Ohio Practical Business Lawyer & Attorney : Teri Rasmussen : Lane Alton & Horst Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

Whether it's multi million or billion dollar merger of public companies like the recent Arby's - Wendy's merger here in Columbus or the stock/asset sale of a large or small privately held company, a crucial part of the transaction is completion of "due diligence."  So what is "due diligence" and why does it matter? 

Due diligence is about making sure that you really are buying what you think you are.  It can be invaluable in uncovering defects which may be deal killers or at least require remediation before closing or a restructuring of the economics of the transaction,  It can also be useful in gaining useful information about the overall strengths and weaknesses of the company that you will need once you are in charge of operating the business. 

Without "due diligence", a buyer may discover too late that the facilities require enormous capital expenditures to compensate for deferred maintenance.  Perhaps the largest customer is very unhappy and in the process of moving its business to another company.  The accounts receivable may be well past due and even uncollectible. 

In larger transactions, "due diligence" can take months, be extremely costly and involve professionals of many kinds (including attorneys and CPAs).  When smaller privately held companies are involved, the process is less complicated, but should not be ignored entirely.  For a helpful rundown of what "due diligence" is all about and the process, visit this FAQ.   

Every company being acquired and every industry is different so different things will be important in any particular "due diligence" process.  However, for a nice overview of the sorts of tgenerally applicable things you should ask about when doing "due diligence", visit "What Does 'Due Diligence' Mean When Buying a Business?"  There are also many many good due diligence checklists available on the web.  Some of the most important things you should be interested in finding out should include:

• Security Interests and liens on the assets being purchased
• Unresolved pending or threatened litigation
• Financial health of the company, including collectibility of accounts receivable
• Identification of the key assets essential to the continued operation of ongoing business being purchased
• Current employee benefits and policies
• Quality of relationships with customers, vendors, and suppliers
• Condition of equipment and facilities
• Agreements among owners relevant to the purchase
• Saleability of inventory

..... And now I get to go home and see if the electricity knocked out yesterday afternoon by the ferocious wind storm remains of Ike has come on yet.  According to the news reports, 2 million people in Ohio are without power and almost 60% of those of us living here in Central Ohio lack electricity.  Some estimates are that it may take up to a week to get it all back on.  Thankfully, my hot water heater runs on gas so at least there'll be no cold showers.

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When buying a business, one of the principal considerations is ensuring that one obtains a "clean" title unencumbered by liens and obligations to others.  I've previously posted about why sophisticated buyers often prefer structuring the acquisition of a business as an asset sale rather than a stock deal to address this concern.  However, even if the transaction is done as an asset sale to minimize the likelihood of unwanted liabilities following the new owner, purchasers must still be concerned about the prospect of "successor liability" if proper precautions are not taken.  If "successor liability" is found to be applicable, the new owner will discover that the overall cost of the transaction is substantially greater than expected.

General "Successor Liability" Conditions.  The seminal case in Ohio regarding "successor liability" is Flaugher v. Cone Automatic Machine Co., 30 Ohio St.3d 60, 507 N.E.2d 331 (1987).  Although the purchaser of a business generally cannot be held liable for the obligations of the seller, Ohio law as interpreted by the Ohio Supreme Court in Flaugher recognizes four specific exceptions to this rule, namely:

• If the new entity has expressly or impliedly agreed to assume the liability
• The transaction amounts to a de facto consolidation or merger
• The new entity is "merely a continuation" of the already existing entity
• The transaction is entered into fraudulently for the purpose of escaping liability

Mere Continuation.  A company will be held to be a "continuation" of an existing entity, and therefore subject to successor liability when the two entities have "significant shared features" such as the same equity ownership, same employees, the same service or product being produced, same supervision, etc.; in addition the dissolution or liquidation of the existing company soon thereafter is seen as a marker that successor liability should be applied.  Inadequacy of consideration for any assets conveyed from the existing entity to the new entity is also a red flag.  Thus, the more the new company looks like the old one, the more likely it is to be vulnerable to successor liability.

De Facto Merger.  The "hallmarks of a de facto merger" were explained by the Ohio Supreme Court in Welco Industries, Inc. v. Applied Companies, 67 Ohio St.3d 344, 617 N.E.2d 1129 (1993) to include:

(1) the continuation of the previous business activity and corporate personnel, (2) a continuity of shareholders resulting from a sale of assets in exchange for stock, (3) the immediate or rapid dissolution of the predecessor corporation, and (4) the assumption by the purchasing corporation of all liabilities and obligations ordinarily necessary to continue the predecessor's business operations.  

Applicable to Contract as Well as Tort Liability.  Initially the "successor liability" doctrine applied primarily to tort liability for claims of negligence and similar actions.  In Welco, however, while the Ohio Supreme Court deslined to find successor liability under the facts of that case, it did indicate that under appropriate facts, a successor corporation might also be held liable for contractual obligations of its preedecessor.  For those wanting an in-depth discussion of Flaughler and Welco and the evolution of the successor liability doctrine in Ohio, the Franklin Couty Court of Appeals' decision in Mandalywala v. Omnitech Electronics, Inc., 2006 Ohio 2872, 2006 Ohio App. LEXIS 2717 contains an excellent discussion.   

Example.  The recent case of Pottschmidt v. Klosterman, 169 Ohio App.3d 824, 865 N.E.2d 111 (2006) provides useful perspective in the practical application of this test for "successor liability" in the extreme case.  In that case, a doctor joined the existing practice of another doctor which was organized as a corporation and became a shareholder in that organization.  Eventually, one of the doctors chose to resign as a shareholder and instituted suit against the corporation for various employment related claims. 

Thereafter, the remaining doctor formed a new corporation with a new bank account, but continued in the same office location with the same furnishings, employees, phone number, and patients.  The departing doctor sought to impose liability upon the new corporation for his employment related claims.  In finding that a de facto merger had occurred and that the new corporation was a "continuation" of the original company (and therefore liable to the departing doctor), the Court of Appeals found:

At trial, however, evidence was presented that the new corporation took possession of the original corporation's office equipment, medical supplies and accounts receivable.  The new corporation served substantially the same patients and was operated in the same building as the original corporation.  There is a single 100% shareholder of both corporations, Dr. Klosterman.  The new corporation pays the monthly office lease and equipment payments that the original corporation previously paid.  The original corporation's employees were employed by the new corporation and were compensated by the new corporation for services rendered to the original corporation....  the original corporation retained no assets.  Moreover, the original corporation closed its corporate bank account, changed the name on the profit sharing accounts and filed a final tax return with the IRS, which effectively constituted an end of the original corporation.   

Although not directly applicable to the sale of a business, it does show the types of things purchasers should try to avoid.  Thus, even in structuring asset transactions, care should be taken in specifically disclaiming unwanted liabilities and in how the post-transaction company should operate.  

Sales Tax Liability.  By statute, if provision is not made for payment of outstanding sales tax, the new owner can remain liable for its predecessor's obligation to the State of Ohio.  And that liability can also extend personally to the equity holders of the new owner.  This is one I did not fully appreciate until recently when I started acting as Outside Counsel for the State of Ohio with respect to the collection of state tax obligations.

Pursuant to Ohio Rev. Code 5739.14, an escrow account containing a sufficient amount to cover any outstanding sales tax obligation must be established:

His successor shall withhold a sufficient amount of the purchase money to cover the amount of such taxes, interest, and penalties due and unpaid until the former owner produces a receipt from the tax commissioner showing that the taxes, interest, and penalties have been paid, or a certificate indicating that no taxes are due.

Thus the prudent business buyer will insist on receiving a Sales Tax Release Certificate which can be obtained by completing a Request for Sales Tax Release and submitting it to the Ohio Department of Taxation.  For further information, click here for instructions provided by the Ohio Department of Taxation.  According to the Department of Taxation, it will take approximately 30-90 days to process the request.  A tax release will be issued by the Department of Taxation after:

• The business has been sold and the seller has filed the final sales tax return (final return should be sent directly to the Central Office, Tax Release Group, with guaranteed funds); AND

• The Department has reviewed the seller's account and found that:  a) All sales tax returns have been filed,  b) all reported tax, interest and penalties have been paid,  c) all filing and reporting requirements have been met.

Penalties for failing to pay state sales tax can be substantial.  In addition, other consequences such as suspension or revocation of any liquor license held by the new owner can occur if payment of sales tax is not made in a timely manner.  Thus, it is important not to overlook this aspect in the midst of everything else involved in the acquisition of a business.

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Nina Kauffman over at the Making It Legal blog just wrote a terrific post using an object lesson to explain exactly why deciding to go forward in a deal "without getting lawyers involved" isn't always the bargain cost-saver envisioned.  Long story short, the "victim" aka buyer didn't ask to see financials, didn't verify the arrangements existing with the landlord, and didn't verify the seller's ownership interest before swapping her hard earned money for a business that turned out not to be the cash cow promised by the seller.  Now she has discovered that the consequences of trying to save money by keeping lawyers out of the transaction are neither pleasant nor inexpensive.

While it is certainly true that this erstwhile buyer could have done all these things without a lawyer and perhaps avoided her unfortunate fate, using a lawyer to assist with the purchase of a business minimizes the likelihood that an important detail pertinent to whether you even want the business will be overlooked.  It can also ensure that the deal is structured in the manner which is most advantageous to you from a tax and basic business perspective.  Although many deals do proceed without a hitch with nary a lawyer in sight, the only one which really matters to you is the one you're doing.  So it all comes down to how much of a gambler you really are; if you're lucky, all will be well, but if you're not, the results can be far more devastating than just a minor disappointment in the road of life.   

Business people sometimes think they can substitute the form documents easily available on the internet, or in self-help books found in the local retail book store or on Amazon, for a trip to the lawyer.  I certainly understand the motivation behind hoping the form downloaded for free will work just fine if you change names, dates, and maybe a few other things.  On my Blogroll, I have even included some websites with what I consider to be generally dynamite forms.  Forms, however, must be utilized responsibly.   

Unfortunately, making sure you have the right document and the right language for your particular situation is very much like making sure you have the right tool for the job when it comes to home repair or any other task.  If you need a screwdriver,  trying to use a hammer is unlikely to lead to optimum results.  To get a flavor for this, check out Ken Adams of the Adams Drafting blog which focuses on all the different ways subtle variances in the language used can change meaning significantly.  Lawyers have the education and experience to understand and make the proper choices.  Do you?  

Forms are a Jumping Off Point, Not the Destination.  Forms are just that - forms.  They are merely a place to start to save the time and expense of drafting from scratch on every occasion.  When I download forms or entire documents used in actual deals from oncle or docstoc, or Findlaw, or anywhere else (and I do that a lot), I rarely, if ever, use them in exactly the same form as downloaded. 

I use downloaded forms as a skeleton to be fleshed out by language from other forms and documents, together with specific language and provisions pertinent to the particular deal that I create myself.  I also delete significant portions of the document downloaded as not relevant or appropriate for the deal before me.  While many deals may be similar, every transaction really is just enough different to require some tailoring of draft documents at my disposal.

Why doesn't the same document work in every deal?  Why can't you just use the lease or Asset Purchase Agreement your buddy got his lawyer to draft or you found on the internet? 

For starters, contract, employment, and especially real estate, law differs in important ways from state to state.  New York may require certain language not necessarily favorable to employers that Ohio does not and which an employer in Ohio may not wish to include at all.  Each state's courts may have reached slightly different interpretations of certain legal concepts and principles which can affect the meaning, and sometimes even the validity, of particular contracts.  Do you as a business person really want to spend the time to determine if the document you got from your friend in Michigan is really going to work the same way here in Ohio?  An Ohio lawyer already knows these details and understands how to apply them to your Ohio transaction.

In addition, documents drafted from the perspective of one party to the transaction are generally not as beneficial to the other.  For example, from a landlord's perspective, there are certain provisions in a lease that should be included which the tenant would prefer to leave out.   Even if you are using a form from "your side", your bargaining position may be different from that of the original party in that position.  While it is theoretically possible to draft a contract or other document neutrally so that it is completely "fair" to both sides, in reality, contracts are generally written in such a way to benefit one side somewhat more than the other.  How great the disparity is often a function of the relative bargaining position of the parties.  An attorney is able to assess your role (and relative leverage) in the transaction and determine the most appropriate language to be used as a consequence.  

• EXAMPLE from an Asset Purchase Agreement - Compare the following three ways of describing the assets being purchased, each of which has a slightly different meaning.  Choosing the right version for your particular deal is crucial.  Having a lawyer on your side can help.

The purchased assets being acquired by the Buyer as a result of this Agreement and the transactions contemplated hereby shall be acquired by the Buyer on an "AS IS, WHERE IS" basis and in their then present condition, and Buyer shall rely solely upon its own examination thereof.

Except as set forth on Schedule 3.5, [to the best of Seller's knowledge and belief], the Assets, including all machinery and equipment, are in good state of repair, in sound operating condition, ordinary wear and tear excepted, and have been given regular maintenance in the ordinary course of business.  

[To the best of Seller's knowledge], All of the facilities of the Seller and its equipment and other tangible assets are in good condition and repair (ordinary wear and tear excepted) and workable, usable, and adequate for the uses to which they have been put by the Seller in the ordinary course of business, and none of such facilities, equipment, or other tangible assets (exclusive of obsolete items no longer used in the Seller's business) is in need of other than routine maintenance or repair

The Ohio State Bar Association also offers some additional considerations why consulting an attorney can be helpful.  Among other advantages is the confidentiality afforded by the attorney-client privilege which may not exist to the same extent with other professionals such as CPAs. 

For some similar thoughts along the same vein with links to still others making the same point, visit Rush Night's posting on the subject on his Rush on Business Blog.

A Final Point.  Some clients think they're helping me by bringing me someone else's form to "fix" for their deal.  Mostly, you're NOT, helping me that is.  I DO have my own forms that I'm used to and know how to tailor to your deal; it will probably take me longer, not less time, to use the form you bring me than my own form.  This is because I already know where I've put certain important language and the sections that typically require modification from one deal to the next; with someone else's form I have to read it especially carefully to make sure it has the same provisions.  It's a little like finding your way to the bathroom in the dark in the middle of the night; most of us can navigate this journey just fine in our own home, but may have difficulty when staying as a guest somewhere unfamilar.

So that's my little commercial on how I and other lawyers actually do add value to your business transaction.  Can a business person get to the same place without a lawyer?  Sure, but if you really wanted to know that much about the Law, you'd probably have gone to law school in the first place.

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The central legal document in the purchase and sale of any business is the Purchase and Sale Agreement. It fleshes out the details behind the key points mentioned in the "letter of intent" and contains the procedures needed to meet or carry out the respective requirements of buyer and seller. Although, customarily, the purchaser is responsible for providing the initial draft, sellers should not assume that the provisions of the Purchase and Sale Agreement (sometimes referred to as the "PSA") require little of their attention.

If an attorney has not yet been consulted for assistance with the transaction, NOW would be an excellent time to remedy that. PSAs vary considerably and, depending upon whether viewed from the perspective of buyer or seller, some language will be more beneficial than other. In addition, provisions appropriate in one deal may actually be harmful in another. For a more in-depth look at the overall process and documentation involved in the purchase and sale of a business, view my seminar PowerPoint presentation Buying and Selling a Business - Legal Insider's Practical Guide. To read my blog post about choosing whether to structure the transaction as an "asset" or "stock" deal, click here .

Regardless of how the transaction is structured, perhaps the most important, and often the most intensely negotiated, part of the PSA to both sellers and, especially, buyers are the "Representations and Warranties", sometimes simply referred to as "Reps and Warranties". A seller's representations and warranties are essentially assurances from the seller and/or seller's shareholders about the nature, scope. and condition of the business. As such, they operate in tandem with a prospective purchaser's due diligence activities, but should definitely not be viewed as a substitute for that. Because liabilities come automatically with the purchase in a stock/equity deal, reps and warranties are particularly important in those transactions. When the deal is largely or entirely seller-financed, a seller's representations and warranties may become somewhat less important because the buyer will have the ability to offset remaining payments due against any problems; however, even here the content of what is said still matters.

For prospective purchasers, there are three main reasons for focusing on a seller's Reps and Warranties:

• Due Diligence. Reps and warranties are often utilized as a device for obtaining disclosure of crucial information about a company and its business and financial affairs. In this way, they can help aid and organize other due diligence activities. In addition, reps and warranties can also help reduce any transitional "learning curve" after the purchase by providing the buyer with much useful information about how the business operates.
• Exit Hatch. Reps and warranties can also serve as a basis for terminating the transaction if due diligence activities of the prospective purchaser reveals false or inconsistent information prior to Closing
• Damages. Reps and warranties establish what is being bought by providing a detailed depiction of the comapny and its business/financial affairs as it will exist at Closing, thus giving the buyer some assurance that the buyer's expectations of what is being purchased will in fact be that. If the reps and warranties turn out not to be true, that can give the buyer the right to refuse to pay the balance of the purchase price or to demand indemnification from the seller.

From a seller's pont of view, the main reason to pay attention to the "reps and warranties" they are asked to make is that it may affect their abilty to receive the full purchase price bargained for if the reps and warranties prove to be incorrect in any way. Depending upon how the agreement is written, this can be true even if the seller didn't know a particular rep and warranty was incorrect.

So what seller reps and warranties should be included? It depends on the individual transaction, but generally all or most of the following will be included;

• Organization and Good Standing - Seller is properly formed from a legal standpoint
• Authorization; Enforceability - Corporate resolution or other appropriate company or shareholder/owner action authorizing the sale has been taken and nothing else must be done for the deal to be enforced against the seller
• No Violation - Seller is not prohibited from selling by any agreement with any other party or any court order
• Title to Assets; Permitted Encumrances - Key provision for both buyers and seller because it defines what is being sold and its value after taking into account debt to creditors.
• Condition of Assets and Facilities - Extent of specificity will reflect s buyer's areas of concern. materiality and knowledge qualifiers may be appropriate, but should be carefully evaluated.
• Financial Statements - Essentially intended as assurance that Buyer can rely upon the accuracy and completeness of financial statements provided by the seller during the due diligence period. Which financial statements and whether they must be "audited" or merely "reviewed" financial statements depends upon factors such as availibility, relevance to the buyer's commercial valuation of the acquisition and the burden and expense to the seller which the buyer wishes to impose and the seller is able and willing to bear
• Environmental Matters - pertinent when real estate is involved
• Customers and Suppliers - References key contracts and provides assurances that they are valid and enforceable
• Litigation - Provides assurance that except as disclosed on a schedule, the company is not involved in any pending or threatened litigation
• Taxes - promises that taxes are paid current or reserved for in the financial statements
• Compliance with Law - Company is not in violation of any state, federal or local law

In a typical transaction, there will be exceptions or matters that need to be disclosed to make reps and warranties accurate. As a compromise between a buyer trying to minimize post-sale risks and a seller reluctant to make absolute blanket reps and warranties, the exceptions or limitation to the reps and warranties are set out on schedules referencing particular reps and warranties and attached to the PSA. Because these schedules alter the scope of the rep and warranty, it is important for the buyer to carefully review the contents of these exhibits.

While all parts of the PSA are important and should be carefully reviewed, the content and language of the seller's reps and warranties can have the most impact on both parties. Thus both buyers and sellers should take extra care to be certain that these reps and warranties properly reflect the deal as they understand it. (And, yes, a good attorney can really help you here..... :-))

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The most fundamental decision to be made in buying or selling a business is whether the transaction should be done as an asset acquisition or a stock deal.  (Of course, with an LLC, it would be a "membership interest" deal instead of stock, but the concept is basically the same.) 

• In an asset acquisition, the seller is the company and the buyer is another entity, often one created by the buyer for the express purpose of acquiring the tangible and intangible real and personal property of the selling company such as machinery, equipment, intellectual property, vehicles, customer lists, and even contracts. 

• In a stock deal, the seller is the company's shareholders and the buyer is buying the right to control the company's assets rather than directly purchasing the assets themselves.

In the case of privately held businesses, sellers are typically counseled to prefer stock deals while buyers are generally strongly encouraged to structure transactions as asset acquisitions.  Why?  What are the advantages and disadvantages to each?

Stock Deals.  Sellers generally prefer stock deals because gains from the sale of the business will be taxed at the more favorable capital gains rate.  Buyers, however, will find that they cannot write off the purchase price as quickly as they could in an asset acqusition and may want to lower the amount they are willing to pay as a consequence. 

One way to bridge the tax treatment gap between buyers and sellers in a stock deal is to allocate a portion of the purchase price to an "employment" or "consulting" agreement with the selling shareholders.  Although the selling shareholder(s) will have to pay ordinary income tax on the amounts received under these agreements, the buyer can claim the amounts as a deduction which may offset other tax disadvantages of structuring the transaction as a stock deal. 

Structuring a transaction as a stock deal is deceptively easy.  All that is necessary is the conveyance of the shareholder's stock certificate to the new owner.  Unlike an asset acquisition, there is no need to re-title vehicles or real property in the name of the new owner.  In addition, there is no need to specifically assign contracts, permits,  licenses, patents, and other intellectual property to the new owner.  Nor must any consents be obtained from any third parties to the transaction unless other agreements such as loan agreements require it.. 

However, from the buyer's standpoint, due diligence in understanding the nature of the financial and business affairs of the company being purchased is especially crucial when doing the deal as a stock purchase.  Because all of the company's liabilities will follow the new owner in a stock deal, such liabilities as employee benefits, tax, environmental and product warranties can inadvertently add considerably to the actual acquisition purchase price in the form of unanticipated expenses after the sale if not fully understood.

Asset Acquisitions.  The main reason buyers should insist upon an asset acquisition in most cases is that it avoids accidentally acquiring unwanted (and perhaps undisclosed or even unknown) liabilities of the selling company.  Suppose, for example that someone has been hurt by a product manufactured by the selling company the day before the transaction closes or perhaps the seller has neglected to mention a vendor or other creditor is owed money.  If the transaction is structured as a stock deal, all of these obligations automatically follow the new owner.  If done as an asset acquisition, the buyer's risk is substantially reduced, if not eliminated.  If the parties wish to have the purchaser of the business assume certain obligations, then those can be specified in the Purchase and Sale Agreement governing the transaction.  

Structuring the transaction as an asset acquisition also generally has beneficial tax benefits for buyers not available in a stock deal.  Assets can be "marked up" to the purchase price and the new owner can enjoy the benefits of depreciation.   If the assets involved include real estate, the adverse tax consequences to sellers  of an asset acquisition may be lessened.

Another useful aspect of an asset acquisition is that certain assets can be excluded from the sale.  This can be helpful in owner-operated businesses in which there may be emotional attachments to certain property.  It can also allow a buyer to avoid paying for items duplicative of property already owned or of little value to the ongoing operation of the company as the buyer intends it.

Documenting the Deal.  While the Purchase and Sale Agreement (sometimes called the PSA) is fairly similar regardless of the method chosen, there are some key distinctions.  If structured as an asset acquisition, the company sells the tangible and intangible personal and real property to another entity, often one created by the prospective purchaser for the particular purpose of buying those assets.  Although, technically, shareholders are not parties in an asset acquisition, they are often required to sign the PSA anyway to stand behind the representations and warranties being made concerning the assets and the company being sold.   If instead, the transaction is structured as a stock deal, the parties to the agreement will be the existing shareholders, not the company, as sellers and the new owners; the company whose shares are being sold is not a party to the transaction. 

In asset deals, PSAs will sometimes specifically mention particular obligations being assumed by the purchaser.  It is also possible in an asset acquisition that the seller will want to retain certain property and the PSA will then specify the "excluded assets" from the deal.

Choosing How to Structure the Transaction.  Asset acquisitions ARE generally more complicated and employees must be "re-employed" by the new company to avoid successor liability issues.  If a buyer is a longtime employee of a company or otherwise extremely familar with the company, the extra protection against unknown liabilities offered by an asset acquisition may not be worth the greater complexity.  In addition, the older the company being purchased is, the more severe the adverse tax consequences for the purchaser in doing a stock deal rather than an asset acqusition; with newer, younger companies, the tax benefits of an asset acquisition may not matter as much to prospective purchasers. 

It is also possible that a company may have beneficial tax attributes such as a net loss carryforward that the purchaser may wish to acquire and which can only be obtained through a stock transaction.  Beneficial employment or insurance ratings might also persuade the prospective purchaser that a stock deal might be the better structure.

On the other hand, a seller dealing with a minority or dissident shareholder may prefer an asset acquisition because it can be accomplished without needing unanimity of all shareholders.  Under Ohio law, generally the approval of the selling company's board of directors and a two-thirds vote of the shareholders is all that is required.  So long as the purchase price is reasonable, the minority or dissident shareholder has no recourse.  In a stock deal,  the minority or dissident shareholder could simply refuse to sell. 

Every deal is different.  Both buyers and sellers must evaluate a number of factors to determine which way their particular transaction should be done.  Advisors such as CPAs and attorneys can often assist in this task, as well as providing useful advice about other aspects of the transaction.

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While it is by no means the only important legal decision to be made when buying or starting a business, would-be entrepreneurs tend to focus on what sort of legal entity that company should be - corporation, partnership, limited liability company, etc. The basic options are fairly clear:

• If you will be the only owner, either a corporation or a limited liability company (sometimes called an LLC) are possibilities. An individual can also operate his or her business without forming either, becoming a sole proprietorship by default.

• A business with multiple owners can be a general or limited partnership, a corporation, or a limited liability company. If no conscious decision is made, a business with two or more owners will automatically be a general partnership.

There are still other more esoteric options, but these are the basic entities available. Making the proper choice among these options requires both a fundamental comprehension of the characteristics of each and an ability to understand how you want to handle and respond to the inevitable challenges ahead for the business. In today's post, I will highlight the basic characteristics of these various entities. In my next post, I will discuss some of the factors to consider when making the choice between them.

Sole Proprietorship Disadvantages. For businesses owned by a single individual, remaining a sole proprietorship has a number of drawbacks. Unless the business is very small and very new, and perhaps even then, operating a business as a sole proprietorship is generally not the best choice. The legal costs of incorporating a business or forming an LLC with a single owner are relatively small (less than $1000) and a more formal business structure can enhance a company's credibility with both vendors and customers, thus leading to growth. At the same time, incorporation or forming an LLC can also offer protection from personal liability for company debts to vendors, for accidents not covered by insurance, and from other creditors if the business ever becomes unable to pay. In addition, transferring ownership of the company, especially for anyone hoping to eventually sell out to investors, is greatly simplified with a corporation or LLC.

If you choose to remain a sole proprietorship "for now", you should still open a separate business checking account to help you keep track of business revenue and especially expenses. In addition, this will help you form good habits regarding keeping business and personal financial affairs separate that will serve you well as your business matures and does require more formal structure.

Corporations as an Option. Corporations are the most established choice for those wanting the benefits of limited liability for their business. In Ohio, corporations are governed by the provisions of Chapter 1701 of the Ohio Revised Code. Corporations are rather easy to form, although contrary to some popular belief, it does require some additional steps beyond merely filing a 2-page Articles of Incorporation with the Secretary of State. Corporations formed in Ohio have Articles of Incorporation and are governed by a Code of Regulations which is analogous to what is sometimes called Bylaws in other states.

Corporations are managed by officers such as a President and Treasurer who answer to directors who are in turn elected by shareholders, with the exception of "close corporations" in which the shareholders act as the directors. While in smaller privately held owner-operated corporations these may all be the same people, technically shareholders - unless they are in a "close corporation" which has affirmatively made such a choice - do not participate in the management of the company's day-today business and financial affairs.

Ownership in the corporation is conferred by the issuance of shares of stock evidenced by stock certificates; in Ohio, technically you have shares - not stock -- in a corporation. Everything from voting influence to the amount of dividends received is directly dependent upon the number of shares one has relative to other shareholders; if one holds 35% of the stock, one has 35% of the voting power and the right to receive 35% of whatever dividends are being distributed. (This can be made modified and become more complicated in corporations with "preferred" stock or other classes of stock.) Ownership can also be diluted if additional shares are issued to others.

By statute, corporations are generally required to observe many formalities and do considerable recordkeeping in order for shareholders to enjoy the benefits of limited liability. Directors and officers must be appointed, even if they are also already in the role of shareholder. Shareholder and director meetings must be held periodically and minutes of those meetings maintained. Ledgers reflecting share ownership allocations must be kept up to date at all times.

To dispense with the necessity of complying with some of the statutory record-keeping and other requirements, shareholders of an Ohio corporation can enter into a written Close Corporation Agreement complying with Ohio Rev. Code §1701.591 if they make an affirmative decision to do so. This agreement can also include provisions sometimes found in a Buy-Sell Agreement dealing with circumstances and conditions under which ownership can be transferred or owners wishing to sever their ties to the business can receive the benefit of their investment.

S-Corp or C-Corp. Businesses considering the corporation form must further choose between being an S-Corporation or a C-Corporation. This is primarily a taxation decision, but the choice does carry certain consequences with it. S-Corps can later convert to C-corps fairly easily, but generally C-corps cannot convert to S-corps later without tax consequences.

S-corporations are designed for smaller businesses. Under federal law, they are restricted to 100 shareholders who must be individuals (or their estate planning trust) who are either U.S. citizens or permanent resident aliens; partnerships, LLCs, or other corporations cannot be shareholders of an S-corporation. In addition, if there will be more than one class of stock or owners will otherwise have differing rights to manage or receive distributions, S-corps are off limits. Entitlement to dividends and voting rights must directly correlate to the corresponding ownership interest.

C-corporations, by contrast, tend to be larger more mature companies. Many, if not most, of America's best known companies are C-Corporations. There are no limitations in a C-corporation as to the number or type of shareholders; LLCs, S-corporations, C-corporations, partnerships, and foreign nationals or companies can all be shareholders of a C-corp. Nor are there any restrictions on the number of classes of shareholders or the types of voting and economic rights shareholders can be given. However, because profits of a C-corp are taxed twice (once as corporate income and once as dividends) and losses must remain at the corporate level rather than being utilized by shareholders, C-corps are generally not appropriate for small and medium sized privately held businesses, especially ones just starting out or ones that are sometimes referred to as "lifestyle" companies.

General and Limited Partnerships Both Largely Obsolete. Partnerships provide some level of limited liability and come in two flavors - general partnerships and limited partnerships. Because of the flexibility of the LLC structure, partnerships have largely been replaced by LLCs as a business form. Consequently, both limited and general partnerships are now obsolete choices except in some very specific and unusual circumstances such as certain estate planning situations.

In a general partnership, all partners participate in the management of the business venture and each is liable for the partnership's debts in proportion to their respective partnership interest (e.g. if three people are equal partners, they are each liable for one-third of the partnership's debt if the partnership has insufficient assets; if A has a 50% partnership interest while B and C each have a 25% partnership interest, A would have liability for 50% of the partnership debt if the partnership has insufficient assets). In a limited partnership, there is a general partner who is responsible for the day-to-day management of the partnership's business and who is likewise liable for the debts of the partnership in the assets of the partnership are insufficient. A limited partnership also has limited partners who must not participate in the management of the partnership's business and are protected from personal liability for partnership debts in return.

Limited Liability Company. The impetus for the emergence of the LLC alternative was the desire of owners to participate directly in management of a business as in a general partnership while retaining the protection from personal liability found in corporations. An LLC has members instead of shareholders and, if desired, managers instead of officers and directors. Instead of shares, members hold Membership Interests which in some cases are also called membership units.

Basically, an LLC is a cross between a partnership and a corporation, allowing owners to have the best of both. Instead of a partnership agreement or a Code of Regulations (or bylaws), LLCs have Operating Agreements. A Limited Liability Company, also known as a LLC, can be structured to include all of the informal decision-making, tax advantages and other benefits of either a General Partnership or a Limited Partnership. In addition, LLC Members do not have to forgo participation in managing the business (as they would need to do in a partnership) to enjoy the limited liability protection against company obligations to suppliers, vendors, and other creditors which is normally associated with corporations.

LLCs are a fairly new entity, first appearing in 1977 in Wyoming, but are now available in all states. Some states such as Delaware also have statutes permitting certain specialized versions. In Ohio, LLCs have only been an available option since 1994 and prior to 1997, Ohio law did not permit one member LLCs. Chapter 1705 of the Ohio Revised Code governs limited liability companies formed in Ohio and provides certain default provisions which will govern if not otherwise determined by the members of the LLC. LLCs can be structured like a limited or a general partnership, or even a corporation with respect to the management of the business. Under the IRS Check-the-Box Regulations adopted in 1997, LLCs can choose to be taxed as either (1) a partnership or sole proprietorship as applicable; or (2) a corporation.

Virtually unlimited flexibility is the hallmark of a limited liability company; essentially, virtually any business arrangement among owners can be easily accommodated. There are also fewer statutory recordkeeping requirements than are imposed on corporations. In addition, allocations and distributions of profits and losses, as well as management and voting rights, need not mirror and conform to the relative ownership interests held in the company. Typically, however, member-managed LLCs tend to duplicate the essence of a partnership, involving participation by all owners in management without giving up limited liability protection. Alternatively, a manager-managed LLC business operations may more closely resemble a limited partnership or corporation with day-to-day management being reserved for the manager(s).

Choice Narrowed to LLC or Corporation. Given the disadvantages of operating a sole proprietorship and the general obsolescence of the partnership alternative, the real choice for most business owners comes down to incorporating the business or organizing it as an LLC. Whether the corporation structure or the LLC alternative is better for a particular business depends on a number of factors. Those factors include the number and type(s) of owners and under what conditions, if any, there will be other owners. In addition, subjective complexities such as whether distinctions in the owners' respective equity and management rights are necessary or appropriate are important.

What really matters, regardless of the legal form chosen, is deciding more personal questions which will arise in every business. What will be the responsibilities of each owner with respect to the business? If a decision has to come to a vote, will each owner have one vote or will votes be by the level of ownership interest or some other formula? Will different kinds of decisions be decided by different kinds of votes, and if so, what will that be? How will profits (and losses) be allocated among owners? What happens if owners want to leave the business; how (and under what circumstances) will transfers of ownership be allowed?

For more details on all of these choices, view my PowerPoint seminar presentation The Legal Side of Getting a Business Up and Running.

For other perspectives focused on other states, see

• Michael Hamblin of the Michigan Business Lawyer blog has made a number of interesting posts recently on the subject of entity selection:

  • Michigan State Law: Choosing the Appropriate Corporate Entity is Crucial for Success of Your Business

  • Instead of Operating Your Business as a Michigan Partnership, Consider Forming a Michigan Limited Liability Company

  • A Michigan Corporation Could be the Right Entity for a New Michigan Business

  • The Basics of a Michigan S Corporation

• Illinois Business Law Journal blog - The Art of Registering a Business: Picking the Right Method of Registration for Your New Business

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Is an employee with a non-compete or confidentiality agreement still bound by it after the employer sells the business to a new owner?  Can the new owner enforce such an agreement which was made between the employee who continues working for the company and the prior owner?

Everyone understands that before buying another company, lots of "due diligence" about finances, customers, products, and general business operations should be done.  While these are certainly important concerns, you must also not lose sight of the "human capital" in the form of employees that you will be inheriting regardless of whether you choose to structure the transaction as an asset or a stock transaction.  How can you be certain that key employees won't depart to work for a competitor?

You can of course "rehire" employees, taking care to have each of them sign new confidentiality and/or noncompete agreements.  But what about employees who simply decide they'd rather go work somewhere else than remain employed under new ownership?  In addition, inevitably, not all of the "rehires" will have signed the new agreements.  There may also be cases where it is simply not feasible to have everyone sign new agreements.  So the issue becomes whether the new owner can rely upon noncompetition and confidentiality agreements predating the change in ownership.

Ohio, like many other states, generally views noncompetition agreements with some degree of skepticism.  Confidentiality agreements must likewise be supported by good business reasons.  As a result, these agreements, while enforceable, will be strictly construed.

The same reluctant enforcement also applies to the ability of new owners to enforce noncompetition and confidentiality agreements made by the employee with the previous owner.  As one might expect, as long as a business merely changes its corporate form (as when a sole proprietor decides to incorporate), but otherwise remains the same with the same ownership  and operations, it has long been the law in Ohio that noncompetes remain enforceable.  Rogers v. Runfola & Assoc., Inc., 57 Ohio St.3d 5, 565 N.E.2d 540 (1991).  It's also fairly clear that if an employee simply chooses of his or her own accord not to work for the new owner, the new owner is permitted to enforce such covenants.  However, where there has been a change in ownership and the employee remains employed, it becomes more complicated.

When ownership of the business changes hands and the employee remains employed for a period of time, Ohio courts ask two basic questions: (1) whether it was contemplated that the noncompete/confidentiality covenant would be assigned; and (2) whether allowing the enforcement of the noncompete/confidentiality covenants against the employee is important to preserve the goodwill of the business sold.  See The Fitness Experience, Inc. v. TFC Fitness Equipment, 355 F. Supp. 2d 877 (N.D. Ohio 2004); Artommick Int'l v. Koch, 143 Ohio App.3d 805, 759 N.E.2d 385 (10th App. Dist. 2001). 

In answering the first question, it is not essential that the underlying noncompete/confidentiality covenant specify that it is assignable, but that is certainly helpful.  Courts have also found that a general assignment of the employment contract without specific mention of the noncompete/confidentiality covenant is sufficient.  In this regard, Ohio is more liberal than many other states which require affirmative provisions allowing assignment. 

In addressing the goodwill issue, Ohio courts may look at the underlying business as it exists following the change in ownership.  For example, in Relizon Co. v. Shelly J. Corp., the Court noted that the new owner had led the employee to believe that his customers would no longer be service dby the company and the Court thus concluded that since it was "unclear" what goodwill was being protected, the noncompete was unenforceable by the new owner.

For more information about how other jurisdictions address this issue, information can be found at 12 A.L.R.5th Enforceability, by purchaser or successor of business, of covenant not to compete entered into by predecessor and its employees.

 PRACTICAL COUNSEL:  

1. When preparing a noncompetition or confidentiality agreement to be signed by employees, be sure to include a provision allowing assignment of the agreement.  This can add value later if you want to sell the business.

2. Don't despair if there isn't a provision allowing assignment of the prior noncompete or confidentiality agreement, but recognize that this may be a loophole.  Some Ohio courts have also found the fact that the new owner tried in vain to have employees sign new noncompete agreements as supporting its conclusion that the prior agreements were nonenforceable so be careful about insisting on new agreements.

3. Don't give courts a reason to decide that allowing enforcement does nothing to preserve the goodwill of the business which has been purchased.  Consider adding something to the business purchase agreement recognizing the importance of the assignment of these agreements.  Be careful how quickly you phase-out marginal aspects of the business.

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