Companies need to be diligent when protecting against cybercrime

If you have never been a victim of identity theft, it’s not because you’re immune to the risk, says Lucas M. Blower, Attorney at Law at Brouse McDowell.

“The reason may be that there are just too many people to get to,” Blower says. “It’s not necessarily because you’re more protected than someone else. It’s just difficult to get to everybody.”

Cybercrimes such as identify theft and data hacking are a reality in today’s world, and there is only so much that companies can do to protect their valuable data, Blower says.

From a liability standpoint, however, you need to be cognizant of the actions that you openly agree to take to secure the interests of your company and its customers.

“If you don’t have proper controls in place for your customers’ data and there is a data breach, you can be held liable under federal law,” Blower says. “In addition, if you put something on your website that explains how you’re going to protect customer data, you need to actually do it.”

Smart Business spoke with Blower about cyberrisks and what you need to know in order to protect your company.

Why is cyberrisk a difficult topic for both companies and the courts?

One problem is that some companies may believe they are insured against cyberrisks as a result of their general liability policies. They have a good argument, at least under the language of some policies, according to Blower.

Many insurance companies, though, are arguing that these policies should be read narrowly, so that they do not apply to cyberrisks. At least some courts have sided with the insurance companies. Even where they haven’t, insurance companies have been putting new exclusions into the policies that would prevent coverage.

What’s happening is policy holders are getting pushed into a market that has a bunch of language that is far less litigated and far more uncertain than the language in the general liability policies.

We’ve been living with general liability policies for a long time. We know what they say and we know what they mean. What policyholders need to know whenever they are buying these cyber insurance policies is that the normal rules of insurance interpretation will still apply.

What can you do to protect your business?

The first thing you need to do is ensure you’re following through with whatever actions you’ve told employees or customers that you’re taking to protect their information. If you don’t comply with the system you’ve agreed to set up and an incident occurs, your insurance carrier could tell you that the loss is excluded from your policy.

In some policies, there is a policy exclusion for a ‘failure to follow minimum required practices.’ So it’s good practice to continuously reassess your exposure to information security and privacy threats.

What about the risk of human error?

There are commonsense steps you can take to protect your company, but the reality is you’re still facing two problems: first, you can’t protect against missteps where people don’t do what they are supposed to do.

Second, you’re not always equipped to respond to the sort of attacks that are coming at you. The threats evolve and change as new defenses are put in place. Given those two areas of vulnerability, there’s no way to manage your risk without an insurance component.

Fortunately for policyholders, there are a number of pro-policyholder rules governing the interpretation of insurance policies that are going to apply to cyber policies as well.

There is a rule that insurance policy language is construed strictly against the drafting party, which is the insurance company. If there’s any ambiguity in the language and you can construe that ambiguity in favor of the policyholder, that’s how you read the contract.

There are protections built into the law that prevent insurance companies from avoiding obligations based on an over-technical reading of their policies after the loss report comes in and is bigger than expected. Insurers aren’t going to have many customers if they’re selling a product that doesn’t actually cover you when you need it.

Insights Legal Affairs is brought to you by Brouse McDowell

Non-solicits as an alternative to non-competes

A non-solicitation agreement is a contract in which an employee agrees not to solicit his or her employer’s clients or customers — either for their own benefit, or for the benefit of a competitor — during employment or upon departure. There are a number of reasons why a business might want to consider using a non-solicitation provision rather than a non-compete.

“All restrictive covenants, which include non-competes and non-solicits, are subject to state law,” says Michael Torchia, a managing member at Semanoff Ormsby Greenberg & Torchia, LLC. “But in most states, non-competes are much more difficult to enforce than non-solicits.”

Smart Business spoke with Torchia about how non-solicits and non-competes differ, in what circumstances non-solicits make more sense, and what specific information should be included in employment agreements.

What are the differences between a non-solicitation agreement and a non-compete?

Generally speaking, a non-compete prevents someone — usually a former employee — from working for a competitor. Non-solicitations do not prevent someone from working for a competitor. Instead, they restrict an employee from soliciting customers and clients from their former employer. Non-solicits can also stop an employee from soliciting other employees from their former employer.

It’s often more appropriate to use a non-solicitation rather than a non-compete. If an employer can live with a former employee working for a competitor, a non-solicitation will do the trick. If an employer is concerned the former employee could harm the company if not bound by a non-solicitation, say by divulging a market strategy, pricing or proprietary formula, then it would make more sense to use a non-compete.

What are the advantages of a non-solicitation agreement as compared to a non-compete?

Non-solicits hold up in court much more easily than non-competes as judges are usually more likely to enforce the former. That’s often because non-solicits are without the presumption against the restraint of trade and free employment — the company is seen as just trying to protect its best interests. A non-solicitation agreement is essentially saying to the judge that the company only seeks to protect what the company has developed, whether that is a customer list or an employee base. With a non-compete, however, the result is someone being unable to work, very often in the only profession or skilled field they know. Judges will often try to avoid making such a ruling.

Non-compete and non-solicit provisions can be contained in the same agreement, most frequently an employment agreement. If a company seeks to enforce multiple provisions, the judge might side with the business about a customer list and recruitment of employees, but will not deny the employee the right to work.

Many states require employers to provide employees additional consideration if they’re asked to sign a non-compete after they’ve already been working at the company. With non-solicits, additional consideration is not normally required. It’s always a good idea to have employees sign agreements before they start with a company rather than after they have already been working.

What specific information should be included in a non-solicitation agreement?

A non-solicitation agreement that seeks to protect customers and clients should include a definition of which customers and clients cannot be restricted. Is it any current customer or client? Is it someone who has been a customer or client in the past two years? Is it someone who is a prospective customer or client?

The non-solicit should also include a time restriction — for example, “during employment and for two years thereafter.” It should also be limited in geographic scope. For example, is the restriction only in Pennsylvania, for the entire country or some other area?

The law of non-competes and non-solicitation agreements changes from state to state and is in constant flux. Cutting and pasting from older agreements or taking forms from other sources is highly discouraged. Consult with an attorney before drafting and presenting any restrictive covenants to employees.

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

Key structural considerations for companies seeking early-stage funding

It’s difficult to focus on the long-term consequences of different financing options when your startup business needs cash just to stay afloat in the near term, says Mark A. Thompson, an associate at Kegler Brown.

Traditional bank financing can be hard to come by, “and that reality is amplified for startups and growth-stage companies with novel ideas and no revenue or operating history that they can lean on to obtain financing for future growth,” he says.

When you need funding, the size of the check often seems more important than the legal structure. But different financing mechanisms give investors different rights and having an adviser who can help you navigate the legal framework for early-stage fundraising is essential.

“The dollar figure of the investment is important, but so is the structure. Entrepreneurs should always ask: What am I really giving up in exchange for the money?” Thompson says.

Smart Business spoke with Thompson about the need to think critically about the structure of early-stage financings.

How does the legal structure of an outside investment affect the cost-benefit analysis?

In equity financing, investors contribute money in exchange for an ownership stake in the company — they share in profits and losses and have some input on company decisions. Equity financing is cheap for the company and the founders in the downside case, because if things go poorly, the investors simply lose their investment. But equity can be expensive on the upside because the founders have given away a share of future earnings and control in order to obtain the financing.

Equity financing also requires the parties to set a valuation for the company to determine the share price for investors. This can be difficult at such an early stage, and be costly down the road. Undervaluation can result in substantial dilution of the founders in later financing rounds; overvaluation can discourage future investment.

In debt financings, the company borrows money from debtholders and promises to repay the money over time with interest. Debtholders do not have an ownership interest in the company, so they generally exercise less control over company decisions and the company’s repayment obligations do not vary with its profits and losses.

Debt financing can be expensive for the company in the downside case (it’s typically secured by collateral and must be repaid even when the company loses money), and cheap on the upside (the debtholders are not entitled to profits above and beyond the amount of the loan and interest).

Hybrid instruments like convertible debt combine attributes of debt and equity. Convertible debt is debt that can be converted into equity upon certain events, such as a later equity financing round. Convertible debt can be advantageous to investors (and costly to founders) because it combines the downside risk protection of debt with the upside potential of equity for investors. However, convertible debt financings avoid the premature valuation issues associated with equity financings, and the underlying documents are generally simpler to negotiate and draft. This helps founders cut down on excessive long-term dilution and upfront transaction costs.

These are basic examples, and you may not have a choice among investors or deal terms. But when you do, it’s important to fully appreciate how deal structures can affect outcomes.

What are some key mistakes companies make at the early investment stage?

One of the biggest mistakes is overreliance on terminology as a substitute for understanding the business deal. The startup space is littered with buzzwords that make for helpful shorthand but can also mean different things to different people.

For example, you might agree in principle with an investor on a ‘preferred stock’ financing or convertible debt. But the actual substance of those deals depends on highly negotiated terms — the exact nature of the preferential rights accompanying preferred stock, the conversion formula for the convertible note. These terms have real impact, and discrepancies can prolong negotiations, make it more difficult to reduce the agreement to writing and ultimately increase legal fees. It’s more efficient to spend time on the details in advance than to have your attorney draft financing documents by trial and error.

Insights Legal Affairs is brought to you by Kegler Brown Hill + Ritter

What you need to know to become a strong franchisor

Franchising is a proven way to expand your business, but it takes discipline and due diligence to ensure you have a concept that can be replicated and be profitable in multiple locations, says Daniel L. Silfani, a Partner at Brouse McDowell.

“People of varying backgrounds should be able to step right in and easily run their franchise unit utilizing the systems that you have developed,” Silfani says. “It’s up to you — as the franchisor — to develop the plan and provide the tools that allow your franchisees to do so effectively.”

In addition to developing a go-to-market strategy to become a successful franchisor, you need to fulfill all the legal obligations that are required to sell franchise units in your desired markets, as well as protect your intellectual property (IP).

Fortunately, there are a number of expert consultants in the franchising industry who have experience doing just that.

“There are a lot of successful franchise systems out there and there is a proven strategy to do it,” Silfani says. “But you have to follow the steps to give yourself the opportunity to succeed.”

Smart Business spoke with Silfani about the key steps to becoming a successful franchisor.

How do you know if your concept has franchising potential?

You need to determine whether your concept can be profitable in more than just one location. Just because you have a business that is doing really well at one site, that doesn’t guarantee success in another spot. You need to know if your concept can work in other geographic and demographic locations to get a true sense as to whether it has franchising potential.

You also need a concept that can be easily replicated. If you can’t put together an operations manual and a business model for a new franchisee to step in and get a new unit up and running in a reasonable amount of time, it’s going to be difficult to grow your business through franchising. If you have opened additional units in different markets and they’ve met or exceeded your expectations, that’s a good early indicator that your concept has franchising potential.

Once you determine potential, what are the key first steps to building a franchise model?

You must take steps to protect your IP, which includes your trademarks and service marks, with the U.S. Patent and Trademark Office. Any franchise system relies on the value of a recognizable logo or brand that entices customers to do business with you. Your franchise identity is part and parcel to your trade or service marks.

If you fail to register in a timely fashion, you may find that you’re not able to protect your franchise brand because it’s being used (in an identical or substantially similar form) by someone else who was the first to file for the protection. In this case, you would need to develop a new brand.

In addition to IP protection, there are legal compliance documents that you need to complete in order to market and sell franchise units within the U.S. At a minimum, you need to prepare a Franchise Disclosure Document that is in compliance with the Federal Trade Commission’s Franchise Rule. Depending on which states you want to expand into, you may also need to register and file a separate form to market and sell franchise units within those particular states.

What value do franchise consultants provide?

Setting up a franchise system is not cheap and some would-be franchisors try to go it alone to save money, but that’s often a mistake. As a franchisor, you need to learn what it takes to evolve from the leader of a single business to a consultant yourself who can guide your franchisees and help them grow their units.

In addition to creating a comprehensive operating manual and training program, you need to develop a set of standards that ensure quality and uniformity in the customer experience and the products and services those customers buy. Research your competition to get a sense for what works and what doesn’t work in your industry. A franchising consultant, along with your legal counsel and your accounting team can help you build an infrastructure that is welcoming to potential franchisees and gives them confidence that they can grow a profitable business under your brand.

Insights Legal Affairs is brought to you by Brouse McDowell

Five tips for building a stronger, more sustainable franchise business

Franchising can be a lucrative opportunity for your business, providing the means to expand both your brand awareness and geographic footprint while also earning additional profit through royalty payments.

But many franchise systems fail because they fail to build an infrastructure that can support the new business model.

“Close to 75 percent of all startup franchisors fail within the first 10 years,” says Kacie N. Davis, associate with Kegler Brown. “A lot of owners see the potential in franchising their business concept and how quickly they can grow their brand and receive a new revenue stream. However, some fail to realize the initial cost of compliance and other important factors. There are things which need to be considered before you franchise.”

Smart Business spoke with Davis about five key tips that can help build a successful, sustainable franchising business.

Tip No. 1 – Establish legally compliant operations from the beginning

Make sure your franchise system is in compliance with all federal and state regulations. The Federal Trade Commission regulates franchise sales and provides the minimum level of compliance for a franchisor. Sales of franchised businesses in violation of the FTC franchise rule are subject to penalties, the ability for franchisees to rescind their contract and other damages.

Various registration states also add a layer of additional compliance. The most important (and costly) piece of compliance for a franchisor is preparing the required Franchise Disclosure Document (FDD). The FDD is a comprehensive regulated report of the franchised business, providing franchisees with detailed information on the investment they are about to make. The FTC requires franchisors to provide prospective franchisees with the FDD at least 14 days before money is exchanged or contracts are signed. Find legal counsel who can help you prepare the FDD and navigate other requirements before you start selling.

Tip No. 2 – Select the right franchisees

Look for motivated, skilled people who are enthusiastic about your brand and concept, not those looking for a business to call their own. Prior industry experience is a plus. You may also want to set a net worth requirement for your franchisees, ensuring you select someone who can afford the franchise and inject enough capital to keep it running. The bottom line: Don’t just accept anyone interested in purchasing a franchise.

Tip No. 3 – Develop a systematic growth plan

Focus on intentional strategic growth rather than growing haphazardly. Everybody wants to see their business grow, but if you don’t have a plan from the start, you could end up with a model that is difficult to manage.

Develop a systematic growth plan of the areas you want to go into rather than just letting people pop up and come to you. Let your market analysis drive the growth plan and make sure you’re growing at a speed which allows you to maintain the necessary support to make it work.

Tip No. 4 – Consider franchisee profitability and satisfaction

Don’t lose sight of the return on investment for your franchisees. Their goal is to develop a business opportunity that provides more money than they would have earned in a traditional employment situation or by opening up their own independent business.

If you don’t focus on what the franchisee can make out of it, you’re going to have a hard time selling additional franchises. Franchisees are more satisfied when you support them through training, marketing support and other services. Give them the blueprint for an ongoing, successful business. This will in turn drive your profits and help sell future franchised units.

Tip No. 5 – Don’t lose sight of the brand and underlying business operation

Once you start franchising, your primary business becomes selling that franchise. However, never lose sight of what the business is that you are selling. Keep building the brand and reputation for that business, whether it’s locally, regionally or nationally, to build your customer base. Focus on improving your operations and systems to keep your business competitive. These efforts will help aid you in selling additional franchised units.

Insights Legal Affairs is brought to you by Kegler Brown Hill + Ritter

How to be prepared for the accelerated union process

In December 2014, the National Labor Relations Board (NLRB) announced final rule governing union representation and election procedures. The rule, which took effect April 14, 2015, allows unions to move much faster in their organization campaigns while shortening employer timelines for providing employees information about unions and the election process.

“Because the time period between the filing of the representation petition and the election has been compressed, employers are severely handicapped in organizing opposition to a union’s organizational campaign,” says Frank P. Spada Jr., an attorney at Semanoff Ormsby Greenberg & Torchia, LLC.

Smart Business spoke with Spada about the expedited election process and how employers can be prepared.

How does the petition filing process work?

If there are least 30 percent of people in a particular bargaining unit — a group of employees who share a community of interest in a variety of factors  — who sign authorization cards, the union can go to the NLRB and request a petition for an election. It’s a secret ballot election and if the union gets 50 percent plus one of the people who voted in that select bargaining unit, the union will be authorized as the collective bargaining representative for those employees and will negotiate with the employer to set the terms and conditions of employment.

Let’s say that there are 100 employees in a bargaining unit and only 60 vote in the election. If the union has 31 people vote for the union then it would be recognized as the collective bargaining representative. The 40 employees who didn’t vote would still be part of the union and pay dues.

What type of information lists are now required?

In the past, only names and classifications of employees were required. The new rule requires employers to disclose full name, address, home and cell phone numbers, personal email addresses and job classification. This allows unions to contact employees directly so they can have a much more focused campaign. This information should be gathered and updated consistently prior to a union organizing effort so there is little delay in developing a strategy to combat unionization and, if necessary, to allow counsel to prepare a statement of position and proceed to a pre-election hearing on the appropriateness of the unit identified by the union.

How can businesses improve relations with their employees?

The management team should be trained on how positive employee relations can help avoid labor issues. If management listens to issues and problems before they fester, it stands to reason that the employees won’t need to go to an outside source to resolve their differences. One of the major reasons that employees seek representation is that supervisors fail to communicate effectively, or discipline employees unfairly or inconsistently.

How should potential bargaining units be identified?

Employers should take steps in advance to strengthen arguments in favor of preferred units should an organizing threat emerge. For example, a union may try to include employees on the manufacturing floor as well as the shipping department within a single bargaining unit. The employer might want to restructure operations or take other steps to enable it to argue to the NLRB that it would be improper for a union to try and organize both the shipping and manufacturing employees in one unit, or that certain parts of the manufacturing operations should be excluded from a petitioned for unit.

What type of plan should businesses have for dealing with organizing threats?

Preparation should begin, prior to any union organizing efforts, to identify individuals in management, human resources or in-house legal, if applicable, that are knowledgeable or can be trained regarding what an employer is legally permitted to do in opposing a union organizing campaign. What is communicated, as well as who communicates it, is very important. A trusted management team member or supervisor who is well liked by the employees should communicate information provided by a legal expert. With the accelerated organizing process, advance preparation by an employer is critical.

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

How form construction documents can ease the stress on your next project

Construction projects come with significant risk as business owners can never be 100 percent certain that the price they agree to pay at the front end of a project is what will have been paid when the project is completed.

“Construction is much more than just the cost of doing business,” says Peter Berg, an associate at Kegler Brown.

“Significant cost overruns or delays in construction can cause major disruption to a company’s business plan.”

With all of the risk involved, business owners need a way to protect themselves. A construction contract created with the help of form construction documents is a relatively easy way to put protections in place that are needed to prevent a disaster from occurring.

“Form construction documents offer the protection you need against significant risk at a small cost,” Berg says. “A construction attorney can guide you through the selection process and suggest modifications needed to better protect your interests.”

Smart Business spoke with Berg about form construction documents and how to use them.

What are form construction documents?

Form construction documents have been pulled together over the years by reputable organizations and are readily available, often online, for relatively small fees.

Form documents can be used for the construction agreement itself, which establishes important touchstones like the project cost and time of construction, but can also include more detailed provisions known as ‘general conditions,’ which lay out the rules everyone must follow on the project.

Form documents can be simple one-page documents with the bare essentials to something much more complex. They can be used on your kitchen remodeling, but they also can be used, and are used on multimillion-dollar projects.

The most well-known entity to produce form construction documents is the American Institute of Architects (AIA), which publishes almost 200 different form documents with various applications in the industry. Other documents are available, however, and should not be overlooked.

The AIA’s biggest competitor is ConsensusDocs, which publishes form construction documents that many regard as being fairer to all parties involved on a typical construction project. Larger contractors often have their own in-house form documents. If you’re asked to sign a construction agreement prepared by the contractor, it’s advisable to consult with an attorney before signing.

What are the advantages of using form construction documents?

These documents are relatively inexpensive and provide valuable flexibility to deal with project-specific risks. While larger projects often require lawyers to negotiate the finer points of the agreement, on many projects, owners can use form construction documents without much change. This allows the owner to be protected while at the same time, not committing a large amount of resources that can be better used elsewhere.

Form documents reflect best practices and are used routinely in the industry. They help ensure everyone is on the same page as far as what is expected of each project participant.

Using form documents also helps contractors and subcontractors price their work as they have a better idea of the risk being assumed. Greater certainty as to risk often leads to lower overall cost.

How important is due diligence when using these documents?

Often, form documents are used with too little thought as to what form document is best for a particular project. The same way we wouldn’t use a hammer to slice bread, the form we use needs to match the task at hand.

Do not use a form document on a project where the form envisions or requires relationships that do not exist or are not needed. For example, construction agreements should not include the architect if the parties never intend for the architect to work on the project after producing the design. This is counterproductive as it creates ambiguities which actually increase risk, rather than guard against it.

Insights Legal Affairs is brought to you by Kegler Brown Hill + Ritter

Understanding the legal ramifications of lifestyle discrimination

As health care and other costs of doing business continue to rise, companies look for ways to save money. Some businesses seek to control high risk lifestyles, which can be considered discriminatory.

“Lifestyle discrimination means treating an employee or applicant differently because of his or her life choices and it encompasses anything from smoking to having tattoos,” says Maura McDaid, an attorney at Semanoff Ormsby Greenberg & Torchia, LLC.

“Even employee relationships fall under the umbrella of daily life choices an employer might seek to control.”

Smart Business spoke with McDaid about lifestyle discrimination and how to avoid it.

What’s behind lifestyle discrimination?

Businesses may base decisions on employee lifestyles for many reasons. Chief among them are financial, competitive, and reputational interests. For instance, smoking or vaping, or lifestyles that lead to obesity or other health risks, impact a company’s health-care bottom line and may cause absenteeism or performance issues. Romance between company employees may create conflicts of interest while some industries fear marriage or dating among individuals employed by competitors jeopardizes confidential or trade secret information.

Although it’s impossible to foresee every circumstance, companies want policies to protect them if a customer, fellow employee, or in the worst case scenario, the press or social media, alert them to damaging or embarrassing employee conduct.

Can employers charge a premium to employees whose activities raise the cost of health insurance?

The Affordable Care Act (ACA) prohibits premium increases for employees with obesity or current medical conditions. Instead, it permits employers to offer up to 30 percent premium rebates for participation in wellness programs and achievement of particular health objectives. It also allows employers to surcharge up to 50 percent of the premium to tobacco users who won’t participate in cessation programs. Some states, however, specifically protect the rights of tobacco users and govern whether and to what extent a higher premium can be charged. Confirm whether and what portion of those costs may be passed on to employees before raising insurance costs for smokers or tobacco users.

How can illegal discrimination based on lifestyle be avoided?

Although no federal law specifically prohibits a company from making employment decisions based on lawful off-duty activities of employees, some states do. Recently, companies have questioned how such state laws impact their policies regarding drug use and testing given the potential abuse of legal substances like so-called designer drugs, prescription and over-the-counter medication. Because some states have legalized marijuana, companies also have been forced to re-examine these policies in order to address worker safety and efficiency concerns.

First, employers need to articulate the business reasons, company culture principles or performance concerns that underpin their policies. Personal prejudice cannot be a motivating factor.

Second, once the company identifies a bona fide consequence, the company must examine whether the policy it proposes to protect that interest will treat employees fairly without regard to age, national origin, religion or other protected class status.

Third, because the legal landscape differs by state, annual review of existing policies and pre-implementation examination of proposed policies by the company’s employment law attorney is recommended.

What questions should be asked when formulating a company policy?

When considering a policy that regulates employee conduct, ask:

  • Is the employee conduct lawful or illegal?
  • Is there an applicable law that protects the employees’ off-duty conduct?
  • What risk/cost does the policy seek to avoid/lower?
  • Will the employer apply the policy consistently, or do situations exist in which it would not be able, or want to, do so?
  • Does the employer want to be in a position of being required to enforce the policy if a violation is brought to its attention?
  • What effect will the policy and its application have on employee morale?
  • Is it worth it?

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

What to do when the sale of your business and real estate are separate

Business owners tired of paying rent to a landlord will often buy or construct a new facility and then create a separate limited liability company to own and manage it. The LLC can then lease space to the company, as well as to outside tenants who pay rent and provide business owners with an additional income stream.

The formula works exceptionally well when the current ownership structure is in place. However, when it comes time to either sell the business or bring in additional owners and/or stakeholders, legal difficulties can arise depending on how the transaction plays out, says David A. Lum, a Partner at Brouse McDowell.

“If the building will be leased to the new buyer, the lease will need to be updated to protect the owner and more appropriately reflect the division of responsibilities between landlord and tenant,” Lum says. “Maintenance and ongoing capital repairs, as well as length of term and renewal options are often the biggest points of negotiation with the new tenant.”

Smart Business spoke with Lum about how these extenuating factors can affect the sale of your business.

What are some key considerations when selling a business in which the physical space is owned by a separate LLC?

When selling both the business and the real estate, you need to make sure that all of the due diligence materials are up to date and clean. Are there any environmental issues that need to be dealt with or title issues like easements or encroachments?

Over the life cycle of a business, these issues can often develop and be overlooked because the landlord and tenant are the same. Potential buyers, and their lenders will certainly do their own research and any significant issues on this front could cause a problem with the overall deal. If you are selling the business to a third party, but they are not buying the real estate, they may want to lease it. In that case, you need to make sure that the lease is formalized.

In closely held businesses, even though the property is held in a separate entity, there is not always a formal written lease. The lease will need to be formalized and will likely be the subject of negotiations during the sale of the business. The term, rent and options are financial points that are always negotiated and maintenance responsibilities also become an issue for discussion.

As the operating entity, the tenant most likely handled all of the maintenance of the property, including capital expenditures. After the sale, the buyer of the business as the tenant in the building will likely require a more customary allocation of maintenance responsibilities. As just a tenant, they will not want to incur costs on capital expenditures toward the building.

How does the structure of the lease affect your options?

If the ownership of the business is the same as the ownership of the real estate, then the lease can always be amended or modified to address any issues with the buyer. However, the situation can be further complicated if the ownership of the business is not identical to the ownership of the real estate — perhaps one portion of a family owns the real estate while another portion owns the business and there is a lease.

While the real estate owner and business owner are related, they have substantially different economic interests to be dealt with in the sale of the business. The value of the business will be affected by the rental rate and other lease terms. This can be further complicated if the buyer of the business does not want to purchase or lease the real estate — where they intend to move or consolidate the business to another location. The business owners may sell the business and capture the value, while the real estate owners (without a strong lease obligation), may be left with an empty building.

How might a 1031 exchange be helpful? 

Tax planning is important to consider in any sale. Depending upon the status of the property, there may be a significant gain on the sale of the real estate. A 1031 like-kind exchange may allow the seller to defer tax on the potential gain, but there are significant preparations and qualifications that must be met to accomplish the exchange. When contemplating a sale of the business and real estate, you should involve your lawyer and your accountant to make sure that the sale is structured appropriately to accomplish your goals.

Insights Legal Affairs is brought to you by Brouse McDowell

Phantom stock: How to incentivize key employees

Key employees all want to own a piece of the action. If the company is phenomenally successful, they want to share in the riches. There are several ways to incentivize key employees over both the short-term and the long-term — stock options, restricted stock, non-voting stock and phantom stock are common methods. Of these options, phantom stock is the best choice for the small business owner.

“Phantom stock provides the key benefits of stock ownership without any of the liability or hassle,” says Peter J. Smith, a member at Semanoff Ormsby Greenberg & Torchia, LLC.

Phantom stock is essentially a cash bonus that is deferred until some triggering event in the future. Typically much larger than an annual bonus, the award is usually contingent upon the phantom stockholder’s continued employment with the company. This aids with retention of key management personnel.

Smart Business spoke with Smith about phantom stock, how it works and how to implement a phantom stock plan.

How does phantom stock work?

Phantom stock is very simple. It is essentially a contract with the employee whereby the employee earns fictional equity rights. It can include both a share in the appreciated value of the business and a share of profits or annual dividend equivalents.

What does a company need to do to implement phantom stock?

A company needs to adopt a plan and issue ‘grants’ to employees based on the terms the business owner desires. The plans are flexible. They can include vesting over time, forfeiture for cause provisions, limited triggering events or a payout over time upon an employee’s death, disability or retirement.

How can phantom stock aid with the retention of key management personnel?

Employees today want to feel that they have a vested interest in the upside of the business and that they’re not just killing themselves to make money for their boss or owner. If you want employees to stay with you and be vested in the long-term growth of your company, a good strategy is to give them a piece of short-term profit and long-term growth. The phantom stock should be set up so the longer they stay the bigger their piece gets.

What are some of the issues associated with employees owning real stock?

There are tax issues as the employees will receive Schedule K-1 tax forms with income allocated to them, but the business owner may not want to make distributions to shareholders to cover the tax liability. Banks may ask that they participate in loans. Shareholders’ agreements will be required to protect the business owner, and administering some stock plans can be complicated.

As shareholders, employees are entitled to detailed financial and other information, and have various rights under business corporation laws. For the entrepreneur or family business, sharing information about profits, expenses, owner compensation or employee compensation with employees may not be desirable. The employees might not be happy to learn that profits could be higher but for the owner’s personal expenses. Owners have to be willing to share information and be open about how they’re operating the business.

How are phantom stock plans taxed?

There are no tax ramifications at the time of grant, so there is no bookkeeping or administration required. Upon a triggering event, money is paid to the employee in accordance with the grant and is taxed as income to the employee, while the company gets a deduction. This is different than stock and more beneficial to the company.

How is the company valued for the purposes of a phantom stock plan?

There are multiple valuation methods a company can choose, but once one is chosen it must be used consistently. An employee can receive a share of the company value at the time of the grant or only the appreciation in value with a baseline set in the grant. This incentivizes the employee to help grow the company.

Is phantom stock only available to corporations?

No. There are many plans for LLCs, as well. They are called phantom interest plans or phantom unit plans.

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