Recent IRC 409(a) valuation considerations

I’ve received a number of comments and emails recently about IRC Section 409(a) considerations, and I thought it would be helpful to pass along information about a couple of recent conversations I’ve had with our service providers on the issues.

As a reminder, we are a venture-backed SMBE (small to mid-sized business) with revenues of less than $20 million per year.  As some of you may know, we consider ourselves to fall under an “illiquid stock” exemption to 409(a), although we have conducted an independent valuation analysis by an outside party in conjunction with a group of significant option grants to employees. 

For some helpful background information on 409(a), you can view this IRC 409(a) background.  There is a somewhat helpful discussion (for those with sufficient working knowledge of 409(a)) of the recent extension of the remedial amendment period of 409(a) to December 31, 2008 available at a Fenwick & West LLP release here.

Our last independent outside valuation was conducted in June, 2006.  We have a stable employee base, and we have not needed to issue a large number of option grants since that time.  However, this past month (January 2008) we wanted to provide some additional incentive stock option grants to some key employees in addition to a couple of recent hires, and we were confronted with the decision about whether to spend money on an additional independent valuation appraisal.  We had negotiated follow on valuation updates to our initial valuation analysis for a period of 12 months, but we did not perform one so we are outside the 12 month window of the first valuation’s direct applicability to the current option grants under IRC 409(a).

Our independent auditor (Moss Adams LLP) suggested that, in the last 2 years, the market for 409(a) valuation analysis had become more crowded with competent service providers, and as they were becoming more comfortable with IRS requirements, the costs were coming down.  When I passed this by our original valuation expert, his response was both understandable (”prices might have come down, but that depends on the service you want”) and enlightening.  The enlightening part from his email is quoted below:

“On the pricing front, we have seen them stabilize around (lower pricing) with certainly cheaper folks just doing option pricing (which is not holding up with the top accounting firms).  We just went through a successful PWC audit as we now do the current value method and PWERM (probability weighted expected return method).  So yes, we can come down…, but need to hold there as it is much more work adding in the PWERM.”  The point being that there are a number of solutions available, but you need to carefully balance maintaining cost controls against whether/how the valuation analysis will hold up.

If you want to see a language around IRC 409(a) in actual employment agreements or employee benefits plans, I encourage you to link through and view them in action in tens of thousands of real documents and clauses drafted by top law firms across the country at http://www.realdealdocs.com/.  If you have any questions or want a referral to one of our service providers, please feel free to comment on the post or email me at jsiegler@realpractice.com.

Top Up provisions and short form merger agreements

A senior partner at one of our large firm clients (a very large AmLaw 100 firm) recently spoke with us about changes in Delaware law regarding top up provisions, and I thought I would pass along the discussion.

Generally, the issue is that acquiring companies will attempt to use a top up merger provision to effectuate a short form merger, which obviates the need for further involvement of either the target company’s board of directors or its shareholders.  This is in contrast to a long form merger, in which a shareholders meeting and approval is required following the tender close.

It is generally quite difficult for an acquiring company to effectuate a short form merger, which has given rise to the relatively recent phenomenon of the “top up” option, which is granted by the target’s board of directors and enables the acquiring company to easily acquire the 90% shareholding required to enable a short form merger.

If you want to see dozens of these types of provisions in high profile merger agreements, go to www.realdealdocs.com and search across the “Agreement and Plan of Merger” category under either the “Agreements” or the “Mergers & Acquisitions” deal categories.  Free previews of these documents are available at http://agreements.realdealdocs.com/Agreement-and-Plan-of-Merger/.  If you really want to drill down into these types of provisions, you can search for those specific clauses at:  http://www.realdealdocs.com/ClauseSearch.aspx

By the way, there is a very helpful discussion about some of the Delaware case law changes regarding these types of provisions at http://www.potteranderson.com/news-publications-0-54.html.  I encourage you to comment here, and I’ll  do my best to respond to you individually, or post further notes as warranted.  Thanks!

Noncompete agreements in California

I recently posted a discussion about employee noncompete covenants based on a friend’s experience in negotiating with a current employer, and I thought it would be helpful to generalize the discussion, and then drill down to the implications for California based employers and employees. 

As a general point, noncompetition agreements (noncompete agreements, or covenants not to compete) may or may not be enforceable depending upon the state law which applies.  From there, the specific facts and circumstances of a particular agreement are important.

As a general rule (and by statute), noncompetition agreements in California are void as a restraint of trade, except those agreements that fit within stated exceptions.  It is a fair operating assumption that, at least in California, a noncompete covenant within an employment agreement is generally unenforceable.  For the more legally inclined, there is a decent discussion of relevant law at http://www.andersenalumni.net/%5CCalifornia%20Non-Compete%20Agreements.pdf.

Of course, there are exceptions listed in the California statute, and they allow noncompete agreements when a business or an interest in a business is sold. The philosophy behind allowing noncompete or noncompetition agreements in the sale of a business is that the buyer of the goodwill of an ongoing business is entitled to restrain the seller of the business from continuing to compete with the buyer. If the seller was allowed to continue to operate, or start a new business in the same line of work, the seller could utilize the goodwill he or she purported to sell.

Noncompete agreements under California law must be limited to preventing the business seller (or selling shareholder or partner) from engaging in a business similar to the business sold in specified locations in which the business was carried on prior to the transfer.  These are generally enforceable for so long as the business continues to be carried on in that area by the buyer or a successor to the buyer.

I recommend that purchasers of a business obtain the seller’s covenant not to compete in every purchase of a business or purchase of an interest in a business. Such a provision is clearly enforceable under California law and it can be very valuable to the buyer of a business. Even if the buyer does not expect the seller to compete, it is wise to include such a provision to preclude the seller from engaging in activities which may be harmful to the business.

From a buyer’s perspective, you cannot anticipate the specific circumstances which may arise or actions which may be taken by another party, and the broad protection offered by a noncompete agreement can be unexpectedly beneficial.

Conversely, if you are the seller of a business, the noncompete agreement should be avoided. If the noncompete agreement is demanded as part of the purchase, attempt to limit the covenant to a defined territory and type of business. You will want to be free to engage in other business activities without objections from the buyer of your business, and the narrower the noncompete covenant, the better.

Focusing in specifically on California employment law, California law does not allow noncompete agreements with employees, other than with employee-owners of a business in the context of a sale of a business as discussed above. In fact, the attempt to restrict a former employee from competing with a business may subject the business to liability for restraint of trade.

Generally, California companies attempting to prevent ex-employees from competing must seek to do so through means other than the use of a noncompete agreement. One popular way of doing so involves protecting trade secrets or other proprietary information such as customer lists, customer information, marketing methods, and production methods through the use of a proprietary information protection agreement (a nondisclosure agreement or confidential disclosure agreement).  Through such an agreement,  an employer can have employees (as well as any other individuals or firms with access to proprietary information) agree that certain information is proprietary to the employer, that they will not disclose it or use it, and that they will protect it from improper disclosure or use.  You can see partial views of large numbers of Noncompete Agreements here.  Using the advanced search functionality at www.realdealdocs.com, you can drill down into specific noncompete agreements by state or other relevant search criteria.

Although an agreement is not legally necessary in order to have a trade secret under California law, the best way to show that certain information was identified as a trade secret and protected from disclosure is by having a nondisclosure agreement signed by all those who have access to the information.

As an aside, it should be noted that for information to be treated as a trade secret, it must be kept secret in order to be entitled to protection, so steps to identify and protect such information must be taken prior to disclosure.

Business owners should appreciate the benefits of a noncompete agreement when buying a business or an interest in a business, and of a nondisclosure agreement to protect the proprietary information of the business.  Careful steps must be taken to preserve these protections in the context of an employment or consulting relationship.

Employee expense reimbursement

As I’ve mentioned previously, our company (Practice Technologies, www.practicetechnologies.com) is an SMBE with revenues of less than $20 million per year.  We have had a relatively employee-friendly expense reimbursement policy, in which we provide employees with a $200 per month provision to cover home office expenses.  This employee expense reimbursement policy recognizes that we have many time demands on our key employees, and it covers a variety of expenses, including cell phones, home business phone lines, home internet connection expenses, etc.  There is a lot of history here, as we started out in the proverbial technologist’s garage, but as we grow, we have questioned whether we should provide this reimbursement policy to all new employees, as we generally expect that everyone be available at the drop of a hat.

There are a lot of considerations here, including:

• Any potential morale/cultural impact of awareness of differnces in the reimbursement policy
• Determining whether there is a bias towards senior/executive management personnel, which is naturally skewed toward founders
• Whether the expense reimbursement constitutes taxable income

The Internal Revenue website is able to (at least partially) answer the third of these questions at http://www.irs.gov/taxtopics/tc514.html.

In terms of answering the other two issues, that’s really an issue that the founders/executive management team needs to answer.  It’s possible to try and hide the issue but, in our experience, it’s far too easy for any differences in the expense reimbursement policy for early employees relative to new hires to leak out.

My recommendation would be to deal with it more explicitly, and let each individual employee, or category of employees, know what their specific policy is.

In terms of documenting expenses so that they are not considered taxable income, there are several easily discernible criteria, for which a starting point is available at the IRS link above.  If you are interested in determining how some public companies treat their employees, there are a variety of ways to start your search.  One place to start is at:  http://www.realdealdocs.com/searchdocument.aspx, and then selecting either employment agreements as a type of document, or simply using the full text option to look for the specific employee expense reimbursement policy.

Personal guarantee agreements

We are in the process of negotiating a line of credit with several commercial banks, with a particular focus on banks who loan to venture capital backed companies.  These banks include Square One Bank (www.square1bank.com), Silicon Valley Bank (www.svb.com), and Comerica Bank (www.comerica.com).  (By the way, I’d be happy to share my experience with the banks and their professionals in the Southern California region with you.  Send me an email at jsiegler@realpractice.com if you want to discuss.)

Our current bank is City National Banks.  Their customer service is outstanding, but they are not particularly well suited to providing loans to emerging companies.  One of the challenges with working with CNB is their insistence that founders and senior executives of emerging companies provide personal guarantees on small business loans, even if the loans are backed by the SBA or other venture investors, including venture capital firms.  In an effort to determine what those Personal Guarantees might look like, I reviewed the documents available at the www.RealDealDocs.com website.

As any entrepreneur would know, it’s a tough balance to strike between belief in your ultimate success and placing a personal guarantee (including your house!) on the line, especially when your employment security is already in play.

NonCompete covenants

A good friend of mine was negotiating his employment agreement with his large company employer ($800 million revenue) in November 2007, and he was concerned about their negotiating position around a noncompete covenant.  Essentially, they wanted to prevent him from working for a competitor for a period of thirty six (36) months, which he felt was onerous.

I gave him a complimentary password to the http://www.RealDealDocs.com/ service, which provides members with access to over one million legal agreements and documents, and over ten million clauses from legal agreements, all  of which have been drafted and filed by public companies, including many of the top law firms along with Fortune 500 companies.

In reviewing the 20,000+ employment agreements in the database, he was able to more effectively negotiate the non-compete clause by showing that 12-24 months was a better market-based term based on the employment agreements on file from public companies in similar industries.

Realdealdocs.com has recently exposed a beta version of its content and navigation at http://agreements.realdealdocs.com, and you can find a complete listing of the Employment Agreements from public companies there.