General Corporate/M&A Matters

Companies looking to compensate their employees and other service providers in equity will often employ stock options or restricted stock (for corporations) or profits interests (for LLCs). An alternative approach that should be considered is to offer so-called “phantom” equity, which is essentially a deferred compensation plan, where the employee receives cash payments that are calculated as if the employee had received an equity grant. (A similar alternative is stock appreciation rights, or SARs, but I will focus on phantom equity here.)

For example, the recipient could receive a cash payment at the time the company is sold that’s equivalent to the distribution that would have gone to someone receiving 1% of the company’s common equity at the time of the grant. There can be other triggering events besides a sale, depending on the plan, including regular company distributions of earnings. Like true equity, the plan can have vesting, repurchase and similar provisions seeking to incentivize the recipient’s continued employment with the company for a lengthy time. So, the employee receives the benefits of equity without the parties having to go through the trouble of documenting an actual issuance of equity. Unfortunately, the term “phantom” seems to imply that it’s somehow fake equity, meaning employees can be skeptical of the concept, so it takes some explanation.

Like any employee compensation plan, phantom equity plans need to be carefully structured using the advice of a qualified tax professional, seeking among other things to avoid issues with Section 409A deferred compensation penalties. As I do not myself have such expertise, I’ll leave out discussion of tax consequences here, except to note that a disadvantage of phantom equity from the employee’s perspective is that the cash payments are taxed as ordinary income, not capital gain, though the tax is assessed only if and when the cash is paid, not when the phantom equity is granted.

One advantage of phantom over true equity is that it’s generally easier to document, saving on legal costs (wait, why am I writing this?). Recipients of phantom equity will not need to be directly accounted for in operating or stockholder agreements, making simpler the mechanics of drafting provisions such as share transfer restrictions, management, and distribution of company earnings. Outside investors may prefer the simpler capital structure, though of course they would take into account the company obligations inherent in the phantom equity when valuing the company and their investment.

From the company’s perspective, phantom equity also avoids creating new shareholders or members that have statutory rights under state law, such as the right to examine records, which as a practical matter are not valuable to the typical service provider.

If you have a small private company with 10 shareholders, the job of issuing share certificates to them, and cancelling and issuing new ones when there are transfers, is a pretty non-time consuming task that can be handled by one of the founders. If you are Microsoft Corporation, where over 30 million shares change hands every day on average, needless to say, a person seated in front of a stock ledger book couldn’t keep up with the flow. Accordingly, for public companies, a back-office infrastructure has developed, with stock transfer agents serving the function of keeping track of record ownership of shares for these companies.

As described in this Q&A from Luis A. Aguilar, one of the Commissioners of the SEC, an important function of transfer agents is to distinguish between restricted shares – ones that were recently sold in an exempt transaction under the Securities Act of 1933 or were issued to company affiliates – and unrestricted, free-trading shares. In my practice, I typically deal with the larger and more established transfer agents, which employ full-time compliance professionals to ensure that restricted shares are policed properly. For example, if a shareholder of a client of mine asks the transfer agent to remove the restrictive legend because the shares have been held over a year and the holder isn’t an affiliate, the compliance department of the transfer agent will want to see an opinion of counsel from my firm, to the effect that the legend can be removed under Rule 144.

Unfortunately, as described by Commissioner Aguilar, some transfer agents are not as scrupulous about adhering to these rules. Under current (non-)regulation, the same individuals can operate a transfer agent, a brokerage firm and a microcap public company. In such a scenario, if those individuals want to initiate a scheme involving the sale of unregistered shares, the transfer agent (being the same people) won’t police the transactions to prevent them from happening. This is just one of many examples cited by Commissioner Aguilar making clear that a more aggressive regulatory approach is needed.

One of the reasons that limited liability companies have become so popular as an alternative to corporations is that the state laws governing LLCs are so much more liberal in terms of formal requirements for documenting company decisions.  For the most part, LLCs are free to shape the management provisions in operating agreements in the manner desired by the parties.  Corporations, in contrast, are required by statute to adhere to certain procedures in their operation.  In particular, the corporation’s Board of Directors must formally approve certain acts, such as issuing new shares or entering into a significant contract, and this approval must be documented, either via minutes of a board meeting or unanimous written consent of the board. …

Cleanup Board ResolutionsRead More »

More than once since I formed Andrew Abramowitz, PLLC, I’ve been asked “What’s the ‘P’ in PLLC?”  The answer is “professional.”  New York requires that business entities engaging in one of the professions regulated at the state level (e.g., law, medicine, architecture) be conducted in a special professional form of the entity, so corporations are called PCs and limited liability companies are called PLLCs.

In the most basic sense, these entities are like the non-professional version of each:  they offer limited liability for shareholders/members (though those individuals remain liable for “any negligent or wrongful act or misconduct”) and pass through taxation for PLLCs and PCs that elect to become S-corporations.  However, there are a couple of important differences that those working with these entities should be aware of:

• Unlike non-professional entities that can be formed immediately upon a filing with the Department of State, there are other hoops to jump through, depending on the profession.  For my law firm, I had to submit evidence to the state that I was in good standing with the state bar.
• Each shareholder/member of the entity must be a licensed practitioner of the applicable profession.  This restricts the ability of the entity to seek outside equity financing from passive investors, and also restricts the entity from being able to issue equity to service providers as compensation.  This rule isn’t universal – Australia permits outside equity investment, and there have been calls to permit it here, as described in this New York Times article.

Particularly for complex and important transactions in a company’s life-cycle – mergers and acquisitions, institutional funding rounds, joint ventures, etc. – it’s typical that the transaction process start with the preparation of a non-binding (usually) term sheet or letter of intent.  These documents are no more than a few pages long and are more informally drafted than definitive agreements.  The purpose is to set forth just the big picture terms of the deal.  For example, a term sheet for an investment round would list the amount being raised, type of security, price per share/unit and various terms of the security (e.g., dividends, management rights, transfer restrictions).  But it would not get into, for example, detailing the company representations about its business that will eventually be contained in the definitive purchase agreement.

There are some attorneys who think that the term sheet/LOI is a wasted step and that the parties should proceed immediately to drafting definitive documentation if they are interested, but I think it’s useful for everyone involved to get the most important substantive terms out on paper and make sure the parties have a meeting of the minds about them before getting lost in the weeds of negotiating the provisions of definitive agreements.  This is not to say that those provisions aren’t important, but the more open issues there are at a particular time, the more likely it is that the parties will get sidetracked and lose sight of the important parts of the deal.

I mentioned earlier that most term sheets and LOIs are non-binding.  Even so, there are typically provisions within the document that are expressly binding, just not the core business terms of the deal that are subject to further negotiation.  Terms that are typically binding include confidentiality, governing law and (if applicable) exclusivity provisions.  There are some cases, however, where the whole term sheet or LOI is stated to be binding, often when the parties want to start business activities right away, though there are still provisions detailing how the parties will go on to draft and negotiate definitive agreements.

I’m often asked whether a newly formed New York-based business should incorporate (for a corporation) or organize (for an LLC) in New York or Delaware.  If the company will actually be doing business in New York, there is no advantage from the perspective of filing fees of using Delaware, because the company will then have to qualify to do business in New York and therefore pay two states’ fees.  In many cases, my advice is to simply go with New York, but there are several factors that may, depending on the situation, argue in favor of Delaware:

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Incorporation in New York or Delaware?Read More »

The SEC’s longstanding position has been that a broker in a private M&A deal that was structured as a stock sale needed to be registered as a broker-dealer.  This requirement did not apply in the context of a sale structured as a sale of assets, since there wasn’t any sale of securities involved, but the eventual structure of a sale is not always known at the beginning of the transaction.  And, in any event, brokers have needed to be registered to be able to handle all acquisitions, however structured.

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The SEC’s Change of Heart on Private M&A BrokersRead More »

My clients are often under the impression that I have at the ready a library of forms such that drafting an agreement for a particular deal is pretty much a matter of filling in the client’s name and the date of the agreement.  In reality, while in most cases the drafting of an agreement means using one or more existing agreements or forms as a starting point, there is usually too much factual variation between different deals to avoid having to engage in some active, brain-taxing drafting.

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Developments in Form AgreementsRead More »