The good and the ugly of convertible debt financing

Convertible debt is a common investment vehicle by which early-stage companies raise capital, where an investor grants to a company a short-term, often interest-bearing loan that converts into equity of the company at a future date. The convertible debt investors agree to push the question of what the company is worth — the valuation — down the road until the company’s next priced funding round. In return, the investors receive certain advantageous terms at the time that the debt converts to equity.

Smart Business spoke with Christian A. Farmakis, shareholder and chairman of the board, and Justine M. Kasznica, shareholder, at Babst Calland, about this investment vehicle.

What are the benefits for these investors?

As with any loan, the convertible debt note accrues interest until a defined maturity date. Unlike a standard promissory note, the convertible note often includes a conversion discount, valuation cap and other terms designed to mitigate the investor’s risk.

With the conversion discount, these investors receive a discount on the price per share at which their note converts to equity at a future priced round. Although discounts vary, it’s commonly set around 20 percent. Thus, if the price per share is set at $1, an investor’s convertible debt note would convert at a price of 80 cents per share.

With a valuation cap, (a) a maximum value of the company is established, solely for the purpose of calculating conversion of debt to equity; and (b) the investor’s price per share will be capped at the agreed upon number.

How can convertible debt negatively impact the startup?

Convertible notes are intended to be short-term investments. But when a company doesn’t get to its priced round quickly — or may require more notes to generate sufficient capital to keep the company in business — the founders can run into trouble.

By the time the company gets to a priced round, the accrual of interest, conversion discounts and valuation caps can result in a disproportionate percentage of the company being owned by the convertible debt investors, leaving the founders and employees as well as future investors with little future upside. Such a scenario can scare away new investors and render a company uninvestable.

How can founders get out of this scenario?

In many cases, this situation can be remedied through a renegotiation of the notes. For example, the valuation cap can be renegotiated or waived by the existing noteholders. Also, noteholders may agree to waive interest payments to reduce the impact of the conversion and the dilution effect on the founders. Still other times, noteholders may be interested in a buyout to get some or all of their money back.

A company’s negotiation and bargaining power is greatly enhanced if it can point to new investors who have conditioned their investment on a cap table adjustment. Noteholders can often be persuaded to give up or alter their contractual rights, if such a decision will help the company get the critical investment it needs to succeed.

What can be done to avoid this problem?

Although startups are often forced to accept bad financing deals just to get enough operating capital to survive, a few best practices can help mitigate some of these issues.

  • Fully understand the impact convertible debt financing rounds will have on shareholder equity positions by working through a variety of conversion and post-financing scenarios with advisers.
  • Where possible, try to treat multiple investments as if they were a single round, with a super-majority vote of the holders needed to amend the notes, making it easier to effectuate future note amendments.
  • When possible, ask for protective provisions such as prepayment rights, voluntary conversion prior to the maturity date and time-based conversion discounts (where the discount is smaller if the company can get to a priced round sooner).
  • Take time to know and cultivate a personal relationship with investors and to communicate regularly the company’s successes and challenges, which can go a long way in gaining goodwill in the event terms need to be renegotiated.

Insights Legal Affairs is brought to you by Babst Calland

Ways to resolve business disputes without litigation

Generally, when a business dispute arises, avoiding litigation can be the only thing two parties agree on. It could be costly, and parties want to avoid it to protect not only their secrets, but also their relationships. 

“No one goes into a business transaction looking for a dispute,” says Nicholas R. Oleski, an associate at McCarthy, Lebit, Crystal & Liffman Co., LPA. “When two parties reach an impasse, lawyers can become involved to find a way around it. And, generally, lawyers will look to negotiate the issue without litigation.”

Smart Business spoke with Oleski about alternatives to litigation when working to resolve business disputes.

Why would avoiding litigation benefit the parties involved?

Costs, confidentially and certainty are reasons parties look to avoid litigation. The process is inherently uncertain. A party might enter the process believing its case is a clear winner, but a judge or jury might not see it that way. Results can’t be guaranteed, even by the best lawyers, and that opens a party up to a great deal of risk, as well as higher-than-expected costs if the process drags out.

It’s also difficult to maintain confidentiality during litigation because court is public, and much of what happens in court becomes public record. There are mechanisms to protect confidential business information, but pleadings and other documents submitted as evidence might not get sealed by the court. Businesses want to avoid litigation when trade secrets aren’t at the center of case but could be disclosed as part of a lawsuit. 

Commercial transaction documents — contracts between the buyer and seller — should provide remedies short of litigation for disputes. The process can have multiple ascending levels, starting with informal talks between executives, before heading into formal alternative dispute resolutions, such as mediation and arbitration.

What is involved in the mediation and arbitration processes? 

Mediation is a formal negotiation procedure during which two parties and their attorneys talk with a mediator — a neutral third party, usually an experienced lawyer, with a background in whatever area the dispute is about — and attempt to resolve the dispute with a nonbinding verdict. Any information exchanged in mediation is considered privileged and can’t be used in court. 

Arbitration is a more adversarial form of negotiation, held in a more formal venue in front of an arbitrator — again, usually a neutral lawyer — who will render a legally binding decision to the parties. Arbitration enforcement is backed by federal and state statutes. The party that wins in arbitration confirms the arbitration award by filing the decision in court, which then confirms the arbitrator’s award. Then the court issues a public judgment that’s fully binding. 

When is litigation the best option when resolving business disputes?

Litigation may be the best way to protect trade secret information when it’s at the center of a dispute. Courts generally will seal or otherwise protect certain sensitive documents, which means the information they contain can only be shared between the parties’ lawyers. 

Both mediation and arbitration may not be desirable if one party is going to need access to the other’s documents regarding the transaction. In this instance, litigation in court may be preferable because the discovery mechanisms are more formal. 

Also, litigation offers the losing party appellate rights through the court of appeals. That option doesn’t exist in arbitration. 

Who should the parties consult with when deciding how best to resolve a business dispute? 

Talk with the internal employees closest to the source of the dispute first to get their input, then consult with internal counsel and discuss the event with them. Outside counsel could be brought in if additional expertise is needed. 

If at all possible, try to work it out with the aggrieved party before involving outside counsel. It’s usually never a bad idea for two sides to try to negotiate with each other to resolve the dispute before involving lawyers. However, it’s important to get lawyers involved before the dispute rises to troubling levels.

Insights Legal Affairs is brought to you by McCarthy, Lebit, Crystal & Liffman Co., LPA

How to avoid common legal pitfalls when starting a business

When forming a business, there are many considerations that should be made to protect the company’s legal and financial future. However, business owners often spend their time focused on what they are good at — making products or delivering services — and fail to assess many legal issues that create future liabilities.

Smart Business spoke with Louise M. Mazur, a partner at Brouse McDowell, about steps new business owners should take to protect their company.

What do new business owners need to know when forming the entity?

Incorporated businesses need a code of regulations that governs the organization of the business. Through this, the founders can create protections that will give them a strong position if they later take on investors for the business, such as delegating voting and nonvoting shares.

Similarly, limited liability companies need articles of organization, which enable the founders to designate themselves as the managing member and tax matter partner. These articles give them control of the day-to-day operations and oversight of the important financial decisions, legally establishing the founder’s authority so it cannot be challenged by future investors.

New businesses should also have an established buy/sell agreement that controls how ownership interests are sold to new investors, which will help avoid disputes with future investors.

There are also ongoing legal responsibilities after a business is formed. For example, a company must regularly update the existence of its business, including updates to the designation of its statutory agent. A company can be cancelled if it fails to file articles of continued existence or does not update its statutory agent. If that occurs, the founders could be, unknowingly, personally liable for the debts and obligations of the business.

How do founders shield themselves from liability?

Founders need to establish a separate mailing address for the company — even if just a P.O. Box — a separate bank account, credit card and line of credit. They should also keep their business receipts separate from personal receipts.

Those who do not establish a clear line between their personal and business identities may have significant problems. For example, if an owner makes a personal purchase on a company credit card, the IRS will classify it as income to the individual, which means the person needs to either declare it as such on his or her taxes, or reimburse the company for the purchase. Failing to do so will lead to penalties.

What should a business do to protect its operations from the start?

An employee should be asked to sign a new hire agreement that contains three components: confidentiality, noncompete, and work-for-hire provisions.

Concerning confidentiality, the employee will acknowledge that certain proprietary information is the property of the business and that the employee is legally prohibited from using the confidential information or sharing confidential information with third parties during and after employment.

Noncompete agreements are designed to restrict an employee’s ability to compete directly with the company, either by setting up a competing business or working for a competitor, within a specified geography and amount of time.

In the employer/employee relationship, the employer owns all rights to the work created by the employee. Nonetheless, the new hire agreement should include a work-for-hire provision to clearly confirm that all of the employee’s works or inventions become the sole property of the employer.

A new business should also develop terms and conditions of sale to outline the required due dates for payment and interest that accrues for late payments. Terms and conditions can also protect a business by placing limitations on liability to customers and minimizing customers’ remedies against the business. Terms and conditions should address how problems will be handled if and when they occur.

Before forming a business, founders should talk with an accountant and an attorney to ensure the company will be on strong legal footing and positioned to optimize any tax advantages. A little foresight at the start goes a long way for a new business.

Insights Legal Affairs is brought to you by Brouse McDowell

Attorney-client privilege: what it is, what it protects, and when it’s broken

The attorney-client privilege is important to foster open discussions between attorneys and their clients. As recently as Jan. 23, 2019, the Pennsylvania Supreme Court reaffirmed the principles of the privilege and the importance of clients and attorneys being able to rely on it. But in order to rely on the privilege, it is necessary for clients to understand what it is.

Smart Business spoke with Ashleigh M. Morales, an attorney with Semanoff Ormsby Greenberg & Torchia, LLC, about the attorney-client privilege and common ways clients accidentally waive the privilege.

What is protected under attorney-client privilege and when is it in effect?

Communications between a client or a potential client and an attorney are protected under the attorney-client privilege. The privilege only applies if it relates to confidential communications — others cannot be present when the communication is made or copied on the email when the communication is sent — and needs to be for the primary purpose of obtaining a legal opinion or legal services (and not for the purpose of committing a crime or a wrongful act). The parties must intend for the communication to be confidential, as well. The privilege protects both oral and written communications. While the privilege would not protect the fact that an attorney and client met at a specific place at a specific time, it would protect the communications that took place there.

When the relationship is between a company (rather than an individual) and an attorney, what constitutes privilege and who is covered by privilege?

In that situation, when the client is a company, the privilege covers communications between the company’s attorney and the company’s employees, officers and agents who are authorized to act on behalf of the company. In addition to the requirements regarding communications that are to be protected by privilege, when a company is the client, the communication must also be regarding a matter that is within the scope of the employee’s, officer’s or agent’s duty to the company.

Why is attorney-client privilege important?

The attorney-client privilege is important because it allows for honest discussion between a client and his or her attorney. Privileged communications are typically not discoverable in litigation and generally cannot be used against the client (as long as the privilege has not been waived).

How do clients waive the attorney-client privilege?

If an email containing a privileged communication is sent to someone other than the acting attorney, attorney-client privilege is waived. Perhaps the privilege was not needed for the last email they forwarded, but it was for the string of emails below it. Clients should be careful when forwarding their attorney’s emails or responding to their attorney and copying others on the email.

Another way to waive the attorney-client privilege is to include another person in your meeting or on your phone call with your attorney. While it may be awkward for your attorney to ask your friend who came with you to wait in another room while you meet, it is necessary to maintain the attorney-client privilege. Also, adding your attorney to an email does not automatically protect the email as privileged — the communication must be for the purpose of requesting or receiving legal advice or services. Therefore, an email from one employee to another employee is not automatically privileged by adding the company’s attorney to the email.

Clients should stop and think before hitting reply all or forwarding their attorney’s email. If the communication is confidential, relates to legal advice and something you would not want discoverable in litigation, keep it between you and your attorney. It is better to play it safe, because once the communication is sent to a third party, the privilege is waived and there is no undoing it.

While privilege may need to be waived to raise a defense or claim, it is important to protect attorney-client privilege unless your attorney advises you that waiving it would be necessary or advisable.

Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia, LLC

Areas of risk in 401(k) plans that expose companies to audits, litigation

Many employers offer a 401(k) retirement plan to their employees. In doing so, employers are generally aware of some of the key fiduciary responsibilities imposed upon them under federal law. However, there are other aspects of the operation and administration of 401(k) plans that can be overlooked. In doing so, employers become vulnerable to litigation and/or governmental audits.

Smart Business spoke with Patrick J. Egan, a partner in the Corporate & Securities and Labor & Employment Practices at Brouse McDowell, about the aspects of plan management companies tend to miss and the risks that creates.

What are the fiduciary duties employers tend to overlook?

In many circumstances, an employer will establish a 401(k) plan for its employees and will fail to ensure that its operation and administration satisfy the requirements imposed under the Employee Retirement Income Security Act (ERISA).

Under the provisions of ERISA, plan sponsors have a responsibility to make sure that the expenses and fees associated with their 401(k) plans are reasonable. If an employer has failed to review and benchmark plan fees for an extended period of time, it could constitute an ERISA fiduciary breach because third-party vendors are generally paid directly from the assets of the 401(k) plan. Thus, the higher the fees, the lower the account balances of the 401(k) participants. Employers should be reviewing and benchmarking the fees assessed by the plan’s service providers by issuing Requests for Proposal (RFPs) about every three years.

Employers also cannot ignore the overall performance of the investment funds offered under their 401(k) plan. If, for example, a large-cap mutual fund has underperformed over the past few years, the employer has a fiduciary duty to analyze it and determine whether it should be removed and replaced by a better-performing fund option.

Why are these aspects of 401(k) plan management under scrutiny?

A series of lawsuits filed by attorneys representing 401(k) participants has brought the issues regarding plan expenses and investment performance into the spotlight. Moreover, these issues have also become a point of emphasis for the U.S. Department of Labor (DOL) when it conducted plan audits. Therefore, employers now need to be more proactive regarding the operation of their plan to mitigate the possibility of any litigation or a DOL audit.

What steps can employers undertake to satisfy their fiduciary obligations?

Employers need significant processes and procedures in place that fully address the operations of their 401(k) plan. For example, employers should consider delegating responsibility to an investment committee that meets periodically to oversee the operations of their 401(k) plan, review the fees assessed by third-party service providers, review the performance of the plan’s investment options and replace underperforming investment options. Further, each investment committee meeting should be documented and the written minutes reviewed and approved at the next meeting.

There is an overall duty under ERISA that fiduciaries must act prudently. The DOL has noted that prudence focuses on the process for making fiduciary decisions. Therefore, having a committee meet periodically to review the 401(k) plan can satisfy these fiduciary responsibilities.

What should companies do to correct any potential fiduciary oversight issues?

Employers should review the current structure and operation of their 401(k) plan. Reaching out to legal counsel may be prudent, as they can conduct a comprehensive review of the process and procedures currently in place and determine whether they are sufficient for purposes of ERISA. Further, legal counsel can assist the employer or investment committee in navigating the RFP process and can also conduct fiduciary training so that the investment committee members fully understand their fiduciary obligations as imposed under ERISA.

Employers need to be aware of the changing regulatory and legal environment and become more involved with their 401(k) plan in order to address increased litigation and governmental oversight.

Insights Legal Affairs is brought to you by Brouse McDowell

The corporate opportunity doctrine when your investors are competitors

Consider this scenario: A startup in the artificial intelligence (AI) space develops a unique algorithm. A larger AI firm is interested in this algorithm but isn’t sure it’ll work. The larger company doesn’t want to buy the startup, but it wants a foot in the door on the new technology and is willing to invest. The startup needs funds but is concerned about the competitive issues created by giving the larger company a board seat and waiving the corporate opportunity doctrine.

“A smaller company is under pressure — in this scenario or others like it — to waive the corporate opportunity doctrine,” says Sara M. Antol, shareholder at Babst Calland. “Before you do that, stop and think about what this will mean. You need to determine whether there’s room to compromise with tailored language that serves the purposes of both the company and the investor.”

Smart Business spoke with Antol and Christian A. Farmakis, shareholder and chairman of the board at Babst Calland, about the corporate opportunity doctrine.

What is the corporate opportunity doctrine?

The corporate opportunity doctrine is part of the duty of loyalty imposed upon corporate fiduciaries. It’s not uncommon for a business owner or entity to invest in another company. If the investment is significant, the investor may demand a board seat to help influence the policies and operations of the company. If this person finds out about an opportunity as a board member, the corporate opportunity doctrine stops that director or officer from personally benefitting from an opportunity that would belong to the corporation, if it meets a four-pronged test:

  • If the corporation is financially able to exploit the opportunity.
  • If the opportunity is within the corporation’s line of business.
  • If the corporation has an interest or expectation relating to the opportunity.
  • If by taking the opportunity, the officer or director is placed in a position adverse or in conflict with the corporation.

How did it become commonplace for this doctrine to be waived?

As private investment increased, investors saw the potential conflict created by the duty of loyalty if they acted to maximize their interests while serving on a board. In 2000, Delaware amended its general corporation law to allow companies to expressly waive that duty in their certificate of incorporation. Since then, other states have adopted similar provisions, such as Pennsylvania’s limited liability company law in 2016.

Today, it’s common for companies to waive the corporate opportunity doctrine. Form investment documents, especially with private equity, often include this language.

Why would a company invest in a competitor and how does it create conflict?

A bigger company looking for the next big thing might invest in startups within its market space. Then, it can leverage the product or technology when the opportunity matures. Frequently, these startups are searching for capital and willing to agree to investment from a larger competitor.

The conflict arises when the larger company wants a waiver of the corporate opportunity doctrine in the investment documents. This allows the larger company to operate in its market space, which is shared by both companies, without restriction. The smaller company, though, may justifiably have concerns about future competition from the larger company.

How can companies find a compromise?

The waiver language can be tailored to address the areas and issues where the two companies might most likely compete. For example, if the larger company ends up competing with the smaller company under the waiver, the investor could lose some investor rights — investor rights that you wouldn’t want a competitor to have, like a board seat, monthly financial information or information about customer opportunities. Instead, perhaps the board seat converts to observer rights and the investor is limited to only receiving annual financial information.

There’s room to negotiate and countless scenarios could be proposed, so founders need to think carefully and assess the situation before agreeing to waive the corporate opportunity doctrine. At the very least they’ll have their eyes open to the risks and know what they’re giving up by agreeing to this waiver.

Insights Legal Affairs is brought to you by Babst Calland

How to capitalize on Cleveland’s commercial real estate market

Commercial real estate deal making has been on the rise in the U.S. As tier one markets tighten, greater attention is being paid to secondary markets, such as the Greater Cleveland area, and even tertiary markets like the Greater Akron area. 

Buyers, sellers and even landlords are in a position to benefit as the buying frenzy continues and vacancy rates drop. However, their ability to capitalize on the current situation in the commercial real estate market is contingent on how well they work a deal. Buyers and sellers stand to have a greater chance of success if they keep on top of the activity in the market, and have a good deal team on their side.

Smart Business spoke with Andrew Perry, Esq., a principal at McCarthy, Lebit, Crystal & Liffman, about what he’s seeing in the commercial real estate market and how to get the best deals. 

How would you characterize the transactional activity in the greater Cleveland’s commercial real estate market?

With respect to the commercial real estate market in Greater Cleveland, it looks as if the industrial side of things has slowed down a bit. That’s likely because the vacancy rate remains under four percent and there has not been much new construction. However, once more product comes online, it’s expected that there should be more activity.  

On the office side, there have been a handful of sales including 200 Public Square and Tower at Erieview. Additionally, because of the conversion of many properties into housing, the amount of office space has declined. That has prompted the announcement of a couple new projects, including phase three of the Flats East Bank and the new mixed-use project catty-corner from the West Side Market.

Nationally, the clients I work with have expanded their presence into new markets in the south. Additionally, I’ve been working increasingly with our clients in the southwest. 

In this real estate deal-making environment, who is benefitting and why?

This has been a much better seller/landlord market than in the past here in Cleveland because of the conversion of old office space into housing and the lack of new construction, especially on the industrial side. However, a saying that sellers should keep in mind as they transact in this environment is don’t count the money until it’s in.  

What should buyers be on the lookout for as they look to purchase property?

Due diligence is still critical. Have your structural inspections done, look at and understand the title commitment, get yourself a zoning report, check with the utility company, and check the demographics to make sure the area is one that works for you and your business. 

What are the more common mistakes you’ve seen that derail commercial real estate deals and how can they be avoided?

Make sure you have a good lawyer and the right broker. Price isn’t everything. A good lawyer will be able to point out pitfalls in an agreement early on. 

Additionally, having the right broker is a must. If you are looking to buy a retail property, make sure you get a retail broker. Similarly, with office or industrial properties, get someone who specializes in those markets. 

Finally, make sure you understand the operating expenses of the property. A deal can go sideways pretty quickly if and when a buyer finds that the operating expenses, required repairs or taxes are not in line with expectations.

What advice would you offer to buyers and sellers looking to capitalize on the current real estate market?

Don’t go in with blinders on. Do your due diligence on the property and make sure that if you are going in with partners that you and they see eye to eye. Having a good partnership and documentation evidencing that partnership are critical. 

Finally, stick to real estate areas you know. Don’t assume that because you did well as a home builder that you’ll do well as a commercial landlord. Too many well-intentioned business expansions fail miserably when confidence exceeds expertise.

Insights Legal Affairs is brought to you by McCarthy, Lebit, Crystal & Liffman

A primer on SAFEs and their use in early-stage financing

In 2013, San Francisco seed accelerator Y Combinator created a Simple Agreement for Future Equity (SAFE), which can be used in lieu of a convertible note. SAFEs spread throughout the California investment community. Now they’re entering regions like Pittsburgh. Investors, however, haven’t always embraced SAFEs as a reasonable vehicle for seed investment. They may be hesitant or uncomfortable with them.

Christian A. Farmakis, shareholder and chairman of the board at Babst Calland, first encountered SAFEs a few years ago when making a personal investment.

“I didn’t know much about it at the time. I initially thought, ‘How is this different than a convertible note?’” he says. “I read it and thought: ‘If the investment goes well, I’m largely in the same position. If the investment doesn’t go well, I will never be repaid, but I never expected to be.’ So, I signed it.”

Smart Business spoke with Farmakis about what entrepreneurs and investors need to understand about SAFEs.

What are the similarities and differences between SAFEs and convertible notes?

A SAFE is essentially a warrant (a contractual right to purchase equity upon the occurrence of a future triggering event, like a later priced investment round), but with the purchase price paid upfront.

SAFEs are like convertible notes in many ways. They can (a) include a discount on the per share price — a 20 percent discount would provide the investor 125 shares rather than 100; (b) include a valuation cap, capping the investor dilution when the triggering event occurs; and (c) give pricing protection for early investors. Because both are early-stage investment vehicles, the price per equity unit is not determined because the company has no company valuation.

A convertible note is a debt instrument. A SAFE is a contract. As such, a convertible note typically earns interest while it remains outstanding; a SAFE doesn’t. Convertible notes usually result in more shares being issued upon conversion — the aggregate value is higher than the original amount due to accrued interest. From this perspective, SAFEs are advantageous to founders.

Notes frequently trigger on a priced round but are intended to be repaid with interest when they mature, say, five years later, if a priced round doesn’t happen. SAFEs do not have this feature. They have no maturity date. At first blush, this convertible note characteristic favors investors. However, consider if this is materially favorable — in most instances, a failed startup usually doesn’t have the funds to repay note holders after its creditors are paid.

How can founders and investors benefit?

Because the baseline forms are available from Y Combinator’s website, SAFEs are fairly standardized, and the expenses associated with getting early-stage investors to sign a SAFE are lower. The startup doesn’t carry SAFEs as debt on its financial statements. Also, if structured properly, founders aren’t diluted as quickly as they might be with conventional debt.

If things go well, SAFEs give investors benefits like the percentage discount, valuation cap and most favored nation on the pricing. If they go badly, SAFEs benefit the founders, but the additional rights an early-stage investor loses aren’t significant. Again, sophisticated investors who put money in early-stage companies generally don’t expect to get paid back if they fail.

What should entrepreneurs be aware of?

Entrepreneurs should carefully consider the pro-rata investment rights usually contained in SAFEs to avoid unintended dilution. They should work with counsel to create a pro-forma cap table before issuing SAFEs to understand the impact upfront.

How have SAFEs changed?

Y Combinator has developed a new form of SAFE for early fundraising that involves larger amounts of money. It measures SAFE ownership after the round of SAFE money is accounted for but before the new money in a priced round (usually Series A) converts and dilutes the SAFE. This form separates the pro-rata investment rights and tailors them to apply to the next round of financing.

What’s your advice for Pittsburgh investors?

There are similarities and differences between convertible notes and SAFEs. Ask questions to see which one makes sense for you as an investment vehicle.

Insights Legal Affairs is brought to you by Babst Calland

Insulating your company from the fallout of a partner’s divorce

Business partners often fail to recognize that their business ownership interest is also a marital asset that will be valued and divided in a divorce. 

“When someone has an ownership interest, it will be appraised by experts and divided in the final divorce judgment,” says Katie Arthurs, a principal at McCarthy, Lebit, Crystal & Liffman Co., L.P.A. “A forensic accountant will obtain certain financial documents from the company to determine its value.”

Divorce cases that do not settle are tried in front of a judge. At trial, financial documents, as well as testimony from people within the company, become public record. That’s why partners should recognize the company’s potential exposure when business interests are not protected from a spouse.

“The information brought forward at trial could lead to sensitive information being disclosed to the competition,” says Richard A. Rabb, a principal at McCarthy, Lebit, Crystal & Liffman Co., L.P.A. “Other legal or tax issues could also be exposed, such as a tax oversight, which could trigger an audit from the IRS. It could also have effects on the business owners’ estate planning if the values used in the trial are applied to gift planning, or they could be used in another partner’s divorce proceedings.”

Smart Business spoke with Arthurs and Rabb about how divorce can affect business partners and their companies, and how to insulate a business from potential fallout.

When is the best time for business partners to address divorce? 

Address it as early as possible. Similar to death provisions and buy-sell provisions, divorce provisions are best handled at the onset of the business. Spell out and document how an owner’s interest in the company would be valued and bought out in the event of divorce.

What should be done to insulate the company from any negative impact of a partner’s divorce?

Operating agreements can outline how divorce will be handled. Often these agreements are boilerplate and don’t contain enough detail. Provide restrictions on the transfer of ownership and specifically disallow spouses as owners. Use lawyers when setting up the business and consider the input of domestic relations counsel. 

A confidentiality agreement or protective order is also valuable, as the divorcing partner will need to turn over corporate documents. These types of agreements/orders will protect documents from being disclosed to third parties, or worse, becoming public record. Depending on the nature of the business, the divorcing partner can ask to seal the court record to prevent information from becoming public.

If divorce becomes imminent, the company should retain its own legal counsel, independent of the divorcing partner, to protect the company’s interests. 

If business partners discover they haven’t covered divorce, how should they address it?

The discussion is better late than never. Business partners who don’t have existing documents that address divorce need to discuss and amend their buy-sell agreement or operating agreement. Address the possible issues and update the corporate records before there is trouble on the horizon.

Unmarried business owners should agree to execute prenuptial agreements prior to marriage. These agreements can exclude the spouse from the business altogether, including any marital appreciation.  

What advice would you offer partners as they approach the conversation of divorce?

Have an open and honest discussion when things are good. That conversation is far less emotional when partners aren’t in the thick of divorce. Meet with counsel and an accountant to seek advice and direction. Divorce is a reality. Business partners should be proactive.

Insights Legal Affairs is brought to you by McCarthy, Lebit, Crystal & Liffman.

How Ohio companies can protect themselves by protecting their data

Ohio’s Senate Bill 220, referred to as the Ohio Data Protection Act, is in effect. It was passed to incentivize companies to voluntarily adopt what’s been determined to be an appropriate cybersecurity program. Its approach offers a legal defense mechanism against lawsuits in exchange for implementation of a written cybersecurity framework.

“If you follow the rules and you take reasonable precautions to prevent a data breach, you’re afforded potentially monumental relief from a civil liability standpoint in the form of a first-of-its-kind affirmative defense,” says Craig S. Horbus, partner, Corporate & Securities, Technology, at Brouse McDowell LPA.

Smart Business spoke with Horbus about the law and how it affects Ohio businesses.

What are reasonable precautions?

Companies are given latitude through the law to determine what are their appropriate cybersecurity framework and protections. This takes into consideration the size and complexity of the business, the sensitivity of the information it possesses and/or controls, the cost involved and its available resources to determine the best fit.

Reasonable precaution is the new standard, which as of yet has no judicial challenge to define it more particularly. However, there are existing standards such as guidelines set by the National Institute of Standards and Technology (NIST) and the Center for Internet Security (CIS) as well as ISO/IEC-27001 information security management, HIPPA and other niche legal guidelines that can be applied based upon the type of company and level of legally necessary data security compliance. Many companies that create, maintain and comply with NIST-based security protocols should qualify as having met reasonable precautions.

Companies that are active in e-commerce or hold any type of personally identifiable information should understand this law and take proactive steps to comply with it.

What constitutes an Ohio business and how many of them are within the law’s safe harbor of protection?

According to the statute, a covered entity is any business that accesses, maintains, communicates or processes personal information or restricted information in or through one or more systems, networks or services located in or outside of Ohio.

While the expectation is that major corporations are already in compliance, most small to midsize companies treat data security as an afterthought and are not up to minimum standards.

What could happen to businesses that become victims of a data breach and have not taken reasonable precautions?

Failure to take the minimum requirements called for in the bill leaves a company at serious risk. A breach can mean more than losing money through civil torts. The fallout from a breach means damages that could impact thousands of victims and irreparable damage to a company’s reputation.

A data breach isn’t easy to clean up. It’s a problem that lasts for years. Stolen credit card information isn’t the worst of it. Typically, those can be cancelled and charges reversed quickly. But hackers that take Social Security numbers and personally identifiable information will sit on that for years before attempting to use it, making it a problem that haunts a company for many years.

What is GDPR and how does it pertain to the new Ohio law?

General Data Protection Regulation (GDPR), which comes out of the European Union, went into effect in May 2018. It is focused not on the location of the company holding sensitive information, but on the location of the data. That has implications for organizations outside the EU that monitor, process or hold information that would be considered EU-based data. Many U.S.-based companies might be unaware that they’re impacted by the law.

Although not listed specifically under the Ohio law, arguably GDPR would qualify as one of the frameworks Ohio’s law seeks to encourage companies to comply with. Companies that are GDPR compliant, which is more far-reaching and provides a higher level of security compliance than many other laws and could become the benchmark, should be able to recognize it as their framework in order to achieve reasonable precautions under Ohio’s law.

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