock? At what price? What if someone wants to sell their stock? i. Can they sell to a 3rd party? 1. Is there a first right of refusal? ii. Do you want a tag-along right? 1. A tag-along right is that a player can sell an amount of stock equal to what another player sells or the other player sells less of his/her percentage How are you going to treat death? i. Who/how will benefit? 1. Immediately or accrue over time? ii. What should the measure be? iii. Will ultimately depend on characteristics of clients Whats your exit strategy? i. What is the long term plan to get money out of the business? 1. Might be operate forever, go public, or acquired by another company ii. Converting entity 1. How to apportion shares? a. By contribution or percentage? 2. What if you have different classes of shares? a. Or, in p-ship, limited partner vs. general partner

IX.

Dissolution and Dissociation a. What happens if someone leaves the firm? i. Under the UPA, if anyone left p-ship that ended the p-ship, but that end was fictional 1. Dissolution meant a demarcation point separating one set of partners from another a. Did the p-ship end or continue? ii. Under the RUPA, they created the word dissociation 1. Dissociation means that if someone leaves the partnership a. Also, withdraw is also a word used iii. Important thing: what happens when someone leaves? 1. Is it a p-ship at-will or for a term? a. When does the leaving partner get to get their money back? i. At-will: when leaving ii. Term: when term up or not hardship for firm to give money back iii. How much do they get? iv. Whats it based on? v. How long do they have to wait? b. RPA 701: Can have a wrongful dissociation i. There is a punishment for this 1. May not get anything at all a. Under old provisions, no goodwill and liable for damages c. Page v. Page i. Story of two brothers who have a p-ship that is a linen supply business 1. Both put in $47,000 and business doesnt go well the first few years 2. All of the sudden, an air force base moves in near business 3. One brother wants to dissolve p-ship a. This brother is the managing partner and has a separate company that holds a note for $41,000 from the p-ship i. Liquidation other brother doesnt get anything ii. Furthermore, other brother doesnt know how to run business ii. Argument: P-ship for term until we make our money back 1. Lower court buys this argument really trying to prevent injustice 2. Appeals court does not buy argument not a term or every p-ship would be for a term b/c no one plans to lose money a. Can dissolve p-ship at-will b. However, even the power to dissolve has the be exercised in good faith i. There are fiduciary duties involved in the dissolution of an entity 23

2.

ii. This puts a limit on the rule that any partner can dissolve a p-ship iii. Fiduciary duty does not leave when firm is dissolving difference b/t corporate opportunity and direct competition iv. You can contract around specific fiduciary duties Conflict b/t continuity and liquidity & Valuation a. P-ship debts i. Individual partners have to pay after p-ship is dried 1. Proportion can be agreed to in PA or in line w/ pro rata share of losses b. Capital accounts i. Must restore capital accounts to zero balance when business ends c. How easy is it to get money out vs. how much are we going to let the leaving partner disrupt the p-ship? i. Bias in p-ship law to let partner leave b/c there is personal liability ii. Bankruptcy causes a lot of issues iii. Liquidation means sell all the assets Buyout is different 1. Can sell as going concern or piece meal a. An operating business is a going concern b. The parts of the business are piece meal d. How do you decide what a leaving partner gets? And how do you measure it? i. Can be agreed upon when business is forming ii. Every business is different iii. Valuing a business 1. One way: what an outsider would pay a. Is As share worth a certain % or something different? i. Do we look at business at whole or should we apply something like a minority discount? ii. Since not majority (lack of voting power, etc.), minority discount discounts what your share is worth iii. Should a control premium be paid to the majority? 2. Goodwill a. When trying to measure, it is very intangible, so difficult to measure b. Could be value in firm member, firm name c. How should it figure into the share paid? i. It does figure in the leaving share unless there was a wrongful dissociation ii. But, should not rely on default provisions d. Spayd v. Turner, Granzow & Hollenkamp i. Tension b/t old-line law firm that does not advertise vs. law firms being operated more and more like businesses nowadays ii. Ultimately, the court says that law firms and becoming more and more business like iii. Not against public policy to include goodwill absent a provision in the PA, but here there is a provision in the PA iv. The definition of goodwill is: the advantage or benefit, which is acquired by an establishment, beyond the mere value of the capital, stock, funds, or property employed therein, in consequence of the general public patronage and encouragement, which it receives from constant or habitual customers, on account of its local position, or common celebrity, or reputation for skill or affluence, or punctuality, or from other accidental circumstances or necessities, or even e. Duties upon leaving i. Leaving partner is no longer liable for debts incurred after dissociation date 24

3.

In theory, leaving partners share should account for outstanding liabilities 2. But, the creditors arent a party to PA and can seek liabilities for debts incurred before dissociation date a. Leaving partner could later seek indemnification 3. New partner is only liable for debts incurred after joining firm a. Except, capital contribution may be used to pay old debts 4. One exception: If creditors dont know partner has left firm, they may reasonably rely on leaving partner and he may be held liable apparent authority ii. When somebody leaves, what happens to them? 1. They will receive some payment a. If paid right away, the ongoing relationship will end b. But, sometimes paid over time and there is an ongoing relationship b/t partner and firm i. Are there fiduciary duties owed to this leaving partner that is like a transferee or assignee? may owe some limited ones f. Tax consequences i. Depending on how buyout is structured, different tax treatment 1. If partners interest liquidated by the firm, then firm gets deduction 2. Generally capital gains tax ii. Know that it is out there, so that this issue may be addressed g. Involuntary dissociation i. Something that needs to be addressed in PA 1. Still duties of good faith a. Cant just kick person out of firm for bad reason i. Can do w/ no reason or good reason, but not bad reason 2. Can have different standards for voluntary/involuntary dissociation a. But be really, really careful b/c it will put greater scrutiny on expulsions h. Calculating Interest i. Generally, you individual interest 1. Which would be % of firm (assets liabilities) ii. Star v. Fordham 1. How do you value a work-in-progress? a. Firm says is to be set off against liabilities b. But, firm says big liability is lease i. However, that is a future liability that is not occurring currently ii. Firm says if we liquidated lease, would owe entire amount today yet, you have incurred the lease when you use the space iii. Problem is this lease accounts for liabilities, but not for future assets Putting together a provision for when someone leaves a. A trigger an event occurs & then based upon that trigger, there is a consequence i. A trigger doesnt have to be an outside event 1. Can be action by partner, board, or simply that happens ii. You have to set up consequence 1. Balancing right/desire to be bought-out vs. a need for continuity a. In most business setups, there are different ways of achieving the same goal 2. One thing to look at: does dissolution produce a different result then withdrawal? a. You can dissolve one entity and start another without some members, but it will depend on how a court determines are your motivations 25

1.

3. All factors are dependant and cannot be looked at alone expulsion,

withdrawal, transfer of rights, dissolution Provisions in a PA i. Dissolution Events definition 1. A trigger a. Death, bankruptcy, disability, etc. i. Definitions can be difficult ii. Optional Buyout of Membership Interest 1. Right to buy a. Right to buy any or all of leaving partners interest 2. Closing of purchase of withdrawn members interest 3. Capital account; undistributed profits 4. Purchase terms varied by agreement iii. Determination and Payment of Purchase Price 1. Determination a. Sample agreement had original agreed upon value that could changed each year thereafter 2. Appraisal a. Under certain conditions, appraisal might be appropriate i. Fall-back plan b. How appraisals work i. Common for each side to pick an appraiser and have a tie-breaking third appraiser if too far apart in # ii. Sometimes to come up w/ that #, the company provides guidelines Different details into how we calculate the value of the company 3. Payment of purchase price a. Lump-sum vs. installments 4. Payout provisions a. Return on partners capital accounts b. Return on partners share of receivables and work in progress c. Current years profits plus x times the partners share of the firm average annual earnings for the last y years d. X times the average annual distribution to the partner over the past y years e. The price determined by the partners or, if they cannot agree, the last agreed valuation or per balance sheet f. Appraisers determined value g. Price 3rd party willing to pay iv. A good attorney sees a lot of alternatives 1. Pay attention to how courts have construed/misconstrued past agreements Expulsion Involuntary w/drawal or buyout a. CDMP v. CDG i. CDG fails to fulfill capital call and claims PA provides that not fulfilling capital call, means forced withdrawal from firm 1. If someone breaches the agreement, then they can be expelled 2. Problem: Pay or walk provision in this case a. Only works if business is on upside, but when losing, not a punishment at all b. Is pay or walk an exclusive remedy or one punishment in addition to damages which are piled on top court says exclusive remedy c. You need to think about how things are going to play out 3. Partner will still be liable for the debts pre-expulsion or withdrawal b. Hypo: Roomates i. Four bedroom house to be bought by three roommates 1. All cash 80% loaned, 20% of own 2. Plan to rent out fourth bedroom to cover expenses ii. Issues b. 26

4.

c.

Gender a. Men and women may have different preferences 2. Cleaning/Maintenance 3. Capital Improvements & Repairs 4. Noise/Disturbance 5. Expenses a. How to split, who covers what, etc. 6. Financial a. How much is our mortgage? i. Can then set rent for roommates and outside roommate ii. Can also determine how much over mortgage we need to collect Budget b. How much to sell house for 7. Indemnification/Liabilities a. 8. Allocation of space rooms 9. Picking a roommate a. Should everyone have to agree? i. Could do majority, unanimous, veto rights, etc. 10. Someone moves out - Choices a. Buy-out i. Who decides? Person moving or persons staying ii. What is the price? when is it fixed (what date)? b. Responsible for share of mortgage (could sublease w/ other roommates having reasonable veto right) c. Sell to 3rd party 11. How do these issues get resolved? a. Negotiation b. Set default/ground rules c. Voting i. Can limit to certain issues d. House manager iii. Big point of exercise: You already know all the issues you are learning informal considerations Cadwalader, Wickersham & Taft v. Beasley i. Beasley, partner at Palm Beach office, was going to quit, but before said anything, firm was closing office and offered Beasley transfer, but declined ii. Suit for damages for forced expulsion when the PA didnt have an expulsion provision 1. Need expulsion provision 2. Could terminate firm, then reform a. but, must do for legitimate business purpose and not for personal reasons i. Must look at emphasis on how court will look at it ii. Still fiduciary duties iii. Default expulsion hard standard b/c some wrong, fraud has to be done 3. Beasley gets money as if firm dissolved, plus punitive damages

1.

X.

Limited Partnerships a. Before LLCs, the entity to use for private investments i. W/ corporation as general partner, creation of a limited liability entity 1. Anybody could be a general partner or limited partner a. Must be at least one of each b. Management and Control Limited partners cant participate in management i. If they participate, they lose status and expose themselves to liability ii. Luddington v. Bodenvest Ltd. 1. You have a bad general partner who likes to take money from the p-ship Granada, Inc. a. Larson, CEO of Granada, sucks out money via loans 27

b.

c.

i. Foothill Thrift loans to Granada w/ security interest being the land owned by the limited p-ship 1. Luddington had security interest, but second-in-line to bank Why is this a hard case? i. Luddington wins b/c bank didnt make loan to p-ship made to Granada 1. Larson decides what Bodenvest does a. Further, you dont have to question if money for p-ship purpose b. But, the bank still makes the loan to Granada and not Bodenvest ii. So, what is the problem here? 1. There is no benefit being shown to the p-ship self-dealing a. When someone is self-dealing, they cannot approve themselves a disinterested party must approve i. Need somebody to sign off on it, so the bank should have made a two-part check (written to Bodenvest and Granada) ii. Bank could have also classified as money used to pay Larsens salary iii. Ratification is difficult b/c so many limited partners difficult to all get on board There are some that think this case would have been different if general p-ship or LLC i. Belief that limited partners are more protected b/c of lack of control ii. Question of authority 1. Did limited partners give Larsen apparent authority?

c.

d.

iii. Gast v. Petsinger 1. Suit claiming limited partners, Garwin and Apt, participated in the business a. Court says question of fact and sends to trial court b. Control rule i. If participate in control, then lose status as limited partner 1. But, this has been whittled down considerably 2. Doesnt apply to LLCs, so why apply here? a. Does it make sense to take away limited liability in world of LLCs? iv. Fox v. I-10 Ltd. 1. Fox is a limited partner who keeps getting pressured into higher capital calls which are done by amendment to the PA a. Pay attention to the provisions in the PA that address amendments to the PA i. Not unanimous vote in this case, only majority v. There are still some restrictions on the transfer of management rights 1. Little left over since Kittner rules vi. The rules that govern general partners are just general p-ship rules w/ few exceptions 1. Issue of when general partner leaves a. How much to pay? b. Can we fire? i. Goes to general partners power 1. More expansive than members power in LLC 2. Publicly traded p-ships a. If a limited p-ship goes public, then it is taxed as corp. no more pass-thru status Why use limited p-ships rather than LLCs? i. You have a truly passive investor and you want to avoid piercing the veil issues ii. You might be dealing w/ international issues 1. Some countries dont recognize LLCs iii. Weak point: in some states LLCs cant hold certain licenses iv. You might want to keep the limited partner passive v. There might be subtle tax differences 1. Important on smaller businesses Family Limited P-ships i. Sometimes, organizations are used for non-pure-business purposes ii. This is a quasi estate planning tool 28

XI.

Funded w/ money from the wealthy parents The kids are given a share in the company through ownership as a limited partner a. Rather than valuing the limited partnership interest at what its worth, the shares are worth less than a corresponding contribution b/c of limits on control of LLP i. Thus, you are taxed less ii. LLPs are used to avoid taxes 3. General partner is usually a corporation a. Trusts or parents could be owners of corporation iii. People get carried away 1. Family Limited P-ships becomes just like a trust a. You must have sometime of business operation going on i. Otherwise, looks like a sham, which it is iv. Ways to set up to avoid IRS 1. Leave enough money to live on so no dipping into assets for personal expenses 2. Run the p-ship w/ business purpose a. Not just to avoid taxes 3. Legitimate reason to pool stock in business a. Such as better investment-management service 4. Keep bank accounts separate from personal accounts Limited Liability P-ships (LLPs) a. WILL NOT BE TESTED ON FINAL EXAM b. Like a general partnership in fact, is one i. All the rules of general p-ships apply to LLPs, except for a few minor rules relating to vicarious liability 1. Creditor can only get the assets of the partner who committed the wrongdoing a. In tort, must be negligent to be held liable b. There are some states that limit personal liability for contracts i. CA being one of them ii. To become LLP, simply file papers with Sec. of State 1. In CA, the only entities that can become LLPs are: a. Accounting firms b. Law firms c. Architecture firms 2. Some states will let anybody be an LLP iii. If you have a choice of being an LLP or LLC, pick the LLC 1. In an LLC, there is no liability 2. In an LLP, you can limit the liability, but still liability exists a. Professional firms cant be LLCs in CA iv. Default rules are RUPA c. Nuances i. To convert, probably required unanimous vote 1. After convert, it is called registration a. After registration, limited liability i. Contractual obligations before registration are full liability ii. Problems/wrinkles 1. It shifts the risks to partners in higher liability areas a. There are areas that get sued more than others b. Higher risk person wants more money kept in company and less distributions i. Also, wants to pay off creditor that they are at risk first c. Indemnification - When do we pay off someone for a claim they paid? i. What are the contribution requirements of that partner? ii. When do I require other partners to contribute money for expense of company or indemnification for partner? iii. Is it possible for a creditor to say I have subrogation rights? 1. Which means I can stand in for firms and call for contributions d. Balancing act b/t protecting high area risk partner and preserving limited liability for other partners 2. What happens if there was malpractice while general p-ship, but injury occurred after conversion to LLP? a. Issue of fact 3. Choice of Law questions 4. Supervisor Liability 29

1. 2.

5. 6. 7. 8. 9.

When is a supervisor liable for negligence committed under supervisor? i. Different from state to state 1. Some states say if supervisor, then liability 2. In CA, youre only liable as supervisor if your supervision was negligent 3. Drafting around liability doesnt really say much a. Who has the power? Veil piercing issue a. Capitalization issue: did we have adequate capital to pay claims or did we leave empty shell? By the time you are going after partners personally, the firm is gone a. Issues really become important if firm in financial troubles Desire to pay off recourse debts over nonrecourse debts a. Recourse debts mean personal liability Still have fiduciary duties a. Wrinkles because of distributions How do deal w/ an employment discrimination claim? a. Hasnt been resolved i. MA: possible to hold all partners liable 1. Question of what wrongdoing needs to be shown a. How much wrongdoing is necessary to get to partners?

a.

d.

XII.

LLLP i. Limited Liability Limited P-ship 1. Doesnt exist in CA 2. Limited partners and general partners a. Possible to make general partner an LLP i. So that the general partner can be an LLP which will have those limits of an LLP ii. Preference is to have corp as general partner SpiderWeb Hypo a. Part I i. Client A starting Internet Co. 1. Innovate software program that attracts customers to websites 2. Inventor B has designed program and website a. Other programmers could take a year and $300,000 3. Needs $50,000/mo. for 24 months a. After 24 months, company will generate $100,000/mo. in profits for at least 5 years b. A only has $250,000 at present ii. Picking an entity 1. Rule out: a. P-ship b. S-Corp. i. Need different classes of stock 2. Questions: a. Pass-thru taxes desired? b. Goal: do you want to go public? c. Is investor wanting to be more involved? i. Might rule out limited p-ship d. Are there stock options? iii. Deal to investor B 1. Program worth 1-year and $300,000 2. What types might we offer to B? a. Flat Price i. Question of ongoing support b. Equity c. License i. Royalties d. Salary 3. Probably going to want B more involved in business a. What salary are we going to offer? b. Do we want to give equity? 30

4.

c. Anything up front for the property (flat payment)? Provisions to include in deal: a. Exclusivity b. Limitations on control/management c. Dissolution/Disassociation i. Right of first refusal ii. Non-compete clause

b.

c.

Part II i. Inventor B has designed software program, no idea how to market 1. Wants deal w/ SpiderWeb (for cash and some profit) 2. Without SpiderWeb, her program will bring no money a. But, B knows w/o program, SpiderWeb may not survive 3. SpiderWeb development of program would cost a year and $200,000 - $300,000 4. SpiderWeb has not formed ii. Advise/negotiate for B 1. Consider forms of payment/control and terms of payment/control a. Licensing Do we want to keep this? b. Salary may sacrifice depending on future prospects of company c. Equity or piece of profits? i. When are rights retained? d. Questions of control/management i. Voting rights? e. Buyout i. Golden parachute 1. If you leave, you get a whole bunch of money ii. Non-compete clause 1. In CA: a. Can protect confidential information and keep person from soliciting your clients b. But cant keep employee from working in/starting similar business Part III i. Investor C may invest $2 Mil in Spider Web - Advise/Negotiate for C 1. Issue of control a. Possible choices: i. Vote on extraordinary business matters ii. Veto right b. Choices may depend on type of entity i. Limited p-ship would not be a good entity for investor control ii. LLC or Corp? 1. What would the investor prefer? a. An LLC allows an investor to exercise any amount of control they want w/o losing their limited liability b. Corp would work b/c they can control who is on the Board i. Problem of fiduciary duties Is that so different from fiduciary duties that you would have to your fellow members in an LLC? Duties not going to be that much different 2. No strong preference b/t LLC and Corp a. Slight advantage for LLC b/c less formalities and can set bar where you want 2. Issue of finances a. How do I get paid and how do I protect my investment? b. How much ownership of the company do you want if nobody is putting in much money? i. Taking too much a stake will de-incentivize the people running the company 1. Rather, incentive to cheat 2. Do not take too much of the pie c. Capital Calls: What if the company needs more money? i. Make sure client is getting the deal they think they are getting 1. What if they are wrong about how much money they need? 31

ii. Sometimes people having different roles in the company should be treated differently XIII. Clarion Optical a. Two people who work at this company, Stone and Randall, are trying to buy out this company called Clarion Optical i. How are they going to finance this purchase? 1. The purchase price is $2 million 2. A couple of different options to finance 3. The various financing components: a. First Component: i. NE Pension Trust 1. Willing to lend 80% of land and building expense - $800,000 a. In the form of a 12% mortgage ii. Michael Grund 1. Willing to invest up to $250,000 if it showed an aftertax IRR of at least 30% 2. Possible suggestion: Take land and building, sell it to Michael Grund a. Michael Grund then gives the company $200,000 down payment b. NE Pension Trust gives the company $800,000 c. Then Clarion leases back land and building i. Payments made to Grund Sale-leaseback provision b. Second Component: i. Georgia Bank and Trust Co. 1. Will lend 80% of book value of accounts receivable (A/R) - $240,000 & 40% of book value of inventory - $200,000, at 15% a. Problem w/ inventory: book value $200,000, market value of $500,000 i. Way to bump up inventory book value is to perform asset purchase ii. ii. Bank of Atlanta 1. Can lend company or Jerry and Iris personally up to $300,000 at 17% w/ personal guarantees a. Each Jerry and Iris had worth close to $250,000 in their own and their spouses investments in separate homes iii. General Insurance Corporate Credit 1. To purchase the existing equipment for $300,000 and lease it back to Clarion for 5 years at $100,000 per year c. Note: Sales-Leaseback provisions are not owners i. The advantage of borrowing money is that Jerry and Iris own 100% of the company no equity given up ii. Rebel Ventures 1. Will lend up to $3.5 million on investment that showed a 60% pretax IRR a. They would require the management team to put up $40,000 of their own funds i. Not lenders investors who desire equity 2. How much equity must be given up for a 60% return? 3. Whats an advantage of equity? a. No financial downside if the company doesnt do well i. Investors dont get to take things away from the business as lenders have the ability to do Advising on entity formation What entity should be formed? a. What questions do you want answered by your client? i. Entities 1. P-ship 2. Limited P-ship 3. LLC 4. S-Corp. 5. C-Corp. 32

XIV.

ii. List of factors: 1. What are the liabilities? a. What are the responsibilities and obligations of somebody involved in these businesses? i. Is it a pass thru entity or not? ii. Are there tax issues involved? iii. If pass thru, who gets the losses and who gets the gains? iv. Is tax counsel necessary? 2. Flexibility how much is necessary? a. Some provide a great deal, but sometimes you dont need 3. Do we want to carve up gains, losses, and distributions in any that doesnt reflect ownership stakes? a. Are there going to be different classes of ownership? b. Are the owners contributing equal amounts of the same type of consideration? i. If not, then are we going to treat them differently? Is same, still treat differently? 4. What is the business and what will its needs be? a. Is it a manufacturing? Tech? Services? Not for profit? i. Is it very lucrative or merely provide a living for somebody? 5. Where will it operate? a. Local, national, international? 6. What are the level of fiduciary duties among the owners? a. Is this good or bad for my client? i. Ex: If client has 5% of company, love fiduciary duties, but if client has 52%, dont like fiduciary duties 7. Do you want stock options? a. Pure stock options or some type of incentive 8. Is there an IPO exit strategy? a. Is the company planning to go public? 9. How and when will the company end? a. What are its dissolution needs? i. In particular, of your client? 10. What are the capital needs of the business? a. What are and what should be the capital requirements on the owners? 11. How will the business make money? a. And how will the owners get that money? i. Salary, distributions, stock options, selling the company 12. Does your client hold a majority or minority interest? 13. Who are the other owners? a. Insiders? Outsiders? Friends? b. How many owners will there be and what are there respective %s? 14. Does your client want or need certain specific protections? a. Something specific to the situation i. Ex: management, doesnt want to be thrown out 15. What are and what should be the voting rights, veto rights (if any)? a. Who makes the decisions and how is control allocated? 16. Is dissolution available and is it available to your client? a. What about withdrawal and what happens upon withdrawal? 17. Do we have a need for non-compete or are we trying to avoid? 18. In the category or buy-out and liquidation, is it available? a. If so, is it forced or involuntary? 19. Are/should there be any restrictions upon the entitys/managements activities? a. Restrictions among the owners i. Ex; non-compete, buy/sell agreement, right of first refusal 20. Should there be transfer restrictions? a. Transfer restrictions dont need to be exactly the same for everybody, but must be rational? 21. Is your employee also playing a role as an employee and/or manager? a. If so, what additional rights and/or protections, if any, should go along w/ that role? 22. Is there a provision for expulsion or for kicking someone out of some position?

33